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have learnt the usage of prepositions in French. Scenario 2: 50 businessmen are surveyed to see whether their marketing skills have improved after attending a week-long seminar on innovative techniques of marketing. Scenario 3: 700 workers, who have been working for over 30 years in the cashew industry, are surveyed for a study to determine if shelling the cashew nuts by hand has led to a medical diagnosis of dermatitis, which is a chronic skin condition. 4.1 The data in the table below was used to estimate the following consumption function: C = 10 + 0.5Y On a graph, draw the consumption function and plot the points from the table. Calculate the “error” for each point in the table, and then calculate the SUM from your “error” calculations. Point Aggregate Income (Y) Aggregate Consumption (C) A B C D E F 10 20 30 40 50 60 13 23 30 32 33 44 4.2 Which of the following consumption functions best fits the values in the table below? 1. C = 10 + 0.2Y 2. C = 6 + 0.8Y 3. C = 4 + 0.7Y 4. C = 10 + 0.5Y Aggregate Income (Y) Aggregate Consumption (C) 6 12 24 48 13 16 20 34 QUESTION 1 Researchers are eager to quantify the effect that studying abroad has on a student’s academic performance after returning to his/her home institution, because they want to quantify the benefits of providing scholarships for study abroad. Could these researchers simply compare the grades of students who studied abroad in a previous semester to the grades of students who did not? QUESTION 2 Identify an example of two variables that are correlated, but where there is no direct causal link between the two variables. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M21_CASE3826_13_GE_C21.indd 442 17/04/19 4:29 AM Glossary absolute advantage The advantage in the production of a good enjoyed by one country over another when it uses fewer resources to produce that good than the other country does. p. 363 automatic destabilizers Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to destabilize GDP. pp. 206, 304 accelerator effect
The tendency for investment to increase when aggregate output increases and to decrease when aggregate output decreases, accelerating the growth or decline of output. p. 318 automatic stabilizers Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP. pp. 206, 304 actual investment The actual amount of investment that takes place; it includes items such as unplanned changes in inventories. p. 175 adjustment costs The costs that a firm incurs when it changes its production level—for example, the administration costs of laying off employees or the training costs of hiring new workers. p. 318 aggregate behavior The behavior of all households and firms together. p. 118 aggregate income The total income received by all factors of production in a given period. p. 170 aggregate output The total quantity of goods and services produced in an economy in a given period. pp. 119, 170 aggregate saving (S) The part of aggregate income that is not consumed. p. 172 aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. p. 244 balance of payments The record of a country’s transactions in goods, services, and assets with the rest of the world; also the record of a country’s sources (supply) and uses (demand) of foreign exchange. p. 386 balance of trade A country’s exports of goods and services minus its imports of goods and services. p. 387 balance on current account The sum of income from exports of goods and services and income from investments and transfers minus payments for imports of goods and services and payments for investments and transfers. p. 387 balanced-budget multiplier The ratio of change in the equilibrium level of output to a change in government spending where the change in government spending is balanced by a change in taxes so as not to create any deficit. The balanced-budget multiplier is equal to 1: The change in Y resulting from the change in G and the equal change in T are exactly the same size as the initial change in G or T. p. 199 aggregate supply The total supply of all goods and services in an economy. p. 244 barter The direct exchange of goods and services for other goods and services. p. 217 animal spirits of entrepreneurs A term coined by Keynes to describe investors’ feelings. p. 317 base year The year chosen for the weights in a fixed-weight procedure. p. 142 appreciation of a currency The rise
in value of one currency relative to another. p. 396 binding situation State of the economy in which the Fed rule calls for a negative interest rate. p. 314 black market A market in which illegal trading takes place at market-determined prices. p. 105 brain drain The tendency for talented people from developing countries to become educated in a developed country and remain there after graduation. p. 415 budget deficit The difference between what a government spends and what it collects in taxes in a given period: G – T. p. 192 business cycle The cycle of short-term ups and downs in the economy. p. 119 capital flight The tendency for both human capital and financial capital to leave developing countries in search of higher expected rates of return elsewhere with less risk. p. 414 capital gain An increase in the value of an asset. p. 293 capital market The input/factor market in which households supply their savings, for interest or for claims to future profits, to firms that demand funds to buy capital goods. p. 71 capital Those goods produced by the economic system that are used as inputs to produce other goods and services in the future. p. 50 catch-up The theory stating that the growth rates of less developed countries will exceed the growth rates of developed countries, allowing the less developed countries to catch up. p. 331 ceteris paribus, or all else equal A device used to analyze the relationship between two variables while the values of other variables are held unchanged. p. 35 change in business inventories The amount by which firms’ inventories change during a period. Inventories are the goods that firms produce now but intend to sell later. p. 135 443 Z01_CASE3826_13_GE_GLOS.indd 443 17/04/19 12:42 AM 444 Glossary circular flow A diagram showing the flows in and out of the sectors in the economy. p. 122 command economy An economy in which a central government either directly or indirectly sets output targets, incomes, and prices. p. 62 commodity monies Items used as money that also have intrinsic value in some other use. p. 219 comparative advantage The advantage in the production of a good enjoyed by one country over another when that good can be produced at lower cost in terms of other goods than it could be in the other country. p. 363 compensation of employees Includes wages, salaries, and various supplements—employer contributions to social insurance and pension funds, for example—paid to households by firms and by the government.
p. 138 complements, complementary goods Goods that “go together”; a decrease in the price of one results in an increase in demand for the other and vice versa. p. 76 constrained supply of labor The amount a household actually works in a given period at the current wage rate. p. 313 consumer goods Goods produced for present consumption. p. 55 consumer price index (CPI) A price index computed each month by the Bureau of Labor Statistics using a bundle that is meant to represent the “market basket” purchased monthly by the typical urban consumer. p. 157 consumer sovereignty The idea that consumers ultimately dictate what will be produced (or not produced) by choosing what to purchase (and what not to purchase). p. 63 consumer surplus The difference between the maximum amount a person is willing to pay for a good and its current market price. p. 110 contraction, recession, or slump The period in the business cycle from a peak down to a trough during which output and employment fall. p. 120 Corn Laws The tariffs, subsidies, and restrictions enacted by the British Parliament in the early nineteenth century to discourage imports and encourage exports of grain. p. 362 corporate bonds Promissory notes issued by firms when they borrow money. p. 124 corporate profits The income of corporations. p. 430 correlated Two variables are correlated if their values tend to move together. p. 430 cost shock, or supply shock A change in costs that shifts the short-run aggregate supply (AS) curve. p. 226 cost-of-living adjustments (COLAs) Contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised. p. 600 cost-push, or supply-side, inflation Inflation caused by an increase in costs. p. 267 cross-price elasticity of demand A measure of the response of the quantity of one good demanded to a change in the price of another good. p. 129 currency debasement The decrease in the value of money that occurs when its supply is increased rapidly. p. 219 current dollars The current prices that we pay for goods and services. p. 140 cyclical deficit The deficit that occurs because of a downturn in the business cycle. p. 207 cyclical unemployment Unemployment that is above frictional plus structural unemployment. p. 274 consumption function The relationship between consumption and income. p. 170 cyclical unemployment The increase in unemployment that occurs during recessions and depressions. p. 157 deadweight loss The total loss of
producer and consumer surplus from underproduction or overproduction. p. 113 deflation A decrease in the overall price level. p. 121 demand curve A graph illustrating how much of a given product a household would be willing to buy at different prices. p. 74 demand schedule Shows how much of a given product a household would be willing to buy at different prices for a given time period. p. 73 demand-pull inflation is initiated by an increase in aggregate demand. p. 587 Inflation that depreciation of a currency The fall in value of one currency relative to another. p. 396 depreciation The amount by which an asset’s value falls in a given period. p. 136 depression A prolonged and deep recession. p. 120 desired, or optimal, level of inventories The level of inventory at which the extra cost (in lost sales) from lowering inventories by a small amount is just equal to the extra gain (in interest revenue and decreased storage cowsts). p. 319 difference-in-differences Difference-in-differences is a method for identifying causality by looking at the way in which the average change over time in the outcome variable is compared to the average change in a control group. p. 435 discouraged-worker effect The decline in the measured unemployment rate that results when people who want to work but cannot find work grow discouraged and stop looking, dropping out of the ranks of the unemployed and the labor force. pp. 154, 324 discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy. p. 191 Z01_CASE3826_13_GE_GLOS.indd 444 17/04/19 12:42 AM disembodied technical change Technical change that results in a change in the production process. p. 337 disposable personal income or after-tax income Personal income minus personal income taxes. The amount that households have to spend or save. p. 140 efficient market A market in which profit opportunities are eliminated almost instantaneously. p. 29 elastic demand A demand relationship in which the percentage change in quantity demanded is larger than the percentage change in price in absolute value (a demand elasticity with an absolute value greater than 1). p. 120 disposable, or after-tax, income (Yd) Total income minus net taxes: Y – T. p. 191 dividends The portion of a firm’s profits that the firm pays out each period to its shareholders. p. 124 Doha Development Agenda An initiative of the World Trade Organization focused on issues of
trade and development. p. 374 Dow Jones Industrial Average An index based on the stock prices of 30 actively traded large companies. The oldest and most widely followed index of stock market performance. p. 295 dumping A firm’s or an industry’s sale of products on the world market at prices below its own cost of production. p. 372 durable goods Goods that last a relatively long time, such as cars and household appliances. p. 134 economic growth An increase in the total output of an economy. Growth occurs when a society acquires new resources or when it learns to produce more using existing resources. pp. 58, 37 economic integration Occurs when two or more nations join to form a free-trade zone. p. 374 economics The study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided. p. 27 efficiency wage theory An explanation for unemployment that holds that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the market-clearing rate. p. 597 embodied technical change Technical change that results in an improvement in the quality of capital. p. 336 empirical economics The collection and use of data to test economic theories. p. 35 employed Any person 16 years old or older (1) who works for pay, either for someone else or in his or her own business for 1 or more hours per week, (2) who works without pay for 15 or more hours per week in a family enterprise, or (3) who has a job but has been temporarily absent with or without pay. p. 152 entrepreneur A person who organizes, manages, and assumes the risks of a firm, taking a new idea or a new product and turning it into a successful business. p. 70 equilibrium The condition that exists when quantity supplied and quantity demanded are equal. At equilibrium, there is no tendency for price to change. p. 177 equity Fairness. p. 37 European Union (EU) The European trading bloc composed of 28 countries (of the 28 countries in the EU, 17 have the same currency—the euro). p. 375 excess demand or shortage The condition that exists when quantity demanded exceeds quantity supplied at the current price. p. 87 excess labor, excess capital Labor and capital that are not needed to produce the firm’s current level of output. p. 318 excess reserves The difference between a bank’s actual reserves and its required reserves. p. 224 Glossary 445 excess supply or surplus
The condition that exists when quantity supplied exceeds quantity demanded at the current price. p. 89 exchange rate The ratio at which two currencies are traded. The price of one currency in terms of another. pp. 368, 386 exogenous variable A variable that is assumed not to depend on the state of the economy—that is, it does not change when the economy changes. p. 181 expansion or boom The period in the business cycle from a trough up to a peak during which output and employment grow. p. 120 expenditure approach A method of computing GDP that measures the total amount spent on all final goods and services during a given period. p. 134 explicit contracts Employment contracts that stipulate workers’ wages, usually for a period of 1 to 3 years. p. 280 export promotion A trade policy designed to encourage exports. p. 420 export subsidies Government payments made to domestic firms to encourage exports. p. 371 factor endowments The quantity and quality of labor, land, and natural resources of a country. p. 370 factors of production The inputs into the production process. Land, labor, and capital are the three key factors of production. pp. 50, 71 favored customers Those who receive special treatment from dealers during situations of excess demand. p. 104 Fed rule Equation that shows how the Fed’s interest rate decision depends on the state of the economy. p. 249 federal budget The budget of the federal government. p. 201 federal debt The total amount owed by the federal government. p. 205 Federal Open Market Committee (FOMC) A group composed of the seven members of the Fed’s Board of Governors, the president of the New York Federal Reserve Bank, and four of Z01_CASE3826_13_GE_GLOS.indd 445 17/04/19 12:42 AM 446 Glossary the other 11 district bank presidents on a rotating basis; it sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in New York. p. 227 Federal Reserve Bank (the Fed) The central bank of the United States. p. 223 federal surplus (+) or (–) deficit Federal government receipts minus expenditures. p. 223 fiat, or token, money Items designated as money that are intrinsically worthless. p. 219 final goods and services Goods and services produced for final use. p. 132 firm An organization that comes into being when a person or a group of people decides to produce a good or service to meet a perceived demand. p
. 125 fiscal drag The negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion. p. 206 fiscal policy The government’s spending and taxing policies. p. 190 fixed-weight procedure A procedure that uses weights from a given base year. p. 142 floating, or market-determined, exchange rates Exchange rates that are determined by the unregulated forces of supply and demand. p. 394 foreign direct investment (FDI) Investment in enterprises made in a country by residents outside that country. p. 334 foreign exchange All currencies other than the domestic currency of a given country. p. 386 frictional unemployment The portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/ skill matching problems. p. 274 full-employment budget What the federal budget would be if the economy were producing at the full-employment level of output. p. 207 General Agreement on Tariffs and Trade (GATT) An international agreement signed by the United States and 22 other countries in 1947 to promote the liberalization of foreign trade. p. 374 a country’s comparative advantage by its factor endowments: A country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product. p. 370 Global South Developing Nations in Asia, Africa, and Latin America. p. 412 households The consuming units in an economy. p. 70 government consumption and gross investment (G) Expenditures by federal, state, and local governments for final goods and services. p. 137 government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending. p. 196 Gramm-Rudman-Hollings Act Passed by the U.S. Congress and signed by President Reagan in 1986, this law set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991. p. 303 graph A two-dimensional representation of a set of numbers or data. p. 41 gross domestic product (GDP) The total market value of all final goods and services produced within a given period by factors of production located within a country. p. 132 gross investment The total value of all newly produced capital goods (plant, equipment, housing, and inventory) produced in a given period. p. 136 gross national income (GNI) GNP converted into dollars using an average of currency
exchange rates over several years adjusted for rates of inflation. p. 146 gross national product (GNP) The total market value of all final goods and services produced within a given period by factors of production owned by a country’s citizens, regardless of where the output is produced. p. 133 gross private domestic investment (I) Total investment in capital—that is, the purchase of new housing, plants, equipment, and inventory by the private (or nongovernment) sector. p. 135 Heckscher-Ohlin theorem A theory that explains the existence of hyperbolic discounting People prefer immediate gratification to even slightly deferred gratification, but exhibit more patience when asked to defer gratification some time in the future. p. 356 hyperinflation A period of very rapid increases in the overall price level. p. 121 identity Something that is always true. p. 172 implementation lag The time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump. p. 301 import substitution An industrial trade strategy that favors developing local industries that can manufacture goods to replace imports. p. 420 income approach A method of computing GDP that measures the income—wages, rents, interest, and profits—received by all factors of production in producing final goods and services. p. 194 income elasticity of demand A measure of the responsiveness of demand to changes in income. p. 129 income The sum of all a household’s wages, salaries, profits, interest payments, rents, and other forms of earnings in a given period of time. It is a flow measure. p. 76 indirect taxes minus subsidies Taxes such as sales taxes, customs duties, and license fees less subsidies that the government pays for which it receives no goods or services in return. p. 138 Industrial Revolution The period in England during the late eighteenth and early nineteenth centuries in which Z01_CASE3826_13_GE_GLOS.indd 446 17/04/19 12:42 AM new manufacturing technologies and improved transportation gave rise to the modern factory system and a massive movement of the population from the countryside to the cities. p. 30 infant industry A young industry that may need temporary protection from competition from the established industries of other countries to develop an acquired comparative advantage. p. 380 inferior goods Goods for which demand tends to fall when income rises. p. 76 inflation An increase in the overall price level. p. 121 inflation rate The percentage change in the price level. p. 282
inflation targeting When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within some specified band over some specified horizon. p. 269 informal economy The part of the economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP. p. 145 investment New capital additions to a firm’s capital stock. Although capital is measured at a given point in time (a stock), investment is measured over a period of time (a flow). The flow of investment increases the capital stock. p. 55 IS curve Relationship between aggregate output and the interest rate in the goods market. p. 228 J-curve effect Following a currency depreciation, a country’s balance of trade may get worse before it gets better. The graph showing this effect is shaped like the letter J, hence the name J-curve effect. p. 399 labor demand curve A graph that illustrates the amount of labor that firms want to employ at each given wage rate. p. 275 labor force The number of people employed plus the number of unemployed. p. 152 labor market The input/factor market in which households supply work for wages to firms that demand labor. p. 71 labor productivity growth The growth rate of output per worker. p. 329 innovation The use of new knowledge to produce a new product or to produce an existing product more efficiently. p. 337 labor supply curve A graph that illustrates the amount of labor that households want to supply at each given wage rate. p. 275 input or factor markets The markets in which the resources used to produce goods and services are exchanged. p. 71 inputs or resources Anything provided by nature or previous generations that can be used directly or indirectly to satisfy human wants. p. 50 intention to treat A method in which we compare two groups based on whether they were part of an initially specified random sample subjected to an experimental protocol. p. 432 intermediate goods Goods that are produced by one firm for use in further processing by another firm. p. 132 invention An advance in knowledge. p. 337 inventory investment The change in the stock of inventories. p. 319 Laffer curve With the tax rate measured on the vertical axis and tax revenue measured on the horizontal axis, the Laffer curve shows that there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate. p. 350 laissez-faire economy Literally from the French: “allow [them] to do.
