upscvision.org
upscvision.org/
3️⃣
NCERT Notes/
4️⃣
✅Class 12: Introductory Microeconomics
Search
4️⃣

✅Class 12: Introductory Microeconomics

Chapter 1 - Introduction to Indian Economic Development
Introduction - Economic Fundamentals
  1. Scarcity and Choice:
      • Basic Individual Need
          1. Food
          1. Clothing
          1. Shelter
      • Scarcity: Resources are limited while wants are virtually unlimited, leading to the need for choices.
      • No individual has all they need; everyone has limited resources.
      • Example: A family farm has land, grains, and labor, but not all goods and services.
  1. Resource Allocation:
      • Each decision-making unit (individual, household, firm) uses available resources to produce goods or services.
      • Resources are allocated efficiently to fulfill needs and wants.
      • Choices: Individuals must choose what to produce based on limited resources.
      • Trade-offs: Choosing more of one good or service may require giving up others.
  1. Goods and Services:
      • Goods are tangible items (e.g., food, clothing), while services are intangible (e.g., education, healthcare).
  1. Compatibility of Production and Demand:
      • The total production in a society should match the collective demand for goods and services.
      • Resources must be allocated based on what society wants.
      • Reallocation may be needed if demand changes.
  1. Economic Concerns:
      • Two fundamental economic problems: resource allocation and distribution.
      • Allocation: Deciding how to use limited resources efficiently to produce various goods and services.
      • Distribution: Determining how the produced goods and services are distributed among individuals.
  1. Complexity of Economies:
      • Real-world economies are more intricate than the simplified society discussed.
      • Economies involve various decision-making units, industries, and sectors.
  1. Definitions:
      • Goods: Physical, tangible items for satisfying wants and needs.
      • Services: Intangible satisfaction of wants and needs, often involving tasks.
      • Individual: A decision-making unit, which can be an individual person, a household, a firm, or any other organization.
      • Resource: Goods and services used to produce other goods and services (e.g., land, labor, tools, machinery).
Production, Allocation, and Distributions
  1. Introduction to Economic Activities:
      • Economic activities include the production, exchange, and consumption of goods and services.
      • All societies face a scarcity of resources, leading to the need for choices.
      • The scarcity of resources results in competing usages and the necessity of resource allocation.
  1. Basic Economic Problems:
      • Societal problems include determining what to produce, how to produce, and for whom to produce.
      • What to produce: Deciding the quantity and type of goods and services to be produced.
      • How to produce: Choosing the allocation of resources and technologies for production.
      • For whom to produce: Distributing the produced goods and services among individuals in the economy.
  1. Production Possibility Frontier:
      • An economy's resources are limited compared to collective desires.
      • Allocation of resources leads to different combinations of goods and services.
      • The production possibility set is the collection of all possible combinations achievable with available resources and technology.
  1. Opportunity Cost:
      • Opportunity cost is the cost of choosing more of one good at the expense of another.
      • Choosing more good results in less of another good due to limited resources.
      • Opportunity cost is a fundamental concept in economics.
  1. Choice and Resource Allocation:
      • Economies must choose from various production possibilities.
      • Allocation of resources to different goods and services is a central problem.
      • Every choice implies trade-offs and opportunity costs.
Economic Systems
  1. Centrally Planned Economy:
      • In a centrally planned economy, the government or central authority makes all crucial economic decisions.
      • The government aims to achieve specific resource allocation and desired goods and services distribution.
      • For example, if essential services like education or healthcare are underproduced, the government intervenes.
      • It also ensures equitable distribution if some individuals face survival threats.
  1. Market Economy:
      • A market economy organizes all economic activities through markets where individuals interact freely.
      • A market is an institution for the exchange of endowments or products.
      • Market interactions can occur in various ways, such as physical locations, telephone, or the Internet.
      • Prices play a crucial role in achieving coordination in a market system.
      • Prices reflect society's valuation of goods and services, signaling to producers the demand for certain products.
      • This system coordinates economic activities through price signals.
  1. Mixed Economies:
      • Most real-world economies are mixed economies, combining government and market-driven decisions.
      • The extent of government intervention varies, with some countries having minimal government involvement (e.g., the United States) and others having a more significant role (e.g., China and India).
      • Over time, the government's role in the economy may change.
Analyzing Economic Mechanisms
  1. Multiple Ways to Solve Economic Problems:
      • Various mechanisms can address the central problems of an economy.
      • Different mechanisms can lead to different resource allocations and distributions of goods and services.
      • The choice of mechanism affects the overall economy.
  1. Analyzing Economic Mechanisms:
      • In economics, the analysis involves understanding the functioning and evaluation of these mechanisms.
      • Positive Economic Analysis: Focuses on how different mechanisms operate and their outcomes.
      • Normative Economic Analysis: Examines whether these mechanisms are desirable.
      • Positive and normative analyses are closely related and not sharply distinguished.
      • Proper understanding requires a balance between both aspects.
Economic Branches
  1. Traditional Economics Division:
      • Economics is traditionally divided into two primary branches: Microeconomics and Macroeconomics.
  1. Microeconomics:
      • Focus: Studies individual economic agents in specific markets for goods and services.
      • Objectives: Analyzes how prices and quantities of goods and services are determined through individual interactions within markets.
      • Scope: Concentrates on micro-level decision-making and market dynamics.
  1. Macroeconomics:
      • Focus: Explores the entire economy as a whole.
      • Objectives: Examines aggregate measures such as total output, employment, and aggregate price levels.
      • Key Questions: Addresses questions related to total output, its determinants, growth trends, resource utilization, unemployment causes, and inflation.
  1. Distinguishing Focus:
      • Microeconomics deals with specific markets and individual economic agents.
      • Macroeconomics studies the overall economic performance, emphasizing macro-level measures.
Chapter 2 - Theory of Consumer Behavior
Introduction
  1. Consumer's Dilemma:
      • Consumer faces choices in allocating income to different goods.
      • Objective: Maximize satisfaction by selecting the best combination of goods based on preferences and budget constraints.
      • Preferences: Reflect individual likes and are central to this choice.
  1. Approaches to Consumer Behavior:
      • Two primary approaches
          1. Cardinal Utility Analysis
          1. Ordinal Utility Analysis
A Brief Theory
  1. Utility and Consumer Choice:
      • Consumers make choices based on the utility, which is the satisfaction or want-satisfying capacity derived from a commodity.
      • Utility is subjective and varies among individuals and over time and place.
  1. Cardinal Utility Analysis:
      • Assumes utility can be expressed numerically.
      • Measures include Total Utility (TU) and Marginal Utility (MU).
      • Total Utility is the overall satisfaction derived from consuming a specific quantity of a commodity, while Marginal Utility is the change in total utility due to consuming one additional unit of the commodity.
      • Marginal Utility diminishes as consumption of a commodity increases, following the Law of Diminishing Marginal Utility.
  1. Demand Curve and Marginal Rate of Substitution:
      • Consumer demand for a commodity is influenced by its price, prices of other goods, income, and preferences.
      • Demand curves show the negative relationship between the price of a commodity and the quantity demanded, following the Law of Demand.
      • The Law of Diminishing Marginal Utility explains the downward-sloping demand curve.
  1. Ordinal Utility Analysis:
      • Focuses on ranking preferences rather than quantifying utility.
      • Represents preferences through indifference curves, which show combinations of goods that provide the same level of satisfaction.
  1. Features of Indifference Curves:
      • Indifference curves slope downward from left to right, indicating the trade-off between goods.
      • Higher indifference curves represent greater satisfaction.
      • Indifference curves never intersect.
Consumer Budget and Budget Constraints
  1. Consumer's Income and Choices:
      • A consumer with a fixed income must make choices about which goods to purchase.
      • The consumer's budget constraints depend on income, the prices of goods, and the available consumption bundles.
  1. Budget Set and Budget Line:
      • Suppose income is 'M', prices are 'P1' and 'P2', and the consumer wants 'X1' bananas and 'X2' mangoes.
      • The consumer can afford the bundle if P1x1 + P2x2 ≤ M. This is the budget constraint.
      • The set of bundles satisfying the constraint is the budget set.
      • The budget line represents this set with P1x1 + P2x2 = M.
  1. Changes in the Budget Set:
      • Income changes and the budget line shifts parallelly (outward for an increase, inward for a decrease).
      • If the price of one good changes, the slope and intercept of the budget line change.
      • An increase in price makes the line steeper (pivots inward), while a price decrease makes it flatter (pivots outward).
  1. Change in the Price of One Good:
      • If the price of one good changes, but income and the price of the other good stay constant, the budget set is affected.
      • An increase in price limits the affordability of the good.
      • A decrease in price increases the affordability of the good.
 
