FULFILLMENT BY:

AT A GLANCE Y What is Economy z How other Social sciences are related to Economics z The Central Economic Problem Y Microeconomics z DeÞnition z Scope z Features z Advantages z Disadvantages Y Macroeconomics z Differences between Microeconomic and Macroeconomics Y Utility z Types of Utility z The law of diminishinwwg marginal utility z Assumptions of the law of diminishing marginal utility z Criticisms of the law z Importance of the law z Relation between the law of diminishing marginal utility and the law of equi-marginal utility z Assumption of the law z SigniÞcance of importance of the law z Limitations of the law

Y Demand z Law of Demand z Why does Demand Curve Slope Downward? z The Market Demand z Assumptions of the 'Law of Demand' z Determinants (Factors Affecting) of Demand Y Elasticity of Demand z Price elasticity of demand z Income Elasticity of Demand z Cross Elasticity of Demand Y Supply z Supply Function z Law of Supply Y Elasticity of Supply z Types of Supply Elasticity Y Market Equilibrium Y Cost of Production z Cost Function z Fixed Cost and Variable Cost z Average Cost and Marginal Cost z Opportunity Cost Y The Market Structures z Perfect Competition z Monopoly z Monopolistic Competition z Oligopoly

7

KIRAN'S INDIAN ECONOMY

The starting point of all economic activity is the existence of human want. Want give rise to efforts and efforts secure satisfaction. The things which directly satisfy human wants are called satisfaction.

WHAT IS ECONOMICS Economics is a social science that deals with human wants and their satisfaction. People have unlimited wants. But the resources to satisfy these wants are limited. They are always engaged in work to secure the things they need for the satisfaction of their wants. The farmer in the Þeld, the worker in the factory, the clerk in the ofÞce, and the teacher in the school are all at work. The basic question that arises here is: Why different people undertake these activities? The answer is that they are working to earn income with which they satisfy their wants. People have multiple wants to satisfy. They have to satisfy their want for food, cloth, shelter, education, health, etc. Thus human wants are unlimited. In a sense they are insatiable. When one want is satisÞed another want takes its place and so on in an endless succession. By doing some work or activity people earn money. This money is used to satisfy their wants. Thus our activities have two common aspects; Þrst, we are all engaged in earning our living, and secondly, these earnings enable us to satisfy our want for different goods and services. This action of earning and spending is called economic activity. The subject matter of economics is generally divided into four parts. They are Production, Consumption, Exchange and Distribution. Production means producing things or creation or addition of utilities to the goods and services to make them capable of satisfying various wants. Consumption deals with human wants and their satisfaction. Exchange refers to transfer of goods and services through the medium of money and various credit instruments. Finally, distribution refers to the sharing of income from production by four factors of production namely, land, labour, capital and organization. Here, we study how wage, rent, interest and proÞt is determined.

How other Social sciences are related to Economics? Economics is closely related to other social sciences especially History, Political science, Law, Psychology and Sociology. The whole discussion of value, depends intimately upon considerations of psychology. Sociology is sometimes deÞned as the social science, that is, the science of all social relations. If sociology is considered in this sense, Economics is a branch of sociology. Sociology deals only with the more general laws which apply to the whole social structure and that it is coordinate with economics and politics and ethics, and not inclusive of them all. Politics is the science of the state and because of many important ways in which the state inßuences, and is inßuenced by the manner in which its people make a living, 8

the Þelds of the two sciences are closely interwoven and have many problems in common. Ethics is the science of moral conduct. It asks the question what ought to be. There was a time when economists held that economics was concerned only with the question, what is, and not with the question, what ought to be. But now a day's most of the economists considered economics as a positive science as well as a normative science. Economics is also closely related to the science of law. Government and law form a framework in which economic forces act. Thus Economics is the repository of information on resource dynamics. Similar to agriculture and human survival, social sciences must continue to appreciate economics for an ever growing matrix of phenomena which upon analysis facilitate learning in every discipline.

