Business Economics II Semester

Module One- Introduction to Business Economics

Contents

Nature and Scope of Managerial Economics

Concept of Utility
Law of Diminishing Marginal Utility
Law of Equi- Marginal Utility
Indifference Curve and its Techniques
Consumer Surplus

References

Business Economics- D.M.Mithani and Anila Bajpai

Business Economics- M.M.Gupta
Modern Economic Theory- K.K.Dewett
Business Economics- H.L.Ahuja

Learning Objectives
To Know about the Definitions of Economics
To know the subject matter of economics
To know about utility analysis
Introduction
Economics (from the Greek [oikos], 'family, household, estate', and [nomos],
'custom, law', hence "household management" and "management of the state") is a social
science that typically studies the production, distribution, and consumption of goods and
services.

Economics is growing very rapidly as the years pass. As new ideas are being discovered and
the old theories are being revised, therefore, it is not possible to give a definition of
economics which has a general acceptance.
For the sake of convenience, the set of definitions given by various economists are generally
classified under four heads:
Economics as a science of wealth.
Economics as a science of material welfare.
Economics as a science of scarcity and choice.
Economics as a science of growth and efficiency.

Definitions

Adam Smith (1723 -1790), the founder of economics, described it as a body of knowledge
which relates to wealth. Accordingly to him if a nation has larger amount of wealth, it can
help in achieving its betterment. He defined economics as:

The study of nature and causes of generating of wealth of a nation.

Adam Smith in his famous book, An Enquiry into the Nature and Causes of the Wealth of
Nations emphasized the production and expansion of wealth as the subject matter of
economics.

The main points of the definitions of economics given by the above classical economists are
that:
(i) Economics is the study of wealth only. It deals with consumption, production, exchange
and distribution aspects of wealth.
(ii) Only those commodities which are scarce are Included In wealth. Non-material goods
such as air, services etc., are excluded from the category of wealth.

Marshalls Definition of Economics:

The neo-classical school led by Dr. Alfred Marshall gave economics a respectable place
among social sciences. He was the first economist who lifted economics from the bad repute
it had fallen. Dr. Alfred Marshall (1842 - 1924) in his book, 'Principles of Economics'
defined Economics as:
Study of mankind in the ordinary business of life; it examines that part of individual and
social actions which is closely connected with the attainment and with the use of material
requisites of well being.
This definition clearly states that Economics is on the one side a study of wealth and on the
other and more important side a part of the study of man.
Characteristics:
The definitions given by Welfare School of Economists have the following main features of
Economics as Material Welfare:
(i) Wealth is not the be all and the end all of human activities: Economics does not regard
wealth as the be all and the end all of the human activities. It is only a mean to the fulfillment
of an end which is human welfare. Welfare and not wealth is; therefore, of primary
importance to man.
(ii) Study of an ordinary man: Economics is a study of an ordinary man who lives in free
society. A person who is cut away from the society is not the subject of study of Economics.
(iii) It does not study all activities of man: Economics does not study all the activities of
man. It is concerned with those actions which can be brought directly or indirectly with the
measuring rod of money.
(iv) Study of material welfare: Economics is concerned with the ways in which man applies
his knowledge, skill to the gifts of Nature for the satisfaction of his material welfare.
For a long time, the definition of Economics given by Alfred Marshall was generally
accepted. It enlarged the scope of economics by taking emphasis that its studies wealth and
man rather than wealth alone

Lionel Robbins claiming his definition Economics precise, scientific and superior, defines
Economics book Nature and Significance of Economics Science' (Published in 1932):
"A science which studies human behavior as a relationship between ends and scarce means
which have alternative uses".
This definition is based on the following five pillars:
Main Pillars of Robbins's Definition:
(i) The Human wants or ends are unlimited: Human wants referred to as ends by Robbins
are unlimited. They increase in quantity and quality over a period of time. They vary among
individuals and overtime for the same individual. It is not possible to find a person who will
say that his wants for goods and services have been completely satisfied. This is because of
the fact that when one want is satisfied, it is replaced by another and there is then no end to it.
(ii) The ends or wants vary in importance: The ends or wants are of varying importance.
They are ranked in order of importance as: (a) necessaries (b) comforts and (c) luxuries. Man
generally satisfies his urgent wants first and less urgent afterwards in order of their
importance.
(iii) Scarcity of resources: Resources are the inputs used in the production of things which
we need. The resources (Land, labor, capital and entrepreneurship) at the disposal of man are
scarce. They are not found in as much quantity as we need them. Scarcity means that we do
not and cannot have enough income or wealth to satisfy our every desire. Scarcity exists
because human wants always exceed what can be produced with limited resources and time
that Nature makes available to man at any one time. Scarcity is a fact of life. It occurs among
the poor and among the rich. The richest person on earth faces scarcity because he too cannot
satisfy all his wants with the limited time available to him.
(iv) According to Robbins: the unlimited ends and the scarce resources provide a foundation
to the field of Economics. Since the human wants are innumerable and the means to satisfy
them are scarce or limited in supply, therefore, an economic problem arises. If all the things
were freely available to satisfy the unlimited human wants, there would not have arisen any
scarcity, hence no economic goods, no need to economic and no economic problem. Scarcity,
thus, can be defined as the excess of human wants over what can be actually produced in the
economy.
(v) Economic resources have alternative uses: The fourth important proposition of Robbins
definition is that the scarce resources available to satisfy human wants have alternative uses.
They can be put to one use at one time. For instance, if a piece of land is used for the
production of sugarcane, it cannot be utilized for the growth of another crop at the same time.
Man, therefore, has to choose the best way of utilizing the scarce resources which have
alternative uses. The scarcity resources and choices are the key problems confronting every
society.

