2. DEMAND AND LAW OF DEMAND
Demand is from Consumer’s side. While answering any question on demand, take supply conditions as
constant.
When own price of commodity changes, take other factors affecting demand constant, while explaining.
When other factors change, take own price constant, while explaining.
In case of substitute goods relationship explanation, use the reason ‘relatively cheaper’ while comparing
prices of the substitutes.
For inferior goods, income level is the main factor.
Price Effect= Income effect + Substitution effect.
In case of Reasons for downward slope of demand curve, own price changes, other factors remain constant in
the explanation as, Demand curve shows relation between own price and quantity demanded of the
commodity.
Income effect shows change in real income(purchasing power) because of change in price of the commodity.
Giffen goods are exception to law of demand. Giffen goods are special kinds of inferior goods on which
consumers spend a large part of their income.
Own price change, other factors constant leads to change in quantity demanded i.e. Extension or contraction
of demand.(Movement along the demand curve)
Price constant, other factors change leads to change in demand i.e. Increase or decrease in demand.(Shift in
demand)
3. THEORY OF CONSUMER BEHAVIOUR
In consumer’s equilibrium explanation, be it cardinal or ordinal utility, first define consumer’s
equilibrium.
Cardinal utility(measurable in numbers) Law of diminishing marginal utility(along with assumptions)
Ordinal utility(order of preference or scale of preference)Principle of diminishing marginal rate of
substitution.
At point of saturation or satiation, i.e. optimum point of satisfaction, MU=0 or TU is maximum.
The IC curve should be convex to the origin(necessary condition) in case of consumer’s equilibrium
approach– ordinal utility
&
MRSxy(slope of IC) = -(Px/Py)(slope of budget line) Sufficient condition
4. ELASTICITY OF DEMAND
DEGREES(HIGHEST TO LOWEST)
Perfectly elastic horizontal line (infinity)
Relatively elastic flat downward slope(% change in quantity demanded greater than %
change in price); luxuries.(>1)
Unitary elastic 1 (% change in quantity demanded= % change in price)
Relatively inelastic steep downward slope(% change in quantity demanded less than %
change in price); necessities.(<1)
Perfectly inelastic vertical line(zero)
In case of Factors affecting elasticity of demand, state after the explanation elastic or
inelastic .
5. SUPPLY—LAW OF SUPPLY AND
ELASTICITY OF SUPPLY
While answering any question on supply or producer’s side, take
demand conditions as constant.
In case of other factors affecting supply, mention ‘at given price of the
commodity’ in the explanation.
Elastic supply(Es>1) When extended cuts the Y-axis and when
further extended cuts the negative X-axis.
Inelastic supply(Es<1) When extended cuts the X-axis.
6. MARKET MECHANISM
• Interaction of both demand and supply forces leading to determination of
equilibrium.
• Demand > Supply Excess demand(shortage of supply) leading to rise in price.
• Supply> Demand Excess supply(deficient demand) leading to fall in price.
• Applications of demand and supply:
Price ceiling: Government interferes in the free market to help out poor consumers.
Maximum legal price which the government should set below the equilibrium price.
Floor price: Government interferes in the free market to help the poor
producers(Indian farmers). Minimum legal price which the government should set
above the equilibrium price.
7. LAWS OF RETURNS
• In case of ‘Explain stages’ 1st
Name and state the law.
• Rate of change in Total is Marginal.
• Increasing Returns: TP first increases at an increasing rate, increases at a
diminishing rate(This change of rate(slope) Point of inflexion); MP increases,
reaches maximum and starts falling; AP starts increasing and reaches maximum.
• Diminishing Returns: TP continues to increase at a diminishing rate and reaches
maximum; MP continues to fall and reaches zero;AP starts falling.
• Negative returns: TP starts falling; MP becomes negative; AP continues to fall but
remains positive.
8. COST AND REVENUE ANALYSIS
Productivity(rate of production) and Cost are opposite sides of the same coin.