The Central Economic Problem Economic problem arises because of scarcity of resources in relation to demand for them. The following reasons for emergence of economic problems;

Y Human wants (or ends) are unlimited: Man is a bundle of wants. There is no end to human wants. As one want is satisÞed, many others crop up and this goes on endlessly. Again one particular want cannot be satisÞed for all times to come e.g. want for food. After fulÞlling it at a particular time, it crops up again and again. Thus wants are not only unlimited but recurring in nature also. In this sense they are insatiable. Wants differ in urgency or intensity. Some wants are more important while others are less important. This enables a man to arrange his wants in order of preference and make a choice among different wants. Y Resources to satisfy wants are limited: Goods and services are produces by an economy with its resources namelyland, labour, capital and enterprise. Unfortunately, such resources are limited in relation to its demand. Due to scarcity of resources, we cannot produce all the goods and services that the various sections of the society need. If more resources are employed for the production of one commodity, less resources are left for production of other goods. Consequently, some wants will have to go unsatisÞed. Therefore an economy has to decide how to make best possible use of its limited resources. Y Resources have alternative uses: The resources of an economy are not only scarce but also have alternative uses and therefore choice has to be made in their use. For example, a plot of land can be used to produce wheat or for construction of a factory or for a school building. If the plot is used for the cultivation of wheat, it cannot

MICRO & MACRO ECONOMICS

be used for other purposes. In other words, production of one commodity has to be sacriÞced for production of other. Thus, the economy constantly faced with choosing better alternative uses to which its resources should be put. In short, the problem of making a choice among alternative uses of resources is called the basic or central problem of an economy. Such problems are common to all economies. The central problems relate to different aspects of resources are cited below : z What to produce and in what quantities : Since human wants are unlimited and the resources of the economy to satisfy them are limited the economy cannot produce all goods and services required by the people. More of one good or service produced means less of other goods. Therefore every society must exactly choose which goods and services are to be produced and in what quantities. For instance, the economy has to decide whether the resources are to be allocated for the production of consumer goods or capital goods, or necessary goods or luxurious goods or civil goods or military goods. After deciding which goods should be produced society has to decide the quantity of each good has to be produces. z How to produce : This problem refers to the choice of technique of production. It means that which combination of resources or factors to be used for the production of goods and services. There are two types of techniques of production. i.e. the capital intensive technique of production and labour intensive techniques of production. More labour and less capital or relatively less labour and more capital can be used for production. Similarly, small scale or large scale production can be used. The guiding principle here is that only those techniques should be employed which cause the least possible cost to produce each unit of a commodity or service. z For whom to produce : This problem refers who will consume the goods and services produces. A few rich and many poor or vice-versa?. The goods and services produced for the people who can purchase them. And the purchasing power of the people depends on how the produced goods and services are distributed among the people who are helped to produce them. i.e., how is the product distributed among the four factors of production-land, labour, capital and enterprise. z The problem of efficiency in production and distribution: EfÞciency in production and distribution is another problem which follows automatically the Þrst three problems mentioned above. Since the resources are limited , it is very important that they are efÞciently used. By efÞciency we mean that resources are being put to their best possible use. Allocation of resources in production is considered efficient when any other alternate allocation cannot increase production of an article even by one unit. Likewise distribution of production among agents of production

is said to be efÞcient when alternate distribution does not make even one person better off without affecting others adversely.

z The problem of full employment of resources : The problem of full employment of resources implies that existing resources, scarce as they are, should not remain unutilized or under-utilized. Production and supply of goods in every economy is generally always small than the demand for them. Hence to maximize production, all the available resources need to be fully utilized. In fact unemployment or under employment of resources is nothing but wastage of resources. Therefore, an economy has to ensure that its resources are fully employed.

z The problem of growth of resources : Since scarcity of resources is a basic fact of life, its impact can be lessened to some extent through growth of resources. Again the scarce resources exhaust gradually on being used. Therefore, to make up their deficiency, growth of resources has become another basic problem of an economy. Economic growth involves expansion of resources and improvement in technology. It is through effective growth of resources and improved technology by countries like America, Canada, Russia, West European countries and Japan that their economies are rich and developed leading to a higher standard of living. It has, therefore, become most essential for all economies especially the poor ones to not only make full use of their resources but also ensure to grow them so as to meet ever increasing demand of their people for goods and services.