Optimal Choice of The Consumer
  1. Basis of Consumer's Choice:
      • Consumers choose their consumption bundles based on their tastes and preferences.
      • Consumers have clear preferences, and they can compare and rank different bundles based on their utility.
  1. Equality of Marginal Rate of Substitution and Price Ratio:
      • The optimal bundle is where the budget line is tangent to an indifference curve.
      • At this point, the slope (MRS) of the indifference curve equals the slope (price ratio) of the budget line.
      • MRS represents how willing a consumer is to substitute one good for another, while the price ratio shows the rate of substitution in the market.
      • If MRS is greater than the price ratio, the consumer can improve utility by adjusting the bundle.
  1. Rationality Assumption:
      • Economic theory assumes consumers are rational, meaning they make choices that maximize their satisfaction in any given situation.
      • Rational consumers choose bundles that provide them with the highest satisfaction.
  1. Consumer's Problem:
      • The consumer's objective is to reach the highest possible indifference curve within their budget set.
      • Monotonic preferences imply that any point below the budget line can be improved upon by moving to a point on the budget line.
  1. Optimal Location on the Budget Line:
      • The optimal bundle lies on the budget line.
      • It is the point where the budget line is tangent to an indifference curve.
      • All other points on the budget line are inferior because they are on a lower indifference curve.
  1. Illustration of Consumer's Optimum:
      • An optimal bundle is where the budget line touches the highest possible indifference curve.
      • It's the point that maximizes satisfaction within the budget constraints.
 