Latest/Modern Definition of Economics:

The modern economists define economics as:
"A science of growth and efficiency".
According to Samuelson:
"Economics is the study of how people and society end up closing, with or without the use of
money, to employ scarce productive resources that could have alternative uses, to produce
various commodities and distribute them for consumption now or in the future among various
persons and groups in society".
It analyses the cost and benefits of improving patterns of resource allocation.
.

Scope of Economics
The scope of economics is the area or boundary of the study of economics. In scope of
economics we answer and analyze the following three main questions:

(i) What is the subject matter of economics?

(ii) What is the nature of economics?
(iii) What are the limitations of economic?
(i) Subject Matter of Economics:
Economics studies mans life and work, not the whele of it, but only one aspect of it. It does
not study how a person is born, how he grows up and dies, how human body is made up and
functions, all these are concerned with biological sciences, Similarly Economics is also not
concerned with how a person thinks and the human organizations being these are a matter of
psychology and political science. Economics only tells us how a man utilizes his limited
resources for the satisfaction of his unlimited wants, a man has limited amount of money and
time, but his wants are unlimited. He must so spend the money and time he has that he
derives maximum satisfaction. This is the subject matter of Economics.

(ii) Nature of Economics:

The economists are also divided regarding the nature of economics. The following questions
are generally covered in the nature of economics.
(a) Is economics a science or an art?
(b) Is it a positive science or a normative science?
(iii) Economics As a Science or An Art:
Economics is both a science and an art. Economics is considered as a science because it is a
systematic knowledge derived from observation, study and experimentation. However, the
degree of perfection of economics laws is less compared with the laws of pure sciences.
An art is the practical application of knowledge for achieving definite ends. A science teaches
us to know a phenomenon and an art teaches us to do a thing. For example, there is inflation
in Pakistan. This information is derived from positive science. The government takes certain
fiscal and monetary measures to bring down the general level of prices in the country. The
study of these fiscal and monetary measures to bring down inflation makes the subject of
economics as an art.
After arriving at a conclusion that economics is both a science as well as an art. Here arises
another controversy. Is economics a positive science or a normative science?
(iv) Economics is Positive or Normative Science:
There again difference of opinions among economists whether economics is a positive or
normative science. Lionel Robbins, Senior and Friedman have described economics as a
positive science. They opined that economics is based on logic. It is a value theory only. It is,
therefore, neutral between ends.
Marshall, Pigou, Hawtrey, Keynes and many other economists regard economics as a
normative science. According to them, the real function of the science is to increase the well-
being of man. They have given suggestions in their works for promotion of human welfare.
For example, Malthus has given suggestions of checking the rising population. M. Keynes
has suggested measures to remove unemployment.
We agree with Mr. Frazer, that an economist who is only an economist is a poor pretty fish.
An economist must come forward to give advice to the problems facing the human being like
depression, unemployment, high prices, etc., for increasing his welfare.
Economics, to conclude, has both theoretical as well as practical side. In other words, it is
both a positive and a normative science.

Micro and Macro Analysis:

In recent years, the subject matter of economics is divided into two broad areas. One of them
is called Microeconomics and the other is called Macroeconomics. These two terms
microeconomics and macroeconomics were first coined and used by Ranger Frisco in 1933.
In recent years, division of economic theory into two separate parts has gained much
importance.
The distinction/difference between Micro and Macro economics is made clear below:
(1) Microeconomics:
Definition:
Microeconomics is a Greek word which means small.
"Microeconomics is the study of specific individual units; particular firms, particular
households, individual prices, wages, individual industries particular commodities. The
microeconomic theory or price theory thus is the study of individual parts of the economy".
It is economic theory in a microscope. For instance, in microeconomic analysis we study the
demand of an individual consumer for a good and from there we go to derive the market
demand for a good (that is demand of a group of individuals for a good). Similarly, in
microeconomic theory we study the behavior of individual firms the fixation of prices output.
In the words of Samuelson:
Microeconomics we examine among other things how individual prices are set, consider
what determines the price of land and capital and enquire into the strength and weaknesses of
market mechanics.
Explanation:
(i) Microeconomics and allocation of resources. The microeconomic theory takes the total
quantity of resources as given. It seeks to explain how they are allocated to the production of
goods. The allocation of resources to the production of goods depends upon the price of
various goods and the prices of factors of production. Microeconomics analyses how the
relative prices of goods and factors are determined. Thus the theory of product pricing and
the theory of factor pricing (rent wages, interest and profit) fall within the domain of micro
economics.
(ii) Micro economics and economic efficiency. The microeconomic theory seeks to explain
whether the problems of scarcity and allocation of resources so determined are efficient.
Economic efficiency involves (a) efficiency in consumption (b) efficiency in production and
distribution and (c) over all economic efficiency. The price theory shows under hat conditions
these efficiencies are achieved.
.
(2) Macroeconomics:
Definition:
The term macro is derived from the Greek word uakpo which means large.
Macroeconomics, the other half of economics, is the study of the behavior of the economy as
a whole. In other words:
"Macroeconomics deals with total or big aggregates such as national income, output and
employment, total consumption, aggregate saving and aggregate investment and the general
level of prices". In the words of Boulding:
Macroeconomics deals not with individual quantities as such but with aggregates of these
quantities, not with individual i.e., but with the national Income, not with individual prices
but with the price level, not with Individual outputs but with the national output. It studies
determination of national output and its growth overtime. It also studies the problems of
recession, unemployment inflation, the balance of international payments and the policies
adopted by the governments to deal with these problems".
Explanation:
The main issues which are addressed in macro economics are in brief as under:
(i) It helps understanding determination of income and employment. Late J.M. Keynes
laid great stress on macro-economic analysis. In his revolutionary book, General Theory,
Employment interest and Money" brought drastic changes in economic thinking. He
explained the forces or factors which determine the level of aggregate employment and
output in the economy.
(ii) Determination of general level of prices. Macro economic analysis answers questions as
to how the general price level is determined and what is the importance of various factors
which influence general price level.
(iii) Economic growth. The macro-economic models help us to formulate economic policies
for achieving long run economic growth with stability. The new developed growth theories
explain the causes of poverty in under developed countries and suggest remedies to overcome
them.
(iv) Macro economics and business cycles. It is in terms of macroeconomics that causes of
fluctuations in the national income are analyzed. It has also been possible now to formulate
policies for controlling business cycles i.e. inflation and deflation.
(v) International trade. Another important subject of macro-economics is to analyze the
various aspects of international trade in goods, services and balance of payment problems, the
effect of exchange rate on balance of payment etc.
(vi) Income shares from the national income. Mr. M. Kalecki and Nicholas Kelder, by
making departure from Ricarde theory, have presented a macro theory of distribution of
income. According to these economists, the relative shares of wages and profits depend upon
the ratio of investment to national income.
(vii) Unemployment. Another macro economic issue is to explain the causes of
unemployment in the economy. Stagflation is another important issue of modern, economics.
The Keynesian and post Keynesian economists are putting lot of efforts in explaining the
causes of cyclical unemployment and high unemployment coupled with inflation and
suggesting remedies to counteract them.
(viii) Macro Economic Policies. Fiscal and monetary policies affect the performance of the
economy. These two major types policies are central in macro economic analysis of the
economy.
(ix) Global Economic System. In macro economic analysis, it is emphasized that a nations
economy is a part of a global economic system. A good or weak performance of a nations
economy can affect the performance of the world economy as a whole.
Micro Economics Macro Economics
Study of small part of the economy Study of large parts of the economy