z The problem of economic growth : Every economy in this world is aiming at its rapid economic growth so as to ensure continuous rise in the living standard of its citizens. For underdeveloped countries, the problem of economic growth is highly crucial and signiÞcant because they have to grow at a higher rate to bring the living standard of their people to the level of developed countries. For this, the rate of economic growth needs to be kept higher than the rate of increase in population. Therefore, an economy has to explore potentials of its growth and generate new resources so that its capacity to produce more goods from year to year.

MICRO ECONOMIC The study of economics is divided by the modern economists into two parts viz. Micro economics and Macro economics. Micro economics and Macro economics, both the terms were used in 1933 by Prof. Ragnar Frisch from Oslo University of Norway. The word micro has been derived from the Greek word `Mikros' i.e. small and the word macro has been derived from Greek word `Makros' i.e. large. 9

KIRAN'S INDIAN ECONOMY

Adam Smith 'The Father of Economics' is considered as founder of Micro Economics. In his book "Wealth of Nations'' published in 1776, he discussed how prices of individual commodities and the factors of production are determined. But Micro Economic analysis in fact was developed & popularized by Dr. Alfred Marshall, the neoclassical economist. He is considered as a real architect of Micro Economics. Dr. Marshall's 'Principles of Economics' was published in 1890 and considered as leading work on economics. Most of his analysis in this book is based on Micro Economic approach. Marginalism principle used by Marshall became an important and indispensible tool of micro analysis. Prof Pigou, J.R. Hicks, Prof. Samuelson, Mrs. Joan Robinson, Chamberlin are the other economist, who have participated in the development of Micro Economics.

Definition of Micro Economic

Y Micro Economics thus deals with a small part of the national economy. It studies the economic actions and behavior of individual units such as individual consumer, individual producer or Þrm, the price of a particular commodity or factor etc.

Y Micro Economics is the study of particular firms, particular households, individual prices, wages, incomes, individual industries, particular commodities. Y Micro Economics is in fact a microscopic study of the economy.

Scope of Micro Economics Micro Economics basically deals with

Y Theory of product pricing : Price of a commodity depends upon the forces of demand and supply. Therefore, analysis of demand and supply side is necessary in order to explain the process of determination of price. So, theory of product pricing is subdivided into theory of demand & theory of production & cost.

Y Theory of factor pricing : Theory of factor pricing i.e. Theory of distribution explains how wages (price for the use of labour), rent (payment for the use of land), interest (Price for the use of capital), proÞts (the reward for the entrepreneur are determined.

Y Theory of economic welfare : Theory of welfare basically deals with efficiency in the allocation of resources. EfÞciency in the allocation of resources is attained when it results in maximization of satisfaction of people. Economic efÞciency involves three efÞciencies: 10

z EfÞciency in production : EfÞciency in production means producing maximum possible amount of goods, from the given amount of resources.

z EfÞciency in consumption : EfÞciency in consumption means distribution of produced goods & services among the people for, consumption, in such away as to maximize total satisfaction of society.

z EfÞciency in the direction of production i.e. overall economic efficiency: Efficiency in the direction of production means production of those goods which are most desired by the people.

Characteristics / Features of Microeconomics Y Nature of Analysis: In micro economics, the behaviour of individual consumers and producers in detail is analysed. It is study of subject matter from particular to general. Y Method: Micro economics divides the economy into various small units and every unit is analysed in detail. It is a slicing method. Y Scope: Micro economic analysis involves product pricing, factor pricing and theory of welfare. Y Application: Both theoretically and practically, micro economics is useful in formulating various policies, resource allocation, public Þnance, international trade, etc. Y Nature of Assumptions: Assumption of “Ceteris Paribus” is always made in every micro economic theory. It means theory is applicable only when 'other things being same'.