Consumer's Demand and Demand Curve
  1. Introduction:
      • The consumer's optimal choice of a good depends on its price, income, prices of other goods, and preferences.
      • When any of these variables change, the quantity of the good chosen by the consumer also changes.
  1. Demand Curve and the Law of Demand:
      • The demand curve shows the relationship between the quantity of a good and its price when other factors remain constant.
      • The demand function is written as X = f(P), where X is quantity, and P is the price.
      • The demand curve is typically negatively sloped, meaning as the price of the good decreases, the quantity demanded increases.
  1. Normal and Inferior Goods:
      • Normal goods: Quantity demanded increases as income increases (e.g., higher quality food).
      • Inferior goods: Quantity demanded decreases as income increases (e.g., low-quality food).
      • A good can be normal at some income levels and inferior at others.
  1. Substitutes and Complements:
      • Substitutes: When the price of a related good (substitute) increases, the demand for the good in question increases (e.g., tea and coffee).
      • Complements: When the price of a related good (complement) increases, the demand for the good in question decreases (e.g., tea and sugar).
  1. Shifts in the Demand Curve:
      • Changes in income, prices of related goods, or preferences can shift the demand curve.
      • Rightward shift for normal goods with an increase in income or a decrease in the price of substitutes.
      • Leftward shift for inferior goods with an increase in income or a decrease in the price of complements.
      • Changes in preferences can also shift the curve (e.g., preference for ice cream in summer).
  1. Movements Along the Demand Curve vs. Shifts:
      • Price changes lead to movements along the demand curve.
      • Changes in other factors (income, prices of related goods, or preferences) result in shifts in the demand curve.
 
Market Demand
  1. Market Demand for a Good
      • Definition: The total demand of all consumers taken together in the market for a good.
      • Derived from individual demand curves.
      • Example: If two consumers demand q₁ and q₂ units of a good at price p, the market demand at p is q₁ + q₂.
      • Graphical representation: Horizontal summation of individual demand curves.
  1. Adding Up Two Linear Demand Curves
      • Example: Consider two consumers with demand curves d₁(p) = 10 - p and d₂(p) = 15 - p.
      • Calculate the market demand at various prices by adding these individual demands.
 
Elasticity of Demand
  1. Definition: Measures the responsiveness of demand to price changes.
  1. Formula: eD = (% change in demand) / (% change in price) or eD = (∆Q / Q) / (∆P / P). Elasticity is usually negative (but we refer to its absolute value).
  1. Values: eD < 1: Inelastic demand (necessities)
      2. eD > 1: Elastic demand (luxuries)
      eD = 1: Unitary-elastic demand
  1. Elasticity along a Linear Demand Curve
      • Elasticity varies along a linear demand curve (q = a - bp).
      • Different at different price levels.
      • It is 0 at p = 0, ∞ at q = 0, and 1 at p = (2a/b).
  1. Factors Determining Price Elasticity of Demand
      • Nature of the good: Necessities tend to be inelastic, while luxuries are elastic.
      • Availability of substitutes: Elasticity is higher when close substitutes exist.
  1. Elasticity and Expenditure
      • Expenditure on a good = Demand × Price.
      • Expenditure changes in the opposite direction of price changes for elastic goods and in the same direction for inelastic goods.
  1. Geometric Measure of Elasticity along a Linear Demand Curve
      • Elasticity Measurement: Elasticity at any point on a linear demand curve is calculated as the ratio of the lower segment to the upper segment of the demand curve.
  1. Constant Elasticity Demand Curve
      • Explanation: Constant elasticity demand curves illustrate perfectly inelastic, perfectly elastic, and unitary elastic demand curves.
      • Characteristics:
        • Perfectly Inelastic: Represented by a vertical demand curve (|eD| = 0).
        • Perfectly Elastic: Represented by a horizontal demand curve (|eD| = ∞).
        • Unitary Elastic: Displayed as a curved shape with |eD| = 1 at every point.
  1. Relationship between Elasticity and Change in Expenditure on a Good
      • Expenditure Response: How the expenditure on a good reacts to price changes is dependent on its price elasticity.
        • If eD < -1, ∆E has the opposite sign as ∆p.
        • If eD > -1, ∆E has the same sign as ∆p.
        • If eD = -1, ∆E = 0.
  1. Sample Example for Elasticity
      • Illustration: An example is used to calculate elasticity - eD = 0.5 (inelastic) when the price of bananas increased from Rs. 5 to Rs. 7, causing the quantity demanded to decrease from 15 to 12.
 
Summary
Consumer Preferences and Demand
1. Budget Set and Budget Line
  • Budget Set: All bundles of goods a consumer can purchase with her income at current market prices.
  • Budget Line: Represents the bundles that fully utilize the consumer's income. It's negatively sloping.
  • Changes: Altered by variations in prices or income.
2. Consumer Preferences
  • Well-defined preferences: Consumers can rank bundles according to their preferences.
  • Monotonicity: Preferences are assumed to be monotonic (they make choices that are at least as good as others).
  • Indifference Curves: Loci of points representing bundles the consumer is indifferent between.
  • Downward Sloping: Monotonicity implies that indifference curves are downward sloping.
3. Representation of Preferences
  • Indifference Map: Shows consumer preferences.
  • Utility Function: An alternative representation for preferences.
4. Consumer's Choice
  • Rational Choice: Rational consumers select their most preferred bundle from the budget set.
  • Optimum Bundle: Found at the point where the budget line is tangent to an indifference curve.
5. Demand Curve
  • Consumer's Demand: Indicates the quantity of a good chosen at different price levels, assuming income and preferences are constant.
  • Downward Sloping: Demand curves typically slope downward.
  • Normal Goods: Demand rises with increased income.
  • Inferior Goods: Demand decreases with increased income.
6. Market Demand Curve
  • Market Demand: Reflects the combined demand of all consumers in the market at various price levels for a specific good.
7. Price Elasticity of Demand
  • Definition: Measures the responsiveness of demand to price changes.
  • Elasticity: A numerical measure, calculated as the percentage change in demand divided by the percentage change in price.
  • Relationship with Total Expenditure: Elasticity of demand and total expenditure are closely linked.
 