” An economy in which individual people and firms pursue their own self-interest without any central direction or regulation. p. 63 land market The input/factor market in which households supply land or other real property in exchange for rent. p. 71 Glossary 447 quantity demanded decreases; as price falls, quantity demanded increases. p. 74 If the costs of law of one price transportation are small, the price of the same good in different countries should be roughly the same. p. 397 law of supply The positive relationship between price and quantity of a good supplied: An increase in market price will lead to an increase in quantity supplied, and a decrease in market price will lead to a decrease in quantity supplied. p. 83 least squares estimates Least squares estimates are those that correspond to the smallest sum of squared distances, or errors. p. 439 legal tender Money that a government has required to be accepted in settlement of debts. p. 219 lender of last resort One of the functions of the Fed: It provides funds to troubled banks that cannot find any other sources of funds. p. 229 life-cycle theory of consumption Least squares estimates are those that correspond to the smallest sum of squared distances, or errors. p. 309 liquidity property of money The property of money that makes it a good medium of exchange as well as a store of value: It is portable and readily accepted and thus easily exchanged for goods. p. 218 Lucas supply function The supply function embodies the idea that output (Y) depends on the difference between the actual price level and the expected price level. p. 354 M1, or transactions money Money that can be directly used for transactions. p. 220 M2, or broad money M1 plus savings accounts, money market accounts, and other near monies. p. 220 macroeconomics The branch of economics that examines the economic behavior of aggregates— income, employment, output, and so on—on a national scale. p. 118 law of demand The negative relationship between price and quantity demanded: Ceteris paribus, as price rises, marginal propensity to consume (MPC) The fraction of a change in income that is consumed. p. 171 Z01_CASE3826_13_GE_GLOS.indd 447 17/04/19 12:42 AM 448 Glossary marginal propensity to import (MPM) The change in imports caused by a $1 change in income. p. 390 marginal propensity to save (MPS) That fraction of
a change in income that is saved. p. 172 marginal rate of transformation (MRT) The slope of the production possibility frontier (ppf). p. 57 marginalism The process of analyzing the additional or incremental costs or benefits arising from a choice or decision. p. 28 market demand The sum of all the quantities of a good or service demanded per period by all the households buying in the market for that good or service. p. 80 market supply The sum of all that is supplied each period by all producers of a single product. p. 86 market The institution through which buyers and sellers interact and engage in exchange. p. 63 medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services. p. 217 minimum efficient scale (MES) The smallest size at which long-run average cost is at its minimum. p. 221 minimum wage laws Laws that set a floor for wage rates—that is, a minimum hourly rate for any kind of labor. p. 277 minimum wage A price floor set for the price of labor. p. 107 model A formal statement of a theory, usually a mathematical statement of a presumed relationship between two or more variables. p. 34 monetary policy The tools used by the Federal Reserve to control the short-term interest rate. pp. 124, 191 money multiplier The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio. p. 226 demanded brought about by a change in price. p. 80 a country’s total exports and total imports. p. 390 movement along a supply curve The change in quantity supplied brought about by a change in price. p. 85 multiplier The ratio of the change in the equilibrium level of output to a change in some exogenous variable. p. 181 NAIRU The nonaccelerating inflation rate of unemployment. p. 287 NASDAQ Composite An index based on the stock prices of over 5,000 companies traded on the NASDAQ Stock Market. The NASDAQ market takes its name from the National Association of Securities Dealers Automated Quotation System. p. 295 natural experiment Selection of a control versus experimental group in testing the outcome of an intervention is made as a result of an exogenous event outside the experiment itself and unrelated to it. p. 423 natural rate of unemployment The unemployment rate that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of frictional unemployment and structural unemployment. pp. 157, 287 near
monies Close substitutes for transactions money, such as savings accounts and money market accounts. p. 220 negative relationship A relationship between two variables, X and Y, in which a decrease in X is associated with an increase in Y and an increase in X is associated with a decrease in Y. p. 43 net business transfer payments Net transfer payments by businesses to others. p. 138 net exports (EX - IM) The difference between exports (sales to foreigners of U.S.- produced goods and services) and imports (U.S. purchases of goods and services from abroad). The figure can be positive or negative. p. 137 net interest The interest paid by business. p. 138 new Keynesian economics A field in which models are developed under the assumptions of rational expectations and sticky prices and wages. p. 675 no-arbitrage condition To effectively price discriminate firms must prevent customers from reselling. p. 307 nominal GDP Gross domestic product measured in current dollars. p. 140 nominal wage rate The wage rate in current dollars. is the wage rate in current dollars. p. 311 nondurable goods Goods that are used up fairly quickly, such as food and clothing. p. 134 nonlabor, or nonwage, income Any income received from sources other than working—inheritances, interest, dividends, transfer payments, and so on. p. 312 nonresidential investment Expenditures by firms for machines, tools, plants, and so on. p. 135 normal goods Goods for which demand goes up when income is higher and for which demand goes down when income is lower. p. 76 normative economics An approach to economics that analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action. Also called policy economics. p. 34 North American Free Trade Agreement (NAFTA) An agreement signed by the United States, Mexico, and Canada in which the three countries agreed to establish all North America as a free-trade zone. p. 375 not in the labor force A person who is not looking for work because he or she does not want a job or has given up looking. p. 152 movement along a demand curve The change in quantity net exports of goods and services (EX - IM) The difference between Ockham’s razor The principle that irrelevant detail should be cut away. p. 34 Z01_CASE3826_13_GE_GLOS.indd 448 17/04/19 12:42 AM Okun’s
Law The theory, put forth by Arthur Okun, that in the short run the unemployment rate decreases about 1 percentage point for every 3 percent increase in real GDP. Later research and data have shown that the relationship between output and unemployment is not as stable as Okun’s “Law” predicts. p. 323 Open Market Desk The office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed. p. 227 open market operations The purchase and sale by the Fed of government securities in the open market. p. 232 opportunity cost The best alternative that we forgo, or give up, when we make a choice or a decision. pp. 51, 28 origin The point at which the horizontal and vertical axes intersect. p. 42 output growth The growth rate of the output of the entire economy. pp. 162, 329 outputs Goods and services of value to households. p. 50 p-value The probability of obtaining the result that you find in the sample data if the null hypothesis of no relationship is true. p. 437 per-capita output growth The growth rate of output per person in the economy. pp. 162, 329 perfect substitutes products. p. 76 Identical permanent income The average level of a person’s expected future income stream. p. 310 personal consumption expenditures (C) Expenditures by consumers on goods and services. p. 134 personal income The total income of households. p. 139 personal saving rate The percentage of disposable personal income that is saved. If the personal saving rate is low, households are spending a large amount relative to their incomes; if it is high, households are spending cautiously. p. 140 personal saving The amount of disposable income that is left after total personal spending in a given period p. 140 Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate. p. 282 planned aggregate expenditure (AE) The total amount the economy plans to spend in a given period. Equal to consumption plus planned investment: AE K C + I p. 177 planned investment (I) Those additions to capital stock and inventory that are planned by firms. p. 175 positive relationship A relationship between two variables, X and Y, in which a decrease in X is associated with a decrease in Y, and an increase in X is associated with an increase in Y. p. 43 potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation. p. 255 positive economics An approach to economics that seeks
to understand behavior and the operation of systems without making judgments. It describes what exists and how it works. p. 34 post hoc, ergo propter hoc Literally, “after this (in time), therefore because of this.” A common error made in thinking about causation: If Event A happens before Event B, it is not necessarily true that A caused B. p. 35 price ceiling A maximum price that sellers may charge for a good, usually set by government. p. 103 price discrimination Charging different prices to different buyers for identical products. p. 305 price feedback effect The process by which a domestic price increase in one country can “feed back” on itself through export and import prices. An increase in the price level in one country can drive up prices in other countries. This in turn further increases the price level in the first country. p. 393 Glossary 449 price floor A minimum price below which exchange is not permitted. p. 107 price rationing The process by which the market system allocates goods and services to consumers when quantity demanded exceeds quantity supplied. p. 101 price surprise Actual price level minus expected price level. p. 354 privately held federal debt The privately held (non-government-owned) debt of the U.S. government. p. 205 producer price indexes (PPIs) Measures of prices that producers receive for products at various stages in the production process. p. 159 producer surplus The difference between the current market price and the cost of production for the firm. p. 111 product or output markets The markets in which goods and services are exchanged. p. 70 production possibility frontier (ppf) A graph that shows all the combinations of goods and services that can be produced if all of society’s resources are used efficiently. p. 55 production The process that transforms scarce resources into useful goods and services. p. 50 productivity growth The growth rate of output per worker. p. 162 productivity, or labor productivity Output per worker hour. p. 322 profit The difference between total revenue and total cost. pp. 83, 173 progressive tax A tax whose burden, expressed as a percentage of income, increases as income increases. p. 418 Income from the property income ownership of real property and financial holdings. It takes the form of profits, interest, dividends, and rents. p. 393 proportional tax A tax whose burden is the same proportion of income for all households. p. 418 prospect theory People evaluate gains and losses from the vantage of a reference point. p
. 356 Z01_CASE3826_13_GE_GLOS.indd 449 17/04/19 12:42 AM 450 Glossary proprietors’ income The income of unincorporated businesses. p. 138 protection The practice of shielding a sector of the economy from foreign competition. p. 371 purchasing-power-parity theory A theory of international exchange holding that exchange rates are set so that the price of similar goods in different countries is the same. p. 397 quantity demanded The amount (number of units) of a product that a household would buy in a given period if it could buy all it wanted at the current market price. p. 72 quantity supplied The amount of a particular product that a firm would be willing and able to offer for sale at a particular price during a given time period. p. 83 quantity theory of money The theory based on the identity M * V K P * Y and the assumption that the velocity of money (V) is constant (or virtually constant). p. 347 queuing Waiting in line as a means of distributing goods and services: a nonprice rationing mechanism. p. 103 quota A limit on the quantity of imports. p. 373 (Sometimes random experiment referred to as a randomized experiment.) A technique in which outcomes of specific interventions are determined by using the intervention in a randomly selected subset of a sample and then comparing outcomes from the exposed and control group. p. 423 ration coupons Tickets or coupons that entitle individuals to purchase a certain amount of a given product per month. p. 104 rational-expectations hypothesis The hypothesis that people know the “true model” of the economy and that they use this model to form their expectations of the future. p. 352 price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks. p. 354 real interest rate The difference between the interest rate on a loan and the inflation rate. p. 160 real wage rate The amount the nominal wage rate can buy in terms of goods and services. p. 311 real wealth effect The change in consumption brought about by a change in real wealth that results from a change in the price level. p. 254 realized capital gain The gain that occurs when the owner of an asset actually sells it for more than he or she paid for it. p. 293 recognition lag The time it takes for policy makers to recognize the existence of a boom or a slump. p. 301 regression discontinuity Regression discontinuity identifies the causal effects of a policy or factor
by looking at two samples that lie on either side of a threshold or cutoff. p. 433 relative-wage explanation of unemployment An explanation for sticky wages (and therefore unemployment): If workers are concerned about their wages relative to the wages of other workers in other firms and industries, they may be unwilling to accept a wage cut unless they know that all other workers are receiving similar cuts. p. 433 rental income The income received by property owners in the form of rent. p. 138 required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve. p. 224 reserves The deposits that a bank has at the Federal Reserve bank plus its vault cash on hand. p. 223 residential investment Expenditures by households and firms on new houses and apartment buildings. p. 135 real business cycle theory An attempt to explain business cycle fluctuations under the assumptions of complete response lag The time that it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself. p. 302 risk-averse Refers to a person’s preference of a certain payoff over an uncertain one with the same expected value. p. 622 run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time. p. 223 scarce Limited. p. 28 services The things we buy that do not involve the production of physical things, such as legal and medical services and education. p. 134 selection bias Selection bias occurs when the sample used is not random. p. 223 shares of stock Financial instruments that give to the holder a share in the firm’s ownership and therefore the right to share in the firm’s profits. p. 124 shift of a demand curve The change that takes place in a demand curve corresponding to a new relationship between quantity demanded of a good and price of that good. The shift is brought about by a change in the original conditions. p. 80 shift of a supply curve The change that takes place in a supply curve corresponding to a new relationship between quantity supplied of a good and the price of that good. The shift is brought about by a change in the original conditions. p. 85 slope A measurement that indicates whether the relationship between variables is positive or negative and how much of a response there is in Y (the variable on the vertical axis) when X (the variable on the horizontal axis) changes. p. 43 Smoot-Hawley tariff The
U.S. tariff law of the 1930s, which set the highest tariffs in U.S. history (60 percent). It set off an international trade war and caused the decline in trade that is often considered one of the causes of the worldwide depression of the 1930s. p. 373 Z01_CASE3826_13_GE_GLOS.indd 450 17/04/19 12:42 AM social overhead capital Basic infrastructure projects such as roads, power generation, and irrigation systems. p. 417 social, or implicit, contracts Unspoken agreements between workers and firms that firms will not cut wages. p. 278 soft trade barriers Regulatory standards and requirements that make foreign competition more difficult p. 371 stability A condition in which national output is growing steadily, with low inflation and full employment of resources. p. 37 stabilization policy Describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible. p. 300 stagflation A situation of both high inflation and high unemployment. pp. 127, 265 Standard and Poor’s 500 (S&P 500) An index based on the stock prices of 500 of the largest firms by market value. p. 295 statistical discrepancy Data measurement error p. 139 statistical significance A result is said to be statistically significant if the computed p-value is less than some presubscribed number, usually 0.05. p. 437 sticky prices Prices that do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded. p. 119 sticky wages The downward rigidity of wages as an explanation for the existence of unemployment. p. 278 stock A certificate that certifies ownership of a certain portion of a firm. p. 293 store of value An asset that can be used to transport purchasing power from one time period to another. p. 217 structural deficit The deficit that remains at full employment. p. 207 that result in a significant loss of jobs in certain industries. pp. 162, 274 substitutes Goods that can serve as replacements for one another; when the price of one increases, demand for the other increases. p. 76 supply curve A graph illustrating how much of a product a firm will sell at different prices. p. 83 supply schedule Shows how much of a product firms will sell at alternative prices. p. 83 surplus of government enterprises enterprises. p. 138 Income of government survivor bias Survivor bias exists when a sample includes only observations that have remained in the sample over time making that sample unrepresentative
of the broader population. p. 429 tariff A tax on imports. p. 371 tax multiplier The ratio of change in the equilibrium level of output to a change in taxes. p. 198 terms of trade The ratio at which a country can trade domestic products for imported products. p. 367 theory of comparative advantage Ricardo’s theory that specialization and free trade will benefit all trading parties, even those that may be “absolutely” more efficient producers. p. 363 time lags Delays in the economy’s response to stabilization policies. p. 300 time series graph A graph illustrating how a variable changes over time. p. 41 trade deficit The situation when a country imports more than it exports. pp. 362, 387 trade feedback effect The tendency for an increase in the economic activity of one country to lead to a worldwide increase in economic activity, which then feeds back to that country. p. 392 trade surplus The situation when a country exports more than it imports. p. 362 structural unemployment The portion of unemployment that is due to changes in the structure of the economy transfer payments Cash payments made by the government to people who do not supply goods, services, or labor Glossary 451 in exchange for these payments. They include Social Security benefits, veterans’ benefits, and welfare payments. p. 122 Treasury bonds, notes, and bills Promissory notes issued by the federal government when it borrows money. p. 124 U.S.-Canadian Free Trade Agreement An agreement in which the United States and Canada agreed to eliminate all barriers to trade between the two countries by 1998. p. 375 unconstrained supply of labor The amount a household would like to work within a given period at the current wage rate if it could find the work. p. 313 unemployed A person 16 years old or older who is not working, is available for work, and has made specific efforts to find work during the previous 4 weeks. p. 152 unemployment rate The ratio of the number of people unemployed to the total number of people in the labor force. pp. 121, 152, 274 unit of account A standard unit that provides a consistent way of quoting prices. p. 218 value added The difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage. p. 132 variable A measure that can change from time to time or from observation to observation. p. 34 velocity of money The ratio of nominal GDP to the stock of money. p. 346 vicious circle of poverty Suggest
s that poverty is self-perpetuating because poor nations are unable to save and invest enough to accumulate the capital stock that would help them grow. p. 414 voting paradox A simple demonstration of how majority-rule voting can lead to seemingly contradictory and inconsistent results. A commonly cited illustration of the kind of inconsistency described in the impossibility theorem. p. 140 Z01_CASE3826_13_GE_GLOS.indd 451 17/04/19 12:42 AM 452 Glossary wealth or net worth The total value of what a household owns minus what it owes. It is a stock measure. p. 76 weight The importance attached to an item within a group of items. p. 140 World Trade Organization (WTO) A negotiating forum dealing with rules of trade across nations. p. 374 X-axis The horizontal line against which a variable is plotted. p. 42 X-intercept The point at which a graph intersects the X-axis. p. 42 Y-axis The vertical line against which a variable is plotted. p. 42 Y-intercept The point at which a graph intersects the Y-axis. p. 42 zero interest rate bound The interest rate cannot go below zero. p. 264 Z01_CASE3826_13_GE_GLOS.indd 452 17/04/19 12:42 AM Index *Notes: Key terms and the page on which they are defined appear in boldface. Page numbers followed by n refer to information in footnotes. A AAA Corporate Bond Rate, 242 Absolute advantage, 363 versus comparative advantage, 363–367 mutual, 363–365 Absolute advantage, 52–53 Accelerator effect, 318 Accounting, 223–224 Acemoglu, Daron, 332n, 418n Actual investment, 175 Adjustment costs, 318 Advantages of backwardness, 331 Africa comparative advantage in, 372 foreign direct investment in, 334 sub-Saharan, economic growth in, 331 African Americans unemployment rate, 154 After-tax (disposable) income, 140, 191 Aggregate behavior, 118 Aggregate demand (AD) aggregate supply and the Phillips Curve, 284–285 inflation and, 285–286 Aggregate demand (AD) curve, 247–253 behavior of the Fed and, 248–249 deriving, 251–253 Fed and price level versus output, 263–264 planned aggregate expenditure and the interest rate and, 247–248 reasons for downward sloping, 254 Aggregate expenditure, planned, 389–391 Agg
Discount rate, 232 Discounted stocks, 294 Discouraged-worker effects, 154, 316, 324 Discretionary fiscal policy, 191 Disembodied technical change, 336–337 Disequilibrium, 180 in the labor market, 352, 355 Disney World, 386 Disposable (after-tax) income, 191 Disposable personal income, 140 Dividends, 124, 293–294 Dodd-Frank bill, 299 Doha Development Agenda, 374 Domestically owned factors of production, 133–134 Doms, Mark, 137n Double coincidence of wants, 217 Double counting, 132 Dow Jones Industrial Average, 295 Duflo, Esther, 414n Dumping, 372, 372–373 economic development in, 372, 380 greenhouse gas emissions produced in, 380 manufacture of iPhone in, 361 quotas and, 373 trade competition from, 380 transition from agriculture to industry in, 332 Dunn, Wendy, 137n Durable goods, 134 Dynamic stochastic general equilibrium (DSGE) models, 355 E Earp, Wyatt, 222, 223 Easterly, William, 414 Eaton, Jonathan, 372n EBay, 109 Econometrics, 33 Economic activity, circular flow, 70–72, 122–123 Economic consensus, 381 Economic development, 33 capital formation in, 414–415 in China, 417–418 corruption and, 416 development interventions and, 422–425 education in, 423–424 export promotion in, 420 health improvements in, 424–425 import substitution in, 420 in India, 417–418 infrastructure capital in, 417 microfinance in, 420–421 movement from agriculture to industry in, 330–331, 418–420 natural experiments in, 423 random experiments in, 423 role of government in, 417–418 sources of, 414–415 strategies of, 417–421 Economic growth, 37, 58 in developing economies, 411–425 disembodied technical change and, 336–337 embodied technical change and, 335–336 history of, 330–332 labor productivity and, 338–339 labor supply and, 331–333, 335 physical capital and, 333–335 sources of, poor countries and, 59–61 technical change and, 335–338 Economic history, 33 Economic integration, 374–375 Economic policy, 36–38 Economic problem, 61 Economic Recovery Tax Act (1981), 350 Economic stability, 37–38 Economics, 27 behavioral, 33, 174 choices in, 27 control groups and experimental, 434 embodied technical change, 335–336 empirical, 35–36 environmental, 33 fields
Shutterstock; page 109, Patti McConville/Alamy Stock Photo Chapter 5: page 118, Aleksandr Davydov/123RF; page 126, Everett Collection/Shutterstock; page 126, Library of Congress Prints and Photographs Division [LC-USF34- 033703-D] Chapter 6: page 131, Maskot/Getty Images; page 135, anyaivanova.123rf.com; page 137, Kheng Guan Toh/Shutterstock; page 141, Photobank/ Fotolia; page 145, Stockbroker/MBI/Alamy Stock Photo Chapter 7: page 151, Kristaps Eberlins/123RF; page 153, Kzenon/123RF; page 155, Richard Wayman/Alamy Stock Photo; page 156, Text Credits Chapter 1: page 41, U.S. Department of Commerce, Bureau of Economic Analysis.; page 42, U.S. Department of Commerce, Bureau of Economic Analysis; page 43, Consumer Expenditures in 2016, U.S. Bureau of Labor Statistics; page 46, U.S. Department of Commerce, Bureau of Economic Analysis Chapter 2: page 59, U.S. Department of Agriculture, Economic Research Service, Agricultural Statistics, Crop Summary Chapter 3: page 74, Alfred Marshall, Principles of Economics, 8th ed. (New York: Macmillan, 1948), p. 59. (The first edition was published in 1890.) Chapter 5: page 126, F. Scott Fitzgerald, The Great Gatsby, Simon and Schuster Publishing, 1925.; page 126, From The Grapes of Wrath by John Steinbeck, renewed © 1967 by John Steinbeck. copyright 1939, Penguin Group (USA) Inc. Chapter 6: page 136, U.S. Bureau of Economic Analysis, March 28, 2018; page 138, U.S. Luxorphoto/Shutterstock; page 156, spixel/ Shutterstock; page 161, Patrizia Tilly/ Shutterstock Chapter 15: page 308, Zero Creatives/Cultura/ Getty Images; page 314, Andy Dean/Fotolia; page 325, Dmitriy Shironosov/123RF Chapter 8: page 169, Jetta Productions/ Blend Images/Alamy Stock Photo; page 174, Nagy-Bagoly Arpad/123RF; page 181, Kwangmoozaa.Shutterstock Chapter 9: page 190, Vlad G/Shutterstock; page 204
, Ryabitskaya Elena.Shutterstock Chapter 10: page 216, Adam Parent/ Shutterstock; page 218, Silva Vaughan-Jones/ Shutterstock; page 222, National Archives and Records Administration; page 231, Geraint Lewis/Alamy Stock Photo Chapter 16: page 329, Owen Suen/Shutterstock; page 332, SeanPavonePhoto/Fotolia; page 336, Rostislav Král.Shutterstock Chapter 17: page 345, Wavebreak Media Ltd/123RF; page 353, lazyllama.Shutterstock Chapter 18: page 361, Dmitry Kalinovsky/123RF; page 372, John Foxx/ Stockbyte/Getty Images; page 373, Kzenon/123RF; page 379, niroworld.123rf. com Chapter 19: page 385, Atstock Productions/ Chapter 11: page 243, Glowimages/Getty Shutterstock; page 389, Ruskpp/Shutterstock Images; page 250, Ian Dagnall/Alamy Stock Photo; page 250, Ron Sachs/CNP/MediaPunch Inc/Alamy Stock Photo; page 252, Bjorn Hoglund.PAL Chapter 12: page 260, Wh1600/E+/Getty Images; page 266, Neil Bradfield.Shutterstock Chapter 13: page 273, Peter Dazeley/ Photographer’s Choice/Getty Images; page 279, Igor Kardasov/Alamy Stock Photo; page 280, Vjom.Shutterstock Chapter 14: page 292, Sharon Oster; page 298, Lynne Carpenter.Shutterstock Chapter 20: page 411, WENN Ltd/Alamy Stock Photo; page 413, TheFinalMiracle/ Fotolia; page 419, Zakir Hossain Chowdhury/ ZUMA Press, Inc./Alamy Live News/Alamy Stock Photo; page 419, Zakir Hossain Chowdhury/ZUMA Press, Inc./Alamy Stock Photo; page 422, mehta123.123rf.com Chapter 21: page 428, Robert Kneschke/ Shutterstock; page 433, Sean Pavone/ Shutterstock; page 434, Birute Vijeikiene.PAL; page 436, imtmphoto.123rf.com Bureau of Economic Analysis, March 28, 2018; page 139, U.S. Bureau of Economic Analysis, March 28, 2018; page 141, U.S. Department of Commerce, Bureau of Economics, “GDP: One of the Great