Advantages of Microeconomics

Y Individual Behaviour Analysis: Micro economics studies behaviour of individual consumer or producer in a particular situation. Y Resource Allocation: Resources are already scare i.e less in quantity. Micro economics helps in proper allocation and utilization of resources to produce various types of goods and services. Y Price Mechanization: Micro economics decides prices of various goods and services on the basis of 'DemandSupply Analysis'. Y Economic Policy: Micro economics helps in formulating various economic policies and economic plans to promote all round economic development. Y Free Enterprise Economy: Micro economics explain operating of a free enterprise economy where individual has freedom to take his own economic decisions. Y Public Finance: It helps the government in Þxing the tax rate and the type of tax as well as the amount of tax to be charged to the buyer and the seller. Y Foreign Trade: It helps in explaining and fixing international trade and tariff rules, causes of

MICRO & MACRO ECONOMICS

disequilibrium in BOP, effects of factors deciding exchange rate, etc.

Y Social Welfare: It not only analyse economic conditions but also studies the social needs under different market conditions like monopoly, oligopoly, etc.

Micro Economics

Macro Economics

4.

Its main tools are demand and supply of particular commodity/factor.

Its main tools are aggregate demand and aggregate supply of the economy as a whole.

5.

It deals with partial equilibrium analysis

It deals with the general equilibrium analysis

Disadvantages / Limitations of Microeconomics

Y Unrealistic Assumptions: Micro economics is based on unrealistic assumptions, especially in case of full employment assumption which does not exist practically. Even behaviour of one individual cannot be generalised as the behaviour of all. Y Inadequate Data: Micro economics is based on the information dealing with individual behaviour, individual customers. Hence, it is difÞcult to get correct information. So because of incorrect data Micro Economics may provide inaccurate results. Y Ceteris Paribus: It assumes that all other things being equal (same) but actually it is not so.

MACRO ECONOMICS The word "macro" is derived from the Greek word "makros" which means "large". Therefore macro economics is the study of economy in its totality or as a whole. It is concerned with the study of national income and not individual income, national saving and not individual saving, aggregate consumption expenditure and not individual consumption expenditure, total production and not production of individual Þrm, price level and not individual price etc. In short it deals with the economy as a whole. The problem of full employment, aggregate consumption, aggregate investment, total savings, general level of prices and variations in them are all the subject matter of macro economics.

UTILITY The concept of utility was introduced to social thoughts by Jeremy Bentham in 1789 and to economic thoughts by Jevons in 1871. The term utility refers to the want satisfying power of a commodity or service. It is the power of a commodity or service to satisfy a want. It is the value in use of the commodity or service because the satisfaction we get from the consumption of a commodity or service is its value in use. Utility is subjective. Utility of a good varies from person to person. It is a psychological phenomenon. It is the feeling of satisfaction, pleasure, happiness or wellbeing which a person derives from the consumption or possession of a commodity or service. Commodity may be poisonous or dangerous to one‘s health, but it possesses utility for those who want them. Thus, utility does not carry any ethical connotation.

Types of Utility The concepts of total utility and the marginal utility are the basic concepts used in the cardinal measurement of utility. Utility is of two types: Marginal Utility (MU): Marginal Utility is the satisfaction derived from consumption of an additional unit of a commodity. Total Utility (TU): Total Utility is the total satisfaction derived from consumption of given units of a commodity. Suppose a consumer, purchases a packet of biscuits, total utility is the satisfaction derived from the consumption of all the biscuits in the packet. In other words, total utility means total satisfaction experience regarding all the units of consumption at a particular point of time, apparently total utility tends to be more with the largest stock and less with the smallest stock.

Micro Economics

Macro Economics

1.

It deals with the study of individual economic units.

It deals with the study of economy as a whole and its aggregates.

2.

It deals with the individual income, individual prices , individual output, etc.

It deals with national income, price level, national output, etc.

The central problem is price determination of commodities and factors of production.

The central problem is the determination of level of income and employment.

3.

Thus marginal utility may be measured as a difference between the utility of the total units of the stock of consumption of a given commodity minus that of consuming one unit less in the stock. In expounding the marginal utility analysis of the consumers demand behaviour, Prof Alfred Marshall has propounded 2 fundamental laws. Y The law of diminishing marginal utility Y The law of equi-marginal utility.

