What economics studies

Definitions over time

The central problems of every economy, because resources are scarce: what to produce, how to produce, and for whom to produce.

The production possibility curve (PPC) — shows the combinations of two goods an economy can produce with its resources fully and efficiently used.

• ›it slopes downward — more of one good means less of the other
• ›it is concave to the origin because the opportunity cost — the amount of one good given up to get more of the other — rises as resources less suited to the second good are shifted to it
• ›a point inside the curve shows unemployment or inefficiency; a point outside is unattainable now; growth shifts the curve outward

Branches — microeconomics studies individual units (a consumer, a firm, a market); macroeconomics studies the economy as a whole (national income, inflation, employment). Positive economics describes what is; normative economics says what ought to be.

The trap: the PPC is concave because opportunity cost increases — a straight-line PPC would mean constant opportunity cost.

Utility and the consumer's choice

Utility — the want-satisfying power of a good. Two approaches measure it.

Cardinal approach (Marshall) — utility can be measured in units ('utils').

• ›total utility (TU) — the total satisfaction from all units consumed
• ›marginal utility (MU) — the extra satisfaction from one more unit
• ›law of diminishing marginal utility — as more units of a good are consumed, each further unit gives less extra satisfaction; when MU is zero, TU is at its maximum; when MU turns negative, TU falls
• ›consumer's equilibrium (one good): MU = price; (two goods): MUx ÷ Px = MUy ÷ Py

Ordinal approach (Hicks and Allen) — satisfaction can only be ranked, not measured.

• ›an indifference curve shows combinations of two goods that give the same satisfaction
• ›it slopes downward and is convex to the origin, because the marginal rate of substitution (MRS) — how much of one good the consumer gives up for one more unit of the other — diminishes
• ›two indifference curves never intersect; a higher curve means higher satisfaction
• ›the budget line shows what the consumer can afford: Px·X + Py·Y = income
• ›equilibrium where the budget line just touches the highest attainable indifference curve: MRS = Px ÷ Py

Worked example — a consumer's MU from successive cups of tea: 20, 15, 10, 5, 0, −5. TU is 20, 35, 45, 50, 50, 45 — highest at the fifth cup, where MU is zero.

The trap: when MU = 0, TU is at its maximum — not zero; TU falls only after MU becomes negative.

Demand and the law of demand

Demand is the quantity of a good a consumer is willing and able to buy at a given price in a given period.

What it depends on — the good's own price, the prices of related goods (substitutes such as tea and coffee; complements such as cars and petrol), the consumer's income, tastes, expectations, and — for market demand — the number of buyers.

The law of demand — other things remaining the same, price and quantity demanded move in opposite directions; the demand curve slopes downward. Reasons: the income effect (a lower price raises real income), the substitution effect (the good becomes cheaper relative to others), diminishing marginal utility, and new buyers entering.

Exceptions

Movement and shift

Normal and inferior goods — demand for a normal good rises with income; for an inferior good it falls as income rises (coarse grains replaced by better food).

The trap: a change in the good's own price causes a movement along the demand curve; anything else shifts the curve.

Elasticity of demand

Price elasticity of demand — how strongly quantity demanded responds to a change in price:

> Ed = percentage change in quantity demanded ÷ percentage change in price (taken as a positive number)

Worked example — price rises from ₹10 to ₹12 (a 20% rise) and quantity falls from 100 to 90 units (a 10% fall): Ed = 10 ÷ 20 = 0.5 — demand is inelastic.

Degrees of elasticity

The total expenditure method — if a fall in price raises total spending, demand is elastic; if spending stays the same, unitary; if it falls, inelastic.

What makes demand elastic — many close substitutes; the good being a luxury; a large share of income spent on it; a long time to adjust; many uses. Salt and life-saving medicines have inelastic demand; branded clothes and holidays, elastic.

Other elasticities

• ›income elasticity — positive for normal goods, negative for inferior goods, greater than 1 for luxuries
• ›cross elasticity — positive for substitutes (tea and coffee), negative for complements (cars and petrol)

The trap: a vertical demand curve is perfectly inelastic (Ed = 0), and a horizontal one perfectly elastic — the flatter the curve, the more elastic the demand.

Points to Remember

• ›Smith 1776 — wealth · Marshall 1890 — welfare · Robbins 1932 — scarcity (ends, scarce means, alternative uses) · Samuelson — growth
• ›what, how, for whom · PPC concave — rising opportunity cost · inside — unemployment · outward shift — growth
• ›micro and macro · positive and normative
• ›law of diminishing MU · MU = 0 → TU maximum · equilibrium MUx/Px = MUy/Py
• ›indifference curve — downward, convex (diminishing MRS), never intersect · budget line · equilibrium MRS = Px/Py
• ›determinants of demand — own price, related prices, income, tastes, expectations
• ›law of demand — inverse; income and substitution effects · Giffen — inferior staple · Veblen — prestige
• ›own price — movement along · other factors — shift
• ›normal goods — demand rises with income · inferior — falls
• ›Ed = %ΔQ ÷ %ΔP · ₹10 → ₹12, 100 → 90 — Ed = 0.5
• ›∞ horizontal · 1 rectangular hyperbola · 0 vertical · total expenditure method
• ›income elasticity negative for inferior goods · cross elasticity + substitutes, − complements
• ›Exam tip: in every elasticity sum, convert both changes to percentages of the original values before dividing — never divide the raw changes