Chapter 3 - Production and Costs
Producer Behavior and Production
1. Introduction
  • Production is the process of converting inputs into output, performed by firms or producers.
  • Firms acquire various inputs like labor, machinery, land, and raw materials to create products.
  • The resulting output can be consumed by end-users or used by other firms for further production.
2. Simplifying Assumptions
  • In the model of production discussed:
    • Production is instantaneous.
    • The terms production and supply are often used interchangeably.
3. Cost of Production and Revenue
  • Firms must pay for the inputs they acquire, which is termed the cost of production.
  • After producing output, firms sell it in the market, earning revenue.
  • Profit is the difference between revenue and cost.
  • The primary objective of a firm is to maximize profit.
Production Function
  1. Definition
      • The production function of a firm establishes a relationship between inputs used and the output produced.
      • It defines the maximum quantity of output achievable for various input quantities.
      • Inputs could include factors like labor, land, and capital.
  1. Example: Farmer's Production Function
      • Consider a farmer using two inputs: land and labor, to produce wheat.
      • A production function describes the relationship between land (K), labor (L), and wheat production (q).
      • The maximum wheat production with 2 hours of labor/day and 1 hectare of land is expressed as q = K × L.
  1. Efficiency and Technology
      • A production function focuses on the efficient use of inputs, aiming for maximum output.
      • It represents a given technology's capabilities, determining the maximum output levels achievable with different input combinations.
      • Technological advancements result in new production functions with increased output potential.
Factors of Production
  1. Definition
      • Factors of production are the inputs used in the production process.
      • The discussed example considers a firm employing two factors of production: labor and capital.
  1. Production Function
      • The production function is expressed as q = f(L, K), where L represents labor, K represents capital, and q is the maximum output attainable.
Short Run and Long Run in Production
  1. Short Run
      • In the short run, either labor or capital, but not both, can be varied, while the other factor remains fixed.
      • The factor that remains constant is termed the fixed factor, and the other factor that can be altered is known as the variable factor.
  1. Example: Short Run Scenario
      • An example is presented in Table 3.1, where capital is held fixed at 4 units.
      • Different levels of output can be achieved by adjusting the quantity of labor in the short run.
  1. Long Run
      • In the long run, all factors of production can be adjusted simultaneously.
      • No fixed factor exists in the long run, as all inputs are flexible.
  1. Time Period Definition
      • The long run typically encompasses a longer time period than the short run.
      • The specific duration of the long run may vary depending on the production process.
      • It is defined by the flexibility to change all inputs, not by a fixed number of days, months, or years.
Types of Products
Total Product (TP)
  • Total Product (TP) represents the output levels when a single input varies while keeping all other inputs constant.
  • Specifically, TP is the relationship between the variable input and output when other inputs remain unchanged.
  • TP is also known as the total return to or total physical product of the variable input.
Average Product (AP)
  • Average Product (AP) is defined as the output per unit of the variable input.
  • The formula for AP is given by: AP = Total Product (TP) / Quantity of Variable Input (L).
  • AP describes the efficiency of the variable input in the production process.
Marginal Product (MP)
  • Marginal Product (MP) is the change in output per unit of change in the variable input, while holding all other inputs constant.
  • The formula for MP is given by: MP = ∆TP / ∆L.
  • MP of the second unit of an input, for example, is calculated by subtracting TP at L units from TP at (L - 1) units.
  • Total Product is the sum of marginal products, and Average Product at any input level is the average of all marginal products up to that level.
 
Law of variable proportions
Understanding the Law of Variable Proportions
  • When plotting the data from Table 3.2 on a graph with labor on the X-axis and output on the Y-axis, we observe a specific pattern.
  • Total Product (TP) increases as labor input increases, but not at a constant rate.
  • The rate at which TP increases is represented by Marginal Product (MP).
  • MP initially increases (up to a certain labor input level) and then starts to decline.
  • This behavior is known as the Law of Variable Proportions or the Law of Diminishing Marginal Product.
Factors Behind the Law of Variable Proportions
  • Factor proportions denote the ratio in which two inputs are combined to produce output.
  • When one factor is held constant while the other increases, factor proportions change.
  • Initially, as the amount of the variable input is increased, factor proportions become more favorable for production, leading to a rise in MP.
  • Beyond a certain employment level, the production process becomes crowded with variable input.
  • For example, a farmer with a fixed land area may experience diminishing returns with labor as adding more labor leads to overcrowding, reducing the efficiency of each worker.
  • This overcrowding effect causes a decline in the marginal product as each additional worker contributes proportionally less to the total output.
General Shapes of the Curves
  • The Total Product (TP) curve typically shows an increasing trend.
  • The Marginal Product (MP) curve increases initially and then decreases, illustrating the Law of Diminishing Marginal Product.
  • The Average Product (AP) curve often mirrors the MP curve, reaching its maximum when MP starts to decline.
 