The law of diminishing marginal utility Law of Diminishing Marginal Utility states that as a consumer consumes a commodity, the satisfaction derived from consumption of every additional unit tends to 11

KIRAN'S INDIAN ECONOMY

diminished/decrease. The reason why Demand Curve is downward sloping is because of law of Diminishing Marginal Utility. Law of Diminishing Marginal Utility is the basis of Law of Demand. Unit of consumption of Commodity

Marginal Utility (MU)

Total Utility (TU)

1

10

10

2

7

17

3

4

21

4

0

21

5

-10

11

From the table it appears as the unit of commodity consumed increases, the marginal utility derived from each successive unit tends to diminish, eventually, marginal utility may become zero and ultimately negative. Zero marginal utility implies complete satisfaction of a given want. It must, however be remembered that, marginal utility varies inversely with the consumption of the stock of a given commodity. The variation is not necessarily proportionate or uniform. Any further addition to consumption after zero, marginal utility becomes negative. A negative marginal utility indicate disutility or dissatisfaction resulting from excessive consumption of a commodity.

Assumptions of the law of diminishing marginal utility The law of diminishing marginal utility is conditional. Its validity is attributed to the following assumptions or conditions:

Y Homogeneity:The law holds true only if all the successive units taken in the process of consumption are homogeneous in character like quality size, taste, ßavors, colour etc. If there is a change in the characteristics of the units of the given commodity, it is quite likely that the marginal utility may tend to increase rather than diminish with the successive addition unit of consumption. Y Continuity:The consumption process is continuous at a given time, that is, units are taken one after another successively without any interval of time. Indeed, the Þrst cup of tea in the morning, and the second one in the evening will not result in diminishing marginal utility.

Y Reasonability : The units of consumption are in reasonable size, that is, of normal standard unit. For instance, we should think of a glass of milk, a cup of tea etc. and not a spoon of milk or tea.

Y Constancy : The law presumes that, there is no change in income, taste, habit or preference of the consumer. Similarly, the price of the commodity is also assumed to be given.

Y Rationality : The consumer is assumed to be a rational economic man whose behaviour is normal and who is aiming at maximization of satisfaction. 12

Criticisms of the law Though the law expresses a universal tendency of consumer’s introspective behaviour, its traditional exposition has been criticized on various counts.

Y The traditional or Marshallian explanation of the law presumes the cardinal measurement of utility. The law assumes that utility can be numerically measured added or subtracted. This is rather not convincing because utility being a subjective or introspective phenomena cannot be measured numerically. It is a feeling experienced by the consumer. We cannot therefore have a objective measure of a subjective feeling. Y The law is based on unrealistic assumptions or conditions. The condition assumed like homogeneity, continuity, constancy and rationality all together present at a time is very difÞcult to Þnd in practice. Y The application of the law to the indivisible bulky commodity seems to be absurd. Because no one would normally buy at a time more than one unit of good like television set, refrigerator, scooter, motor car etc. It would be absurd to talk of increase in the stock of such goods and marginal utility thus derived. Y The law unrealistically assumes constant marginal utility of money, which is highly unsatisfactory, with the increase in purchase of goods, for consumption, the marginal utility of money will increase due to the diminishing stock of purchasing power.

Importance of the law The law of diminishing marginal utility has great economic signiÞcance, theoretical as well as practical. From the theoretical point of view the law is important because,

Y The law explains the behaviour and the equilibrium condition of a rational consumer with respect to a single want and commodity. Y The law of diminishing marginal utility is the basic law of economics. It provides the foundation for various laws of consumption. The law of demand is the outcome of the law of diminishing marginal utility. The law of demand states that larger quantities are purchased at a lower price. The reason is that as more units of a commodity are purchased its marginal utility to the consumer becomes less and less and so he gives lesser importance to additional units of a commodity. Therefore, he will buy additional units of a commodity only at a lower price. Y The law explains the paradox of value. The value-in-use and value-in-exchange for a commodity are different. Diamonds have great value-in-exchange, as they are scarce in supply, they have greater marginal utility, and therefore, value is high. On the other hand, water is in abundant supply and its marginal utility is very low. Therefore, it commands no price even though its total utility is high. Thus water has great value in use but no value in exchange. Diamonds have great value in exchange though they are less useful than water. The