As production increases, cost of production always increases.
Production Total Cost
Increases at an increasing rate increases at a diminishing rate
Increases at a diminishing rate increases at an increasing rate
Always refer to law of variable proportions , in the explanation of shape of cost curves.
In case of revenue, in all forms of market, Price=Average Revenue.
In case of Perfect competition, P=AR=MR.(price-taker)
In case of Imperfect Market, P=AR but AR>MR.
In case of imperfect market, if price reduces at a constant rate,i.e., AR is a straight line, then
Slope of MR curve= 2 Slope of AR curve.
9. FORMS OF MARKET
In order of highest to lowest elasticity of demand:
Perfect Competition(Infinity; highest) very Large number of buyers &
sellers; Homogeneous(identical or perfect substitutes) product; price taker; single
seller or buyer cannot influence the market price; normal profit in the long run
because of freedom of entry and exit.
Monopolistic Competition(elastic negatively sloping demand curve) Fairly
large number of buyers and sellers; product differentiation i.e. close substitutes(in
terms of physical characteristics, environmental factors, brand name); partial
price makers; freedom of entry and exit ensuring normal profit in the long run.
10. Contd….
Monopoly(inelastic negatively sloped demand curve) single seller
of the product i.e. firm itself is the industry price maker; no close
substitutes; high barriers to entry(abnormal profit in the long run); price
discrimination.
Oligopoly(indeterminate demand curve) few big sellers of the
product; may produce homogeneous or differentiated product;
interdependence(action-reaction of rival firms).
11. PRODUCER’S EQUILIBRIUM
&
DETERMINATION OF EQUILIBRIUM PRICE AND OUTPUT
UNDER PERFECT COMPETTION
In case of Producer’s equilibrium question, define producer’s equilibrium first.
TR-TC Approach: Equilibrium is where the vertical distance between TR and TC
is maximum which is the profit-maximising level of output.
MR-MC Approach:
Rule 1– Whether to produce or not in the short- run– P or AR >=AVC.
Rule 2– Necessary condition is MR=MC.
Rule 3– Sufficient condition is that MC<MR at slightly lower output and MC>MR
for slightly higher output for profit maximisation rather than profit minimisation.
12. CONTD…
Break-even point: TR=TC or AR=AC.
Show break-even point using normal profit diagram of perfect
competition in the short run.
This Photo by Unknown Author is licensed under CC BY-SA
13. Contd…
Shut-down point: AR=AVC.
In long run, only show normal profit diagram under perfect competition.
This Photo by Unknown Author is licensed under CC BY
14. THEORY OF INCOME AND
EMPLOYMENT
• Ex-ante demand which means desired concept.
• AD= C + I + G + (X-M)
where, C= desired consumption expenditure by households.
I= desired investment expenditure by firms
G= desired government spending by the govt.
(X-M)= net exports.
• AD falls with fall in any of the above components, other components remaining constant.
• AD does NOT fall with fall in imports.
15. Contd….
• Excess demand or inflationary gap is always at full employment level
of output (fixed supply)i.e. maximum production of the economy.
• Deficient demand or deflationary gap(at full employment) leads to
underemployment equilibrium in the economy.
16. BALANCE OF PAYMENTS AND
EXCHANGE RATE
• Exchange rate means price of one currency in terms of the other.
• Depreciation or appreciation happens under free market forces of demand and supply under
flexible exchange rate system.
• Devaluation or revaluation is done by the central bank under fixed exchange rate system.
• Depreciation of domestic currency appreciation of foreign currency which means domestic
goods become cheaper, foreign goods costlier leading to increase in exports and may lead to
fall in imports.
• Increase in exports lead to increase in supply of foreign currency which increases the exchange
rate (appreciation of foreign currency/depreciation of domestic currency)
• Rise in exchange rate leads to excess supply of foreign exchange.