Study of individual units of the economy Study of the whole economy

Gives a partial picture of the economy Gives total picture of the whole economy

Traditional approach Modern approach

Covers limited area of study Covers wider scope

Mainly studies Price theory Mainly studies Income and employment

Called as Slicing method Called as lumping method

Called as partial equilibrium analysis Called as general equilibrium analysis

Gives us a worms eye view of the Gives us a birds eye view of the economy
economy
It studies individual who is mortal It studies the society which is immortal
Theory of Consumer Behavior:
There are two main approaches to the of consumer behavior of demand. The first approach is
the Marginal Utility or Cardinalist Approach. The second is the Ordinalist Approach.

Concept of Utility:
Jevon (1835 -1882) was the first economist who introduces the concept of utility in
economics. According to him:
"Utility is the basis on which the demand of a individual for a commodity depends upon".
Utility is defined as:
"The power of a commodity or service to satisfy human want".
Utility is thus the satisfaction which is derived by the consumer by consuming the goods.
Util:A unit of measure of utility

Types of Utility

Form Utility
When a utility is created or increased by changing the shape or form of goods

Place Utility
Transferring goods from place where it is available abundance to places where
there is a scarcity creates place utility

Time Utility
It refers to creation of utility by storing goods when they are available in plenty
and supplying them during the off season when they are needed
 Cardinal Utility vs. Ordinal Utility
Cardinal Utility: Assigning numerical values to the amount of satisfaction
Ordinal Utility: Not assigning numerical values to the amount of satisfaction but
indicating the order of preferences, that is, what is preferred to what

LAW OF DIMINISHING MARGINAL UTILITY

Introduction

This is one of the most fundamental laws of consumption.

Original version Prof.H.H.Goosen

It described as the first law of Goosen.

Modified and Final version Alfred Marshall.Hence , it is called as Marshallian law

in Economics

Total utility - the level of happiness derived from consuming the all the units of good

Marginal utility (MU) of an additional unit. Change in utility derived from consuming
an additional unit of a good.

Zero Utility Consumption of an additional unit results in no Utility

Negative Utility Instead of giving utility , a unit gives disutility

Statement
The law of diminishing marginal utility, as defined by Alfred Marshall (1842-1924) states
that

- The additional benefit which a person derives from a given increase of his stock of
anything diminishing with every increase in the stock that he already has

On the basis of the statement, we can say that utility of a commodity depends on the
quantity of a commodity. It can be expressed in terms a mathematical equation.

MU x = f (Qx)
Assumptions of the Law

The Consumer acts rationally

The Consumer consumes only one commodity

Different units of the commodity are homogeneous

A commodity has no substitutes

A commodity is consumed in suitable doses

Utility of a commodity can be measured in terms of numbers

There is no interval between the consumption of successive units

Price of the commodity, income, tastes and habits etc of a consumer remains constant

Utility of a product depends on the quantity of that commodity alone

Explanation

It may here be noted that as a person consumes more and more units of a commodity, the
marginal utility of the additional units begins to diminish but the total utility goes on
increasing at a diminishing rate.
When the marginal utility comes to zero or we say the point of satiety is reached, the total
utility is the maximum. If consumption is increased further from this point of satiety, the
marginal utility becomes negative and total utility begins to diminish.
The relationship between total utility and marginal utility is now explained with the help of
following schedule and a graph.
Schedule:
Units of Apples Consumed Marginal Utility (in Utils)
Total Utility (in Utils)
Daily
1 7 7
2 11 4 (11-7)
3 13 2 (13-11)
4 14 1 (14-13)
5 14 0 (14-14)
6 13 -1 (13-14)