MICRO & MACRO ECONOMICS

price of a commodity is thus, related to its marginal utility. Y Prof. Marshall has built up his theory of taxation and public expenditure on the basis of the law of diminishing marginal utility. The principle of progression has been deduced in the theory of taxation by the application of this law, to money. Further, it is argued that there should be equitable distribution of wealth because the utility derived by the rich from money is much less than what could accrue to the poor. If Rs. 100 deducted from the rich man’s income, means only a small sacriÞce of comparatively little utility, while the addition to the amount to the poor man’s income, will increase his satisfaction by more than what a rich man has lost, therefore, methods should be devised to redistribute the national income on a more equitable basis.

The law has the following practical significance as well

Y To the producer, the law serves as a guide to promote sales by reducing prices. Because, when the price falls, to attain equilibrium the consumer has to decrease the marginal utility to that extent. To do this he has to purchase more goods as the marginal utility diminishes only when the stock increases. Y The law is useful to the Þnance minister in formulating an appropriate tax policy. He can justify progressive taxation on higher income on the ground that rich people will feel relatively lesser impact of the tax burden as the marginal utility of money is lower with the increase in income. Y Similarly socialists can agitate for a redistribution of wealth to promote welfare on the ground that the transfer will cause more gain to the poor and less sacriÞce to the rich.

Exceptions to the law of diminishing marginal utility Under the assumptions of homogeneity, continuity, reasonability, constancy and rationality, the law is deemed to be universal. In certain cases, however, it has been observed that a consumer tends to attain increasing marginal utility with an increase in the stock of a commodity consumed or acquired. Such cases are treated as exception to the law of diminishing marginal utility. These exceptions are: Y Hobbies: It is often argued that in the case of hobbies like stamp collection, collection of antique goods, collection of old coins etc, every additional unit gives more pleasure, that is, marginal utility, tends to increase. No doubt this is true, but, it is not a genuine exception to the law of diminishing utility, because in such cases, homogeneity condition of the law is violated. Indeed each time a new variety of stamp or coin or antique is collected by a person but not of the same variety. Y Alcoholics : The law seems to be inapplicable to alcoholics as intoxicants increases with every successive dose of liquor. This is true, but the rationality condition of the law is violated. The introspective behaviour of an alcoholic at that time is irrational or abnormal. Y Misers: In the case of a miser, it is pointed out that

greed increases with every additional acquisition of money. Hence, the marginal utility of money does not diminish for him with more and more money. But, when the miser spends his money his utility of the commodity will be diminishing perhaps more rapidly than in the case of others. Hence, a miser’s behaviour cannot be a signiÞcance exception to the law of diminishing marginal utility. Y Music and poetry : In the case of music and poetry it’s commonly experienced that a repeat gives a better satisfaction than the Þrst one. Hence, it is thought that the law of diminishing marginal utility may not be applicable here. But there is a limit to repeated hearing of the same music and poetry because, it will become monotonous and yields disutility, so it is not a genuine exception to the law. Y Reading : Since more reading gives more knowledge a scholar would get more and more satisfaction with every additional book. But, here we may point out that it is not a real exception to the law as the condition of homogeneity is violated here. Knowledge and satisfaction increases by reading different books and not the same book over and over again.

