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M.A. Previous Economics Paper I Micro Economic M.A. PREVIOUS ECONOMICS PAPER I MICRO ECONOMIC ANALYSIS WRITTEN BY SEHBA HUSSAIN EDITED BY PROF.SHAKOOR KHAN M.A. PREVIOUS ECONOMICS PAPER I MICRO ECONOMIC ANALYSIS BLOCK 1 PARTIAL AND GENERAL EQUILIBRIUM, LAW OF DEMAND AND DEMAND ANALYSIS PAPER I MICRO ECONOMIC ANALYSIS BLOCK 1 PARTIAL AND GENERAL EQULIBRIUM, LAW OF DEMAND AND DEMAND ANALYSIS CONTENTS Page number Unit 1 Introduction to Demand Theory 4 Unit 2 Concepts of Demand and Supply 22 Unit 3 Theories of Demand 42 BLOCK 1 PARTIAL AND GENERAL EQULIBRIUM, LAW OF DEMAND AND DEMAND ANALYSIS The block opens with introduction to demand theory. Basic concepts of Demand are explained with Concept of Elasticity of Demand, Price Elasticity of Demand, Income Elasticity of Demand and Cross Price Elasticity. The unit also gives you the insight of various market forms. The second unit covers different concepts of demand and supply. Models of Demand and Supply are discussed along with Demand and Supply Curves. The general and partial equilibrium approaches are also discussed in depth. The figurative representation of the approaches is taken to give readers an easy way to understand the concepts. The third unit takes us into the domain of theories of demand. The Utility theory; Income and substitution effect; Indifference Curve; Revealed Preference; The Slutsky theorem and the Hicks Theory are discussed with price formation and discovery. UNIT 1 INTRODUCTION TO DEMAND THEORY Objectives After studying this unit, you should be able to understand and appreciate: The concept of microeconomics and relevance of Demand The need to identify or define the concept of Demand. How to define elasticity of Demand Relevance of Price Elasticity of Demand Understand the approach to Income Elasticity of Demand The concept of Cross Price Elasticity Know the other forms of Markets in context of Microeconomics Structure 1.1 Introduction 1.2 Basic concepts of Demand 1.3 Concept of Elasticity of Demand 1.4 Price Elasticity of Demand 1.5 Income Elasticity of Demand 1.6 Cross Price Elasticity 1.7 Other Market Forms 1.8 Summary 1.9Further readings 1.1 INTRODUCTION Besides Macroeconomics, the other basic way to view economics is the ―Microeconomic‖ view. This view concerns itself with the particulars of a specific segment of the population or a specific industry within the larger population of good and service providers. More importantly, from a financial standpoint microeconomics concerns itself with the distribution of products, income, goods and services. Of course it is this distribution, which directly affects financial markets and the overall value of any particular resource at a specific point in time. If there is one concept integral to an understanding of microeconomics it is the law of supply and demand. A more detailed look at supply and demand as well as how they affect price will be helpful in understanding microeconomics. Before discussing supply and demand it is helpful to understand what price is as a concept and how it relates to supply and demand. Price is essentially the feedback both the buyer and seller receive about the relative demand of a product, good or service. When the price is high then demand will be low and when the price is low demand will be high. There are two laws intrinsically related to microeconomics. These two laws are the Law of Supply and the Law of Demand. A closer look at each will illustrate how they relate to pricing and the distribution of goods and services. According to the LAW OF DEMAND, as price goes up; the quantity demanded by consumers goes down. As the price falls, the quantity demanded by consumers goes up. This law concerns itself with the consumer side of microeconomics. It tells us the quantity desired of a given product or service at a given price. The LAW OF SUPPLY concerns itself with the entrepreneur or business, which supplies the products and services. This law tells us the amount of a product or service businesses will provide at a given price. Essentially, if everything else remains the same, businesses will supply more of a product or service at a higher price than they will at a lower price. This is because the higher price will attract more providers who seek to make a profit on the good or service. By the same token a low price will not attract additional suppliers and as a result the overall supply will remain low. These two laws help to determine the overall price level of a product with a defined market. When evaluating the prices of an undefined market then another factor must be considered. This additional factor is called OPPORTUNITY COST. Opportunity cost is the relative loss of opportunity one must deal with in making a decision to invest time and money in something else. Needless