The above table shows that when a person consumes no apples, he gets no satisfaction. His
total utility is zero. In case he consumes one apple a day, he gains seven units of satisfaction.
His total utility is 7 and his marginal utility is also 7.
In case he consumes second apple, he gains extra 4 utils (MU). Thus given him a total utility
of 11 utils from two apples. His marginal utility has gone down from 7 utils to 4 utils because
he has a less craving for the second apple.
Same is the case with the consumption of third apple. The marginal utility has now fallen to 2
utils while the total utility of three apples has increased to 13 utils (7 + 4 + 2). In case the
consumer takes fifth apple, his marginal utility falls to zero utils and if he consumes sixth
apple also, the total showing total utility and marginal utility is plotted in figure below:
Diagram/Curve:

Trends in Utility

Total Utility goes on increasing at a diminishing rate with consumption of additional

units

Total Utility will be the highest when Marginal Utility is Zero

Total Utility declines when Marginal Utility becomes negative

Marginal Utility will be the highest in the beginning, decline in the latter stages,
becomes zero and negative at the end

Exceptions to the law

The law will not operate under following conditions

Either abnormal or subnormal persons

Miser

Rare collections like Stamps, coins etc

Size of the commodity consumed is too small

If there is considerable interval between the consumption of additional units

In case of drunkards
Practical Importance

It is the basis for the negative slope of the Demand curve

It is the basis for determining the demand for the goods and services
It is the basis for progressive taxation policy
It is the basis for advocating redistribution of income in favour of poor peopleIt is the
basis for the theory of value
It is the basis to distinguish between value-in-exchange and value-in-use
expenditure of consumers
The law applies not only to commodities but also to money

Law of Equi-Marginal Utility: (Equilibrium of the Consumer Through the Law of

Equi-Marginal Utility): Other Names of this Law:
Law of Substitution OR Law of Maximum Satisfaction OR Law of Indifference OR
Proportion Rule OR Gossen's Second Law.
In the cardinal utility analysis, the principle of equal marginal utility occupies an important
place.

Definition and Statement of Law of Equi-Marginal Utility:

The law of equi-marginal utility is simply an extension of law of diminishing marginal
utility to two or more than two commodities. The law of equilibrium utility is known, by
various names. It is named as the Law of Substitution, the Law of Maximum Satisfaction, the
Law of Indifference, the Proportionate Rule and the Gossens Second Law.

In cardinal utility analysis, this law is stated by Lipsey in the following words:
The household maximizing the utility will so allocate the expenditure between commodities
that the utility of the last penny spent on each item is equal.
As we know, every consumer has unlimited wants. However, the income this disposal at any
time is limited. The consumer is, therefore, faced with a choice among many commodities
that he can and would like to pay. He, therefore, consciously or unconsciously compress the
satisfaction which he obtains from the purchase of the commodity and the price which he
pays for it. If he thinks the utility of the commodity is greater or at-least equal to the loss of
utility of money price, he buys that commodity.
As he buys more and more of that commodity, the utility of the successive units begins to
diminish. He stops further purchase of the commodity at a point where the marginal utility of
the commodity and its price are just equal. If he pushes the purchase further from his point of
equilibrium, then the marginal utility of the commodity will be less than that of price and the
household will be loser. A consumer will be in equilibrium with a single commodity
symbolically:
MUx = Px
A prudent consumer in order to get the maximum satisfaction from his limited means
compares not only the utility of a particular commodity and the price but also the utility of the
other commodities which he can buy with his scarce resources. If he finds that a particular
expenditure in one use is yielding less utility than that of other, he will tie to transfer a unit of
expenditure from the commodity yielding less marginal utility. The consumer will reach his
equilibrium position when it will not be possible for him to increase the total utility by uses.
The position of equilibrium will be reached when the marginal utility of each good is in
proportion to its price and the ratio of the prices of all goods is equal to the ratio of their
marginal utilities.
The consumer will maximize total utility from his income when the utility from the last rupee
spent on each good is the same. Algebraically, this is:
MUa / Pa = MUb / Pb = MUc = Pc = MUn = Pn
Here: (a), (b), (c). (n) are various goods consumed.

Assumptions of Law of Equi-Marginal Utility:

The main assumptions of the law of equi-marginal utility are as under.
(i) Independent utilities. The marginal utilities of different commodities are independent of
each other and diminish with more and more purchases.
(ii) Constant marginal utility of money. The marginal utility of money remains constant to
the consumer as he spends more and more of it on the purchase of goods.
(iii) Utility is cardinally measurable.
(iv) Every consumer is rational in the purchase of goods.
Example and Explanation of Law of Equi-Marginal Utility:
The doctrine of equi-marginal utility can be explained by taking an example. Suppose a
person has $5 with him whom he wishes to spend on two commodities, tea and cigarettes.
The marginal utility derived from both these commodities is as under:

Schedule:
Units of Money MU of Tea MU of Cigarettes
1 10 12
2 8 10
3 6 8
4 4 6
5 2 3
$5 Total Utility = 30 Total Utility = 30
A rational consumer would like to get maximum satisfaction from $5.00. He can spend
money in three ways:
(i) $5 may be spent on tea only.
(ii) $5 may be utilized for the purchase of cigarettes only.
(iii) Some rupees may be spent on the purchase of tea and some on the purchase of cigarettes.
If the prudent consumer spends $5 on the purchase of tea, he gets 30 utility. If he spends $5
on the purchase of cigarettes, the total utility derived is 39 which are higher than tea. In order
to make the best of the limited resources, he adjusts his expenditure.
(i) By spending $4 on tea and $1 on cigarettes, he gets 40 utility (10+8+6+4+12 = 40).
(ii) By spending $3 on tea and $2 on cigarettes, he derives 46 utility (10+8+6+12+10 = 46).
(iii) By spending $2 on tea and $3 on cigarettes, he gets 48 utility (10+8+12+10+8 = 48).
(iv) By spending $1 on tea and $4 on cigarettes, he gets 46 utility (10+12+10+8+6 = 46).
The sensible consumer will spend $2 on tea and $3 on cigarettes and will get maximum
satisfaction. When he spends $2 on tea and $3 on cigarette, the marginal utilities derived
from both these commodities is equal to 8. When the marginal utilities of the two
commodities are equalizes, the total utility is then maximum, i.e., 48 as is clear from the
schedule given above.