The law of equi-marginal utility The law of equi-marginal utility is an extension of the law of diminishing marginal utility. This law is called the law of substitution or the law of maximum satisfaction. It is obvious that the law of diminishing marginal utility is applicable only to a single want with one commodity in use. But, in reality there may be a number of wants to be satisÞed at a time, and, these various wants are to be satisÞed with several goods. To analyse, such a situation, one has to extend the law of diminishing marginal utility and such an extended form is called the law of equimarginal utility. The law of equi-marginal utility is based on the three characteristics of wants, that is, wants are comparative, substitutable and complementary. The law takes the following factors as its starting point:

Y Consumer has limited income or limited stock of a given commodity. Y The consumer has more than one want to satisfy. This he can do either by purchasing the required number of commodities out of a given income or putting a given commodity to various uses to satisfy his different wants. Y The consumer is rational and seeks to maximize his wants and his satisfaction. Y He has no control over the price of the commodity, but the prices are given. Under these conditions the law indicates how to acquire maximum satisfaction by spending the given income for purchasing various goods to satisfy a number of wants. The law of equi-marginal utility states that, other things being equal, a consumer gets maximum total utility from spending his given income, when he allocates his expenditure to the purchase of different goods in such a way that the marginal utilities derived from the last unit of 13

KIRAN'S INDIAN ECONOMY

money spent on each item of expenditure tends to be equal, that is, to say that the consumer maximizes his satisfaction, which he obtains equi-marginal utility from all the goods purchased at a given time. To consider the condition of consumer’s equilibrium with respect to maximum total satisfaction a proportionality rule in terms of equi-marginal utility has been formulated by Marshall. The proportionality rule states that when the ratio’s of marginal utility to prices of different goods are equalized with the given marginal utility of money income of the consumer, total utility so derived would be the maximum and the consumer will be at equilibrium under this condition. So long as the ratios of marginal utility of money are not equalized, the consumer will go on redistributing his expenditure from one commodity to another, buying less of one, and more of another, that is substituting one for the other, till these ratios become equal. In symbolic terms, that proportionality rule may be stated as follows:

Mu= Marginal utility P= Price M= Marginal utility of a given money income. a, b, c,= Refers to different goods. Relation between the law of diminishing marginal utility and the law of equi-marginal utility Y The law of equi-marginal utility is an extension of the law of diminishing marginal utility. It considers the satisfaction derived from the number of commodities at a time. The law of diminishing marginal utility is applicable only to a single commodity whereas the law of equi-marginal utility is applicable to several commodities at a time, therefore, it has greater practical value. Y The law of equi-marginal utility also accepts the basic principle of diminishing marginal utility, that is, as consumption of a commodity increases, its marginal utility decreases.

Y Both the laws advocate the same principle that marginal utility must be proportional to the price to maximize total utility. The law of diminishing marginal utility however deals with a single commodity only and states that no consumer shall pay a price for the commodity greater than its marginal utility. Thus with a single commodity his equilibrium condition is marginal utility equals price. The same logic is extended further by law of equi-marginal utility and states that in the case of several commodities the equilibrium condition is the marginal utility of all commodities should be proportional to their prices. 14

Assumption of the law The law of equi-marginal utility is based on the following assumptions.

Y The consumer is a rational economic man who seeks to maximize his total satisfaction Y Utility is measurable in cardinal terms. Y The consumer has a given scale of preference for the goods in consideration. He has perfect knowledge of utility derived. Y Prices of goods are unchanged. Y Income of the consumer is Þxed. Y Marginal utility of money is constant Y Wants and goods are substitutable.

Significance of importance of the law The law has theoretical as well as practical utility. Theoretically it is a useful device for analyzing the behaviour of a rational consumer logically it is a convincing tool to describe the conditions of consumer equilibrium. It opens up analytical areas; it serves as a background for the traditional theory of value.The law has the following practical usefulness also:

Y It applies to consumption : The law indicates how a consumer derives maximum satisfaction with the help of the principal of substitution; the consumer is able to make the best choice of his wants to gain maximum total satisfaction. It serves as a guide to the consumers to bring about the optimum allocation of his income and expenditure. It thus determines the relative demand for different goods. Y It applies to production : To the producer the law is useful because the very principle of substitution lies in the optimum allocation of resources. The producer can have the most economical or optimal combination of factors of production, when the last unit of investment expenditure brings equal productivity to all the factors of production employed. Y It applies to exchange : This principle has an important bearing on the determination of value. The scarcity of a commodity is reßected through rising prices, in an exchange phenomenon- the market. It, thus, helps in readjustment of resources and adjustment of demand and supply by substitution. Y It applies to distribution : The general theory of distribution involves the principle of substitution. In distributing the rewards of the various agents of production, there shares are determined by the principle of marginal productivity. An optimum distribution is one based on the marginal productivity of factors. This is how the law of substitution is applicable here. Y It applies to welfare and public Þnance: Modern states are welfare states and consider the maximization of social beneÞts in their revenue and expenditure activities. The principle of ‘maximum social advantage’ involves the law of substitution when it proposes that revenues must be distributed in such a way that the last unit of