Returns to Scale
Understanding Returns to Scale
  • The Law of Variable Proportions arises when one factor is held constant, and the other is increased. But what if both factors can change? This scenario typically occurs in the long run.
  • In the long run, a special case emerges when both factors are increased by the same proportion, which is referred to as scaling-up factors.
  • The behavior of production functions with respect to this proportional change in inputs defines the concept of Returns to Scale (RTS).
Types of Returns to Scale
  1. Constant Returns to Scale (CRS):
      • CRS occurs when a proportional increase in all inputs results in an increase in output by the same proportion.
      • If all inputs are doubled, and the output also doubles, the production function exhibits CRS.
  1. Increasing Returns to Scale (IRS):
      • IRS occurs when a proportional increase in all inputs results in an increase in output by a larger proportion.
      • If, after doubling all inputs, the output increases by more than double, the production function exhibits IRS.
  1. Decreasing Returns to Scale (DRS):
      • DRS holds when a proportional increase in all inputs results in an increase in output by a smaller proportion.
      • If doubling all inputs leads to an output increase of less than double, the production function exhibits DRS.
Returns to Scale in Production Function
  • Consider a production function: q = f(x1, x2) where q is the output, x1 is factor 1, and x2 is factor 2.
  • In the long run, if both factors are scaled up by a factor of t (t > 1), three scenarios can occur:
      1. Constant Returns to Scale: f(tx1, tx2) = t * f(x1, x2)
      1. Increasing Returns to Scale: f(tx1, tx2) > t * f(x1, x2)
      1. Decreasing Returns to Scale: f(tx1, tx2) < t * f(x1, x2)
Returns to Scale reflect how output changes when all factors are scaled up in the long run.
Costs
Multiple Input Combinations for Output
  1. Firms can produce a given level of output using various combinations of inputs.
  1. The selection of input combinations depends on minimizing costs, considering factors' prices and technology.
Cobb-Douglas Production Function
  1. A Cobb-Douglas production function is defined as: q = x₁^α * x₂^β.
  1. α and β are constants, and the firm produces q output using x₁ of factor 1 and x₂ of factor 2.
  1. The behavior of production functions with respect to the scaling of inputs defines Returns to Scale (RTS).
Short Run Costs
  1. The short run involves fixed and variable inputs.
  1. Total Fixed Cost (TFC) remains constant regardless of output.
  1. Total Variable Cost (TVC) is incurred when the firm adjusts variable inputs.
  1. Total Cost (TC) is the sum of TVC and TFC: TC = TVC + TFC.
  1. Short Run Average Cost (SAC) is TC per unit of output: SAC = TC / q.
  1. Average Variable Cost (AVC) is TVC per unit of output: AVC = TVC / q.
  1. Average Fixed Cost (AFC) is TFC per unit of output: AFC = TFC / q.
  1. SAC = AVC + AFC.
Short Run Marginal Cost (SMC)
  1. SMC is the change in TC per unit change in output: SMC = ΔTC / Δq.
  1. SMC rises after the point of diminishing returns to a factor.
  1. SMC initially falls as production increases, then it starts rising.
  1. It is undefined at zero output level.
Shapes of Short Run Cost Curves
  1. AFC is a rectangular hyperbola and decreases as output increases.
  1. AVC is 'U'-shaped, falling initially, then rising after the point of diminishing returns.
  1. SAC is also 'U'-shaped, first falling and then rising.
  1. SMC curve is 'U'-shaped; initially, it falls and then starts rising.
Long Run Costs
  1. In the long run, all inputs are variable, and there are no fixed costs.
  1. Long Run Average Cost (LRAC) is defined as cost per unit of output: LRAC = TC / q.
  1. Long Run Marginal Cost (LRMC) is the change in TC per unit change in output.
Shapes of Long Run Cost Curves
  1. Long Run Average Cost (LRAC) is 'U'-shaped, with the minimum point corresponding to constant returns to scale (CRS).
  1. Long Run Marginal Cost (LRMC) is 'U'-shaped and intersects the LRAC curve at the minimum point.
Summary
  1. Production Function
      • Production function determines the maximum output for various input combinations.
      • The short-run has fixed inputs, while the long run allows for variable inputs.
2. Total Product and Marginal Product
  • Total product depicts the relationship between a variable input and output with other inputs constant.
  • Marginal product (MP) is the additional output produced by one more unit of a variable input.
  • MP and average product (AP) curves are inverse 'U'-shaped.
  • MP intersects AP from above at AP's peak.
3. Input Combinations
  • Firms choose input combinations that minimize costs for a given level of output.
  • Total cost is the sum of total variable cost (TVC) and total fixed cost (TFC).
  • Average cost is the sum of average variable cost (AVC) and average fixed cost (AFC).
  • Average fixed cost (AFC) is downward-sloping.
4. Short Run Costs
  • Short-run costs include TFC and TVC.
  • Short-run average cost (SAC) is TC per unit of output.
  • Short-run marginal cost (SMC) measures the change in TC per unit change in output.
  • SAC = AVC + AFC.
  • SAC, AVC, and SMC are 'U'-shaped.
  • SMC cuts AVC and SAC from below at their minimum points.
5. Long Run Costs
  • Long-run has variable inputs; there are no fixed costs.
  • Long-run average cost (LRAC) is TC per unit of output.
  • Long-run marginal cost (LRMC) measures the change in TC per unit change in output.
  • Both LRAC and LRMC are 'U'-shaped.
  • LRMC cuts LRAC from below at the minimum point of LRAC.
 
 
Chapter 4 - Theory of Firm under Perfect Competition
Firm Behavior and Supply
1. Introduction
  • This chapter explores how firms decide the quantity of output to produce based on the assumption of profit maximization.
  • A firm is viewed as a profit maximizer, and output decisions are aligned with this goal.
2. Profit Maximization
  • The central idea is that firms produce the quantity that maximizes their profit.
  • Profit maximization involves analyzing how various factors, such as output and costs, affect a firm's profit.
3. Supply Curve
  • The chapter delves into how a firm's supply curve is determined.
  • The supply curve illustrates the relationship between the quantity a firm produces and the market price.
  • A firm's supply curve shows the levels of output produced at different market prices.
4. Aggregating Supply Curves
  • The concept of aggregating supply curves of individual firms is discussed.
  • This process allows us to derive the market supply curve, which shows the total quantity supplied in the market at different prices.
 