Inventions of the 20th Century,” Survey of Current Business, January 2000, pp. 36–39; page 146, Data from GNI per capita, PPP (current international $), The World Bank Group, Retrieved from http://data.worldbank.org/ indicator/NY.GNP.PCAP.PP.CD Chapter 7: page 153, Economic Report of the President, 2015 and U.S. Bureau of Labor Statistics; page 154, U.S. Bureau of Labor Statistics; page 156, U.S. Bureau of Labor Statistics; page 158, U.S. Bureau of Labor Statistics; page 159, U.S. Bureau of Labor Statistics Chapter 8: page 170, John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936), First Harbinger Ed. (New York: Harcourt Brace Jovanovich, 1964), p. 96. Chapter 9: page 201, U.S. Bureau of Economic Analysis, March 28, 2018. Chapter 10: page 222, Casey Tefertiller, Wyatt Earp: The Life Behind the Legend, John Wiley & Sons, Inc., 1997; page 205, Anton Pavlovich Chekhov, The Plays of Tchekhov,Chatto and Windus, 1923; page 234, Federal Reserve Statistical Release, Factors affecting Reserve Balances, Board of Governors of the Federal Reserve System Chapter 13: page 283, U.S Bureau of Labor Statistics Chapter 14: page 301, Janet Yellen, 2015 in a speech in San Francisco Chapter 15: page 317, The General Theory of Employment, Interest, and Money (1936), First Harbinger Ed. (New York: Harcourt Brace Jovanovich, 1964), pp. 149, 152. Chapter 16: page 331, Economic Report of the President, 2018, Table B-4; page 333, 469 Z03_CASE3826_13_GE_CRED.indd 469 26/04/19 4:59 PM 470 Credits Economic Report of the President, 2018; page 334, U.S. Department of Commerce, Bureau of Economic Analysis., Fixed Asset Tabl; page 335, Statistical Abstract of the United States, 1990, Table 215, and 2012, Table 229, and Bureau of the Census, 2017, Table 2, Educational Attainment; page 337, National Academies, “Rising Above the Gathering Storm: Energizing the Employing America for a Brighter
Future,” National Academies Press, 2007.; page 339, Based on Economic Growth and the Environment, Quarterly Journal of Economics, Vol.110, No.2, May 1995. pp. 353–357; page 340, The Limits to Growth Book by Dennis Meadows, Donella Meadows, Jørgen Randers, and William W. Behrens III; page 342, United States Department of Agriculture; page 343, “World Bank Supports Move to Accelerate Indonesia’s Economic Growth through Science, Technology, and Innovation,” www.worldbank.org, March 29, 2013. Used by permission Chapter 19: page 387, Bureau of Economic Analysis, March 21, 2018. Chapter 20: page 412, Data from UN, Millennium Development Goal Data, 2015.; page 416, Based on World Bank, World Wide Governance Indicators Report, Policy Paper 5430, 2014.; page 419, Based on World development report, 2009 Reshaping Economics Geography; page 427, Datas from The World Bank Group Z03_CASE3826_13_GE_CRED.indd 470 26/04/19 4:59 PM This page is intentionally left blank Z03_CASE3826_13_GE_CRED.indd 471 26/04/19 4:59 PM This page is intentionally left blank Z03_CASE3826_13_GE_CRED.indd 472 26/04/19 4:59 PM-20 Therefore the individual will not be willing to pay as much for each additional unit and this results in a downward sloping demand curve. At a price of Rs. 40 per unit x, individual’s demand for x was 5 units. The 6th unit of commodity x will be worth less than the 5th unit. The individual will be willing to buy the 6th unit only when the price drops below Rs. 40 per unit. Hence, the law of diminishing marginal utility explains why demand curves have a negative slope. 2.1.2 Ordinal Utility Analysis Cardinal utility analysis is simple to understand, but suffers from a major drawback in the form of quantification of utility in numbers. In real life, we never express utility in the form of numbers. At the most, we can rank various alternative combinations in terms of having more or less utility. In other words, the consumer does not measure utility in numbers, though she often ranks various consumption bundles. This forms the starting point of this topic – Ord
inal Utility Analysis. A consumer’s preferences over the set of available bundles can often be A represented diagrammatically. We have already seen that the bundles available to the consumer can be plotted as points in a twodimensional diagram. The points representing bundles which give the consumer equal utility can generally be joined to obtain a curve like the one in Figure 2.3. The consumer is said to be indifferent on the different bundles because each point of the bundles give the consumer equal utility. Such a curve joining all points representing bundles among which the consumer is indifferent is called an indifference curve. All the points such as A, B, C and D lying on an indifference curve provide the consumer with the same level of satisfaction. Indifference curve. An indifference curve joins all points representing bundles which are considered indifferent by the consumer. It is clear that when a consumer gets one more banana, he has to forego some mangoes, so that her total utility level remains the same and she remains on the same indifference curve. Therefore, indifference curve slopes downward. The amount of mangoes that the consumer has to forego, in order to get an additional banana, her total utility level being the same, is called marginal rate of substitution (MRS). In other words, MRS is simply the rate at which the consumer will substitute bananas for mangoes, so that her total utility remains constant. So, MRS =\| ∆ Y / X ∆ \| 3. One can notice that, in the table 2.2, as we increase the quantity of bananas, the quantity of mangoes sacrificed for each additional banana declines. In other words, MRS diminishes with increase in the number of bananas. As the number 11 / ∆ \|= ∆ X Y / ∆ X if ( ∆ Y / ∆ X ) 0 ≥ = −∆ Y / ∆ X if ( ∆ Y / ∆ X ) 0 < MRS =\| ∆ Y / ∆ \| means that MRS equals only the magnitude of the expression X /Y ∆ ∆. If it means MRS=3. 2019-20 Table 2.2: Representation of Law of Diminishing Marginal Rate of Substitution Combination Quantity of bananas (Qx) Quantity of Mangoes (Qy) MRS A 1 15 - B 2 12 3:1 C 3 10 2:1 D 4 9 1:1 of bananas with the consumer increases, the MU derived from each additional banana falls. Similarly,
with the fall in quantity of mangoes, the marginal utility derived from mangoes increases. So, with increase in the number of bananas, the consumer will feel the inclination to sacrifice small and smaller amounts of mangoes. This tendency for the MRS to fall with increase in quantity of bananas is known as Law of Diminishing Marginal Rate of Substitution. This can be seen from figure 2.3 also. Going from point A to point B, the consumer sacrifices 3 mangoes for 1 banana, going from point B to point C, the consumer sacrifices 2 mangoes for 1 banana, and going from point C to point D, the consumer sacrifices just 1 mango for 1 banana. Thus, it is clear that the consumer sacrifices smaller and smaller quantities of mangoes for each additional banana. Shape of an Indifference Curve It may be mentioned that the law of Diminishing Marginal Rate of Substitution causes an indifference curve to be convex to the origin. This is the most common shape of an indifference curve. But in case of goods being perfect substitutes4, the marginal rate of substitution does not diminish. It remains the same. Let’s take an example. Table 2.3: Representation of Law of Diminishing Marginal Rate of Substitution 12 Combination Quantity of five Quantity of five MRS Rupees notes (Qx) Rupees coins (Qy) A 1 8 - B 2 7 1:1 C 3 6 1:1 D 4 5 1:1 Here, the consumer is indifferent for all these combinations as long as the total of five rupee coins and five rupee notes remains the same. For the consumer, it hardly matters whether she gets a five rupee coin or a five rupee note. So, irrespective of how many five rupee notes she has, the consumer will sacrifice only one five rupee coin for a five rupee note. So these two commodities are perfect substitutes for the consumer and indifference curve depicting these will be a straight line. In the figure.2.4, it can be seen that consumer sacrifices the same number of five-rupee coins each time he has an additional five-rupee note. 4 Perfect Substitutes are the goods which can be used in place of each other, and provide exactly the same level of utility to the consumer. 2019-20 Monotonic Preferences Consumer’s preferences are assumed to be such that between any two bundles (x1, x2) and (y1, y2), if (
x1, x2) has more of at least one of the goods and no less of the other good compared to (y1, y2), then the consumer prefers (x1, x2) to (y1, y2). Preferences of this kind are called monotonic preferences. Thus, a consumer’s preferences are monotonic if and only if between any two bundles, the consumer prefers the bundle which has more of at least one of the goods and no less of the other good as compared to the other bundle. Indifference Map The consumer’s preferences over all the bundles can be represented by a family of indifference curves as shown in Figure 2.5. This is called an indifference map of the consumer. All points on an indifference curve represent bundles which are considered indifferent by the consumer. Monotonicity of preferences imply that between any two indifference curves, the bundles on the one which lies above are preferred to the bundles on the one which lies below. Features of Indifference Curve slopes curve 1. Indifference downwards from left to right: An indifference curve slopes downwards from left to right, which means that in order to have more of bananas, the consumer has to forego some mangoes. If the consumer does not forego some mangoes with an increase in number of bananas, it will mean consumer having more of bananas with same number of mangoes, taking her to a higher indifference curve. Thus, as long as the consumer is on the same indifference curve, an increase in bananas must be compensated by a fall in quantity of mangoes. Indif ference Curve for per fect substitutes. Indifference curve depicting two commodities which are perfect substitutes is a straight line. Indifference Map. A family of indifference curves. The arrow indicates that bundles on higher indifference curves are preferred by the consumer to the bundles on lower indifference curves. 13 Slope of the Indifference Curve. The indifference curve slopes downward. An increase in the amount of bananas along the indifference curve is associated with a decrease in the amount of mangoes. If ∆ x1 > 0 then ∆ x2 < 0. 2019-20 2.Higher indifference curve gives greater level of utility: As long as marginal utility of a commodity is positive, an individual will always prefer more of that commodity, as more of the commodity will increase the level of satisfaction. Table 2.4: Representation of different level of utilities from different combination of goods Combination Quantity of bananas Quantity of Mangoes A 1 10 B 2 10 C 3
10 Consider the different combination of bananas and mangoes, A, B and C depicted in table 2.4 and figure 2.7. Combinations A, B and C consist of same quantity of mangoes but different quantities of bananas. Since combination B has more bananas than A, B will provide the individual a higher level of satisfaction than A. Therefore, B will lie on a higher indifference curve than A, depicting higher satisfaction. Likewise, C has more bananas than B (quantity of mangoes is the same in both B and C). Therefore, C will provide higher level of satisfaction than B, and also lie on a higher indifference curve than B. A higher indifference curve consisting of combinations with more of mangoes, or more of bananas, or more of both, will represent combinations that give higher level of satisfaction. Higher indifference curves give greater level of utility. 3.Two indifference curves never intersect each other: Two indifference curves intersecting each other will lead to conflicting results. To explain this, let us allow two indifference curves to intersect each other as shown in the figure 2.8. As points A and B lie on the same indifference curve IC1, utilities derived from combination A and combination B will give the same level of satisfaction. Similarly, as points A and C lie on the same indifference curve IC2, utility derived from combination A and from combination C will give the same level of satisfaction7,10) B (9,7) IC1 Ic2 C (9,5) Bananas Two indifference curves never intersect each other 14 2019-20 From this, it follows that utility from point B and from point C will also be the same. But this is clearly an absurd result, as on point B, the consumer gets a greater number of mangoes with the same quantity of bananas. So consumer is better off at point B than at point C. Thus, it is clear that intersecting indifference curves will lead to conflicting results. Thus, two indifference curves cannot intersect each other. 2.2 THE CONSUMER’S BUDGET Let us consider a consumer who has only a fixed amount of money (income) to spend on two goods. The prices of the goods are given in the market. The consumer cannot buy any and every combination of the two goods that she may want to consume. The consumption bundles that are available to the consumer depend on the prices of the two goods and the income of the consumer. Given her fixed income and the prices of the two goods, the consumer can afford to
buy only those bundles which cost her less than or equal to her income. 2.2.1 Budget Set and Budget Line Suppose the income of the consumer is M and the prices of bananas and mangoes are p1 and p2 respectively5. If the consumer wants to buy x1 quantities of bananas, she will have to spend p1x1 amount of money. Similarly, if the consumer wants to buy x2 quantities of mangoes, she will have to spend p2x2 amount of money. Therefore, if the consumer wants to buy the bundle consisting of x1 quantities of bananas and x2 quantities of mangoes, she will have to spend p1x1 + p2x2 amount of money. She can buy this bundle only if she has at least p1x1 + p2x2 amount of money. Given the prices of the goods and the income of a consumer, she can choose any bundle as long as it costs less than or equal to the income she has. In other words, the consumer can buy any bundle (x1, x2) such that p1x1 + p2x2 ≤ M (2.1) The inequality (2.1) is called the consumer’s budget constraint. The set of bundles available to the consumer is called the budget set. The budget set is thus the collection of all bundles that the consumer can buy with her income at the prevailing market prices. EXAMPLE 2.1 Consider, for example, a consumer who has Rs 20, and suppose, both the goods are priced at Rs 5 and are available only in integral units. The bundles that this consumer can afford to buy are: (0, 0), (0, 1), (0, 2), (0, 3), (0, 4), (1, 0), (1, 1), (1, 2), (1, 3), (2, 0), (2, 1), (2, 2), (3, 0), (3, 1) and (4, 0). Among these bundles, (0, 4), (1,3), (2, 2), (3, 1) and (4, 0) cost exactly Rs 20 and all the other bundles cost less than Rs 20. The consumer cannot afford to buy bundles like (3, 3) and (4, 5) because they cost more than Rs 20 at the prevailing prices. 5 Price of a good is the amount of money that the consumer has to pay per unit
of the good she wants to buy. If rupee is the unit of money and quantity of the good is measured in kilograms, the price of banana being p1 means the consumer has to pay p1 rupees per kilograms of banana that she wants to buy. 15 2019-20 If both the goods are perfectly divisible6, the consumer’s budget set would consist of all bundles (x1, x2) such that x1 and x2 are any numbers greater than or equal to 0 and p1x1 + p2x2 ≤ M. The budget set can be represented in a diagram as in Figure 2.9. All bundles in the positive quadrant which are on or below the line are included in the budget set. The equation of the line is p1x1 + p2x2 = M (2.2) The line consists of all bundles which cost exactly equal to M. This line is called the budget line. Points below the budget line represent bundles which cost strictly less than M. Budget Set. Quantity of bananas is measured along the horizontal axis and quantity of mangoes is measured along the vertical axis. Any point in the diagram represents a bundle of the two goods. The budget set consists of all points on or below the straight line having the equation p1x1 + p2x2 = M. The equation (2.2) can also be written as7 The budget line is a straight line with horizontal intercept x 2 = pM 1 − p p 2 2 x 1 (2.3) M p and vertical 1 intercept M p. The horizontal intercept represents the bundle that the consumer can buy if she spends her entire income on bananas. Similarly, the vertical intercept represents the bundle that the consumer can buy if she spends her 2 16 entire income on mangoes. The slope of the budget line is – p 1 p. 2 Price Ratio and the Slope of the Budget Line Think of any point on the budget line. Such a point represents a bundle which costs the consumer her entire budget. Now suppose the consumer wants to have one more banana. She can do it only if she gives up some amount of the other good. How many mangoes does she have to give up if she wants to have an extra quantity of bananas? It would depend on the prices of the two goods. A quantity of banana costs p1. Therefore, she will have to reduce her expenditure on mangoes by p1 amount, if she wants one more quantity of banana. With p1
, she could buy p 1 p quantities of mangoes. Therefore, if the consumer wants to 2 have an extra quantity of bananas when she is spending all her money, she will have to give up p 1 p quantities of mangoes. In other words, in the given market 2 6The goods considered in Example 2.1 were not divisible and were available only in integer units. There are many goods which are divisible in the sense that they are available in non-integer units also. It is not possible to buy half an orange or one-fourth of a banana, but it is certainly possible to buy half a kilogram of rice or one-fourth of a litre of milk. 7In school mathematics, you have learnt the equation of a straight line as y = c + mx where c is the vertical intercept and m is the slope of the straight line. Note that equation (2.3) has the same form. 2019-20 Derivation of the Slope of the Budget Line Mangoes The slope of the budget line measures the amount of change in mangoes required per unit of change in bananas along the budget line. Consider any two points (x1, x2) and (x1 + ∆x1, x2 + ∆x2) on the budget line.a It must be the case that p1x1 + p2x2 = M (2.4) and, p1(x1 + ∆x1) + p2(x2 + ∆x2) = M Subtracting (2.4) from (2.5), we obtain p1∆x1 + p2∆x2 = 0 By rearranging terms in (2.6), we obtain ∆ Bananas (2.5) (2.6) (2.7) a∆ (delta) is a Greek letter. In mathematics, ∆ is sometimes used to denote ‘a change’. Thus, ∆x1 stands for a change in x1 and ∆x2 stands for a change in x2. conditions, the consumer can substitute bananas for mangoes at the rate p 1 p. The absolute value8 of the slope of the budget line measures the rate at which the consumer is able to substitute bananas for mangoes when she spends her entire budget. 2 2.2.2 Changes in the Budget Set The set of available bundles depends on the prices of the two goods and the income
of the consumer. When the price of either of the goods or the consumer’s income changes, the set of available bundles is also likely to change. Suppose the consumer’s income changes from M to M ′ but the prices of the two goods remain unchanged. With the new income, the consumer can afford to buy all bundles (x1, x2) such that p1x1 + p2x2 ≤ M′. Now the equation of the budget line is 17 Equation (2.8) can also be written as p1x1 + p2x2 = M′ x 2 = pM2.8) (2.9) Note that the slope of the new budget line is the same as the slope of the budget line prior to the change in the consumer’s income. However, the vertical intercept has changed after the change in income. If there is an increase in the 8The absolute value of a number x is equal to x if x ≥ 0 and is equal to – x if x < 0. The absolute value of x is usually denoted by \|x\|. 2019-20 income, i.e. if M' > M, the vertical as well as horizontal intercepts increase, there is a parallel outward shift of the budget line. If the income increases, the consumer can buy more of the goods at the prevailing market prices. Similarly, if the income goes down, i.e. if M' < M, both intercepts decrease, and hence, there is a parallel inward shift of the budget line. If income goes down, the availability of goods goes down. Changes in the set of available bundles resulting from changes in consumer’s income when the prices of the two goods remain unchanged are shown in Figure 2.10. Mangoes Mangoes M'<M M'>M Bananas Bananas 10 Changes in the Set of Available Bundles of Goods Resulting from Changes in the Consumer’s Income. A decrease in income causes a parallel inward shift of the budget line as in panel (a). An increase in income causes a parallel outward shift of the budget line as in panel (b). Now suppose the price of bananas change from p1 to p'1 but the price of mangoes and the consumer’s income remain unchanged. At the new price of bananas, the consumer can afford to buy all bundles (x1,x2) such that p'1x1 + p2x2 ≤ M. The
equation of the budget line is Equation (2.10) can also be written as p'1x1 + p2x2 = M x 2 = M p 2 – p' 1 p 2 x 1 (2.10) (2.11) Note that the vertical intercept of the new budget line is the same as the vertical intercept of the budget line prior to the change in the price of bananas. However, the slope of the budget line and horizontal intercept have changed after the price change. If the price of bananas increases, ie if p'1> p1, the absolute value of the slope of the budget line increases, and the budget line becomes steeper (it pivots inwards around the vertical intercept and horizontal intercept decreases). If the price of bananas decreases, i.e., p'1< p1, the absolute value of the slope of the budget line decreases and hence, the budget line becomes flatter (it pivots outwards around the vertical intercept and horizontal intercept increases). Figure 2.11 shows change in the budget set when the price of only one commodity changes while the price of the other commodity as well as income of the consumer are constant. A change in price of mangoes, when price of bananas and the consumer’s income remain unchanged, will bring about similar changes in the budget set of the consumer. 18 2019-20 Mangoes Mangoes Bananas Bananas 11 Changes in the Set of Available Bundles of Goods Resulting from Changes in the Price of bananas. An increase in the price of bananas makes the budget line steeper as in panel (a). A decrease in the price of bananas makes the budget line flatter as in panel (b). 2.3 OPTIMAL CHOICE OF THE CONSUMER The budget set consists of all bundles that are available to the consumer. The consumer can choose her consumption bundle from the budget set. But on what basis does she choose her consumption bundle from the ones that are available to her? In economics, it is assumed that the consumer chooses her consumption bundle on the basis of her tatse and preferences over the bundles in the budget set. It is generally assumed that the consumer has well defined preferences over the set of all possible bundles. She can compare any two bundles. In other words, between any two bundles, she either prefers one to the other or she is indifferent between the two. Equality of the Marginal Rate of Substitution and the Ratio of the Prices The optimum bundle of the consumer is located at the
point where the budget line is tangent to one of the indifference curves. If the budget line is tangent to an indifference curve at a point, the absolute value of the slope of the indifference curve (MRS) and that of the budget line (price ratio) are same at that point. Recall from our earlier discussion that the slope of the indifference curve is the rate at which the consumer is willing to substitute one good for the other. The slope of the budget line is the rate at which the consumer is able to substitute one good for the other in the market. At the optimum, the two rates should be the same. To see why, consider a point where this is not so. Suppose the MRS at such a point is 2 and suppose the two goods have the same price. At this point, the consumer is willing to give up 2 mangoes if she is given an extra banana. But in the market, she can buy an extra banana if she gives up just 1 mango. Therefore, if she buys an extra banana, she can have more of both the goods compared to the bundle represented by the point, and hence, move to a preferred bundle. Thus, a point at which the MRS is greater, the price ratio cannot be the optimum. A similar argument holds for any point at which the MRS is less than the price ratio. 19 2019-20 In economics, it is generally assumed that the consumer is a rational individual. A rational individual clearly knows what is good or what is bad for her, and in any given situation, she always tries to achieve the best for herself. Thus, not only does a consumer have well-defined preferences over the set of available bundles, she also acts according to her preferences. From the bundles which are available to her, a rational consumer always chooses the one which gives her maximum satisfaction. In the earlier sections, it was observed that the budget set describes the bundles that are available to the consumer and her preferences over the available bundles can usually be represented by an indifference map. Therefore, the consumer’s problem can also be stated as follows: The rational consumer’s problem is to move to a point on the highest possible indifference curve given her budget set. If such a point exists, where would it be located? The optimum point would be located on the budget line. A point below the budget line cannot be the optimum. Compared to a point below the budget line, there is always some point on the budget line which contains more of at least one of the
goods and no less of the other, and is, therefore, preferred by a consumer whose preferences are monotonic. Therefore, if the consumer’s preferences are monotonic, for any point below the budget line, there is some point on the budget line which is preferred by the consumer. Points above the budget line are not available to the consumer. Therefore, the optimum (most preferred) bundle of the consumer would be on the budget line. Where on the budget line will the optimum bundle be located? The point at which the budget line just touches (is tangent to), one of the indifference curves would be the optimum.9 To see why this is so, note that any point on the budget line other than the point at which it touches the indifference curve lies on a lower indifference curve and hence is inferior. Therefore, such a point cannot be the consumer’s optimum. The optimum bundle is located on the budget line at the point where the budget line is tangent to an indifference curve. (, * 1 Figure 2.12 illustrates the * consumer’s optimum. At x x, the ) 2 budget line is tangent to the black coloured indifference curve. The first thing to note is that the indifference curve just touching the budget line is the highest possible indifference curve given the consumer’s budget set. Bundles on the indifference curves above this, like the grey one, are not affordable. Points on the indifference curves below this, like the blue one, are certainly inferior to the points on the indifference curve, just touching the budget line. Any other point on the budget line lies on a lower indifference curve and hence, is inferior to Consumer’s Optimum. The point (x ∗ 2 ), at which the budget line is tangent to an indifference curve represents the consumers is the consumer’s optimum bundle. x x. Therefore, 1 To be more precise, if the situation is as depicted in Figure 2.12 then the optimum would be located at the point where the budget line is tangent to one of the indifference curves. However, there are other situations in which the optimum is at a point where the consumer spends her entire income on one of the goods only. 20 2019-20 2.4 DEMAND In the previous section, we studied the choice problem of the consumer and derived the consumer’s optimum bundle given the prices of the goods, the consumer’s income and her preferences. It was observed that the amount of a good that the consumer chooses
optimally, depends on the price of the good itself, the prices of other goods, the consumer’s income and her tastes and preferences. The quantity of a commodity that a consumer is willing to buy and is able to afford, given prices of goods and consumer’s tastes and preferences is called demand for the commodity. Whenever one or more of these variables change, the quantity of the good chosen by the consumer is likely to change as well. Here we shall change one of these variables at a time and study how the amount of the good chosen by the consumer is related to that variable. 2.4.1 Demand Curve and the Law of Demand 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 very important and this relation is called the demand function. Thus, the consumer’s demand function for a good Demand Curve. The demand curve is a relation between the quantity of the good chosen by a consumer and the price of the good. The independent variable (price) is measured along the vertical axis and dependent variable (quantity) is measured along the horizontal axis. The demand curve gives the quantity demanded by the consumer at each price. Functions Consider any two variables x and y. A function y = f (x) is a relation between the two variables x and y such that for each value of x, there is an unique value of the variable y. In other words, f (x) is a rule which assigns an unique value y for each value of x. As the value of y depends on the value of x, y is called the dependent variable and x is called the independent variable. 1 EXAMPLE Consider, for example, a situation where x can take the values 0, 1, 2, 3 and suppose corresponding values of y are 10, 15, 18 and 20, respectively. Here y and x are related by the function y = f (x) which is defined as follows: f (0) = 10; f (1) = 15; f (2) = 18 and f (3) = 20. EXAMPLE Consider another situation where x can take the values 0, 5, 10 and 20. And suppose corresponding values of y are 100, 90, 70 and 40, respectively. 2 21 2019-20 Here, y