Curve/Diagram of Law of Equi-Marginal Utility:

The law of equi-marginal utility can be explained with the help of diagrams.

In the figure 2.3 MU is the marginal utility curve for tea and KL of cigarettes. When a
consumer spends OP amount ($2) on tea and OC ($3) on cigarettes, the marginal utility
derived from the consumption of both the items (Tea and Cigarettes) is equal to 8 units (EP =
NC). The consumer gets the maximum utility when he spends $2 on tea and $3 on cigarettes
and by no other alternation in the expenditure.
We now assume that the consumer spends $1 on tea (OC/ amount) and $4 (OQ/) on cigarettes.
If CQ/ more amounts are spent cigarettes, the added utility is equal to the area CQ/ N/N. On
the other hand, the expenditure on tea falls from OP amount ($2) to OC/ amount ($1). There
is a toss of utility equal to the area C/PEE. The loss is utility (tea) is greater than that The loss
in utility (tea) is maximum satisfaction except the combination of expenditure of $2 on tea
and $3 on cigarettes.
This law is known as the Law of maximum Satisfaction because a consumer tries to get the
maximum satisfaction from his limited resources by so planning his expenditure that the
marginal utility of a rupee spent in one use is the same as the marginal utility of a rupee spent
on another use.
It is known as the Law of Substitution because consumer continuous substituting one good
for another till he gets the maximum satisfaction.
It is called the Law of Indifference because the maximum satisfaction has been achieved by
equating the marginal utility in all the uses. The consumer than becomes indifferent to
readjust his expenditure unless some change fakes place in his income or the prices of the
commodities, etc.
Limitations/Exceptions of Law of Equi-Marginal Utility:
(i) Effect on fashions and customs: The law of equi-marginal utility may become
inoperative if people forced by fashions and customs spend money on the purchase of those
commodities which they clearly knows yield less utility but they cannot transfer the unit of
money from the less advantageous uses to the more advantageous uses because they are
forced by the customs of the country.
(ii) Ignorance or carelessness: Sometimes people due to their ignorance of price or
carelessness to weigh the utility of the purchased commodity do not obtain the maximum
advantage by equating the marginal utility in all the uses.
(iii) Indivisible units: If the unit of expenditure is not divisible, then again the law may
become inoperative.
(iv) Freedom of choice: If there is no perfect freedom between various alternatives, the
operation of law may be impeded.

Importance of Law of Equi-Marginal Utility:

1. The theory of consumption
2. Choice between savings and consumption
3. Optimum utilization of time
4. The theory of production
5. Theory of distribution
6. Theory of exchange
7. Theory of price
8. The theory of public finance

Theory of Ordinal Utility/Indifference Curve Analysis:

Definition and Explanation:
The indifference curve indicates the various combinations of two goods which yield equal
satisfaction to the consumer.
The indifference curve analysis approach was first introduced by Slustsky, a Russian
Economist in 1915. Later it was developed by J.R. Hicks and R.G.D. Allen in the year 1928.

Assumptions:
The ordinal utility theory or the indifference curve analysis is based on four main
assumptions.
(i) Rational behavior of the consumer: It is assumed that individuals are rational in making
decisions from their expenditures on consumer goods.
(ii) Utility is ordinal: Utility cannot be measured cardinally. It can be, however, expressed
ordinally. In other words, the consumer can rank the basket of goods according to the
satisfaction or utility of each basket.
(iii) Diminishing marginal rate of substitution: In the indifference curve analysis, the
principle of diminishing marginal rate of substitution is assumed.
(iv) Consistency in choice: The consumer, it is assumed, is consistent in his behavior during
a period of time. For insistence, if the consumer prefers combinations of A of good to the
combinations B of goods, he then remains consistent in his choice. His preference, during
another period of time does not change. Symbolically, it can be expressed as:

If A > B, then B > A

(iv) Consumers preference not self contradictory: The consumers preferences are not
self contradictory. It means that if combinations A is preferred over combination B is
preferred over C, then combination A is preferred over combination A is preferred over C.
Symbolically it can be expressed:
If A > B and B > C, then A > C
(v) Goods consumed are substitutable: The goods consumed by the consumer are
substitutable. The utility can be maintained at the same level by consuming more of some
goods and less of the other. There are many combinations of the two commodities which are
equally preferred by a consumer and he is indifferent as to which of the two he receives.
Example:
For example, a person has a limited amount of income which he wishes to spend on two
commodities, rice and wheat. Let us suppose that the following commodities are equally
valued by him:
Various Combinations:
a) 16 Kilograms of Rice Plus 2 Kilograms of Wheat
b) 12 Kilograms of Rice Plus 5 Kilograms of Wheat
c) 11 Kilograms of Rice Plus 7 Kilograms of Wheat
d) 10 Kilograms of Rice Plus 10 Kilograms of Wheat
e) 9 Kilograms of Rice Plus 15 Kilograms of Wheat
It is matter of indifference for the consumer as to which combination he buys. He may buy 16
kilograms of rice and 2 kilograms of wheat or 9 kilograms of rice and 15 kilograms of wheat.
All these combinations are equally preferred by him.
An indifference curve thus is composed of a set of consumption alternatives each of which
yields the same total amount of satisfaction. These combinations can also be shown by an
indifference curve.
Figure/Diagram of Indifference Curve:
The consumers preferences can be shown in a diagram with an indifference curve. The
indifference showing nothing about the absolute amounts of satisfaction obtained. It merely
indicates a set of consumption bundles that the consumer views as being equally satisfactory.
In fig. 3.1 we measure the quantity of wheat along X-axis (in kilograms) and along Y-axis,
the quantity of rice (in kilograms). IC is an indifference curve.
It is shown in the diagram that a consumer may buy 12 kilograms of rice and 5 kilograms of
wheat or 9 kilograms of rice and 15 kilogram of wheat. Both these combinations are equally
preferred by him and he is indifferent to these two combinations. When the scale of
preference of the consumer is graphed, by joining the points a, b, c, d, e, we obtain an
Indifference Curve IC.
Every point on indifference curve represents a different combination of the two goods and the
consumer is indifferent between any two points on the indifference curve. All the
combinations are equally desirable to the consumer. The consumer is indifferent as to which
combination he receives. The Indifference Curve IC thus is a locus of different combinations
of two goods which yield the same level of satisfaction.
An Indifference Map:
A graph showing a whole set of indifference curves is called an indifference map. Each
successive curve further from the original curve indicates a higher level of total satisfaction.