MICRO & MACRO ECONOMICS

expenditure brings equal welfare and satisfaction to all classes of people.

Limitations of the law The law has been subject to certain criticism or limitations. They are as follows:

Y The law is based on unrealistic assumption, being, an extension of the law of diminishing marginal utility, it involves all the unrealistic assumptions and conditions such as homogeneity, continuity, constancy etc. Y The proportionality rule presumes cardinal measurement of utility, but, it is not an unrealistic phenomenon. Y The law cannot be applied to indivisible goods. On practical grounds, it looks ridiculous to equate utility of television set to coffee for a rupee. Y Consumer does not behave rationally all the time quite often; his behaviour is inßuenced by habit, social customs, fashions advertising, propaganda etc. Y It has also been pointed out by many critics, that it is; wrong to assume that the marginal utility of money will remain constant. Actually when money is spent, the remaining units of money will tend to have a greater marginal utility. Thus there is a backward operation of the law of diminishing marginal utility. Y Ignorance on the part of the consumer about market prices and utility of different goods and the uncertain scale of preference due to his wavering mind also pose a limitation to the operation of this law.

“The demand for a commodity at a given price is more than what it would be at a higher price and less than what it would be at a lower price” The law of demand can be illustrated through a demand schedule and through demand curve. Demand schedule shows various quantities of good or service that people will buy at various possible prices during some speciÞed period, while holding constant all other relevant economic variables on which demand depends. A demand schedule is presented below: Price

Quantity Demanded

10

20

8

40

6

60

4

80

2

100

Why does Demand Curve Slope Downward? When price falls the quantity demanded of a commodity rises and vice versa, other things remaining the same. It is due to this law of demand that demand curve slopes downward to the right. There are two factors due to which quantity demanded increases when price falls:

DEMAND

Y Demand for a commodity refers to the quantity of the commodity that people are willing and able to purchase at a speciÞc price per unit of time, other factors (such as price of related goods, income, tastes and preferences, advertising, etc) being constant. Demand includes the desire to buy the commodity accompanied by the willingness to buy it and sufÞcient purchasing power to purchase it. Y Whenever anything become cheaper people buy more but always there are exception for example, if family used to buy 1 kg of salt but if the price of salt comes down, the family does not buy more salt. Y Demand curve is downward sloping because when price is reducing, quantity is increasing and the relation between price and quantity is negative and when we plot in curve it will always be downward sloping. Y Demand curve shows only possibilities that how much you could have bought; you may be willing to buy at different prices.

Law of Demand It states that quantity demanded of a commodity increases with fall in its price and vis-a-versa, other things being constant. It states that there is an inverse relation between quantity demanded and price of a commodity, “Ceteris Paribas” (Latin phrase).

Y Income effect : When the price of a commodity falls the consumer can buy more quantity of the commodity with his given income. Or, if he chooses to buy the same amount of quantity as before, some money will be left with him because he has to spend less on the commodity due to its lower price. In other words, as a result of fall in the price of a commodity, consumer’s real income or purchasing power increases. This increase in real income induces the consumer to buy more of that commodity. This is called income effect of the change in price of the commodity. This is one reason why a consumer buys more of a commodity when its price falls. Y Substitution effect: The other important reason why the quantity demanded of a commodity rises as its price falls is the substitution effect. When price of a commodity falls, it becomes relatively cheaper than other commodities. This induces the consumer to substitute the commodity 15

ISBN 978-81-942495-2-8

Code No. KP 2673