Microeconomics: Nature, Elasticity, Demand, Supply & Equilibrium
1. Nature and Scope of Microeconomics (16 Marks)
Microeconomics is an important branch of economics that deals with the study of individual economic units such as consumers, firms, industries and markets. It focuses on how individuals and firms make decisions regarding the allocation of scarce resources and how these decisions affect prices, output and the distribution of income. Microeconomics is also known as price theory because it explains the determination of prices of goods and services in the market.
The nature of microeconomics is analytical and specific. It studies the behaviour of individual consumers with respect to demand for goods and services and the behaviour of producers regarding production and supply. It is based on the assumption of ceteris paribus, which means other factors remain constant while studying the effect of one variable. Microeconomics uses marginal analysis such as marginal utility, marginal cost and marginal productivity to explain economic decisions. It is a static analysis because it studies equilibrium at a particular point in time.
The scope of microeconomics is very wide. It includes the theory of demand which explains consumer behaviour, the law of demand and elasticity of demand. It also includes the theory of production and cost which deals with production techniques and cost structures of firms. Another important area is the theory of price determination under different market conditions such as perfect competition, monopoly and monopolistic competition. Microeconomics also covers the theory of distribution which explains the determination of wages, rent, interest and profit. Welfare economics is another important part of microeconomics which deals with social welfare and economic efficiency. Thus, microeconomics helps in understanding the working of an economic system at the micro level.
2. Elasticity of Demand (16 Marks)
Elasticity of demand refers to the degree of responsiveness of the quantity demanded of a commodity to changes in its determinants such as price, income and prices of related goods. It measures how sensitive consumers are to changes in economic variables. The concept of elasticity of demand was introduced by Alfred Marshall.
Types of Elasticity
- Price elasticity of demand measures the responsiveness of quantity demanded to a change in the price of the commodity. When a small change in price leads to a large change in quantity demanded, demand is said to be elastic. When quantity demanded changes less in response to a change in price, demand is inelastic. If quantity demanded does not change at all with a change in price, demand is perfectly inelastic.
- Income elasticity of demand measures the responsiveness of quantity demanded to changes in consumer income. In the case of normal goods, demand increases with an increase in income. In the case of inferior goods, demand decreases when income increases.
- Cross elasticity of demand measures the responsiveness of demand for one commodity to changes in the price of another commodity. It helps in understanding the relationship between substitute and complementary goods.
Elasticity of demand is very important in practical life. It helps producers in fixing prices of their products. It is useful for the government in framing taxation policies. It also helps in understanding consumer behaviour and forecasting demand. Thus, elasticity of demand plays a significant role in economic analysis.
3. Law of Demand and Law of Supply (16 Marks)
The law of demand states that, other things remaining constant, when the price of a commodity rises, the quantity demanded falls, and when the price falls, the quantity demanded rises. This shows an inverse relationship between price and quantity demanded. The law of demand is based on assumptions such as constant income, unchanged tastes and preferences, and constant prices of related goods.
The law of demand operates due to various reasons such as the law of diminishing marginal utility, the income effect and the substitution effect. Graphically, the demand curve slopes downward from left to right, indicating the inverse relationship between price and quantity demanded.
The law of supply states that, other things remaining constant, the higher the price of a commodity, the greater will be the quantity supplied, and the lower the price, the smaller will be the quantity supplied. There is a direct relationship between price and quantity supplied. The law of supply operates due to the profit motive of producers and better utilization of resources at higher prices.
The supply curve slopes upward from left to right. Both demand and supply together play an important role in determining the price of a commodity in the market.
4. Equilibrium (Price Determination) (16 Marks)
Market equilibrium refers to a situation where the quantity demanded of a commodity is equal to its quantity supplied at a particular price. At this price, there is neither excess demand nor excess supply in the market. This price is known as the equilibrium price and the quantity is known as the equilibrium quantity.
If the market price is higher than the equilibrium price, quantity supplied exceeds quantity demanded, leading to excess supply. Due to excess supply, producers reduce the price. If the market price is lower than the equilibrium price, quantity demanded exceeds quantity supplied, leading to excess demand. Due to excess demand, price rises. Thus, market forces of demand and supply automatically bring the price back to equilibrium.
Equilibrium is an important concept in microeconomics as it explains price determination under free market conditions. It helps in understanding how markets adjust themselves through the price mechanism.
5. Utility Approach to Consumer Behaviour (16 Marks)
Utility refers to the satisfaction derived by a consumer from the consumption of goods and services. The utility approach assumes that utility can be measured and compared. Total utility refers to the total satisfaction obtained from consumption of a given quantity of a commodity, while marginal utility refers to the additional satisfaction obtained from consuming one more unit of a commodity.
The law of diminishing marginal utility states that as consumption of a commodity increases, the marginal utility derived from each additional unit goes on diminishing. This law explains the downward-sloping demand curve.
According to the utility approach, a consumer is in equilibrium when they allocate their income in such a way that the marginal utility per rupee spent on each commodity is equal. Symbolically, consumer equilibrium is attained when MUx / Px = MUy / Py.
The utility approach helps in understanding consumer behavior and forms the basis of demand analysis in microeconomics.