and x are related by the function y = f (x ) which is defined as follows: f (0) = 100; f (10) = 90; f (15) = 70 and f (20) = 40. Very often a functional relation between the two variables can be expressed in algebraic form like y = 5 + x and y = 50 – x A function y = f (x) is an increasing function if the value of y does not decrease with increase in the value of x. It is a decreasing function if the value of y does not increase with increase in the value of x. The function in Example 1 is an increasing function. So is the function y = x + 5. The function in Example 2 is a decreasing function. The function y = 50 – x is also decreasing. Graphical Representation of a Function A graph of a function y = f (x) is a diagrammatic representation of the function. Following are the graphs of the functions in the examples given above. 22 Usually, in a graph, the independent variable is measured along the horizontal axis and the dependent variable is measured along the vertical axis. However, in economics, often the opposite is done. The demand curve, for example, is drawn by taking the independent variable (price) along the vertical axis and the dependent variable (quantity) along the horizontal axis. The graph of an increasing function is upward sloping or and the graph of a decreasing function is downward sloping. As we can see from the diagrams above, the graph of y = 5 + x is upward sloping and that of y = 50 – x, is downward sloping. 2019-20 gives the amount of the good that the consumer chooses at different levels of its price when the other things remain unchanged. The consumer’s demand for a good as a function of its price can be written as X = f (P) (2.12) where X denotes the quantity and P denotes the price of the good. The demand function can also be represented graphically as in Figure 2.13. The graphical representation of the demand function is called the demand curve. The relation between the consumer’s demand for a good and the price of the good is likely to be negative in general. In other words, the amount of a good that a consumer would optimally choose is likely to increase when the price of the good falls and it is likely to decrease with a rise in the price of the good. 2.4.2 Deriving a
Demand Curve from Indifference Curves and Budget Constraints Consider an individual consuming bananas (X1)and mangoes (X2), whose income is M and market prices of X1 and X2 are 2P'respectively. Figure (a) depicts 2X'quantities her consumption equilibrium at point C, where she buys of bananas and mangoes respectively. In panel (b) of figure 2.14, we plot 1P'against 1X'which is the first point on the demand curve for X1. 1P'and 1X'and Deriving a demand curve from indifference curves and budget constraints 2P'Suppose the price of X1 drops to 1P with and M remaining constant. The budget set in panel (a), expands and new consumption equilibrium is on a X'). higher indifference curve at point D, where she buys more of bananas ( 1 Thus, demand for bananas increases as its price drops. We plot 1P against 1X in panel (b) of figure 2.14 to get the second point on the demand curve for X1. Likewise the price of bananas can be dropped further to 1P, resulting in further increase in consumption of bananas to 1X gives us the third point on the demand curve. Therefore, we observe that a drop in price of bananas results in an increase in quality of bananas purchased by an individual who maximises his utility. The demand curve for bananas is thus negatively sloped. ∧ 1P plotted against 1X. >1 X ∧ ∧ ∧ The negative slope of the demand curve can also be explained in terms of the two effects namely, substitution effect and income effect that come into play when price of a commodity changes. when bananas become cheaper, the consumer maximises his utility by substituting bananas for mangoes in order to derive the same level of satisfaction of a price change, resulting in an increase in demand for bananas. 23 2019-20 Moreover, as price of bananas drops, consumer’s purchasing power increases, which further increases demand for bananas (and mangoes). This is the income effect of a price change, resulting in further increase in demand for bananas. Law of Demand: Law of Demand states that other things being equal, there is a negative relation between demand for a commodity and its price. In other words, when price of the commodity increases, demand for it falls and when price of the commodity decreases, demand for it rises, other factors remaining the same. Linear Demand A linear demand curve can be written as
d(p) = a – bp; 0 ≤ p ≤ a b = 0; p > a b (2.13) where a is the vertical intercept, –b is the slope of the demand curve. At price 0, the demand is a, and at price equal to a b, the demand is 0. The Linear Demand Curve. The diagram depicts the linear demand curve given by equation 2.13. slope of the demand curve measures the rate at which demand changes with respect to its price. For a unit increase in the price of the good, the demand falls by b units. Figure 2.15 depicts a linear demand curve. 2.4.3 Normal and Inferior Goods The demand function is a relation between the consumer’s demand for a good and its price when other things are given. Instead of studying the relation between the demand for a good and its price, we can also study the relation between the consumer’s demand for the good and the income of the consumer consumer demands can increase or decrease with the rise in income depending on the nature of the good. For most goods, the quantity that a consumer chooses, increases as the consumer’s income increases and decreases as the consumer’s income decreases. Such goods are called normal goods. Thus, a consumer’s demand for a normal good moves in the same direction as the income of the consumer. However, there are some goods the demands for which move in the opposite direction of the income of the consumer. Such goods are called inferior goods. As the income of the consumer increases, the demand for an inferior good falls, and as the income decreases, the demand for an inferior A rise in the purchasing power (income) of the consumer can sometimes induce the consumer to reduce the consumption of a good. In such a case, the substitution effect and the income effect will work in opposite directions. The demand for such a good can be inversely or positively related to its price depending on the relative strengths of these two opposing effects. If the substitution effect is stronger than the income effect, the demand for the good and the price of the good would still be inversely related. However, if the income effect is stronger than the substitution effect, the demand for the good would be positively related to its price. Such a good is called a Giffen good. 24 2019-20 good rises. Examples of inferior goods include low quality food items like coarse cereals. A good can be a normal good for the consumer at some
levels of income and an inferior good for her at other levels of income. At very low levels of income, a consumer’s demand for low quality cereals can increase with income. But, beyond a level, any increase in income of the consumer is likely to reduce her consumption of such food items as she switches to better quality cereals. 2.4.4 Substitutes and Complements We can also study the relation between the quantity of a good that a consumer chooses and the price of a related good. The quantity of a good that the consumer chooses can increase or decrease with the rise in the price of a related good depending on whether the two goods are substitutes or complementary to each other. Goods which are consumed together are called complementary goods. Examples of goods which are complement to each other include tea and sugar, shoes and socks, pen and ink, etc. Since tea and sugar are used together, an increase in the price of sugar is likely to decrease the demand for tea and a decrease in the price of sugar is likely to increase the demand for tea. Similar is the case with other complements. In general, the demand for a good moves in the opposite direction of the price of its complementary goods. In contrast to complements, goods like tea and coffee are not consumed together. In fact, they are substitutes for each other. Since tea is a substitute for coffee, if the price of coffee increases, the consumers can shift to tea, and hence, the consumption of tea is likely to go up. On the other hand, if the price of coffee decreases, the consumption of tea is likely to go down. The demand for a good usually moves in the direction of the price of its substitutes. 2.4.5 Shifts in the Demand Curve The demand curve was drawn under the assumption that the consumer’s income, the prices of other goods and the preferences of the consumer are given. What happens to the demand curve when any of these things changes? Given the prices of other goods and the preferences of a consumer, if the income increases, the demand for the good at each price changes, and hence, there is a shift in the demand curve. For normal goods, the demand curve shifts rightward and for inferior goods, the demand curve shifts leftward. Given the consumer’s income and her preferences, if the price of a related good changes, the demand for a good at each level of its price changes, and hence, there is a shift in the demand curve. If there is an
increase in the price of a substitute good, the demand curve shifts rightward. On the other hand, if there is an increase in the price of a complementary good, the demand curve shifts leftward. The demand curve can also shift due to a change in the tastes and preferences of the consumer. If the consumer’s preferences change in favour of a good, the demand curve for such a good shifts rightward. On the other hand, the demand curve shifts leftward due to an unfavourable change in the preferences of the consumer. The demand curve for ice-creams, for example, is likely to shift rightward in the summer because of preference for ice-creams goes up in summer. Revelation of the fact that cold-drinks might be injurious to health can adversely affect preferences for cold-drinks. This is likely to result in a leftward shift in the demand curve for cold-drinks. 25 2019-20 Shifts in Demand. The demand curve in panel (a) shifts leftward and that in panel (b) shifts rightward. Shifts in the demand curve are depicted in Figure 2.16. It may be mentioned that shift in demand curve takes place when there is a change in some factor, other than the price of the commodity. 2.4.6 Movements along the Demand Curve and Shifts in the Demand Curve As it has been noted earlier, the amount of a good that the consumer chooses depends on the price of the good, the prices of other goods, income of the consumer and her tastes and preferences. The demand function is a relation between the amount of the good and its price when other things remain unchanged. The demand curve is a graphical representation of the demand function. At higher prices, the demand is less, and at lower prices, the demand is more. Thus, any change in the price leads to movements along the demand curve. On the other hand, changes in any of the other things lead to a shift in the demand curve. Figure 2.17 illustrates a movement along the demand curve and a shift in the demand curve. 26 Movement along a Demand Curve and Shift of a Demand Curve. Panel (a) depicts a movement along the demand curve and panel (b) depicts a shift of the demand curve. 2.5 MARKET DEMAND In the last section, we studied the choice problem of the individual consumer and derived the demand curve of the consumer. However, in the market for a 2019-20 good, there are many consumers.
It is important to find out the market demand for the good. The market demand for a good at a particular price is the total demand of all consumers taken together. The market demand for a good can be derived from the individual demand curves. Suppose there are only two Derivation of the Market Demand Curve. The market demand curve can be derived as a horizontal summation of the individual demand curves. consumers in the market for a good. Suppose at price p′, the demand of consumer 1 is q′1 and that of consumer 2 is q′2. Then, the market demand of the good at p′ ˆq and that of is q′1 + q′2. Similarly, at price ˆp, if the demand of consumer 1 is 1 ˆ ˆq, the market demand of the good at ˆp is 1 ˆ consumer 2 is. Thus, the q+ q market demand for the good at each price can be derived by adding up the demands of the two consumers at that price. If there are more than two consumers in the market for a good, the market demand can be derived similarly. 2 2 The market demand curve of a good can also be derived from the individual demand curves graphically by adding up the individual demand curves horizontally as shown in Figure 2.18. This method of adding two curves is called horizontal summation. Adding up Two Linear Demand Curves Consider, for example, a market where there are two consumers and the demand curves of the two consumers are given as d1(p) = 10 – p and d2(p) = 15 – p (2.14) (2.15) Furthermore, at any price greater than 10, the consumer 1 demands 0 unit of the good, and similarly, at any price greater than 15, the consumer 2 demands 0 unit of the good. The market demand can be derived by adding equations (2.14) and (2.15). At any price less than or equal to 10, the market demand is given by 25 – 2p, for any price greater than 10, and less than or equal to 15, market demand is 15 – p, and at any price greater than 15, the market demand is 0. 2.6 ELASTICITY OF DEMAND The demand for a good moves in the opposite direction of its price. But the impact of the price change is always not the same. Sometimes, the demand for a good changes considerably even for small price changes.
On the other hand, there are some goods for which the demand is not affected much by price changes. 27 2019-20 Demands for some goods are very responsive to price changes while demands for certain others are not so responsive to price changes. Price elasticity of demand is a measure of the responsiveness of the demand for a good to changes in its price. Price elasticity of demand for a good is defined as the percentage change in demand for the good divided by the percentage change in its price. Priceelasticity of demand for a good eD = percentage change in demand for the good percentage change in the price of the good Q ∆ Q P ∆ P × 100 × 100 Q ∆  ∆    = = (2.16a) (2.16b) Where, P∆ is the change in price of the good and Q∆ is the change in quantity of the good. EXAMPLE Suppose an individual buy 15 bananas when its price is Rs. 5 per banana. when the price increases to Rs. 7 per banana, she reduces his demand to 12 bananas. 2.2 Price Per banana (Rs.) : P Quantity of bananas demanded : Q Old Price : P1 = 5 New Price : P2 = 7 Old quantity : Q1 = 15 New quantity: Q2 = 12 In order to find her elasticity demand for bananas, we find the percentage change in quantity demanded and its price, using the information summarized in table. Note that the price elasticity of demand is a negative number since the demand for a good is negatively related to the price of a good. However, for simplicity, we will always refer to the absolute value of the elasticity. Percentage change in quantity demanded = Q ∆ Q 1 × 100 =    Q Q − 2 1 Q 1    × 100 = 12 15 − 15 × 100 = − 20 Percentage change in Market price = P ∆ P 1 × 100 =    × 100 = 7 5 − 5 × 100 40 = 28 2019-20 Therefore, in our example, as price of bananas increases by 40 percent, demand for bananas drops by 20 percent. Price elasticity of demand De = 20 40 = 0.5. Clearly, the demand for bananas is not very responsive to a change in price of bananas. When the percentage change in quantity
demanded is less than the percentage change in market price, De is estimated to be less than one and the demand for the good is said to be inelastic at that price. Demand for essential goods is often found to be inelastic. When the percentage change in quantity demanded is more than the percentage change in market price, the demand is said to be highly responsive to changes in market price and the estimated De is more than one. The demand for the good is said to be elastic at that price. Demand for luxury goods is seen to be highly responsive to changes in their market prices and De >1. When the percentage change in quantity demanded equals the percentage change in its market price, De is estimated to be equal to one and the demand for the good is said to be Unitary-elastic at that price. Note that the demand for certain goods may be elastic, unitary elastic and inelastic at different prices. In fact, in the next section, elasticity along a linear demand curve is estimated at different prices and shown to vary at each point on a downward sloping demand curve. 2.6.1 Elasticity along a Linear Demand Curve Let us consider a linear demand curve q = a – bp. Note that at any point on the demand curve, the change in demand per unit change in the price q ∆ ∆ = –b. p Substituting the value of q ∆ ∆ in (2.16b), p we obtain, eD = – b p q puting the value of q, eD = – bp – bp a (2.17) From (2.17), it is clear that the elasticity of demand is different at different points on a linear demand curve. At p = 0, the elasticity is 0, at q = 0, elasticity is ∞. At p = a b 2, the elasticity is 1, at any price greater than 0 and less Elasticity along a Linear Demand Curve. Price elasticity of demand is different at different points on the linear demand curve. than a b 2, elasticity is less than 1, and at any price greater than a b 2, elasticity is greater than 1. The price elasticities of demand along the linear demand curve given by equation (2.17) are depicted in Figure 2.19. 29 2019-20 Geometric Measure of Elasticity along a Linear Demand Curve The elasticity of a linear demand curve can easily be measured geometrically.
The elasticity of demand at any point on a straight line demand curve is given by the ratio of the lower segment and the upper segment of the demand curve at that point. To see why this is the case, consider the following figure which depicts a straight line demand curve, q = a – bp. Suppose at price p 0, the demand for the good is q0. Now consider a small change in the price. The new price is p1, and at that price, demand for the good is q1. ∆q = q1q0 = CD and ∆p = p1p0 = CE. Therefore, eD = Op Oq = CD CE × 0 0 Op Oq Since ECD and Bp0D are similar triangles, CD CE = 0 p D 0 p B. But 0 p D 0 p B = o Oq o p B eD = 0 op. Since, Bp0D and BOA are similar triangles, 0 q D p B = 0 DA DB Thus, eD = DA DB. The elasticity of demand at different points on a straight line demand curve can be derived by this method. Elasticity is 0 at the point where the demand curve meets the horizontal axis and it is ∝ at the point where the demand curve meets the vertical axis. At the midpoint of the demand curve, the elasticity is 1, at any point to the left of the midpoint, it is greater than 1 and at any point to the right, it is less than 1. Note that along the horizontal axis p = 0, along the vertical axis q = 0 and at the midpoint of the demand curve p = a b. 2 Constant Elasticity Demand Curve The elasticity of demand on different points on a linear demand curve is different varying from 0 to ∞. But sometimes, the demand curves can be such that the elasticity of demand remains constant throughout. Consider, for example, a vertical demand curve as the one depicted in Figure 2.20(a). Whatever be the price, the demand is given at the level q. A price never leads to a change in the demand for such a demand curve and \|eD\| is always 0. Therefore, a vertical demand curve is perfectly inelastic. Figure 2.20 (b) depics a horizontal demand curve, where market price remains constant at P, whatever be the level of demand for the commodity. At de = ∞. A any other price, quantity demanded drops to
zero and therefore horizontal demand curve is perfectly elastic. 30 2019-20 Constant Elasticity Demand Curves. Elasticity of demand at all points along the vertical demand curve, as shown in panel (a), is 0. Elasticity of demand at all point along the horizontal demand curve, as shown in panel (b) is ∞. Elasticity at all points on the demand curve in panel (c) is 1. Figure 2.20(c) depicts a demand curve which has the shape of a rectangular hyperbola. This demand curve has a property that a percentage change in price along the demand curve always leads to equal percentage change in quantity. Therefore, \|eD\| = 1 at every point on this demand curve. This demand curve is called the unitary elastic demand curve. 2.6.2 Factors Determining Price Elasticity of Demand for a Good The price elasticity of demand for a good depends on the nature of the good and the availability of close substitutes of the good. Consider, for example, necessities like food. Such goods are essential for life and the demands for such goods do not change much in response to changes in their prices. Demand for food does not change much even if food prices go up. On the other hand, demand for luxuries can be very responsive to price changes. In general, demand for a necessity is likely to be price inelastic while demand for a luxury good is likely to be price elastic. Though demand for food is inelastic, the demands for specific food items are likely to be more elastic. For example, think of a particular variety of pulses. If the price of this variety of pulses goes up, people can shift to some other variety of pulses which is a close substitute. The demand for a good is likely to be elastic if close substitutes are easily available. On the other hand, if close substitutes are not available easily, the demand for a good is likely to be inelastic. 2.6.3 Elasticity and Expenditure The expenditure on a good is equal to the demand for the good times its price. Often it is important to know how the expenditure on a good changes as a result of a price change. The price of a good and the demand for the good are inversely related to each other. Whether the expenditure on the good goes up or down as a result of an increase in its price depends on how responsive the demand for the good is to the price change. Consider an increase in the price of a good. If the percentage
decline in quantity is greater than the percentage increase in the price, the expenditure on the good will go down. For example, see row 2 in table 2.5 which shows that as price of a commodity increases by 10%, its demand drops by 12%, resulting in a decline in expenditure on the good. On the other hand, if the percentage decline in quantity is less than the percentage increase in the price, the expenditure on 31 2019-20 the good will go up (See row 1 in table 2.5). And if the percentage decline in quantity is equal to the percentage increase in the price, the expenditure on the good will remain unchanged (see row 3 in table 2.5). Now consider a decline in the price of the good. If the percentage increase in quantity is greater than the percentage decline in the price, the expenditure on the good will go up(see row 4 in table 2.5). On the other hand, if the percentage increase in quantity is less than the percentage decline in the price, the expenditure on the good will go down(see row 5 in table 2.5). And if the percentage increase in quantity is equal to the percentage decline in the price, the expenditure on the good will remain unchanged (see row 6 in table 2.5). The expenditure on the good would change in the opposite direction as the price change if and only if the percentage change in quantity is greater than the percentage change in price, ie if the good is price-elastic (see rows 2 and 4 in table 2.5). The expenditure on the good would change in the same direction as the price change if and only if the percentage change in quantity is less than the percentage change in price, i.e., if the good is price inelastic (see rows 1 and 5 in table 2.5). The expenditure on the good would remain unchanged if and only if the percentage change in quantity is equal to the percentage change in price, i.e., if the good is unit-elastic (see rows 3 and 6 in table 2.5). Table 2.5: For hypothetic cases of price rise and drop, the following table summarises the relationship between elasticity and change in expenditure of a commodity Change Change in % Change % Change Impact on Nature of price in Price Quantity in price in quantity Expenditure Elasticity of (P) demand (Q) demand = P×Q demand de 1 ↑ ↓ +10 -8 ↑ Price Inelastic 2 ↑ ↓ +10 -12
↓ Price Elastic 3 ↑ ↓ +10 -10 No Change Unit Elastic 4 ↓ ↑ -10 +15 ↑ Price Elastic 5 ↓ ↑ -10 +7 ↓ Price Inelastic 6 ↓ ↑ -10 +10 No Change Unit Elastic Rectangular Hyperbola An equation of the form xy = c where x and y are two variables and c is a constant, giving us a curve called rectangular hyperbola. It is a downward sloping curve in the x-y plane as shown in the diagram. For any two points p and q on the curve, the areas of the two rectangles Oy1px1 and Oy2qx2 are same and equal to c. If the equation of a demand curve takes the form pq = e, where e is a constant, it will be a rectangular hyperbola, where price (p) times quantity (q) is a constant. With such a demand curve, no matter at what point the consumer consumes, her expenditures are always the same and equal to e. 32 2019-20 Relationship between Elasticity and change in Expenditure on a Good Suppose at price p, the demand for a good is q, and at price p + ∆p, the demand for the good is q + ∆q. At price p, the total expenditure on the good is pq, and at price p + ∆p, the total expenditure on the good is (p + ∆p)(q + ∆q). If price changes from p to (p + ∆p), the change in the expenditure on the good is, (p + ∆p)(q + ∆q) – pq = q∆p + p∆q + ∆p∆q. For small values of ∆p and ∆q, the value of the term ∆p∆q is negligible, and in that case, the change in the expenditure on the good is approximately given by q∆p + p∆q. Approximate change in expenditure = ∆E = q∆p + p∆q = ∆p(p[q(1 + ∆ ∆ q p p q )] = ∆p[q(1 + eD)]. Note that if eD < –1, then q (1 + eD) < 0, and hence, ∆E has the opposite sign as ∆p, if eD > –1,
then q (1 + eD) > 0, and hence, ∆E has the same sign as ∆p, if eD = –1, then q (1 + eD ) = 0, and hence, ∆E = 0 • The budget set is the collection of all bundles of goods that a consumer can buy with her income at the prevailing market prices. • The budget line represents all bundles which cost the consumer her entire income. The budget line is negatively sloping. • The budget set changes if either of the two prices or the income changes. • The consumer has well-defined preferences over the collection of all possible bundles. She can rank the available bundles according to her preferences over them. • The consumer’s preferences are assumed to be monotonic. • An indifference curve is a locus of all points representing bundles among which the consumer is indifferent. • Monotonicity of preferences implies that the indifference curve is downward sloping. • A consumer’s preferences, in general, can be represented by an indifference map. • A consumer’s preferences, in general, can also be represented by a utility function. • A rational consumer always chooses her most preferred bundle from the budget set. • The consumer’s optimum bundle is located at the point of tangency between the budget line and an indifference curve. • The consumer’s demand curve gives the amount of the good that a consumer chooses at different levels of its price when the price of other goods, the consumer’s income and her tastes and preferences remain unchanged. • The demand curve is generally downward sloping. • The demand for a normal good increases (decreases) with increase (decrease) in the consumer’s income. • The demand for an inferior good decreases (increases) as the income of the consumer increases (decreases). • The market demand curve represents the demand of all consumers in the market 33 2019-20 taken together at different levels of the price of the good. • The price elasticity of demand for a good is defined as the percentage change in demand for the good divided by the percentage change in its price. • The elasticity of demand is a pure number. • Elasticity of demand for a good and total expenditure on the good are closely related. s s s Budget set Preference Indifference curve Monotonic preferences C C C C C Indifference map,Utility function Demand Demand curve Income effect Inferior good Complement KKKKK
