ECONOMIC

ENVIRONMEN
T
GulRukh Zahid
Consumer goods

■ Consumer goods are products bought for consumption by the

average consumer. Also called final goods, consumer goods
are the end result of production and manufacturing.
■ There are two types of consumer goods: durable goods and
non-durable goods. Durable goods are products that have a
longer lifespan, usually lasting for three or more years, while
non-durable goods are products that are consumed quickly
and have a shorter lifespan.
■ Examples of durable goods include automobiles,
appliances, furniture, and electronics. These goods are
usually more expensive and are considered long-term
investments by consumers.
■ Examples of non-durable goods include food, clothing,
personal care items, and cleaning supplies. These goods
are typically less expensive and are used up quickly,
requiring consumers to purchase them on a regular basis.
■ Consumer goods play a significant role in the economy as
they represent a major portion of the demand for goods and
services. The production and consumption of consumer goods
drive economic growth and are a key indicator of the overall
health of the economy.
Producer goods

■ producer goods, also called intermediate goods, in

economics, goods manufactured and used in further
manufacturing, processing, or resale. Producer goods either
become part of the final product or lose their distinct identity
in the manufacturing stream.
■ Examples of producer goods include machinery, equipment,
tools, and raw materials. These goods are often used to
produce other goods, such as cars or furniture, or to provide
services, such as transportation or construction.
■ Unlike consumer goods, which are purchased by individuals or
households, producer goods are typically purchased by
businesses or organizations. The production of these goods is a
key component of the supply chain and is critical to the
success of many industries.
■ From an economic perspective, the production and
consumption of producer goods is important for driving
economic growth and productivity. Investment in capital
goods, such as new machinery or equipment, can help
businesses increase their production capacity and improve
efficiency, leading to increased profits and economic
growth.
■ Producer goods play a crucial role in the economy by
enabling businesses to produce the goods and services that are
consumed by individuals and households.
Goods and services
■ Goods and services are the output of an economic system.
Goods are tangible items sold to customers. while services
are tasks performed for the benefit of the recipients.
■ Examples of goods are automobiles, appliances, and
clothing. Examples of services are legal advice, house
cleaning, and consulting services. The output of a business
can lie somewhere between these two concepts. For example,
a landscaping company could sell a homeowner a tree
(goods) and also mow the lawn (a service).
Demand

■ Demand reflects a decision about which wants to satisfy.

■ The quantity demanded of a good or service is the amount
that consumers plan to buy during a given time period at a
particular price. The quantity demanded is not necessarily
the same as the quantity actually bought. Sometimes the
quantity demanded exceeds the amount of goods available,
so the quantity bought is less than the quantity demanded.
The law of Demand

■ The law of demand states Other things remaining the same,

the higher the price of a good, the smaller is the quantity
demanded; and the lower the price of a good, the greater is
the quantity demanded.
■ Figure 3.1 shows the demand curve for energy bars. A
demand curve shows the relationship between the quantity
demanded of a good and its price when all other influences on
consumers’ planned purchases remain the same.
Supply
■ A supply is more than just having the resources and the
technology to produce something. Resources and
technology are the constraints that limit what is possible.
■ The quantity supplied of a good or service is the amount that
producers plan to sell during a given time period at a particular
price. The quantity supplied is not necessarily the same
amount as the quantity actually sold. Sometimes the quantity
supplied is greater than the quantity demanded, so the quantity
sold is less than the quantity supplied
The law of supply

■ The law of supply states:

■ Other things remaining the same, the higher the price of a
good, the greater is the quantity supplied; and the lower
the price of a good, the smaller is the quantity supplied
 What Is a Market? What Is
Competition??
■ A market is a group of buyers and sellers of a particular good or
service. The buyers as a group determine the demand for the product,
and the sellers as a group determine the supply of the product.
■ Economists use the term competitive market to describe a market in
which there are so many buyers and so many sellers that each has a
negligible impact on the market price.
■ we assume that markets are perfectly competitive. To reach this highest form of
competition, a market must have two characteristics: (1) The goods offered for
sale are all exactly the same, and (2) the buyers and sellers are so numerous that
no single buyer or seller has any influence over the market price.
Production possibility frontier