In the fig. 3.2 three indifference curves IC1, IC2 and IC3 have been shown. The various
combinations of goods of wheat and rice lying on IC1 yield the same level of satisfaction to
the consumer. The combinations of goods lying on higher indifference curve IC2 contain
more both the goods wheat and rice. The indifference curve IC2 gives more satisfaction to the
consumer than IC1. Similarly, the set of combinations of two goods on IC3 yields still higher
satisfaction to the consumer than IC2. In short, the further away a particular curve is from the
origin, the higher level of satisfaction it represents.

Definition and Explanation:

The concept of marginal rate substitution (MRS) was introduced by Dr. J.R. Hicks and Prof.
R.G.D. Allen to take the place of the concept of diminishing marginal utility.

For example, there are two goods X and Y which are not perfect substitute of each other.
The consumer is prepared to exchange goods X for Y. How many units of Y should be given
for one unit of X to the consumer so that his level of satisfaction remains the same?

Marginal rate of substitution (MRS) can also be defined as:

The ratio of exchange between small units of two commodities, which are equally valued or
preferred by a consumer.

Schedule:
The concept of MRS can be easily explained with the help of schedule given below:

Marginal Rate of Substitution

Combination Good X Good Y MRS of X for Y

1 1 13 --
2 2 9 4:1
3 3 6 3:1
4 4 4 2:1
5 5 3 1:1
In the table given above, all the five combinations of good X and good Y give the same
satisfaction to the consumer. If he chooses first combination, he gets 1 unit of good X and 13
units of good Y.

In the second combination, he gets one more unit of good X and is prepared to give 4 units of
good Y for it to maintain the same level of satisfaction. The MRS is therefore, 4:1.

In the third combination, the consumer is willing to sacrifice only 3 units of good Y for
getting another unit of good X. The MRS is 3:1.

Likewise, when the consumer moves from 4th to 5th combination, the MRS of good X for
good Y falls to one (1:1). This illustrates the diminishing marginal rate of substitution.

Diagram/Figure:
The concept of marginal rate of substitution (MRS) can also be illustrated with the help of the
diagram.
In the fig. 3.3 above as the consumer moves down from combination 1 to combination 2, the
consumer is willing to give up 4 units of good Y (Y) to get an additional unit of good X
(X).

When the consumer slides down from combinations 2, 3 and 4, the length of Y becomes
smaller and smaller, while the length of X is remain the same. This shows that as the stock
of the consumer for good X increases, his stock of good Y decreases.

He, therefore, is willing to give less units of Y to obtain an additional unit of good X. In other
words, the MRS of good X for good Y falls as the consumer has more of good X and less of
good Y. The indifference curve IC slopes downward from left to the right. This means a
negative and diminishing rate of substitution of one commodity for the other.

Properties/Characteristics of Indifference Curve:

Definition, Explanation and Diagram:
An indifference curve shows combination of goods between which a person is indifferent.
The main attributes or properties or characteristics of indifference curves are as follows:

(1) Indifference Curves are Negatively Sloped:

The indifference curves must slope down from left to right. This means that an indifference
curve is negatively sloped. It slopes downward because as the consumer increases the
consumption of X commodity, he has to give up certain units of Y commodity in order to
maintain the same level of satisfaction.
In fig. 3.4 the two combinations of commodity cooking oil and commodity wheat is shown
by the points a and b on the same indifference curve. The consumer is indifferent towards
points a and b as they represent equal level of satisfaction.

(2) Higher Indifference Curve Represents Higher Level:

A higher indifference curve that lies above and to the right of another indifference curve
represents a higher level of satisfaction and combination on a lower indifference curve yields
a lower satisfaction.

(3) Indifference Curve are Convex to the Origin:

This is an important property of indifference curves. They are convex to the origin (bowed
inward). This is equivalent to saying that as the consumer substitutes commodity X for
commodity Y, the marginal rate of substitution diminishes of X for Y along an indifference
curve.
In this figure (3.6) as the consumer moves from A to B to C to D, the willingness to substitute
good X for good Y diminishes. This means that as the amount of good X is increased by
equal amounts, that of good Y diminishes by smaller amounts. The marginal rate of
substitution of X for Y is the quantity of Y good that the consumer is willing to give up to
gain a marginal unit of good X. The slope of IC is negative. It is convex to the origin.

(4) Indifference Curve Cannot Intersect Each Other:

Given the definition of indifference curve and the assumptions behind it, the indifference
curves cannot intersect each other. It is because at the point of tangency, the higher curve will
give as much as of the two commodities as is given by the lower indifference curve. This is
absurd and impossible.

In fig 3.7, two indifference curves are showing cutting each other at point B. The
combinations represented by points B and F given equal satisfaction to the consumer because
both lie on the same indifference curve IC2. Similarly the combinations shows by points B
and E on indifference curve IC1 give equal satisfaction top the consumer.