Budget line Indifference Marginal Rate of substitution Diminishing rate of substitution Consumer’s optimum Law of demand Substitution effect Normal good Substitute Price elasticity of demand. What do you mean by the budget set of a consumer? 2. What is budget line? 3. Explain why the budget line is downward sloping. 4. A consumer wants to consume two goods. The prices of the two goods are Rs 4 and Rs 5 respectively. The consumer’s income is Rs 20. (i) Write down the equation of the budget line. (ii) How much of good 1 can the consumer consume if she spends her entire income on that good? (iii) How much of good 2 can she consume if she spends her entire income on that good? (iv) What is the slope of the budget line? Questions 5, 6 and 7 are related to question 4. 5. How does the budget line change if the consumer’s income increases to Rs 40 but the prices remain unchanged? 6. How does the budget line change if the price of good 2 decreases by a rupee but the price of good 1 and the consumer’s income remain unchanged? 7. What happens to the budget set if both the prices as well as the income double? 8. Suppose a consumer can afford to buy 6 units of good 1 and 8 units of good 2 if she spends her entire income. The prices of the two goods are Rs 6 and Rs 8 respectively. How much is the consumer’s income? 9. Suppose a consumer wants to consume two goods which are available only in integer units. The two goods are equally priced at Rs 10 and the consumer’s income is Rs 40. (i) Write down all the bundles that are available to the consumer. (ii) Among the bundles that are available to the consumer, identify those which cost her exactly Rs 40. 10. What do you mean by ‘monotonic preferences’? 11. If a consumer has monotonic preferences, can she be indifferent between the bundles (10, 8) and (8, 6)? 12. Suppose a consumer’s preferences are monotonic. What can you say about her preference ranking over the bundles (10, 10), (10, 9) and (9, 9)? 34 2019-20 13. Suppose your friend is indifferent to the bundles (5, 6) and (6, 6). Are the preferences of your friend monotonic? 14. Suppose there are
two consumers in the market for a good and their demand functions are as follows: d1(p) = 20 – p for any price less than or equal to 20, and d1(p) = 0 at any price greater than 20. d2(p) = 30 – 2p for any price less than or equal to 15 and d1(p) = 0 at any price greater than 15. Find out the market demand function. 15. Suppose there are 20 consumers for a good and they have identical demand functions: d(p) = 10 – 3p for any price less than or equal to 10 3 and d1(p) = 0 at any price greater than 10 3. What is the market demand function? 16. Consider a market where there are just two consumers and suppose their demands for the good are given as follows: Calculate the market demand for the good. p 1 2 3 4 5 6 d1 9 8 7 6 5 4 d2 24 20 18 16 14 12 17. What do you mean by a normal good? 18. What do you mean by an ‘inferior good’? Give some examples. 19. What do you mean by substitutes? Give examples of two goods which are substitutes of each other. 20. What do you mean by complements? Give examples of two goods which are complements of each other. 21. Explain price elasticity of demand. 22. Consider the demand for a good. At price Rs 4, the demand for the good is 25 units. Suppose price of the good increases to Rs 5, and as a result, the demand for the good falls to 20 units. Calculate the price elasticity. 23. Consider the demand curve D (p) = 10 – 3p. What is the elasticity at price 5 3? 24. Suppose the price elasticity of demand for a good is – 0.2. If there is a 5 % increase in the price of the good, by what percentage will the demand for the good go down? 25. Suppose the price elasticity of demand for a good is – 0.2. How will the expenditure on the good be affected if there is a 10 % increase in the price of the good? 27. Suppose there was a 4 % decrease in the price of a good, and as a result, the expenditure on the good increased by 2 %. What can you say about the elasticity of demand? 35 2019-20 Chapter 3 PPPPProduction and Costs
roduction and Costs roduction and Costs roduction and Costs roduction and Costs In the previous chapter, we have discussed the behaviour of the consumers. In this chapter as well as in the next, we shall examine the behaviour of a producer. Production is the process by which inputs are transformed into ‘output’. Production is carried out by producers or firms. A firm acquires different inputs like labour, machines, land, raw materials etc. It uses these inputs to produce output. This output can be consumed by consumers, or used by other firms for further production. For example, a tailor uses a sewing machine, cloth, thread and his own labour to ‘produce’ shirts. A farmer uses his land, labour, a tractor, seed, fertilizer, water etc to produce wheat. A car manufacturer uses land for a factory, machinery, labour, and various other inputs (steel, aluminium, rubber etc) to produce cars. A rickshaw puller uses a rickshaw and his own labour to ‘produce’ rickshaw rides. A domestic helper uses her labour to produce ‘cleaning services’. We make certain simplifying assumptions to start with. Production is instantaneous: in our very simple model of production no time elapses between the combination of the inputs and the production of the output. We also tend to use the terms production and supply synonymously and often interchangeably. In order to acquire inputs a firm has to pay for them. This is called the cost of production. Once output has been produced, the firm sell it in the market and earns revenue. The difference between the revenue and cost is called the firm’s profit. We assume that the objective of a firm is to earn the maximum profit that it can. In this chapter, we discuss the relationship between inputs and output. Then we look at the cost structure of the firm. We do this to be able to identifiy the output at which A Firm Effort firms profits are maximum. 3.1 PRODUCTION FUNCTION The production function of a firm is a relationship between inputs used and output produced by the firm. For various quantities of inputs used, it gives the maximum quantity of output that can be produced. 2019-20 Consider the farmer we mentioned above. For simplicity, we assume that the farmer uses only two inputs to produce wheat: land and labour. A production function tells us the maximum amount of wheat he can produce for a given amount of land that he uses, and a
given number of hours of labour that he performs. Suppose that he uses 2 hours of labour/ day and 1 hectare of land to produce a maximum of 2 tonnes of wheat. Then, a function that describes this relation is called a production function. One possible example of the form this could take is: q = K × L, Where, q is the amount of wheat produced, K is the area of land in hectares, L is the number of hours of work done in a day. Describing a production function in this manner tells us the exact relation between inputs and output. If either K or L increase, q will also increase. For any L and any K, there will be only one q. Since by definition we are taking the maximum output for any level of inputs, a production function deals only with the efficient use of inputs. Efficiency implies that it is not possible to get any more output from the same level of inputs. A production function is defined for a given technology. It is the technological knowledge that determines the maximum levels of output that can be produced using different combinations of inputs. If the technology improves, the maximum levels of output obtainable for different input combinations increase. We then have a new production function. The inputs that a firm uses in the production process are called factors of production. In order to produce output, a firm may require any number of different inputs. However, for the time being, here we consider a firm that produces output using only two factors of production – labour and capital. Our production function, therefore, tells us the maximum quantity of output (q) that can be produced by using different combinations of these two factors of productionsLabour (L) and Capital (K). We may write the production function as q = f(L,K) (3.1) where, L is labour and K is capital and q is the maximum output that can be produced. Table 3.1: Production Function Factor Capital Labour 10 12 13 2 0 3 10 18 24 29 33 3 0 7 18 30 40 46 50 4 0 10 24 40 50 56 57 5 0 12 29 46 56 58 59 6 0 13 33 50 57 59 60 0 1 2 3 4 5 6 A numerical example of production function is given in Table 3.1. The left column shows the amount of labour and the top row shows the amount of capital. As we move to the right along any row, capital increases and as we move down along any column, labour increases. For different values of the two factors, 37 2019-
20 Isoquant In Chapter 2, we have learnt about indifference curves. Here, we introduce a similar concept known as isoquant. It is just an alternative way of representing the production function. Consider a production function with two inputs labour and capital. An isoquant is the set of all possible combinations of the two inputs that yield the same maximum possible level of output. Each isoquant represents a particular level of output and is labelled with that amount of output. Let us return to table 3.1 notice that the output of 10 units can be produced in 3 ways (4L, 1K), (2L, 2K), (1L, 4K). All these combination of L, K lie on the same isoquant, which represents the level of output 10. Can you identify the sets of inputs that will lie on the isoquant q = 50? The diagram here generalizes this concept. We place L on the X axis and K on the Y axis. We have three isoquants for the three output levels, namely q = q1, q = q2 and q = q3. Two input combinations (L1, K2) and (L2, K1) give us the same level of output q1. If we fix capital at K1 and increase labour to L3, output increases and we reach a higher isoquant, q = q2. When marginal products are positive, with greater amount of one input, the same level of output can be produced only using lesser amount of the other. Therefore, isoquants are negatively sloped. the table shows the corresponding output levels. For example, with 1 unit of labour and 1 unit of capital, the firm can produce at most 1 unit of output; with 2 units of labour and 2 units of capital, it can produce at most 10 units of output; with 3 units of labour and 2 units of capital, it can produce at most 18 units of output and so on. In our example, both the inputs are necessary for the production. If any of the inputs becomes zero, there will be no production. With both inputs positive, output will be positive. As we increase the amount of any input, output increases. 3.2 THE SHORT RUN AND THE LONG RUN Before we begin with any further analysis, it is important to discuss two concepts– the short run and the long run. In the short run, at least one of the factor – labour or capital – cannot be varied, and therefore,
remains fixed. In order to vary the output level, the firm can vary only the other factor. The factor that remains fixed is called the fixed factor whereas the other factor which the firm can vary is called the variable factor. Consider the example represented through Table 3.1. Suppose, in the short run, capital remains fixed at 4 units. Then the corresponding column shows the different levels of output that the firm may produce using different quantities of labour in the short run. 38 2019-20 In the long run, all factors of production can be varied. A firm in order to produce different levels of output in the long run may vary both the inputs simultaneously. So, in the long run, there is no fixed factor. For any particular production process, long run generally refers to a longer time period than the short run. For different production processes, the long run periods may be different. It is not advisable to define short run and long run in terms of say, days, months or years. We define a period as long run or short run simply by looking at whether all the inputs can be varied or not. 3.3 TOTAL PRODUCT, AVERAGE PRODUCT AND MARGINAL PRODUCT 3.3.1 Total Product Suppose we vary a single input and keep all other inputs constant. Then for different levels of that input, we get different levels of output. This relationship between the variable input and output, keeping all other inputs constant, is often referred to as Total Product (TP) of the variable input. Let us again look at Table 3.1. Suppose capital is fixed at 4 units. Now in the Table 3.1, we look at the column where capital takes the value 4. As we move down along the column, we get the output values for different values of labour. This is the total product of labour schedule with K2 = 4. This is also sometimes called total return to or total physical product of the variable input. This is shown again in the second column of table in 3.2 Once we have defined total product, it will be useful to define the concepts of average product (AP) and marginal product (MP). They are useful in order to describe the contribution of the variable input to the production process. 3.3.2 Average Product Average product is defined as the output per unit of variable input. We calculate it as AP L = TP L L (3.2) The last column of table 3.2 gives us a numerical example of average product of labour (with capital fixed at 4)
for the production function described in table 3.1. Values in this column are obtained by dividing TP (column 2) by L (Column 1). 3.3.3 Marginal Product Marginal product of an input is defined as the change in output per unit of change in the input when all other inputs are held constant. When capital is held constant, the marginal product of labour is MP L = Change in output Change in input = LTP ∆ L ∆ (3.3) where ∆ represents the change of the variable. The third column of table 3.2 gives us a numerical example of Marginal Product of labour (with capital fixed at 4) for the production function described in table 3.1. Values in this column are obtained by dividing change in TP by 39 2019-20 change in L. For example, when L changes from 1 to 2, TP changes from 10 to 24. MPL= (TP at L units) – (TP at L – 1 unit) (3.4) Here, Change in TP = 24 -10 = 14 Change in L = 1 Marginal product of the 2nd unit of labour = 14/1 = 14 Since inputs cannot take negative values, marginal product is undefined at zero level of input employment. For any level of an input, the sum of marginal products of every preceeding unit of that input gives the total product. So total product is the sum of marginal products. Table 3.2: Total Product, Marginal product and Average product Labour 0 1 2 3 4 5 6 TP 0 10 24 40 50 56 57 MPL 10 14 16 10 6 1 APL 10 12 13.33 12.5 11.2 9.5 40 Average product of an input at any level of employment is the average of all marginal products up to that level. Average and marginal products are often referred to as average and marginal returns, respectively, to the variable input. 3.4 THE LAW OF DIMINISHING MARGINAL PRODUCT AND THE LAW OF VARIABLE PROPORTIONS If we plot the data in table 3.2 on graph paper, placing labour on the X-axis and output on the Y-axis, we get the curves shown in the diagram below. Let us examine what is happening to TP. Notice that TP increases as labour input increases. But the rate at which it increases is not constant. An increase in labour from 1 to 2 increases TP by 10 units. An increase in labour from 2 to 3 increases TP
by 12. The rate at which TP increases, as explained above, is shown by the MP. Notice that the MP first increases (upto 3 units of labour) and then begins to 2019-20 fall. This tendency of the MP to first increase and then fall is called the law of variable proportions or the law of diminishing marginal product. Law of variable proportions say that the marginal product of a factor input initially rises with its employment level. But after reaching a certain level of employment, it starts falling. Why does this happen? In order to understand this, we first define the concept of factor proportions. Factor proportions represent the ratio in which the two inputs are combined to produce output. As we hold one factor fixed and keep increasing the other, the factor proportions change. Initially, as we increase the amount of the variable input, the factor proportions become more and more suitable for the production and marginal product increases. But after a certain level of employment, the production process becomes too crowded with the variable input. Suppose table 3.2 describes the output of a farmer who has 4 hectares of land, and can choose how much labour he wants to use. If he uses only 1 worker, he has too much land for the worker to cultivate alone. As he increases the number of workers, the amount of labour per unit land increases, and each worker adds proportionally more and more to the total output. Marginal product increases in this phase. When the fourth worker is hired, the land begins to get ‘crowded’. Each worker now has insufficient land to work efficiently. So the output added by each additional worker is now proportionally less. The marginal product begins to fall. We can use these observations to describe the general shapes of the TP, MP and AP curves as below. 3.5 SHAPES OF TOTAL PRODUCT, MARGINAL PRODUCT AND AVERAGE PRODUCT CURVES An increase in the amount of one of the inputs keeping all other inputs constant results in an increase in output. Table 3.2 shows how the total product changes as the amount of labour increases. The total product curve in the input-output plane is a positively sloped curve. Figure 3.1 shows the shape of the total product curve for a typical firm. We measure units of labour along the horizontal axis and output along the vertical axis. With L units of labour, the firm can at most produce q1 units of output. According to the law of variable proportions, the marginal product of an input initially rises and then after a
certain level of employment, it starts falling. The MP curve therefore, looks like an inverse ‘U’-shaped curve as in figure 3.2. Let us now see what the AP curve looks like. For the first unit of the variable input, one can easily check that the MP and the Output q1 TPL O Fig. 3.1 L Labour Total Product. This is a total product curve for labour. When all other inputs are held constant, it shows the different output levels obtainable from different units of labour. 41 2019-20 AP are same. Now as we increase the amount of input, the MP rises. AP being the average of marginal products, also rises, but rises less than MP. Then, after a point, the MP starts falling. However, as long as the value of MP remains higher than the value of the AP, the AP continues to rise. Once MP has fallen sufficiently, its value becomes less than the AP and the AP also starts falling. So AP curve is also inverse ‘U’-shaped. Output P APL MPL L Labour O Fig. 3.2 As long as the AP increases, it must be the case that MP is greater than AP. Otherwise, AP cannot rise. Similarly, when AP falls, MP has to be less than AP. It, follows that MP curve cuts AP curve from above at its maximum. Average and Marginal Product. These are average and marginal product curves of labour. Figure 3.2 shows the shapes of AP and MP curves for a typical firm. The AP of factor 1 is maximum at L. To the left of L, AP is rising and MP is greater than AP. To the right of L, AP is falling and MP is less than AP. 3.6 RETURNS TO SCALE The law of variable proportions arises because factor proportions change as long as one factor is held constant and the other is increased. What if both factors can change? Remember that this can happen only in the long run. One special case in the long run occurs when both factors are increased by the same proportion, or factors are scaled up. When a proportional increase in all inputs results in an increase in output by the same proportion, the production function is said to display Constant returns to scale (CRS). When a proportional increase in all inputs results in an increase in output by a larger proportion, the production function is said to display Increasing Returns to Scale (IRS) Decreasing Returns to Scale (DRS) holds when
a proportional increase in all inputs results in an increase in output by a smaller proportion. For example, suppose in a production process, all inputs get doubled. As a result, if the output gets doubled, the production function exhibits CRS. If output is less than doubled, then DRS holds, and if it is more than doubled, then IRS holds. Returns to Scale Consider a production function q = f (x1, x2) where the firm produces q amount of output using x1 amount of factor 1 and x2 amount of factor 2. Now suppose the firm decides to increase the employment level of both the factors t (t > 1) times. Mathematically, we 42 2019-20 can say that the production function exhibits constant returns to scale if we have, f (tx1, tx2) = t.f (x1, x2) ie the new output level f (tx1, tx2) is exactly t times the previous output level f (x1, x2). Similarly, the production function exhibits increasing returns to scale if, f (tx1, tx2) > t.f (x1, x2). It exhibits decreasing returns to scale if, f (tx1, tx2) < t.f (x1, x2). 3.7 COSTS In order to produce output, the firm needs to employ inputs. But a given level of output, typically, can be produced in many ways. There can be more than one input combinations with which a firm can produce a desired level of output. In Table 3.1, we can see that 50 units of output can be produced by three different input combinations (L = 6, K = 3), (L = 4, K = 4) and (L = 3, K = 6). The question is which input combination will the firm choose? With the input prices given, it will choose that combination of inputs which is least expensive. So, for every level of output, the firm chooses the least cost input combination. Thus the cost function describes the least cost of producing each level of output given prices of factors of production and technology. Cobb-Douglas Production Function Consider a production function β q = x1 α x2 where α and β are constants. The firm produces q amount of output using x1 amount of factor 1 and x2 amount of factor 2. This is called a 2x, we Cobb-Douglas production function. Suppose with x1 = have q0 units of output,
i.e. 1x α 1x and x2 = 2x β q0 = If we increase both the inputs t (t > 1) times, we get the new output 43 q1 = (t 1x )α (t = t α + β 1x α 2x )β 2x β When α + β = 1, we have q1 = tq0. That is, the output increases t times. So the production function exhibits CRS. Similarly, when α + β > 1, the production function exhibits IRS. When α + β < 1 the production function exhibits DRS. 3.7.1 Short Run Costs We have previously discussed the short run and the long run. In the short run, some of the factors of production cannot be varied, and therefore, remain fixed. The cost that a firm incurs to employ these fixed inputs is called the total fixed cost (TFC). Whatever amount of output the firm 2019-20 produces, this cost remains fixed for the firm. To produce any required level of output, the firm, in the short run, can adjust only variable inputs. Accordingly, the cost that a firm incurs to employ these variable inputs is called the total variable cost (TVC). Adding the fixed and the variable costs, we get the total cost (TC) of a firm TC = TVC + TFC (3.6) In order to increase the production of output, the firm must employ more of the variable inputs. As a result, total variable cost and total cost will increase. Therefore, as output increases, total variable cost and total cost increase. In Table 3.3, we have an example of cost function of a typical firm. The first column shows different levels of output. For all levels of output, the total fixed cost is Rs 20. Total variable cost increases as output increases. With output zero, TVC is zero. For 1 unit of output, TVC is Rs 10; for 2 units of output, TVC is Rs 18 and so on. In the fourth column, we obtain the total cost (TC) as the sum of the corresponding values in second column (TFC) and third column (TVC). At zero level of output, TC is just the fixed cost, and hence, equal to Rs 20. For 1 unit of output, total cost is Rs 30; for 2 units of output, the TC is Rs 38 and so on. The short run average cost (SAC) incurred by the firm
is defined as the total cost per unit of output. We calculate it as SAC = TC q (3.7) In Table 3.3, we get the SAC-column by dividing the values of the fourth column by the corresponding values of the first column. At zero output, SAC is undefined. For the first unit, SAC is Rs 30; for 2 units of output, SAC is Rs 19 and so on. Similarly, the average variable cost (AVC) is defined as the total variable cost per unit of output. We calculate it as 44 Also, average fixed cost (AFC) is AVC = TVC q AFC = TFC q Clearly, SAC = AVC + AFC (3.8) (3.9) (3.10) In Table 3.3, we get the AFC-column by dividing the values of the second column by the corresponding values of the first column. Similarly, we get the AVC-column by dividing the values of the third column by the corresponding values of the first column. At zero level of output, both AFC and AVC are undefined. For the first unit of output, AFC is Rs 20 and AVC is Rs 10. Adding them, we get the SAC equal to Rs 30. The short run marginal cost (SMC) is defined as the change in total cost per unit of change in output SMC = change in total cos change in output t = TC ∆ q ∆ (3.11) where ∆ represents the change in the value of the variable. 2019-20 The last column in table 3.3 gives a numerical example for the calculation of SMC. Values in this column are obtained by dividing the change in TC by the change in output, at each level of output. Thus at q=5, Change in TC = (TC at q=5) - (TC at q=4) (3.12) = (53) – (49) = 4 Change in q = 1 SMC = 4/1 = 4 Table 3.3: Various Concepts of Costs Output (units) (q) TFC (Rs) TVC (Rs 10 20 20 20 20 20 20 20 20 20 20 20 0 10 18 24 29 33 39 47 60 75 95 TC (Rs) 20 30 38 44 49 53 59 67 80 95 115 AFC (Rs) – 20 10 6.67 5 4 3.33 2.86 2.5 2.22 2 AVC (
Rs) – 10 9 8 7.25 6.6 6.5 6.7 7.5 8.33 9.5 SAC (Rs) – 30 19 14.67 12.25 10.6 9.83 9.57 10 10.55 11.5 SMC (Rs) – 10 8 6 5 4 6 8 13 15 20 Just like the case of marginal product, marginal cost also is undefined at zero level of output. It is important to note here that in the short run, fixed cost cannot be changed. When we change the level of output, whatever change occurs to total cost is entirely due to the change in total variable cost. So in the short run, marginal cost is the increase in TVC due to increase in production of one extra unit of output. For any level of output, the sum of marginal costs up to that level gives us the total variable cost at that level. One may wish to check this from the example represented through Table 3.3. Average variable cost at some level of output is therefore, the average of all marginal costs up to that level. In Table 3.3, we see that when the output is zero, SMC is undefined. For the first unit of output, SMC is Rs 10; for the second unit, the SMC is Rs 8 and so on. Costs TVC TC c3 c2 c1 TFC Shapes of the Short Run Cost Curves Now let us see what these short run cost curves look like. You could plot the data from in table 3.3 by placing output on the x-axis and costs on the y-axis. O Fig. 3.3 q1 Otput Costs. These are total fixed cost (TFC), total variable cost (TVC) and total cost (TC) curves for a firm. Total cost is the vertical sum of total fixed cost and total variable cost. 45 2019-20 Previously, we have discussed that in order to increase the production of output the firm needs to employ more of the variable inputs. This results in an increase in total variable cost, and hence, an increase in total cost. Therefore, as output increases, total variable cost and total cost increase. Total fixed cost, however, is independent of the amount of output produced and remains constant for all levels of production. Cost F C O q1 AFC Output Fig. 3.4 Figure 3.3 illustrates the shapes of total fixed cost, total variable cost and total cost curves for a typical firm. We place
output on the x-axis and costs on the y-axis. TFC is a constant which takes the value c1 and does not change with the change in output. It is, therefore, a horizontal straight line cutting the cost axis at the point c1. At q1, TVC is c2 and TC is c3. Average Fixed Cost. The average fixed cost curve is a rectangular hyperbola. The area of the rectangle OFCq1 gives us the total fixed cost. AFC is the ratio of TFC to q. TFC is a constant. Therefore, as q increases, AFC decreases. When output is very close to zero, AFC is arbitrarily large, and as output moves towards infinity, AFC moves towards zero. AFC curve is, in fact, a rectangular hyperbola. If we multiply any value q of output with its corresponding AFC, we always get a constant, namely TFC. 46 Figure 3.4 shows the shape of average fixed cost curve for a typical firm. We measure output along the horizontal axis and AFC along the vertical axis. At q1 level of output, we get the corresponding average fixed cost at F. The TFC can be calculated as TFC = AFC × quantity = OF × Oq1 = the area of the rectangle OFCq1 We can also calculate AFC from TFC curve. In Figure 3.5, the horizontal straight line cutting the vertical axis at F is the TFC curve. At q0 level of output, total fixed cost is equal to OF. At q0, the corresponding point on the TFC curve is A. Let the angle ∠AOq0 be θ. The AFC at q0 is TFC quantity AFC = Cost F O Fig. 3.5 A q0 TFC Output = 0 Aq Oq = tanθ 0 The Total Fixed Cost Curve. The slope of the angle ∠AOq0 gives us the average fixed cost at q0. 2019-20 Let us now look at the SMC curve. Marginal cost is the additional cost that a firm incurs to produce one extra unit of output. According to the law of variable proportions, initially, the marginal product of a factor increases as employment increases, and then after a certain point, it decreases. This means initially to produce every extra unit of output, the requirement of the factor becomes less and less, and then after a certain point, it becomes greater and greater. As a result, with the factor price given,