■ The production possibilities frontier shows the combinations

of output—in this case, cars and computers—that the economy
can possibly produce. The economy can produce any
combination on or inside the frontier. Points outside the
frontier are not feasible given the economy’s resources. The
slope of the production possibilities frontier measures the
opportunity cost of a car in terms of computers. This
opportunity cost varies, depending on how much of the two
goods the economy is producing
Market Equilibrium
■ An equilibrium is a situation in which opposing forces
balance each other. Equilibrium in a market occurs when the
price balances buying plans and selling plans. The
equilibrium price is the price at which the quantity
demanded equals the quantity supplied. The equilibrium
quantity is the quantity bought and sold at the equilibrium
price. A market moves toward its equilibrium because
■ Price regulates buying and selling plans.
■ Price adjusts when plans don’t match.
■ The table lists the quantity demanded and the quantity
supplied as well as the shortage or surplus of bars at each
price. If the price is $1.00 a bar, 15 million bars a week are
demanded and 6 million bars are supplied. There is a shortage
of 9 million bars a week, and the price rises.
■ If the price is $2.00 a bar, 7 million bars a week are demanded
and 13 million bars are supplied. There is a surplus of 6
million bars a week, and the price falls. If the price is $1.50 a
bar, 10 million bars a week are demanded and 10 million bars
are supplied. There is neither a shortage nor a surplus, and the
price does not change. The price at which the quantity
demanded equals the quantity supplied is the equilibrium price,
and 10 million bars a week is the equilibrium quantity.
Normal good
■ A normal good is a type of good whose demand increases
when consumer income increases, while other factors such as
price and availability remain constant. As income increases,
consumers are able to afford more goods and services, and
therefore, they are more likely to purchase more of the
normal goods that they desire.
■ Examples of normal goods may include clothing, food,
housing, and transportation. As consumers' income increases,
they may be more likely to purchase higher-quality products
or upgrade their living arrangements, such as buying a bigger
house or a nicer car.
 Inferior Goods
■ An inferior good is a type of good whose demand decreases when
consumer income increases. This is in contrast to normal goods, where
demand increases when consumer income increases. An inferior good is
often considered a lower-quality or less desirable product, and
consumers may switch to purchasing more expensive, higher-quality
goods as their income increases.
■ Examples of inferior goods may include generic or store-brand
products, fast food, and low-quality clothing. As consumer incomes rise,
they may choose to purchase name-brand products, healthier food
options, and higher-quality clothing items, making these goods normal
goods.
■ Inferior goods can be an important factor to consider in economic
analysis and forecasting, as changes in consumer income levels can
affect overall demand and market trends for different products.
Luxury good
■ luxury good is a product or service that is considered to be of high
quality, rare, exclusive, and expensive, often exceeding the
purchasing power of most consumers. Luxury goods are generally
associated with status, prestige, and a high social or cultural value.
■ Examples of luxury goods include high-end designer clothing, luxury
watches, luxury cars, private jets, yachts, fine jewelry, and high-end
electronics. These goods are often marketed to wealthy individuals who
have the purchasing power to afford them, and are often associated
with symbols of wealth and success.
■ The demand for luxury goods is driven by a variety of factors, including
social status, wealth, exclusivity, and the desire for unique or high-
quality products. As such, luxury goods are often considered to be a
status symbol and are purchased as a means of displaying one's wealth or
social status.
Demand equation
■ Initially, the price is $20 a pizza, and the quantity sold is 10 pizzas an
hour. Then the demand for pizza increases. The demand curve shifts
rightward to D1. In part (a), the price rises by $10 to $30 a pizza, and the
quantity increases by 3 to 13 pizzas an hour. In part (b), the price rises by
only $1 to $21 a pizza, and the quantity increases by 10 to 20 pizzas an
hour. The price change is smaller and the quantity change is larger in
case
(b) than in case (a). The quantity supplied is more responsive to a change
in the price in case (b) than in case (a).
Solve for the function

■ From the demand function Qdx = 12-2P x (P x is given in dollars), derive (a) the
individual’s demand schedule and (b) the individual’s demand curve, (c) What is the
maximum quantity this individual will ever demand of commodity X per time
period?
■ Table below gives two demand schedules of an individual for commodity X. The
second (Qd0x) resulted from an increase in the individual’s money income (while
keeping everything else constant)
■ (a) Plot the points of the two demand schedules on the same set of axes and get the two
demand curves
■ (b) What would happen if the price of X fell from $5 to $3 before the
individual’s income rose?
 Marginal propensity to consume
■ The marginal propensity to consume (MPC) is a
concept in economics that measures the increase
in consumer spending that results from an increase
in income. It represents the proportion of additional
income that is spent on consumption.
■ The MPC is calculated as the change in consumption
divided by the change in income. For example, if a
$100 increase in income leads to a $60 increase in
consumption, the MPC is 0.6 ($60/$100).
■ The equation for marginal propensity to consume (MPC) is
the
change in consumption (ΔC) divided by the change in
income (ΔY): MPC = ΔC / ΔY
■ The MPC represents the increase in consumer spending
that results from an increase in income. It is the
proportion of additional income that is spent on
consumption. For example, if a $1,000 increase in
income leads to a $700 increase in consumption, the
MPC is:
MPC = $700 / $1,000 = 0.7
■ This means that for every additional dollar of income,
consumers will spend 70 cents on consumption.
■ Why does a higher price reduce the quantity demanded?
For two reasons:
■ Substitution effect
■ Income effect
Substitution Effect