to say, determining opportunity cost is very complicated and hard to evaluate in terms of economics. Opportunity Cost is also used in evaluating the net cost of any good or service currently being utilized by an individual or the market as a whole. This can be illustrated by the decision a city makes to allocate a zone of land toward public recreation in the form of a park. The opportunity cost in this situation would be the loss of revenue the city would suffer by allocating the park instead of zoning the land for industrial use. Most situations involving opportunity cost are not so clear though. The important concept to take away from opportunity costs is that for every purchasing or investing decision made there are other alternatives, which one is giving up. Therefore one is not just investing $5000 in government bonds but one is choosing to invest in bonds over funding the education of a child or of taking a vacation to the Bahamas for the entire family. Whether the investment is good or not depends on the value the family and the individual places on the alternative. These are the type of insights a microeconomic view can give the individual investor when applied correctly. 1.2 BASIC CONCEPTS OF DEMAND Supply and demand is an economic model based on price, utility and quantity in a market. It concludes that in a competitive market, price will function to equalize the quantity demanded by consumers, and the quantity supplied by producers, resulting in an economic equilibrium of price and quantity. An increase in the quantity produced or supplied will typically result in a reduction in price and vice-versa. Similarly, an increase in the number of workers tends to result in lower wages and vice-versa. The model incorporates other factors changing equilibrium as a shift of demand and/or supply. 1.2.1 Law of Demand The Law of Demand states that other things held constant, as the price of a good increases, the quantity demanded will fall. Other factors that can influence demand include: 1. Income - Generally, as income increases, we are able to buy more of most goods. When demand for a good increases when incomes increase, we call that good a "normal good". When demand for a good decreases when incomes increase, then that good is called an inferior good. 2. Price of related products - Related goods come in two types, the first of which are "substitutes". Substitutes are similar products that can be used as alternatives. Examples of substitute goods are Coke/Pepsi, and butter/margarine. Usually, people substitute away to the less expensive good. Other related products are classified as "complements". Complements are products that are used in conjunction with each other. Examples of complements are pencil/eraser, left/right shoes, and coffee/sugar. 3. Tastes and preferences - Tastes are a major determinant of the demand for products, but usually does not change much in the short run. 4. Expectations - When you expect the price of a good to go up in the future, you tend to increase your demand today. This is another example of the rule of substitution, since you are substituting away from the expected relatively more expensive future consumption. 1.2.2 Demand Curves Demand curves isolate the relationship between quantity demanded and the price of the product, while holding all other influences constant (in latin: ceteris paribus). These curves show how many of a product will be purchased at different prices. Note that demand is represented by the entire curve, not just one point on the curve, and represents all the possible price-quantity choices given the ceteris paribus assumptions. When the price of the product changes, quantity demanded changes, but demand does not change. Price changes involve a movement along the existing demand curve. Market demand is the summation of all the individual demand curves of those in the market. It is the horizontal sum of individual curves and add up all the quantities demanded at each price. The main interest is in market demand curves, because they are averages of individual behaviour tend to be well-behaved. When any influence other than the price of the product changes, such as income or tastes, demand changes, and the entire demand curve will shift (either upward or downward). A shift to the right (and up) is called an increase in demand, while a shift to the left (and down) is called a decrease in demand. In example, there are two ways to discourage smoking: raise the price through taxes or; make the taste less desirable. 1.2.3 Law of Supply As the price of a product rises, ceteris paribus, suppliers will offer more for sale. This implies that price and quantity supplied are positively related. The major factor that influences supply is the "cost of production", and includes: 1.
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