If combination F is equal to combination B in terms of satisfaction and combination E is

equal to combination B in satisfaction. It follows that the combination F will be equivalent to
E in terms of satisfaction. This conclusion looks quite funny because combination F on IC2
contains more of good Y (wheat) than combination which gives more satisfaction to the
consumer. We, therefore, conclude that indifference curves cannot cut each other.
(5) Indifference Curves do not Touch the Horizontal or Vertical Axis:
One of the basic assumptions of indifference curves is that the consumer purchases
combinations of different commodities. He is not supposed to purchase only one commodity.
In that case indifference curve will touch one axis. This violates the basic assumption of
indifference curves.

Price Line or Budget Line:

Definition and Explanation:
The understanding of the concept of budget line is essential for knowing the theory of
consumers equilibrium.

"A budget line or price line represents the various combinations of two goods which can be
purchased with a given money income and assumed prices of goods".

For example, a consumer has weekly income of Rs60. He purchases only two goods, packets
of biscuits and packets of coffee. The price of each packet of biscuits is Rs6 and the price of
each packet of coffee is Rs12. Given the assumed income and the price, of the two goods, the
consumer can purchase various combination of goods or market combination of goods
weekly.

Schedule:
The various alternative market baskets (combinations of goods) are shown in the table below:

Packets of Biscuits Per

Market Basket Packets of Coffee Per Week
Week

A 10 0

B 8 1

C 6 2

D 4 3

E 2 4
 F 0 5

Income Rs60 Per Week = Packets of Biscuits Costs Rs6 = Packets of Coffee is Priced
Rs12 Each
(i) Market basket A in the table above shows that if the whole amounts of Rs60 is spent on
the purchase of biscuits, then the consumer buys 10 packets of biscuits at a price of Rs6 each
and nothing is left to purchase coffee.

(ii) Market basket F shows the other extreme. If the consumer spends the entire amount of
Rs60 on the purchase of coffee, a maximum of 5 packets of coffee can be purchased with it at
a price of Rs12 each with nothing left over for the purchase of biscuits.

(iii) The intermediate market baskets B to E shows the mixes of packets of biscuits and
packets of coffee that the cost a total of Rs60. For example, in combination of market basket
C, the consumer can purchase 6 packets of biscuits and 2 packets of coffee with a total cost of
Rs60.

Budget Line:
The budget line is an important element analysis of consumer behavior. The indifference map
shows peoples preferences for the combination of two goods. The actual choices they will
make, however, depends on their income. The budget line is drawn as a continuous line. It
identifies the options from which the consumer can choose the combination of goods.

Diagram/Figure:

In the fig. 3.9 the line AF shows the various combinations of goods the consumer can
purchase. This line is called the budget line.

It shows 6 possible combinations of packets of biscuits and packets if coffee which a

consumer can purchase weekly. These combinations are indicated by points A, B, C, D, E
and. Point A indicates that 10 packet of biscuits can be purchased if the entire income of
Rs60 is devoted to the purchase of biscuits. Similarly, point F shows the purchase of 5
packets of coffee for the entire income of Rs60 per week.

The budget line AF indicates all the combinations of packets of biscuits and packets of coffee
which a consumer can buy given the assumed prices and income. In case, a consumer decides
to purchase combination of goods inside the budget line such as G, then it involves a total
outlay that is smaller then the amount of Rs60 per week. Any point outside the budget line
such as H requires an outlay larger than the consumers weekly income of Rs60.

Shifts in Budget Line:

The price line is determined by the income of the consumer and the prices of goods in the
market. If there is a change in the income of the consumer or in the prices of goods, the price
line shifts in response to a exchange in these two factors.

(i) Income changes: When there is change in the income of the consumer, the prices of
goods remaining the same, the price line shifts from the original position. It shifts upward or
to the right hand side in a parallel position with the rise in income.

A fall in the level of income, product prices remaining unchanged, the price line shifts left
side from the original position. With a higher income, the consumer can purchase more of
both goods than before but the cost of one good in terms of the other remains the same.

In the fig. 3.10 (a), a change in income is shown when product prices remain unchanged. The
rise in income results in a parallel upward shifts in the budget line from L/ M/ to L2M2. The
consumer is able to purchase more of both the goods A and B.

(ii) Price changes. Now let us consider that there is a change in the price of one good. The
income of the consumer and price of other good is held constant. When there is a fall in the
price of one good say commodity A, the consumer purchases more of that good than before.
A price change causes the budget line to rotate about point L fig. 3.10 (b).
 It becomes flatter and give the new budget line from LM/ to LM2. A flatter budget line
means that the relative price of the good A on the horizontal axis is lower. If the greater
amount is spent on the purchase of good A, the consumer can buy increased OM2 amount of
good A.

Consumer's Equilibrium Through Indifference Curve Analysis:

Definition:
"The term consumers equilibrium refers to the amount of goods and services which the
consumer may buy in the market given his income and given prices of goods in the market".

The aim of the consumer is to get maximum satisfaction from his money income. Given the
price line or budget line and the indifference map:

"A consumer is said to be in equilibrium at a point where the price line is touching the
highest attainable indifference curve from below".

Explanation:

The consumers consumption decision is explained by combining the budget line and the
indifference map. The consumers equilibrium position is only at a point where the price line
is tangent to the highest attainable indifference curve from below.

(1) Budget Line Should be Tangent to the Indifference Curve:

The consumers equilibrium in explained by combining the budget line and the indifference
map.

Diagram/Figure:
 In the diagram 3.11, there are three indifference curves IC1, IC2 and IC3. The price line PT is
tangent to the indifference curve IC2 at point C. The consumer gets the maximum satisfaction
or is in equilibrium at point C by purchasing OE units of good Y and OH units of good X
with the given money income.