initially the SMC falls, and then after a certain point, it rises. SMC curve is, therefore, ‘U’-shaped. Cost V O Fig. 3.6 B q0 AVC Output The Average Variable Cost Curve. The area of the rectangle OVBq0 gives us the total variable cost at q0. At zero level of output, SMC is undefined. The TVC at a particular level of output is given by the area under the SMC curve up to that level. Now, what does the AVC curve look like? For the first unit of output, it is easy to check that SMC and AVC are the same. So both SMC and AVC curves start from the same point. Then, as output increases, SMC falls. AVC being the average of marginal costs, also falls, but falls less than SMC. Then, after a point, SMC starts rising. AVC, however, continues to fall as long as the value of SMC remains less than the prevailing value of AVC. Once the SMC has risen sufficiently, its value becomes greater than the value of AVC. The AVC then starts rising. The AVC curve is therefore ‘U’-shaped. As long as AVC is falling, SMC must be less than the AVC. As AVC rises, SMC must be greater than the AVC. So the SMC curve cuts the AVC curve from below at the minimum point of AVC. In Figure 3.7, we measure output along the horizontal axis and TVC along the vertical axis. At q0 level of output, OV is the total variable cost. Let the angle ∠E0q0 be equal to θ. Then, at q0, the AVC can be calculated as AV C = = TVC output Eq Oq = tan θ 0 0 Cost V O Fig. 3.7 TVC Output E q0 The Total Variable Cost Curve. The slope of the angle ∠EOqo gives us the average variable cost at qo. 47 2019-20 In Figure 3.6 we measure output along the horizontal axis and AVC along the vertical axis. At q0 level of output, AVC is equal to OV. The total variable cost at q0 is TVC = AVC × quantity = OV × Oq0 = the area of the rectangle OV Bq0. Let us now look at S
AC. SAC is the sum of AVC and AFC. Initially, both AVC and AFC decrease as output increases. Therefore, SAC initially falls. After a certain level of output production, AVC starts rising, but AFC continuous to fall. Initially the fall in AFC is greater than the rise in AVC and SAC is still falling. But, after a certain level of production, rise in AVC becomes larger than the fall in AFC. From this point onwards, SAC is rising. SAC curve is therefore ‘U’-shaped. It lies above the AVC curve with the vertical difference being equal to the value of AFC. The minimum point of SAC curve lies to the right of the minimum point of AVC curve. Similar to the case of AVC and SMC, as long as SAC is falling, SMC is less than the SAC. When SAC is rising, SMC is greater than the SAC. SMC curve cuts the SAC curve from below at the minimum point of SAC. Figure 3.8 shows the shapes of short run marginal cost, average variable cost and short run average cost curves for a typical firm. AVC reaches its minimum at q1 units of output. To the left of q1, AVC is falling and SMC is less than AVC. To the right of q1, AVC is rising and SMC is greater than AVC. SMC curve cuts the AVC curve at ‘P ’ which is the minimum point of AVC curve. The minimum point of SAC curve is ‘S ’ which corresponds to the output q2. It is the intersection point between SMC and SAC curves. To the left of q2, SAC is falling and SMC is less than SAC. To the right of q2, SAC is rising and SMC is greater than SAC. Cost SMC SAC AVC S P O Fig. 3.8 q1 q2 Output Short Run Costs. Short run marginal cost, average variable cost and average cost curves. 3.7.2 Long Run Costs In the long run, all inputs are variable. There are no fixed costs. The total cost and the total variable cost therefore, coincide in the long run. Long run average cost (LRAC) is defined as cost per unit of output, i.e. LRAC = TC q (3.13) Long run marginal cost (LRMC) is the change
in total cost per unit of change in output. When output changes in discrete units, then, if we increase production th unit will be from q1–1 to q1 units of output, the marginal cost of producing q1 measured as LRMC = (TC at q1 units) – (TC at q1 – 1 units) (3.14) 48 2019-20 Just like the short run, in the long run, the sum of all marginal costs up to some output level gives us the total cost at that level. Shapes of the Long Run Cost Curves We have previously discussed the returns to scales. Now let us see their implications for the shape of LRAC. IRS implies that if we increase all the inputs by a certain proportion, output increases by more than that proportion. In other words, to increase output by a certain proportion, inputs need to be increased by less than that proportion. With the input prices given, cost also increases by a lesser proportion. For example, suppose we want to double the output. To do that, inputs need to be increased, but less than double. The cost that the firm incurs to hire those inputs therefore also need to be increased by less than double. What is happening to the average cost here? It must be the case that as long as IRS operates, average cost falls as the firm increases output. DRS implies that if we want to increase the output by a certain proportion, inputs need to be increased by more than that proportion. As a result, cost also increases by more than that proportion. So, as long as DRS operates, the average cost must be rising as the firm increases output. CRS implies a proportional increase in inputs resulting in a proportional increase in output. So the average cost remains constant as long as CRS operates. It is argued that in a typical firm IRS is observed at the initial level of production. This is then followed by the CRS and then by the DRS. Accordingly, the LRAC curve is a ‘U’-shaped curve. Its downward sloping part corresponds to IRS and upward rising part corresponds to DRS. At the minimum point of the LRAC curve, CRS is observed. Let us check how the LRMC curve looks like. For the first unit of output, both LRMC and LRAC are the same. Then, as output increases, LRAC initially falls, and then, after a certain point, it rises. As long as average cost is falling, marginal cost must be
less than the average cost. When the average cost is rising, marginal cost must be greater than the average cost. LRMC curve is therefore a ‘U’-shaped curve. It cuts the LRAC curve from below at the minimum point of the LRAC. Figure 3.9 shows the shapes of the long run marginal cost and the long run average cost curves for a typical firm. LRMC Cost LRAC M LRAC reaches its minimum at q1. To the left of q1, LRAC is falling and LRMC is less than the LRAC curve. To the right of q1, LRAC is rising and LRMC is higher than LRAC. O Fig. 3.9 q1 Output Long Run Costs. Long run marginal cost and average cost curves. 49 2019-20 quantity of output that can be produced. y y y • For different combinations of inputs, the production function shows the maximum • In the short run, some inputs cannot be varied. In the long run, all inputs can be • Total product is the relationship between a variable input and output when all varied. other inputs are held constant. • For any level of employment of an input, the sum of marginal products of every unit of that input up to that level gives the total product of that input at that employment level. • Both the marginal product and the average product curves are inverse ‘U’-shaped. The marginal product curve cuts the average product curve from above at the maximum point of average product curve. • In order to produce output, the firm chooses least cost input combinations. • Total cost is the sum of total variable cost and the total fixed cost. • Average cost is the sum of average variable cost and average fixed cost. • Average fixed cost curve is downward sloping. • Short run marginal cost, average variable cost and short run average cost curves are ‘U’-shaped. • SMC curve cuts the AVC curve from below at the minimum point of AVC. • SMC curve cuts the SAC curve from below at the minimum point of SAC. • In the short run, for any level of output, sum of marginal costs up to that level gives us the total variable cost. The area under the SMC curve up to any level of output gives us the total variable cost up to that level. • Both LRAC and LRMC curves are ‘U’ shaped. • LRMC curve cuts the LRAC curve from below at the minimum point of LRAC.
50 Production function Long run Marginal product Law of diminishing marginal product KKKKK Cost function Short run Total product Average product Law of variable proportions Returns to scale Marginal cost, Average cost. Explain the concept of a production function. 2. What is the total product of an input? 3. What is the average product of an input? 4. What is the marginal product of an input? 5. Explain the relationship between the marginal products and the total product of an input. 6. Explain the concepts of the short run and the long run. 7. What is the law of diminishing marginal product? 8. What is the law of variable proportions? 9. When does a production function satisfy constant returns to scale? 10. When does a production function satisfy increasing returns to scale? 2019-20 11. When does a production function satisfy decreasing returns to scale? 12. Briefly explain the concept of the cost function. 13. What are the total fixed cost, total variable cost and total cost of a firm? How are they related? 14. What are the average fixed cost, average variable cost and average cost of a firm? How are they related? 15. Can there be some fixed cost in the long run? If not, why? 16. What does the average fixed cost curve look like? Why does it look so? 17. What do the short run marginal cost, average variable cost and short run average cost curves look like? 18. Why does the SMC curve cut the AVC curve at the minimum point of the AVC curve? 19. At which point does the SMC curve cut the SAC curve? Give reason in support of your answer. 20. Why is the short run marginal cost curve ‘U’-shaped? 21. What do the long run marginal cost and the average cost curves look like? 22. The following table gives the total product schedule of labour. Find the corresponding average product and marginal product schedules of labour. 23. The following table gives the average product schedule of labour. Find the total product and marginal product schedules. It is given that the total product is zero at zero level of labour employment. 24. The following table gives the marginal product schedule of labour. It is also given that total product of labour is zero at zero level of employment. Calculate the total and average product schedules of labour. 25. The following table shows the total cost schedule of a firm. What is the total fixed cost schedule of this firm? Calculate the TVC, AFC, AVC
, SAC and SMC schedules of the firm TPL 0 15 35 50 40 48 APL 2 3 4 4.25 4 3.5 MPL 3 5 7 5 3 1 TC 10 30 45 55 70 90 120 51 2019-20 26. The following table gives the total cost schedule of a firm. It is also given that the average fixed cost at 4 units of output is Rs 5. Find the TVC, TFC, AVC, AFC, SAC and SMC schedules of the firm for the corresponding values of output. 27. A firm’s SMC schedule is shown in the following table. The total fixed cost of the firm is Rs 100. Find the TVC, TC, AVC and SAC schedules of the firm TC 50 65 75 95 130 185 TC 500 300 200 300 500 800 28. Let the production function of a firm be Q = 5 1 L K 2 1 2 Find out the maximum possible output that the firm can produce with 100 units of L and 100 units of K. 29. Let the production function of a firm be Q = 2L2K2 Find out the maximum possible output that the firm can produce with 5 units of L and 2 units of K. What is the maximum possible output that the firm can produce with zero unit of L and 10 units of K? 30. Find out the maximum possible output for a firm with zero unit of L and 10 units of K when its production function is Q = 5L + 2K 52 2019-20 Chapter 4 y of the Firmirmirmirmirm y of the F y of the F The Theor The Theor The Theory of the F y of the F The Theor The Theor under Perererererfect Competition fect Competition fect Competition under P under P fect Competition fect Competition under P under P In the previous chapter, we studied concepts related to a firm’s production function and cost curves. The focus of this chapter is different. Here we ask : how does a firm decide how much to produce? Our answer to this question is by no means simple or uncontroversial. We base our answer on a critical, if somewhat unreasonable, assumption about firm behaviour – a firm, we maintain, is a ruthless profit maximiser. So, the amount that a firm produces and sells in the market is that which maximises its profit. Here, we also assume that the firm sells whatever it produces so that ‘output’ and quantity sold are often used interchangebly. The
structure of this chapter is as follows. We first set up and examine in detail the profit maximisation problem of a firm. Then,0 we derive a firm’s supply curve. The supply curve shows the levels of output that a firm chooses to produce at different market prices. Finally, we study how to aggregate the supply curves of individual firms and obtain the market supply curve. 4.1 PERFECT COMPETITION: DEFINING FEATURES In order to analyse a firm’s profit maximisation problem, we must first specify the market environment in which the firm functions. In this chapter, we study a market environment called perfect competition. A perfectly competitive market has the following defining features: 1. The market consists of a large number of buyers and sellers 2. Each firm produces and sells a homogenous product. i.e., the product of one firm cannot be differentiated from the product of any other firm. 3. Entry into the market as well as exit from the market are free 4. for firms. Information is perfect. The existence of a large number of buyers and sellers means that each individual buyer and seller is very small compared to the size of the market. This means that no individual buyer or seller can influence the market by their size. Homogenous products further mean that the product of each firm is identical. So a buyer can choose to buy from any firm in the market, and she gets the same product. Free entry and exit mean that it is easy for firms to enter the market, as well as to leave it. This condition is essential 2019-20 for the large numbers of firms to exist. If entry was difficult, or restricted, then the number of firms in the market could be small. Perfect information implies that all buyers and all sellers are completely informed about the price, quality and other relevant details about the product, as well as the market. These features result in the single most distinguishing characteristic of perfect competition: price taking behaviour. From the viewpoint of a firm, what does price-taking entail? A price-taking firm believes that if it sets a price above the market price, it will be unable to sell any quantity of the good that it produces. On the other hand, should the set price be less than or equal to the market price, the firm can sell as many units of the good as it wants to sell. From the viewpoint of a buyer, what does price-taking entail? A buyer would obviously like to buy the good at the lowest possible price. However, a
price-taking buyer believes that if she asks for a price below the market price, no firm will be willing to sell to her. On the other hand, should the price asked be greater than or equal to the market price, the buyer can obtain as many units of the good as she desires to buy. Price-taking is often thought to be a reasonable assumption when the market has many firms and buyers have perfect information about the price prevailing in the market. Why? Let us start with a situation where each firm in the market charges the same (market) price. Suppose, now, that a certain firm raises its price above the market price. Observe that since all firms produce the same good and all buyers are aware of the market price, the firm in question loses all its buyers. Furthermore, as these buyers switch their purchases to other firms, no “adjustment” problems arise; their demand is readily accommodated when there are so many other firms in the market. Recall, now, that an individual firm’s inability to sell any amount of the good at a price exceeding the market price is precisely what the price-taking assumption stipulates. 4.2 REVENUE We have indicated that in a perfectly competitive market, a firm believes that it can sell as many units of the good as it wants by setting a price less than or equal to the market price. But, if this is the case, surely there is no reason to set a price lower than the market price. In other words, should the firm desire to sell some amount of the good, the price that it sets is exactly equal to the market price. A firm earns revenue by selling the good that it produces in the market. Let the market price of a unit of the good be p. Let q be the quantity of the good produced, and therefore sold, by the firm at price p. Then, total revenue (TR) of the firm is defined as the market price of the good (p) multiplied by the firm’s output (q). Hence, TR = p × q 54 To make matters concrete, consider the following numerical example. Let the market for candles be perfectly competitive and let the market price of a box of candles be Rs 10. For a candle manufacturer, Table 4.1 shows how total revenue is related to output. Notice that when no box is sold, TR is equal to zero; if one box of candles is sold, TR is equal to 1×Rs 10= Rs 10; if two boxes of
candles are produced, TR is equal to 2 × Rs 10 = Rs 20; and so on. Table 4.1: Total Revenue Boxes sold TR (in Rs) 0 1 2 3 4 5 0 10 20 30 40 50 We can depict how the total revenue changes as the quantity sold changes through a Total Revenue Curve. A total revenue curve plots 2019-20 the quantity sold or output on the X-axis and the Revenue earned on the Y-axis. Figure 4.1 shows the total revenue curve of a firm. Three observations are relevant here. First, when the output is zero, the total revenue of the firm is also zero. Therefore, the TR curve passes through point O. Second, the total revenue increases as the output goes up. Moreover, the equation ‘TR = p × q’ is that of a straight line because p is constant. This means that the TR curve is an upward rising straight line. Third, consider the slope of this straight line. When the output is one unit (horizontal distance Oq1 in Figure 4.1), the total revenue (vertical height Aq1 in Figure 4.1) is p × 1 = p. Therefore, the slope of the straight line is Aq1/Oq1 = p. The average revenue ( AR ) of a firm is defined as total revenue per unit of output. Recall that if a firm’s output is q and the market price is p, then TR equals p × q. Hence AR = p TR q = × q q = p In other words, for a price-taking firm, average revenue equals the market price. Revenue O Fig. 4.1 TR Output A q1 Total Revenue curve. The total revenue curve of a firm shows the relationship between the total revenue that the firm earns and the output level of the firm. The slope of the curve, Aq1/Oq1, is the market price. Price p O Fig. 4.2 Price Line Output Price Line. The price line shows the relationship between the market price and a firm’s output level. The vertical height of the price line is equal to the market price, p. Now consider Figure 4.2. Here, we plot the average revenue or market price (y-axis) for different values of a firm’s output (x-axis). Since the market price is fixed at p, we obtain a horizontal straight line that cuts the y-axis at a height equal to p. This
horizontal straight line is called the price line. It is also the firm’s AR curve under perfect competition The price line also depicts the demand curve facing a firm. Observe that the demand curve is perfectly elastic. This means that a firm can sell as many units of the good as it wants to sell at price p. The marginal revenue (MR) of a firm is defined as the increase in total revenue for a unit increase in the firm’s output. Consider table 4.1 again. Total revenue from the sale of 2 boxes of candles is Rs.20. Total revenue from the sale of 3 boxes of candles is Rs.30. Marginal Revenue (MR) = Change in total revenue Changein quantity = 30 - 20 3 - 2 = 10 55 2019-20 Is it a coincidence that this is the same as the price? Actually it is not. Consider the situation when the firm’s output changes from q1 to q2. Given the market price p, MR = (pq2 –pq1)/ (q2 –q1) = [p (q2 –q1)]/ (q2 –q1) = p Thus, for the perfectly competitive firm, MR=AR=p In other words, for a price-taking firm, marginal revenue equals the market price. Setting the algebra aside, the intuition for this result is quite simple. When a firm increases its output by one unit, this extra unit is sold at the market price. Hence, the firm’s increase in total revenue from the one-unit output expansion – that is, MR – is precisely the market price. 4.3 PROFIT MAXIMISATION A firm produces and sells a certain amount of a good. The firm’s profit, denoted by π 1, is defined to be the difference between its total revenue (TR) and its total cost of production (TC ). In other words π = TR – TC Clearly, the gap between TR and TC is the firm’s earnings net of costs. A firm wishes to maximise its profit. The firm would like to identify the quantity q0 at which its profits are maximum. By definition, then, at any quantity other than q0, the firm’s profits are less than at q0. The critical question is: how do we identify q0? For profits to be maximum, three conditions must hold at q0: 1. The price, p, must equal MC 2. Marg
inal cost must be non-decreasing at q0 3. For the firm to continue to produce, in the short run, price must be greater than the average variable cost (p > AVC); in the long run, price must be greater than the average cost (p > AC). 4.3.1 Condition 1 Profits are the difference between total revenue and total cost. Both total revenue and total cost increase as output increases. Notice that as long as the change in total revenue is greater than the change in total cost, profits will continue to increase. Recall that change in total revenue per unit increase in output is the marginal revenue; and the change in total cost per unit increase in output is the marginal cost. Therefore, we can conclude that as long as marginal revenue is greater than marginal cost, profits are increasing. By the same logic, as long as marginal revenue is less than marginal cost, profits will fall. It follows that for profits to be maximum, marginal revenue should equal marginal cost. In other words, profits are maximum at the level of output (which we have called q0) for which MR = MC For the perfectly competitive firm, we have established that the MR = P. So the firm’s profit maximizing output becomes the level of output at which P=MC. 4.3.2 Condition 2 Consider the second condition that must hold when the profit-maximising output level is positive. Why is it the case that the marginal cost curve cannot slope 1It is a convention in economics to denote profit with the Greek letter π. 56 2019-20 downwards at the profitmaximising output level? To answer this question, refer once again to Figure 4.3. Note that at output levels q1 and q4, the market price is equal to the marginal cost. However, at the output level q1, the marginal cost curve is downward sloping. We claim that q1 cannot be a profit-maximising output level. Why? Observe that for all output levels slightly to the left of q1, the market price is lower than the marginal cost. But, the argument outlined in section 3.1 immediately implies that the firm’s profit at an output level slightly smaller than q1 exceeds that corresponding to the output level q1. This being the case, q1 cannot be a profit-maximising output level. Conditions 1 and 2 for profit maximisation. The figure is used to demonstrate that when the market price is p, the output level
of a profitmaximising firm cannot be q1 (marginal cost curve, MC, is downward sloping), q2 and q3 (market price exceeds marginal cost), or q5 and q6 (marginal cost exceeds market price). 4.3.3 Condition 3 Consider the third condition that must hold when the profitmaximising output level is positive. Notice that the third condition has two parts: one part applies in the short run while the other applies in the long run. Case 1: Price must be greater than or equal to AVC in the short run We will show that the statement of Case 1 (see above) is true by arguing that a profitmaximising firm, in the short run, will not produce at an output level wherein the market price is lower than the AVC. Price, costs E p O Fig. 4.4 SMC SAC AVC Output B A q1 Price-AVC Relationship with Profit Maximisation (Short Run). The figure is used to demonstrate that a profit-maximising firm produces zero output in the short run when the market price, p, is less than the minimum of its average variable cost (AVC). If the firm’s output level is q1, the firm’s total variable cost exceeds its revenue by an amount equal to the area of rectangle pEBA. Let us turn to Figure 4.4. Observe that at the output level q1, the market price p is lower than the AVC. We claim that q1 cannot be a profit-maximising output level. Why? Notice that the firm’s total revenue at q1 is as follows TR = Price × Quantity = Vertical height Op × width Oq1 = The area of rectangle OpAq1 57 2019-20 Similarly, the firm’s total variable cost at q1 is as follows TVC = Average variable cost × Quantity = Vertical height OE × Width Oq1 = The area of rectangle OEBq1 Now recall that the firm’s profit at q1 is TR – (TVC + TFC); that is, [the area of rectangle OpAq1] – [the area of rectangle OEBq1] – TFC. What happens if the firm produces zero output? Since output is zero, TR and TVC are zero as well. Hence, the firm’s profit at zero output is equal to – TFC. But, the area of rectangle Op
Aq1 is strictly less than the area of rectangle OEBq1. Hence, the firm’s profit at q1 is [(area EBAp)-TFC], which is strictly less than what it obtains by not producing at all. So, the firm will choose not to produce at all, and exit from the market. Price, costs LRMC 58 Case 2: Price must be greater than or equal to AC in the long run We will show that the statement of Case 2 (see above) is true by arguing that a profit-maximising firm, in the long run, will not produce at an output level wherein the market price is lower than the AC. Let us turn to Figure 4.5. Observe that at the output level q1, the market price p is lower than the (long run) AC. We claim that q1 cannot be a profit-maximising output level. Why? Notice that the firm’s total revenue, TR, at q1 is the area of the rectangle OpAq1 (the product of price and quantity) while the firm’s total cost, TC, is the area of the rectangle OEBq1 (the product of average cost and quantity). Since the area of rectangle OEBq1 is larger than the area of rectangle OpAq1, the firm incurs a loss at the output level q1. But, in the long run set-up, a firm that shuts down production has a profit of zero. Again, the firm chooses to exit in this case. 4.3.4 The Profit Maximisation Problem: Graphical Representation Using the material in sections 3.1, 3.2 and 3.3, let us graphically firm’s profit represent a E p O Fig. 4.5 B A q1 LRAC Output Price-AC Relationship with Profit Maximisation (Long Run). The figure is used to demonstrate that a profit-maximising firm produces zero output in the long run when the market price, p, is less than the minimum of its long run average cost (LRAC). If the firm’s output level is q1, the firm’s total cost exceeds its revenue by an amount equal to the area of rectangle pEBA. Geometric Representation of Profit Maximisation (Short Run). Given market price p, the output level of a profit-maximising firm is q0. At q0, the firm’s profit
is equal to the area of rectangle EpAB. 2019-20 maximisation problem in the short run. Consider Figure 4.6. Notice that the market price is p. Equating the market price with the (short run) marginal cost, we obtain the output level q0. At q0, observe that SMC slopes upwards and p exceeds AVC. Since the three conditions discussed in sections 3.1-3.3 are satisfied at q0, we maintain that the profit-maximising output level of the firm is q0. What happens at q0? The total revenue of the firm at q0 is the area of rectangle OpAq0 (the product of price and quantity) while the total cost at q0 is the area of rectangle OEBq0 (the product of short run average cost and quantity). So, at q0, the firm earns a profit equal to the area of the rectangle EpAB. 4.4 SUPPLY CURVE OF A FIRM A firm’s ‘supply’ is the quantity that it chooses to sell at a given price, given technology, and given the prices of factors of production. A table describing the quantities sold by a firm at various prices, technology and prices of factors remaining unchanged, is called a supply schedule. We may also represent the information as a graph, called a supply curve. The supply curve of a firm shows the levels of output (plotted on the x-axis) that the firm chooses to produce corresponding to different values of the market price (plotted on the y-axis), again keeping technology and prices of factors of production unchanged. We distinguish between the short run supply curve and the long run supply curve. 4.4.1 Short Run Supply Curve of a Firm Let us turn to Figure 4.7 and derive a firm’s short run supply curve. We shall split this derivation into two parts. We first determine a firm’s profit-maximising output level when the market price is greater than or equal to the minimum AVC. This done, we determine the firm’s profit-maximising output level when the market price is less than the minimum AVC. Case 1: Price is greater than or equal to the minimum AVC Suppose the market price is p1, which exceeds the minimum AVC. We start out by equating p1 with SMC on the rising part of the SMC curve; this leads to the output level q1.