 
How to Recognize Perfect Competition
  1. Key Features of Perfect Competition
  • Perfect competition is characterized by the following features:
      1. Large Number of Buyers and Sellers
          • The market comprises numerous buyers and sellers.
          • Individual buyers and sellers are small relative to the entire market, meaning they have no significant influence on market dynamics.
      1. Homogeneous Products
          • Each firm produces and sells an identical, undifferentiated product.
          • A buyer can purchase this product from any firm in the market, and the quality remains the same.
      1. Free Entry and Exit
          • Firms can easily enter or exit the market.
          • This condition ensures a large number of firms exist, promoting competition.
      1. Perfect Information
          • All market participants have complete and accurate information about prices, product quality, and other relevant market details.
2. Price Taking Behavior
  • The most distinguishing characteristic of perfect competition is price-taking behavior.
  • Price-taking firms believe that setting prices above the market price will result in the inability to sell their products.
  • Price-taking buyers understand that offering a price below the market price will likely lead to no firms willing to sell to them.
  • Both firms and buyers are constrained by the market price and must align with it.
3. Rationale for Price-Taking Assumption
  • The assumption of price-taking behavior is reasonable in markets with many firms and perfect information.
  • If a firm sets prices higher than the market price, it loses all buyers to competitors, without causing adjustment problems.
  • Individual firms' inability to sell above the market price aligns with the price-taking assumption.
Revenue
1. Introduction
  • In a perfectly competitive market, firms operate with specific pricing behaviors and considerations.
2. Revenue in Perfect Competition
  • Firms in perfect competition believe they can sell as many units of a good as they want by setting a price equal to or less than the market price.
  • Total Revenue (TR) is the product of the market price (p) and the quantity of goods produced and sold (q), expressed as TR = p × q.
3. Total Revenue Curve
  • The Total Revenue Curve shows the relationship between the quantity sold (output) on the X-axis and the total revenue earned on the Y-axis.
  • Key observations: TR is zero when output is zero, TR increases as output rises, and the TR curve is a straight line with a constant slope (equal to p).
4. Average Revenue (AR)
  • AR is defined as total revenue per unit of output and, in a perfectly competitive firm, equals the market price (AR = p).
  • The AR curve is a horizontal line called the price line, representing perfectly elastic demand.
5. Marginal Revenue (MR)
  • MR is the change in total revenue for a one-unit increase in output.
  • For a price-taking firm in perfect competition, MR is equal to the market price (MR = AR = p).
6. Intuition for MR in Perfect Competition
  • The increase in total revenue when a firm increases its output by one unit precisely equals the market price.
  • Therefore, for a price-taking firm, MR matches the market price.
Profit Maximization Conditions
1. Profit Maximization Equation
  • A firm's profit, denoted as π, is the difference between its total revenue (TR) and total cost of production (TC): π = TR - TC.
2. Identifying the Profit-Maximizing Quantity (q0)
  • A firm aims to identify the quantity (q0) that maximizes its profit.
  • Conditions for maximum profit:
      1. Price (p) must equal Marginal Cost (MC).
      1. Marginal Cost (MC) must not be decreasing at q0.
      1. In the short run, the price must be greater than the Average Variable Cost (AVC); in the long run, the price must be greater than the Average Cost (AC).
3. Condition 1: Price Equals Marginal Cost
  • For maximum profits, marginal revenue (MR) should equal marginal cost (MC).
  • In perfect competition, MR is equal to the market price (MR = P), so the profit-maximizing output level is where P = MC.
4. Condition 2: Non-Decreasing Marginal Cost
  • The marginal cost curve should not slope downwards at the profit-maximizing output level. This ensures maximum profits.
  • A downward-sloping MC curve at that level indicates an incorrect choice.
5. Condition 3: Price Exceeds Costs
  • In the short run, the market price (p) must be greater than Average Variable Cost (AVC) to continue production.
  • In the long run, the market price (p) must exceed the Average Cost (AC) to sustain operations.
6. Graphical Representation of Profit Maximization (Short Run)
  • A graphical representation shows the profit-maximizing quantity (q0) at which the market price equals the marginal cost (P = MC).
  • At q0, the firm earns a profit equal to the area of the rectangle EpAB.
Supply Curve of a Firm
1. Supply and Supply Schedule
  • A firm's supply is the quantity it chooses to sell at a given price while keeping technology and factor prices constant.
  • A supply schedule is a table that shows the quantities a firm will sell at various prices.
  • A supply curve is a graphical representation of the firm's choices, showing output levels (x-axis) corresponding to different market prices (y-axis).
2. Short Run Supply Curve
  • In the short run, a firm supplies output when the market price is greater than or equal to the minimum Average Variable Cost (AVC).
  • The short-run supply curve includes the rising segment of Short-Run Marginal Cost (SMC) above the minimum AVC and zero output below that point.
3. Long Run Supply Curve
  • In the long run, a firm supplies output when the market price is greater than or equal to the minimum Long-Run Average Cost (LRAC).
  • The long-run supply curve includes the rising segment of Long-Run Marginal Cost (LRMC) above the minimum LRAC and zero output below that point.
4. Shutdown Point
  • The shutdown point is where a firm ceases production in the short run when the price falls below the minimum AVC (short run) or LRAC (long run).
5. Normal Profit and Break-even Point
  • Normal profit is the minimum profit required to keep a firm in business.
  • Any profit below this level will lead to an exit from the industry in the long run.
  • The break-even point is where a firm earns normal profit; it's the point where the supply curve intersects the minimum LRAC curve (in the short run, the SAC curve).
6. Opportunity Cost
  • Opportunity cost is the forgone gain from the next best alternative activity.
  • It helps measure the return given up when making a particular decision, especially in resource allocation.
Determinants of Firm’s Supply Curve
1. Technological Progress
  • Technological progress or innovation allows a firm to produce more output with the same level of inputs.
  • This results in a rightward (downward) shift of the marginal cost (MC) curve, leading to an increase in the firm's supply at any given market price.
2. Input Prices
  • A change in input prices, such as an increase in the wage rate of labor, affects a firm's cost of production.
  • Higher input prices lead to an increase in both average and marginal cost at any output level.
  • This results in a leftward (upward) shift of the MC curve, leading to a decrease in the firm's supply at any given market price.
3. Impact of a Unit Tax on Supply
  • A unit tax is a tax imposed by the government per unit of output sold.
  • It increases the cost of production for the firm, as the firm has to pay the unit tax for each unit produced and sold.
  • The imposition of a unit tax leads to an increase in both long-run average cost (LRAC) and long-run marginal cost (LRMC) at all levels of output, shifting both curves upward.
  • The long-run supply curve of the firm shifts to the left (upward) after the imposition of the unit tax, leading to a reduced supply at any given market price.
 