The consumer cannot be in equilibrium at any other point on indifference curves. For
instance, point R and S lie on lower indifference curve IC1 but yield less satisfaction. As
regards point U on indifference curve IC3, the consumer no doubt gets higher satisfaction but
that is outside the budget line and hence not achievable to the consumer. The consumers
equilibrium position is only at point C where the price line is tangent to the highest attainable
indifference curve IC2 from below.

Income Effect : Represents change in consumers equilibrium position when the income of the
consumer change while all other determinants of demand remains constant.

P1 ICC

Commodity A P2 N1
N
IC3
N2 IC2
IC1

O Q2 Q Q1

Commodity B

In the diagram,
N is the original equilibrium position.
N1 is the new equilibrium position with a rise in income.
N2 is the new equilibrium when income falls.
If we join N, N1 and N2 then we get Income Consumption Curve (ICC). The ICC traces the
relationship between changes in the level of income and corresponding changes in the level of
consumption and the level of equilibrium. Thus, when income increases, the consumer moves to
higher equilibrium position and vice-versa.

Price Effect : Represents change in consumers equilibrium position when the price of one good
changes while the price of another remains constant.

Commodity A
N1 N N2 PCC

IC1 IC2 IC3

O Q2 Q Q1
Commodity B

PCC
Q1

Commodity A Q N2
N IC 3
Q2 IC 2
N1 IC 1

O P
Commodity B

In the first diagram, N is the original equilibrium position, N2 is the new equilibrium position
with a fall in the price of good B. (Fall in price leads to rise in demand) N1 is the new
equilibrium position with a rise in price of B (rise in price leads to fall in demand). If we join N,
N2 and N1, we get the Price Consumption Curve (PCC) which explains the relationship between
change in price and the level of consumption.
In the second diagram, N is the original equilibrium position. N2 is the new equilibrium
position with a fall in the price of A. Fall in price of A leads to rise in the demand for A. N1 is
the new equilibrium position with the rise in the price of A. Rise in price leads to fall in demand
for A. if we join N, N2 and N1, we get the Price Consumption Curve (PCC) which explains the
relationship between change in price and the level of consumption.
It is necessary to note that price effect is the result of both income effect and substitution
effect. As price of the product falls it becomes relatively cheaper. Hence cheaper products are
substituted for costlier product (substitution effect). Similarly, as price falls, the real income of
the consumer rises as and as such with the help of same amount of money income a consumer
will buy more quantity (income effect). Thus price effect =substitution effect + income effect.
 Substitution Effect
The substitution effect explains as to what happens to the consumers equilibrium position
when price of both goods changes price of one rises and price of another falls.

Price of A rises
6 N
P1

2 N1 IC

O 2 Q6 Q1

Price of commodity B falls

In the diagram, N is the original equilibrium position. At N the consumer is consuming 6A +

2B when price of A rises and price of B falls, there will be a new budget line P1 and Q1. N is the
new equilibrium position on the same indifference curve. At N1 the consumer will be consuming
2A + 6B. the combination may change, but his total level of satisfaction remains the same even
after change in the price of both goods A and B.

Thus, Hicks explains how there will be a change in the equilibrium position of a consumer
when there is a change in his income, a change in the price of one commodity and a change in the
prices of both the commodities other things remaining constant.

Consumer Surplus

First developed by Jules Dupuit, French civil engineer and economist, in 1844 and
popularized by British economist Alfred Marshall, the concept depended on the
assumption that degrees of consumer satisfaction (utility) are measurable.

Consumer surplus is defined as the difference between what consumers are

willing to pay for a unit of the good and the amount consumers actually do pay
for the product.

In other words it is the difference between the price a consumer pays for an item and
the price he would be willing to pay rather than do without it.

Consumer Surplus is a measure of the welfare that people gain from the
consumption of goods and services, or a measure of the benefits they derive from
the exchange of goods.

Definitions

Consumers Surplus is the difference between the potential price and the actual
price F.W.Taussig.
 Consumers surplus can be measured by the difference between total utility derived
in terms of money and the total amount of money spent on the goods

Assumptions
Quantitative or Cardinal measurement of utility is possible

Marginal Utility of Money remains constant

The Consumer derives Diminishing Marginal Utility by consuming successive units

of a commodity

Units of Marginal Market Price Consumer s

Mangoes Utility Per Surplus
(in Rs.) of Mango
Successive (in Rs.)
Units of
Mangoes

1 8 5 3

2 7 5 2

3 6 5 1

4 5 5 0

4 26 20 6

Criticisms
Unrealistic Assumptions
 The concept of consumer surplus cannot be applied in case of the basic necessities
of life
Importance

Helps to evaluate Economic Welfare

Helps in pricing Decisions

Helps the government in its Taxation Policy

Shifts in Budget Line (in detail )

1) Condition = Price is K
Income Increases

B1

Commodity A

O L L1
Commodity B

2) Condition = Price is K
Income decreases

B1

Commodity A

O L1 L
Commodity B
3) Condition = Income is K
Price of both commodities increases

B1

Commodity A

O L1 L
Commodity B

4) Condition = Income is K
Price of both commodities decreases

B1

Commodity A

O L L1
Commodity B

5) Condition = Income is K
Price of A remains K
Price of B increases

Commodity A

O L1 L

Commodity B
6) Condition = Income is K
Price of B remains K
Price of A increases

Commodity A
B1

O L
Commodity B

7) Condition = Income is K
Price of A increases
Price of B decreases

Commodity A
B1

O L L1

Commodity B

8) Condition = Income is K
Price of A decreases
Price of B increases

B1

Commodity A
B

O L1 L

Commodity B