Note also that the AVC at q1 does not exceed the market price, p1. Thus, all three conditions highlighted in section 3 are satisfied at q1. Hence, when the market price is p1, the firm’s output level in the short run is equal to q1. Case 2: Price is less than the minimum AVC Suppose the market price is p2, which is less than the minimum AVC. We have argued (see Price, costs p1 p2 O Fig. 4.7 SMC SAC AVC q1 Output Market Price Values. The figure shows the output levels chosen by a profit-maximising firm in the short run for two values of the market price: p1 and p2. When the market price is p1, the output level of the firm is q1; when the market price is p2, the firm produces zero output. 59 2019-20 condition 3 in section 3) that if a profit-maximising firm produces a positive output in the short run, then the market price, p2, must be greater than or equal to the AVC at that output level. But notice from Figure 4.7 that for all positive output levels, AVC strictly exceeds p2. In other words, it cannot be the case that the firm supplies a positive output. So, if the market price is p2, the firm produces zero output. Price, costs O Fig. 4.8 Supply Curve (SMC) SAC AVC Output Combining cases 1 and 2, we reach an important conclusion. A firm’s short run supply curve is the rising part of the SMC curve from and above the minimum AVC together with zero output for all prices strictly less than the minimum AVC. In figure 4.8, the bold line represents the short run supply curve of the firm. The Short Run Supply Curve of a Firm. The short run supply curve of a firm, which is based on its short run marginal cost curve (SMC) and average variable cost curve (AVC), is represented by the bold line. 4.4.2 Long Run Supply Curve of a Firm Let us turn to Figure 4.9 and derive the firm’s long run supply curve. As in the short run case, we split the derivation into two parts. We first determine the firm’s profit-maximising output level when the market price is greater than or equal to the minimum (long run) AC.
This done, we determine the firm’s profitmaximising output level when the market price is less than the minimum (long run) AC. Price, costs p1 p2 O Fig. 4.9 60 LRMC LRAC q1 Output Profit maximisation in the Long Run for Different Market Price Values. The figure shows the output levels chosen by a profitmaximising firm in the long run for two values of the market price: p1 and p2. When the market price is p1, the output level of the firm is q1; when the market price is p2, the firm produces zero output. Case 1: Price greater than or equal to the minimum LRAC Suppose the market price is p1, which exceeds the minimum LRAC. Upon equating p1 with LRMC on the rising part of the LRMC curve, we obtain output level q1. Note also that the LRAC at q1 does not exceed the market price, p1. Thus, all three conditions highlighted in section 3 are satisfied at q1. Hence, when the market price is p1, the firm’s supplies in the long run become an output equal to q1. Case 2: Price less than the minimum LRAC Suppose the market price is p2, which is less than the minimum LRAC. We have 2019-20 LRAC Price, costs Supply Curve(LRMC) argued (see condition 3 in section 3) that if a profit-maximising firm produces a positive output in the long run, the market price, p2, must be greater than or equal to the LRAC at that output level. But notice from Figure 4.9 that for all positive output levels, LRAC strictly exceeds p2. In other words, it cannot be the case that the firm supplies a positive output. So, when the market price is p2, the firm produces zero output. Combining cases 1 and 2, we reach an important conclusion. A firm’s long run supply curve is the rising part of the LRMC curve from and above the minimum LRAC together with zero output for all prices less than the minimum LRAC. In Figure 4.10, the bold line represents the long run supply curve of the firm. The Long Run Supply Curve of a Firm. The long run supply curve of a firm, which is based on its long run marginal cost curve (LRMC) and long run average cost curve (LRAC), is represented by the bold line
. Fig. 4.10 Output O 4.4.3 The Shut Down Point Previously, while deriving the supply curve, we have discussed that in the short run the firm continues to produce as long as the price remains greater than or equal to the minimum of AVC. Therefore, along the supply curve as we move down, the last price-output combination at which the firm produces positive output is the point of minimum AVC where the SMC curve cuts the AVC curve. Below this, there will be no production. This point is called the short run shut down point of the firm. In the long run, however, the shut down point is the minimum of LRAC curve. 4.4.4 The Normal Profit and Break-even Point The minimum level of profit that is needed to keep a firm in the existing business is defined as normal profit. A firm that does not make normal profits is not going to continue in business. Normal profits are therefore a part of the firm’s total costs. It may be useful to think of them as an opportunity cost for entrepreneurship. Profit that a firm earns over and above the normal profit is called the super-normal profit. In the long run, a firm does not produce if it earns anything less than the normal profit. In the short run, however, it may produce even if the profit is less than this level. The point on the supply curve at which a firm earns only normal profit is called the break-even point of the firm. The point of minimum average cost at which the supply curve cuts the LRAC curve (in short run, SAC curve) is therefore the break-even point of a firm. Opportunity cost In economics, one often encounters the concept of opportunity cost. Opportunity cost of some activity is the gain foregone from the second best activity. Suppose you have Rs 1,000 which you decide to invest in your family business. What is the opportunity cost of your action? If you do not invest 61 2019-20 this money, you can either keep it in the house-safe which will give you zero return or you can deposit it in either bank-1 or bank-2 in which case you get an interest at the rate of 10 per cent or 5 per cent respectively. So the maximum benefit that you may get from other alternative activities is the interest from the bank-1. But this opportunity will no longer be there once you invest the money in your family business. The opportunity cost of investing the money in your family business is therefore
the amount of forgone interest from the bank-1. 4.5 DETERMINANTS OF A FIRM’S SUPPLY CURVE In the previous section, we have seen that a firm’s supply curve is a part of its marginal cost curve. Thus, any factor that affects a firm’s marginal cost curve is of course a determinant of its supply curve. In this section, we discuss two such factors. 4.5.1 Technological Progress Suppose a firm uses two factors of production – say, capital and labour – to produce a certain good. Subsequent to an organisational innovation by the firm, the same levels of capital and labour now produce more units of output. Put differently, to produce a given level of output, the organisational innovation allows the firm to use fewer units of inputs. It is expected that this will lower the firm’s marginal cost at any level of output; that is, there is a rightward (or downward) shift of the MC curve. As the firm’s supply curve is essentially a segment of the MC curve, technological progress shifts the supply curve of the firm to the right. At any given market price, the firm now supplies more units of output. 4.5.2 Input Prices A change in input prices also affects a firm’s supply curve. If the price of an input (say, the wage rate of labour) increases, the cost of production rises. The consequent increase in the firm’s average cost at any level of output is usually accompanied by an increase in the firm’s marginal cost at any level of output; that is, there is a leftward (or upward) shift of the MC curve. This means that the firm’s supply curve shifts to the left: at any given market price, the firm now supplies fewer units of output. Impact of a unit tax on supply A unit tax is a tax that the government imposes per unit sale of output. For example, suppose that the unit tax imposed by the government is Rs 2. Then, if the firm produces and sells 10 units of the good, the total tax that the firm must pay to the government is 10 × Rs 2 = Rs 20. How does the long run supply curve of a firm change when a unit tax is imposed? Let us turn to figure 4.11. Before the unit tax is imposed, LRMC0 and LRAC0 are, respectively, the long run marginal cost curve and the
long run average cost curve of the firm. Now, suppose the government puts in place a unit tax of Rs t. Since the firm must pay an extra Rs t for each unit of the good produced, the firm’s long run average cost and long run marginal cost at any level of output increases by Rs t. In Figure 4.11, LRMC1 and LRAC1 are, respectively, the long run marginal cost curve and the long run average cost curve of the firm upon imposition of the unit tax. 62 2019-20 Recall that the long run supply curve of a firm is the rising part of the LRMC curve from and above the minimum LRAC together with zero output for all prices less than the minimum LRAC. Using this observation in Figure 4.12, it is immediate that S0 and S1 are, respectively, the long run supply curve of the firm before and after the imposition of the unit tax. Notice that the unit tax shifts the firm’s long run supply curve to the left: at any given market price, the firm now supplies fewer units of output. Costs p 0 + t p0 O LRMC1 LRAC1 LRMC0 LRAC0 Output Price p 0 + t p0 O t q0 Fig. 4.11 Fig. 4.12 S1 S0 q0 Output Cost Curves and the Unit Tax. LRAC0 and LRMC0 are, respectively, the long run average cost curve and the long run marginal cost curve of a firm before a unit tax is imposed. LRAC1 and LRMC1 are, respectively, the long run average cost curve and the long run marginal cost curve of a firm after a unit tax of Rs t is imposed. 4.6 MARKET SUPPLY CURVE Supply Curves and Unit Tax. S0 is the supply curve of a firm before a unit tax is imposed. After a unit tax of Rs t is imposed, S1 represents the supply curve of the firm. The market supply curve shows the output levels (plotted on the x-axis) that firms in the market produce in aggregate corresponding to different values of the market price (plotted on the y-axis). How is the market supply curve derived? Consider a market with n firms: firm 1, firm 2, firm 3, and so on. Suppose the market price is fixed at p. Then, the output produced by the n firms in aggregate is [supply of firm 1 at price p] + [supply of
firm 2 at price p] +... + [supply of firm n at price p]. In other words, the market supply at price p is the summation of the supplies of individual firms at that price. 63 Let us now construct the market supply curve geometrically with just two firms in the market: firm 1 and firm 2. The two firms have different cost structures. 1p while firm 2 2p. Assume also that Firm 1 will not produce anything if the market price is less than will not produce anything if the market price is less than 2p is greater than 1p. In panel (a) of Figure 4.13 we have the supply curve of firm 1, denoted by S1; in panel (b), we have the supply curve of firm 2, denoted by S2. Panel (c) of Figure 4.13 shows the market supply curve, denoted by Sm. When the market 1p, both firms choose not to produce any amount of the price is strictly below good; hence, market supply will also be zero for all such prices. For a market 2019-20 price greater than or equal to 1p but strictly less than 2p, only firm 1 will produce a positive amount of the good. Therefore, in this range, the market supply curve coincides with the supply curve of firm 1. For a market price greater than or 2p, both firms will have positive output levels. For example, consider a equal to situation wherein the market price assumes the value p3 (observe that p3 2p ). Given p3, firm 1 supplies q3 units of output while firm 2 supplies q4 exceeds units of output. So, the market supply at price p3 is q5, where q5 = q3 + q4. Notice how the market supply curve, Sm, in panel (c) is being constructed: we obtain Sm by taking a horizontal summation of the supply curves of the two firms in the market, S1 and S2. Price p3 p2 p1 O Fig. 4.13 S1 S2 Sm q3 (a) O q4 (b) O q5 Output (c) The Market Supply Curve Panel. (a) shows the supply curve of firm 1. Panel (b) shows the supply curve of firm 2. Panel (c) shows the market supply curve, which is obtained by taking a horizontal summation of the supply curves of the two firms. It should be noted that the market supply
curve has been derived for a fixed number of firms in the market. As the number of firms changes, the market supply curve shifts as well. Specifically, if the number of firms in the market increases (decreases), the market supply curve shifts to the right (left). We now supplement the graphical analysis given above with a related numerical example. Consider a market with two firms: firm 1 and firm 2. Let the supply curve of firm 1 be as follows S1(p) =  0  p  : – 10 : p p < ≥ 10 10 Notice that S1(p) indicates that (1) firm 1 produces an output of 0 if the market price, p, is strictly less than 10, and (2) firm 1 produces an output of (p – 10) if the market price, p, is greater than or equal to 10. Let the supply curve of firm 2 be as follows S2(p) =  0  p  : – 15 : p p < ≥ 15 15 The interpretation of S2(p) is identical to that of S1(p), and is, hence, omitted. Now, the market supply curve, Sm(p), simply sums up the supply curves of the two firms; in other words Sm(p) = S1(p) + S2(p) 64 2019-20 But, this means that Sm(p) is as follows Sm(p) =  0  p   p (  – 10 – 10) + ( p – 15) = : : 2 – 25 : p p p p < ≥ ≥ 10 10 15 and p < 15 4.7 PRICE ELASTICITY OF SUPPLY The price elasticity of supply of a good measures the responsiveness of quantity supplied to changes in the price of the good. More specifically, the price elasticity of supply, denoted by eS, is defined as follows Price elasticity of supply, eS = Percentage change in quantity supplied Percentage change in price = ∆ Q Q ∆ P P × 100 × 100 = ∆ Q P × ∆ P Q Where Q∆ is the change in quantity of the good supplied to the market as market price changes by P∆. To make matters concrete, consider the following numerical example. Suppose the market for cricket balls is perfectly competitive. When the price of a cricket ball is Rs
10, let us assume that 200 cricket balls are produced in aggregate by the firms in the market. When the price of a cricket ball rises to Rs 30, let us assume that 1,000 cricket balls are produced in aggregate by the firms in the market. The percentage change in quantity supplied and market price can be estimated using the information summarised in the table below: Price of Cricket balls (P) Old price : P1 = 10 New price : P2 = 30 Quantity of Cricket balls produced and sold (Q) Old quantity : Q1 = 200 New quantity: Q2 = 1000 Percentage change in quantity supplied= ∆ Q Q 1 × 100 = = − Q Q 2 1 Q 1 × 100 − 1000 200 200 × 100 = 400 Percentage change in market price = ∆ P P 1 × 100 65 2019-20 = = P 2 − P 1 P 1 − 30 10 10 × 100 × 100 Therefore, price elasticity of supply, eS = 400 200 = 2 = 200 When the supply curve is vertical, supply is completely insensitive to price and the elasticity of supply is zero. In other cases, when supply curve is positively sloped, with a rise in price, supply rises and hence, the elasticity of supply is positive. Like the price elasticity of demand, the price elasticity of supply is also independent of units. The Geometric Method Consider the Figure 4.14. Panel (a) shows a straight line supply curve. S is a point on the supply curve. It cuts the price-axis at its positive range and as we extend the straight line, it cuts the quantity-axis at M which is at its negative range. The price elasticity of this supply curve at the point S is given by the ratio, Mq0/Oq0. For any point S on such a supply curve, we see that Mq0 > Oq0. The elasticity at any point on such a supply curve, therefore, will be greater than 1. In panel (c) we consider a straight line supply curve and S is a point on it. It cuts the quantity-axis at M which is at its positive range. Again the price elasticity of this supply curve at the point S is given by the ratio, Mq0/Oq0. Now, Mq0 < Oq0 and hence, eS < 1. S can be any point on the supply curve, and therefore at all points on such a supply curve eS < 1. Now
we come to panel (b). Here the supply curve goes through the origin. One can imagine that the point M has coincided with the origin here, i.e., Mq0 has become equal to Oq0. The price elasticity of this supply curve at the point S is given by the ratio, Oq0/Oq0 which is equal to 1. At any point on a straight line, supply curve going through the origin price elasticity will be one. Price Price Price p0 S p0 S p0 S M O Fig. 4.14 q0 (a) Output O q0 Output O M q0 Output (b) (c) Price Elasticity Associated with Straight Line Supply Curves. In panel (a), price elasticity (eS) at S is greater than 1. In panel (b), price elasticity (eS) at S is equal to 1. In panel (c), price elasticity (eS) at S is less than 1. 66 2019-20 • In a perfectly competitive market, firms are price-takers. • The total revenue of a firm is the market price of the good multiplied by the firm’s output of the good. • For a price-taking firm, average revenue is equal to market price. • For a price-taking firm, marginal revenue is equal to market price. • The demand curve that a firm faces in a perfectly competitive market is perfectly elastic; it is a horizontal straight line at the market price. • The profit of a firm is the difference between total revenue earned and total cost incurred. • If there is a positive level of output at which a firm’s profit is maximised in the short run, three conditions must hold at that output level (i) p = SMC (ii) SMC is non-decreasing (iii) p ≥ AV C. • If there is a positive level of output at which a firm’s profit is maximised in the long run, three conditions must hold at that output level p = LRMC (i) (ii) LRMC is non-decreasing (iii) p ≥ LRAC. • The short run supply curve of a firm is the rising part of the SMC curve from and above minimum AVC together with 0 output for all prices less than the minimum AVC. • The long run supply curve of a firm is the rising part of the LRMC curve from and above minimum LRAC together with 0 output
for all prices less than the minimum LRAC. • Technological progress is expected to shift the supply curve of a firm to the right. • An increase (decrease) in input prices is expected to shift the supply curve of a firm to the left (right). • The imposition of a unit tax shifts the supply curve of a firm to the left. • The market supply curve is obtained by the horizontal summation of the supply curves of individual firms. • The price elasticity of supply of a good is the percentage change in quantity supplied due to one per cent change in the market price of the good. s s s Perfect competition Profit maximisation Market supply curve Revenue, Profit Firms supply curve Price elasticity of supply KKKKK. What are the characteristics of a perfectly competitive market? 2. How are the total revenue of a firm, market price, and the quantity sold by the firm related to each other? 3. What is the ‘price line’? 4. Why is the total revenue curve of a price-taking firm an upward-sloping straight line? Why does the curve pass through the origin? 67 2019-20 5. What is the relation between market price and average revenue of a price- taking firm? 6. What is the relation between market price and marginal revenue of a price- taking firm? 7. What conditions must hold if a profit-maximising firm produces positive output in a competitive market? 8. Can there be a positive level of output that a profit-maximising firm produces in a competitive market at which market price is not equal to marginal cost? Give an explanation. 9. Will a profit-maximising firm in a competitive market ever produce a positive level of output in the range where the marginal cost is falling? Give an explanation. 10. Will a profit-maximising firm in a competitive market produce a positive level of output in the short run if the market price is less than the minimum of AVC? Give an explanation. 11. Will a profit-maximising firm in a competitive market produce a positive level of output in the long run if the market price is less than the minimum of AC? Give an explanation. 12. What is the supply curve of a firm in the short run? 13. What is the supply curve of a firm in the long run? 14. How does technological progress affect the supply curve of a firm? 15. How does the imposition of a unit tax affect the supply curve of a firm? 16.