Market Supply Curve
1. Introduction
  • The market supply curve represents the aggregate output levels supplied by all firms in the market at different market prices.
  • The market supply at a specific price is derived by summing the individual supplies of all firms in the market at that price.
2. Deriving the Market Supply Curve
  • A market supply curve can be constructed geometrically using the supply curves of individual firms.
  • A numerical example shows how two firms (Firm 1 and Firm 2) with different supply curves contribute to the overall market supply.
3. Impact of Changing Number of Firms
  • The market supply curve depends on the number of firms in the market.
  • If the number of firms increases (decreases), the market supply curve shifts to the right (left).
Price Elasticity of Supply
1. Definition of Price Elasticity of Supply (eS)
  • The price elasticity of supply measures the responsiveness of the quantity supplied of a good to changes in the price of the good.
  • It is expressed as the percentage change in quantity supplied divided by the percentage change in price.
2. Formula for Price Elasticity of Supply (eS)
  • eS = [(Percentage change in quantity supplied) / (Percentage change in price)] × 100
  • The change in quantity supplied (∆Q) is divided by the change in price (∆P) to calculate eS.
3. Interpretation of eS Values
  • If eS = 0, the supply curve is vertical, indicating complete insensitivity to price changes.
  • If eS > 0, the supply curve is positively sloped, with a rise in price leading to an increase in supply.
  • The price elasticity of supply is independent of units and can be greater or less than 1.
4. Geometric Method
  • The price elasticity of supply can be determined graphically by examining a supply curve.
  • A straight-line supply curve with Mq0 > Oq0 results in eS > 1.
  • A straight-line supply curve with Mq0 < Oq0 leads to eS < 1.
  • A supply curve through the origin has eS = 1 at all points.
 
Summary
1. Perfectly Competitive Firms
  • In a perfectly competitive market, firms are price-takers, meaning they accept the market price as given.
2. Total Revenue of a Firm
  • Total revenue of a firm is the market price of the good multiplied by the firm's output.
3. Average Revenue and Marginal Revenue
  • For a price-taking firm, average revenue is equal to the market price.
  • For a price-taking firm, marginal revenue is also equal to the market price.
  • The demand curve that a firm faces in a perfectly competitive market is perfectly elastic, represented by a horizontal straight line at the market price.
4. Firm Profit
  • A firm's profit is the difference between total revenue earned and total cost incurred.
5. Short Run Profit Maximization
  • In the short run, a firm maximizes profit at a positive output level if three conditions are met:
    • (i) Market price (p) equals short-run marginal cost (SMC).
    • (ii) SMC is non-decreasing.
    • (iii) Market price (p) is greater than or equal to average variable cost (AVC).
6. Long Run Profit Maximization
  • In the long run, a firm maximizes profit at a positive output level if three conditions are met:
    • (i) Market price (p) equals long-run marginal cost (LRMC).
    • (ii) LRMC is non-decreasing.
    • (iii) Market price (p) is greater than or equal to long-run average cost (LRAC).
7. Short Run and Long Run Supply Curve
  • The short-run supply curve of a firm is the rising part of the short-run marginal cost (SMC) curve from and above the minimum average variable cost (AVC), with zero output for prices less than the minimum AVC.
  • The long-run supply curve of a firm is the rising part of the long-run marginal cost (LRMC) curve from and above the minimum long-run average cost (LRAC), with zero output for prices less than the minimum LRAC.
8. Factors Affecting Supply Curve
  • Technological progress shifts a firm's supply curve to the right, leading to increased supply.
  • An increase in input prices shifts a firm's supply curve to the left, resulting in reduced supply.
  • The imposition of a unit tax also shifts the supply curve of a firm to the left.
9. Market Supply Curve
  • The market supply curve is derived by horizontally summing the supply curves of individual firms in a perfectly competitive market.
10. Price Elasticity of Supply
  • The price elasticity of supply measures the responsiveness of quantity supplied to changes in the market price.
 
