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

http://en.wikipedia.org/wiki/Economic_modelhttp://en.wikipedia.org/wiki/Markethttp://en.wikipedia.org/wiki/Perfect_competitionhttp://en.wikipedia.org/wiki/Economic_equilibrium

price of the product changes, quantity demanded changes, but demand does not change.

Price changes involve a moveme