How does an increase in the price of an input affect the supply curve of a firm? 17. How does an increase in the number of firms in a market affect the market supply curve? 18. What does the price elasticity of supply mean? How do we measure it? 19. Compute the total revenue, marginal revenue and average revenue schedules in the following table. Market price of each unit of the good is Rs 10. Quantity Sold TR MR AR 0 1 2 3 4 5 6 20. The following table shows the total revenue and total cost schedules of a competitive firm. Calculate the profit at each output level. Determine also the market price of the good. Quantity Sold TR (Rs) TC (Rs) Profit 10 15 20 25 30 35 5 7 10 12 15 23 33 40 68 2019-20 21. The following table shows the total cost schedule of a competitive firm. It is given that the price of the good is Rs 10. Calculate the profit at each output level. Find the profit maximising level of output. Output TC (Rs 10 5 15 22 27 31 38 49 63 81 101 123 22. Consider a market with two firms. The following table shows the supply schedules of the two firms: the SS1 column gives the supply schedule of firm 1 and the SS2 column gives the supply schedule of firm 2. Compute the market supply schedule. 23. Consider a market with two firms. In the following table, columns labelled as SS1 and SS 2 give the supply schedules of firm 1 and firm 2 respectively. Compute the market supply schedule. Price (Rs) SS1 (units) SS2 (units) 0 1 2 3 4 5 6 Price (Rs SS1 (kg SS2 (kg) 0 0 0 0 0.5 1 1.5 2 2.5 24. There are three identical firms in a market. The following table shows the supply schedule of firm 1. Compute the market supply schedule. Price (Rs SS1 (units) 0 0 2 4 6 8 10 12 14 69 2019-20? 25. A firm earns a revenue of Rs 50 when the market price of a good is Rs 10. The market price increases to Rs 15 and the firm now earns a revenue of Rs 150. What is the price elasticity of the firm’s supply curve? 26. The market price of a good changes from Rs 5 to Rs 20. As a result, the quantity supplied by a firm increases by 15 units. The price elasticity of the firm
’s supply curve is 0.5. Find the initial and final output levels of the firm.? 27. At the market price of Rs 10, a firm supplies 4 units of output. The market price increases to Rs 30. The price elasticity of the firm’s supply is 1.25. What quantity will the firm supply at the new price? 70 2019-20 Chapter 5 e c i r P pf p* p1 SS DD O q'1 q'1 q* q2 q1 Quantity MarkMarkMarkMarkMarket Equilibrium et Equilibrium et Equilibrium et Equilibrium et Equilibrium This chapter will be built on the foundation laid down in Chapters 2 and 4 where we studied the consumer and firm behaviour when they are price takers. In Chapter 2, we have seen that an individual’s demand curve for a commodity tells us what quantity a consumer is willing to buy at different prices when he takes price as given. The market demand curve in turn tells us how much of the commodity all the consumers taken together are willing to purchase at different prices when everyone takes price as given. In Chapter 4, we have seen that an individual firm’s supply curve tells us the quantity of the commodity that a profit-maximising firm would wish to sell at different prices when it takes price as given and the market supply curve tells us how much of the commodity all the firms taken together would wish to supply at different prices when each firm takes price as given. In this chapter, we combine both consumers’ and firms’ behaviour to study market equilibrium through demand-supply analysis and determine at what price equilibrium will be attained. We also examine the effects of demand and supply shifts on equilibrium. At the end of the chapter, we will look at some of the applications of demand-supply analysis. 5.1 EQUILIBRIUM, EXCESS DEMAND, EXCESS SUPPLY A perfectly competitive market consists of buyers and sellers who are driven by their self-interested objectives. Recall from Chapters 2 and 4 that objectives of the consumers are to maximise their respective preference and that of the firms are to maximise their respective profits. Both the consumers’ and firms’ objectives are compatible in the equilibrium. An equilibrium is defined as a situation where the plans of all consumers and firms in the market match and the market clears. In equilibrium, the aggregate quantity that all firms wish to sell equals the quantity that all the consumers in the market wish to buy; in
other words, market supply equals market demand. The price at which equilibrium is reached is called equilibrium price and the quantity bought and sold at this price is called equilibrium quantity. Therefore, (p, q) is an equilibrium if qD(p∗) = qS(p∗) 2019-20 where p∗ denotes the equilibrium price and qD(p∗) and qS(p∗) denote the market demand and market supply of the commodity respectively at price p∗. If at a price, market supply is greater than market demand, we say that there is an excess supply in the market at that price and if market demand exceeds market supply at a price, it is said that excess demand exists in the market at that price. Therefore, equilibrium in a perfectly competitive market can be defined alternatively as zero excess demand-zero excess supply situation. Whenever market supply is not equal to market demand, and hence the market is not in equilibrium, there will be a tendency for the price to change. In the next two sections, we will try to understand what drives this change. Out-of-equilibrium Behaviour From the time of Adam Smith (1723-1790), it has been maintained that in a perfectly competitive market an ‘Invisible Hand’ is at play which changes price whenever there is imbalance in the market. Our intuition also tells us that this ‘Invisible Hand’ should raise the prices in case of ‘excess demand’ and lower the prices in case of ‘excess supply’. Throughout our analysis we shall maintain that the ‘Invisible Hand’ plays this very important role. Moreover, we shall take it that the ‘Invisible Hand’ by following this process is able to reach the equilibrium. This assumption will be taken to hold in all that we discuss in the text. 5.1.1 Market Equilibrium: Fixed Number of Firms Recall that in Chapter 2 we have derived the market demand curve for pricetaking consumers, and for price-taking firms the market supply curve was derived in Chapter 4 under the assumption of a fixed number of firms. In this section with the help of these two curves we will look at how supply and demand forces work together to determine where the market will be in equilibrium when the number of firms is fixed. We will also study how the equilibrium price and quantity change due to shifts in demand and supply curves. Figure 5.1 illustrates equilibrium for a perfectly competitive market with
a fixed number of firms. Here SS denotes the market supply curve and DD denotes the market demand curve for a commodity. The market supply curve SS the shows how much of commodity firms would wish to supply at different prices, and the demand curve DD tells us how much of the commodity, the consumers would be willing to purchase at different prices. Graphically, an equilibrium is a point where the market supply curve intersects the market demand curve because this is where the market demand equals market supply. At any other point, either there is excess supply or Price p2 p* p1 SS DD O q'1 q'2 q* q2 q1 Quantity Fig. 5.1 Market Equilibrium with Fixed Number of Firms. Equilibrium occurs at the intersection of the market demand curve DD and market supply curve SS. The equilibrium quantity is q* and the equilibrium price is p. At a price greater than p, there will be excess supply, and at a price below p, there will be excess demand. 72 2019-20 there is excess demand. To see what happens when market demand does not equal market supply, let us look in figure 5.1 again. In Figure 5.1, if the prevailing price is p1, the market demand is q1 whereas the market supply is 1q'. Therefore, there is excess demand in the market equal to 1q' q1. Some consumers who are either unable to obtain the commodity at all or obtain it in insufficient quantity will be willing to pay more than p1. The market price would tend to increase. All other things remaining the same as price rises, quantity demanded falls and quantity supplied increases. The market moves towards the point where the quantity that the firms want to sell is equal to the quantity that the consumers want to buy. This happens when price is p, the supply decisions of the firms only match with the demand decisions of the consumers. 2q') at that price giving rise to excess supply equal to Similarly, if the prevailing price is p2, the market supply (q2) will exceed the 2q'q2. market demand ( Some firms will not be then able to sell quantity they want to sell; so, they will lower their price. All other things remaining the same as price falls, quantity demanded rises, quantity supplied falls, and at p, the firms are able to sell their desired output since market demand equals market supply at that price. Therefore, p is the equilibrium price and the corresponding quantity q* is the equilibrium
quantity. To understand the equilibrium price and quantity determination more clearly, let us explain it through an example. EXAMPLE Let us consider the example of a market consisting of identical1 farms producing same quality of wheat. Suppose the market demand curve and the market supply curve for wheat are given by: 5.1 qD = 200 – p for 0 ≤ p ≤ 200 = 0 for p > 200 qS = 120 + p for p ≥ 10 = 0 for 0 ≤ p < 10 where qD and qS denote the demand for and supply of wheat (in kg) respectively and p denotes the price of wheat per kg in rupees. Since at equilibrium price market clears, we find the equilibrium price (denoted by p) by equating market demand and supply and solve for p. Rearranging terms, qD(p) = qS(p) 200 – p* = 120 + p* 2p* = 80 p* = 40 Therefore, the equilibrium price of wheat is Rs 40 per kg. The equilibrium quantity (denoted by q) is obtained by substituting the equilibrium price into either the demand or the supply curve’s equation since in equilibrium quantity demanded and supplied are equal. 1Here, by identical we mean that all farms have same cost structure. 73 2019-20 Alternatively, qD = q = 200 – 40 = 160 qS = q* = 120 + 40 = 160 Thus, the equilibrium quantity is 160 kg. At a price less than p, say p1 = 25 qD = 200 – 25 = 175 qS = 120 + 25 = 145 Therefore, at p1 = 25, qD > qS which implies that there is excess demand at this price. Algebraically, excess demand (ED) can be expressed as ED(p) = qD – qS = 200 – p – (120 + p) = 80 – 2p Notice from the above expression that for any price less than p(= 40), excess demand will be positive. Similarly, at a price greater than p, say p2 = 45 qD = 200 – 45 = 155 qS = 120 + 45 = 165 Therefore, there is excess supply at this price since qS > qD. Algebraically, excess supply (ES) can be expressed as ES(p) = qS – qD = 120 + p – (200 – p) = 2p – 80 Notice from the above expression that for any price greater than p(= 40),
excess supply will be positive. Therefore, at any price greater than p, there will be excess supply, and at any price lower than p,there will be excess demand. Wage Determination in Labour Market Here we will briefly discuss the theory of wage determination under a perfectly competitive market structure using the demand-supply analysis. The basic difference between a labour market and a market for goods is with respect to the source of supply and demand. In the labour market, households are the suppliers of labour and the demand for labour comes from firms whereas in the market for goods, it is the opposite. Here, it is important to point out that by labour, we mean the hours of work provided by labourers and not the number of labourers. The wage rate is determined at the intersection of the demand and supply curves of labour where the demand for and supply of labour balance. We shall now see what the demand and supply curves of labour look like. To examine the demand for labour by a single firm, we assume that the labour is the only variable factor of production and the labour market is perfectly competitive, which in turn, implies that each firm takes wage rate as given. Also, the firm we are concerned with, is perfectly competitive in 74 2019-20 nature and carries out production with the goal of profit maximisation. We also assume that given the technology of the firm, the law of diminishing marginal product holds. The firm being a profit maximiser will always employ labour upto the point where the extra cost she incurs for employing the last unit of labour is equal to the additional benefit she earns from that unit. The extra cost of hiring one more unit of labour is the wage rate (w). The extra output produced by one more unit of labour is its marginal product (MPL) and by selling each extra unit of output, the additional earning of the firm is the marginal revenue (MR) she gets from that unit. Therefore, for each extra unit of labour, she gets an additional benefit equal to marginal revenue times marginal product which is called Marginal Revenue Product of Labour (MRPL). Thus, while hiring labour, the firm employs labour up to the point where w = MRPL and MRPL = MR × MPL Since we are dealing with a perfectly competitive firm, marginal revenue is equal to the price of the commoditya and hence marginal revenue product of labour in this case is equal to the value of marginal product of labour (VMPL). As long as the VMPL is greater than the wage rate, the firm will earn
more profit by hiring one more unit of labour, and if at any level of labour employment VMPL is less than the wage rate, the firm can increase her profit by reducing a unit of labour employed. Wage Given the assumption of the law of diminishing marginal product, the fact that the firm always produces at w = VMPL implies that the demand curve for labour is downward sloping. To explain why it is so, let us assume at some wage rate w1, demand for labour is l1. Now, suppose the wage rate increases to w2. To maintain the wage-VMPL equality, VMPL should also increase. The price of the commodity remaining constantb, this is possible only if MPL increases which in turn implies that less labour should be employed owing to the diminishing marginal. Hence, at higher wage, less labour is demanded thereby sloping demand, curve. To arrive at the market demand curve from individual firms’ demand curve, we simply labour by individual firms at different wages and since labour as wage increases, the market demand curve is also downward sloping. Wage is determined at the point where the labour demand and supply curves intersect. Labour(in hrs) w* DL SL O l* aRecall from Chapter 4 that for a perfectly competitive firm, marginal revenue equals price. bSince the firm under consideration is perfectly competitive, it believes it cannot influence the price of the commodity. 75 2019-20 Having explored the demand side, we now turn to the supply side. As already mentioned, it is the households which determine how much labour to supply at a given wage rate. Their supply decision is essentially a choice between income and leisure. On the one hand, individuals enjoy leisure and find work irksome and on the other, they value income for which they must work. So there is a trade-off between enjoying leisure and spending more hours for work. To derive the labour supply curve for a single individual, let us assume at some wage rate w1, the individual supplies l1 units of labour. Now suppose the wage rises to w2. This increase in wage rate will have two effects: First, due to the increase in wage rate, the opportunity cost of leisure increases which makes leisure costlier. Therefore, the individual will want to enjoy less leisure. As a result, they will work for longer hours. Second, because of the increase in wage rate to w2, the purchasing power of the individual increases. So, she would want to spend more on leisure activities. The final effect of the
increase in wage rate will depend on which of the two effects predominates. At low wage rates, the first effect dominates the second and so the individual will be willing to supply more labour with an increase in wage rate. But at high wage rates, the second effect dominates the first and the individual will be willing to supply less labour for every increase in wage rate. Thus, we get a backward bending individual labour supply curve which shows that up to a certain wage rate for every increase in wage rate, there is an increased supply of labour. Beyond this wage rate for every increase in wage rate, labour supply will decrease. Nevertheless, the market supply curve of labour, which we obtain by aggregating individuals’ supply at different wages, will be upward sloping because though at higher wages some individuals may be willing to work less, many more individuals will be attracted to supply more labour. With an upward sloping supply curve and downward sloping demand curve, the equilibrium wage rate is determined at the point where these two curves intersect; in other words, where the labour that the households wish to supply is equal to the labour that the firms wish to hire. This is shown in the diagram. Shifts in Demand and Supply In the above section, we studied market equilibrium under the assumption that tastes and preferences of the consumers, prices of the related commodities, incomes of the consumers, technology, size of the market, prices of the inputs used in production, etc remain constant. However, with changes in one or more of these factors either the supply or the demand curve or both may shift, thereby affecting the equilibrium price and quantity. Here, we first develop the general theory which outlines the impact of these shifts on equilibrium and then discuss the impact of changes in some of the above mentioned factors on equilibrium. Demand Shift Consider Figure 5.2 in which we depict the impact of demand shift when the number of firms is fixed. Here, the initial equilibrium point is E where the market demand curve DD0 and the market supply curve SS0 intersect so that q0 and p0 are the equilibrium quantity and price respectively. 76 2019-20 Price p2 p0 Price SS0 G E p0 p1 E F DD2 DD0 O Fig. 5.2 q0 q2 (a) q¢¢ 0 Quantity O q1 0 q1 q0 (b) SS0 DD0 DD1 Quantity Shifts in Demand. Initially, the market equilibrium is at E. Due to the shift in demand to the right, the new equilibrium is at G
as shown in panel (a) and due to the leftward shift, the new equilibrium is at F, as shown in panel (b). With rightward shift the equilibrium quantity and price increase whereas with leftward shift, equilibrium quantity and price decrease. Now suppose the market demand curve shifts rightward to DD2 with supply curve remaining unchanged at SS0, as shown in panel (a). This shift indicates that at any price the quantity demanded is more than before. Therefore, at price p0 now there is excess demand in the market equal to 0 0q q''. In response to this excess demand some individuals will be willing to pay higher price and the price would tend to rise. The new equilibrium is attained at G where the equilibrium quantity q2 is greater than q0 and the equilibrium price p2 is greater than p0. Similarly if the demand curve shifts leftward to DD1, as shown in panel (b), at any price the quantity demanded will be less than what it was before the shift. Therefore, at the initial equilibrium price p0 now there will be excess supply in q' q in response to which some firms will reduce the price the market equal to 0 of their commodity so that they can sell their desired quantity. The new equilibrium is attained at the point F at which the demand curve DD1 and the supply curve SS0 intersect and the resulting equilibrium price p1 is less than p0 and quantity q1 is less than q0. Notice that the direction of change in equilibrium price and quantity is same whenever there is a shift in demand curve. 0 Having developed the general theory, we now consider some examples to understand how demand curve and the equilibrium quantity and price are affected in response to a change in some of the aforementioned factors which are also enlisted in Chapter 2. More specifically, we would analyse the impact of increase in consumers’ income and an increase in the number of consumers on equilibrium. Suppose due to a hike in the salaries of the consumers, their incomes increase. How would it affect equilibrium? With an increase in income, consumers are able to spend more money on some goods. But recall from Chapter 2 that the consumers will spend less on an inferior good with increase in income whereas for a normal good, with prices of all commodities and tastes and preferences of the consumers held constant, we would expect the demand for the good to increase at each price as a result of which the market demand curve will shift rightward. Here we consider the example of a normal good like clothes, the demand for which increases
with increase in income of consumers, thereby causing a rightward shift in the demand curve. However, this income increase does not have any impact on 77 2019-20 the supply curve, which shifts only due to some changes in the factors relating to technology or cost of production of the firms. Thus, the supply curve remains unchanged. In the Figure 5.2 (a), this is shown by a shift in the demand curve from DD0 to DD2 but the supply curve remains unchanged at SS0. From the figure, it is clear that at the new equilibrium, the price of clothes is higher and the quantity demanded and sold is also higher. Now let us turn to another example. Suppose due to some reason, there is increase in the number of consumers in the market for clothes. As the number of consumers increases, other factors remaining unchanged, at each price, more clothes will be demanded. Thus, the demand curve will shift rightwards. But this increase in the number of consumers does not have any impact on the supply curve since the supply curve may shift only due to changes in the parameters relating to firms’ behaviour or with an increase in the number of firms, as stated in Chapter 4. This case again can be illustrated through Figure 5.2(a) in which the demand curve DD0 shifts rightward to DD2, the supply curve remaining unchanged at SS0. The figure clearly shows that compared to the old equilibrium point E, at point G which is the new equilibrium point, there is an increase in both price and quantity demanded and supplied. Supply Shift In Figure 5.3, we show the impact of a shift in supply curve on the equilibrium price and quantity. Suppose, initially, the market is in equilibrium at point E where the market demand curve DD0 intersects the market supply curve SS0 such that the equilibrium price is p0 and the equilibrium quantity is q0. 78 Shifts in Supply. Initially, the market equilibrium is at E. Due to the shift in supply curve to the left, the new equilibrium point is G as shown in panel (a) and due to the rightward shift the new equilibrium point is F, as shown in panel (b). With rightward shift, the equilibrium quantity increases and price decreases whereas with leftward shift,equilibrium quantity decreases and price increases. Now, suppose due to some reason, the market supply curve shifts leftward to SS2 with the demand curve remaining unchanged, as shown in panel (a). Because of the shift, at the prevailing price
, p0, there will be excess demand equal to 0q '' qo in the market. Some consumers who are unable to obtain the good will be willing to pay higher prices and the market price tends to increase. The new equilibrium is attained at point G where the supply curve SS2 intersects the demand curve DD0 such that q2 quantity will be bought and sold at price p2. Similarly, when supply curve shifts rightward, as shown in panel (b), at p0 there will be supply excess of 2019-20 goods equal to q0 0q '. In response to this excess supply, some firms will reduce their price and the new equilibrium will be attained at F where the supply curve SS1 intersects the demand curve DD0 such that the new market price is p1 at which q1 quantity is bought and sold. Notice the directions of change in price and quantity are opposite whenever there is a shift in supply curve. Now with this understanding, we can analyse the behaviour of equilibrium price and quantity when various aspects of the market change. Here, we will consider the effect of an increase in input price and an increase in number of firms on equilibrium. Let us consider a situation where all other things remaining constant, there is an increase in the price of an input used in the production of a commodity. This will increase the marginal cost of production of the firms using this input. Therefore, at each price, the market supply will be less than before. Hence, the supply curve shifts leftward. In the Figure 5.3(a), this is shown by a shift in the supply curve from SS0 to SS2. But this increase in input price has no impact on the demand of the consumers since it does not depend on the input prices directly. Therefore, the demand curve remains unchanged. In Figure 5.3(a), this is shown by the demand curve remaining unchanged at DD0. As a result, compared to the old equilibrium, now the market price rises and quantity produced decreases. Let us discuss the impact of an increase in the number of firms. Since at each price now more firms will supply the commodity, the supply curve shifts to the right but it does not have any effect on the demand curve. This example can be illustrated by Figure 5.3(b) where the supply curve shifts from SS0 to SS1 whereas the demand curve remains unchanged at DD0. From the figure, we can say that there will be a decrease in price of the commodity and increase in the quantity produced compared
to the initial situation. Simultaneous Shifts of Demand and Supply What happens when both demand and supply curves shift simultaneously? The simultaneous shifts can happen in four possible ways: (i) Both supply and demand curves shift rightwards. (ii) Both supply and demand curves shift leftwards. (iii) Supply curve shifts leftward and demand curve shifts rightward. (iv) Supply curve shifts rightward and demand curve shifts leftward. The impact on equilibrium price and quantity in all the four cases are given in Table 5.1. Each row of the table describes the direction in which the equilibrium price and quantity will change for each possible combination of the simultaneous shifts in demand and supply curves. For instance, from the second row of the table, we see that due to a rightward shift in both demand and supply curves, the equilibrium quantity increases invariably but the equilibrium price may either increase, decrease or remain unchanged. The actual direction in which the price will change will depend on the magnitude of the shifts. Check this yourself by varying the magnitude of shifts for this particular case. In the first two cases which are shown in the first two rows of the table, the impact on equilibrium quantity is unambiguous but the equilibrium price may change, if at all, in either direction depending on the magnitudes of shifts. In the next two cases, shown in the last two rows of the table, the effect on price is unambiguous whereas effect on quantity depends on the magnitude of shifts in the two curves. 79 2019-20 Table 5.1: Impact of Simultaneous Shifts on Equilibrium Shift in Demand Shift in Supply Quantity Price Leftward Leftward Decreases Rightward Rightward Increases Leftward Rightward Rightward Leftward May increase, decrease or remain unchanged May increase, decrease or remain unchanged May increase, decrease or remain unchanged May increase, decrease or remain unchanged Decreases Increases Here we give diagrammatic representations for case (ii) and case (iii) in Figure 5.4 and leave the rest as exercises for the readers. 80 Simultaneous Shifts in Demand and Supply. Initially, the equilibrium is at E where the demand curve DD0 and supply curve SS0 intersect. In panel (a), both the supply and the demand curves shift rightward leaving price unchanged but a higher equilibrium quantity. In panel (b), the supply curve shifts rightward and demand curve shifts leftward leaving quantity unchanged but a lower equilibrium price. In the Figure 5.4(a), it can be seen that due to rightward shifts in

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