Chapter 5 - Market Equilibrium
Market equilibrium and applications
1. Demand Curves and Market Demand
  • In Chapter 2, we learned about demand curves for individual consumers, showing the quantity they are willing to buy at different prices when taking the price as given.
  • The market demand curve represents the combined quantity all consumers are willing to purchase at different prices when all individuals take the price as given.
2. Supply Curves and Market Supply
  • In Chapter 4, we explored individual firm supply curves, indicating the quantity a profit-maximizing firm wishes to sell at various prices when taking the price as given.
  • The market supply curve shows the total quantity all firms would like to supply at different prices when each firm takes the price as given.
3. Market Equilibrium
  • In this chapter, we bring together consumer and firm behaviors to analyze market equilibrium using demand-supply analysis.
  • Market equilibrium is the price at which supply and demand are balanced, and the quantity demanded equals the quantity supplied. It's the intersection point of the market demand and supply curves.
4. Effects of Demand and Supply Shifts
  • We examine the consequences of shifts in demand and supply curves on market equilibrium.
  • When the demand curve shifts, it impacts the equilibrium price and quantity. The same occurs when the supply curve shifts.
5. Applications of Demand-Supply Analysis
  • The chapter concludes by discussing various applications of demand-supply analysis in real-world scenarios.
Equilibrium, Excess demand, Excess supply
1. Equilibrium Definition
  • Equilibrium is a state where consumers’ and firms' plans align, and market supply equals market demand. It's the point at which market price and quantity are determined.
2. Market Equilibrium in Perfect Competition
  • In a perfectly competitive market, firms produce based on self-interest, aiming to maximize profits, while consumers seek to maximize their preferences.
  • Equilibrium is reached when the quantity firms wish to sell equals what consumers wish to buy at a given price.
  • The equilibrium price (p*) and quantity (q*) are achieved when qD(p*) = qS(p*), denoting the equality of market demand and supply.
3. Market Equilibrium and the Invisible Hand
  • The concept of the "Invisible Hand" drives price changes to reach equilibrium when imbalances occur.
  • In cases of excess supply or demand, prices adjust to restore equilibrium.
4. Market Equilibrium with Fixed Number of Firms
  • When the number of firms is fixed, equilibrium is determined by the intersection of market demand and supply curves.
  • Shifts in demand curves affect equilibrium quantity and, to some extent, price, but supply curves have no direct impact on price.
5. Wage Determination in the Labor Market
  • In labor markets, firms demand labor, while households supply it.
  • Equilibrium wage rates occur when the supply of labor matches the demand for labor, influenced by the trade-off between income and leisure.
6. Shifts in Demand and Supply
  • Changes in factors such as consumer incomes, technology, input prices, etc., can shift supply and demand curves.
  • The direction and magnitude of these shifts determine the new equilibrium price and quantity.
7. Market Equilibrium with Free Entry and Exit
  • In cases of free entry and exit of firms, equilibrium prices align with minimum average costs, ensuring firms earn normal profits.
  • Changes in demand have a greater effect on the quantity supplied, while equilibrium prices remain unchanged.
8. Simultaneous Shifts in Demand and Supply
  • When both supply and demand curves shift, the effects on equilibrium price and quantity depend on the direction and magnitude of the shifts.
  • Simultaneous shifts can result in either increased or decreased equilibrium quantities and prices.
9. Applications and Examples
  • The chapter discusses applications and provides examples to illustrate concepts like equilibrium price determination and the impact of changes in demand and supply.
Government Intervention- Price Control
  1. Price Ceiling
  • The price ceiling is the government-imposed maximum allowable price on certain goods, usually essential items. It's set below the market equilibrium price to ensure affordability for consumers.
  • Excess demand often results from price ceilings, leading to potential shortages. Rationing systems may be implemented to distribute the available quantity fairly.
  1. Price Ceiling Consequences
  • Price ceilings, coupled with rationing, can create problems for consumers, including long queues and potential black markets.
  • Ration coupons are issued, limiting the amount of the goods an individual can buy.
  1. Price Floor
  • Price floors are government-imposed minimum prices, often used in agricultural price support programs and minimum wage legislation.
  • Price floors are set above the market equilibrium price, preventing prices from falling below a particular level.
  1. Price Floor Effects
  • Imposing a price floor above the market equilibrium price results in excess supply, as firms want to supply more than consumers demand.
  • In agricultural support, the government may need to buy the surplus to maintain the floor price.
Summary
Equilibrium and Price Control in Perfectly Competitive Markets
1. Market Equilibrium
  • In a perfectly competitive market, equilibrium occurs when market demand equals market supply.
  • Equilibrium price and quantity are determined at the intersection of market demand and supply curves, assuming a fixed number of firms.
2. Equilibrium Determinants
  • Firms employ labor until the marginal revenue product equals the wage rate.
  • Shifting the demand curve rightward increases equilibrium quantity and price, while shifting it leftward decreases both.
  • Shifting the supply curve rightward increases equilibrium quantity and decreases price, and shifting it leftward decreases quantity and increases price.
3. Simultaneous Shifts
  • When both demand and supply curves shift in the same direction, equilibrium quantity changes, but price changes depend on the magnitude of the shifts.
  • When they shift in opposite directions, price changes can be determined, while quantity changes depend on the shifts' magnitudes.
4. Free Entry and Exit
  • In perfectly competitive markets with identical firms and free entry/exit, the equilibrium price equals the minimum average cost.
  • A shift in demand affects equilibrium quantity and the number of firms but not price.
  • The impact of a demand shift on quantity is more significant with free entry and exit compared to a market with a fixed number of firms.
5. Price Control
  • Imposing a price ceiling below the equilibrium price leads to excess demand.
  • Imposing a price floor above the equilibrium price leads to excess supply.
 
 
 
 
.
 
Copyright 2022 UPSC Vision