■ When the price of a good rises, other things remaining the

same, its relative price—its opportunity cost—rises.
Although each good is unique, it has substitutes—other
goods that can be used in its place. As the opportunity cost
of a good rises, the incentive to economize on its use and
switch to a substitute becomes stronger.
Income Effect

■ When a price rises, other things remaining the same, the

price rises relative to income. Faced with a higher price and
an unchanged income, people cannot afford to buy all the
things they previously bought. They must decrease the
quantities demanded of at least some goods and services.
Normally, the good whose price has increased will be one of
the goods that people buy less of.
Income effect
■ The income effect refers to the change in an individual's
purchasing power or consumer behavior resulting from a
change in their income level, while holding prices
constant. In other words, when an individual's income
increases, they may purchase more goods and services
than before, or when their income decreases, they may
purchase fewer goods and services than before.
■ For example, suppose an individual receives a pay raise,
increasing their income. In that case, they may choose to
spend more money on leisure activities, such as dining
out or taking vacations, or on luxury goods, such as a
new car or designer clothing. Alternatively, if an
individual experiences a decrease in income, they may
choose to cut back on expenses by reducing the number
of restaurant meals or buying cheaper clothes.
A Shift of the Demand Curve

■ If the price of a good remains constant but some other

influence on buying plans changes, there is a change in
demand for that good. We illustrate a change in demand as a
shift of the demand curve. For example, if more people work
out at the gym, consumers buy more energy bars regardless
of the price of a bar. That is what a rightward shift of the
demand curve shows—more energy bars are demanded at
each price.
A Change in Supply
■ When any factor that influences selling plans other than the
price of the good changes, there is a change in supply.
Six main factors bring changes in supply.
They are changes in
■ The prices of factors of production
■ The prices of related goods produced
■ Expected future prices
■ The number of suppliers
■ Technology
■ The state of nature
Question to plot demand curve
■ For example, suppose the price of coffee increases significantly. As
a result, some consumers may decide to switch to tea or other
cheaper beverages, because the relative price of coffee has gone
up. This substitution effect occurs because consumers are always
seeking to maximize their satisfaction or utility, and they do so by
choosing the best combination of goods or services based on their
available income and the prices of those goods or services.
Supply equation
■ From the specific supply function Qs x = 20P x (P x is given in dollars), derive
■ (a) the producer’s supply schedule and
■ (b) the producer’s supply curve.
Elasticity
■ Consumers usually buy more of a good when its price is lower,
when their incomes are higher, when the prices of its substitutes
are higher, or when the prices of its complements are lower. Our
discussion of demand was qualitative, not quantitative. That is,
we discussed the direction in which the quantity demanded
moves but not the size of the change. Economists use the
concept of elasticity to measure how much consumers respond
to changes in these variables.
■ “A measure of the responsiveness of quantity demanded
or quantity supplied to a change in one of its
determinants.”
Price Elasticity of Demand

■ A measure of how much the quantity demanded of a good

responds to a change in the price of that good, computed as
the percentage change in quantity demanded divided by the
percentage change in price.
■ The law of demand states that a fall in the price of a good raises the
quantity demanded. The price elasticity of demand measures how
much the quantity demanded responds to a change in price. Demand
for a good is said to be “elastic” if the quantity demanded responds
substantially to changes in the price. Demand is said to be “inelastic”
if the quantity demanded responds only slightly to changes in the
price.
Elasticity of demand

■ The price elasticity of demand is a units-free measure of

the responsiveness of the quantity demanded of a good to a
change in its price when all other influences on buying plans
remain the same.
■ Elasticity is a units-free measure because the percentage
change in each variable is independent of the units in which
the variable is measured. The ratio of the two percentages is a
number without units.
■Demand is said to be elastic if e >1, inelastic if e <1, and
unitary elastic if e =1.
■ If the elasticity of demand is greater than 1, the demand is
considered elastic, meaning that a small change in price leads
to a large change in quantity demanded. If the elasticity of
demand is less than 1, the demand is considered inelastic,
meaning that a change in price has little effect on the quantity
demanded. If the elasticity of demand is equal to 1, the
demand is considered unit elastic, meaning that a change in
price leads to an equal change in quantity demanded.
Calculating Price Elasticity of Demand
■ Because the quantity demanded of a good is negatively related to
its price, the percentage change in quantity will always have the
opposite sign as the percentage change in price.
■ In this example, the percentage change in price is a positive 10
percent (reflecting an increase), and the percentage change in
quantity demanded is a negative 20 percent (reflecting a decrease).
For this reason, price elasticities of demand are sometimes
reported as negative numbers.
The Factors That Influence the
Elasticity of Demand

The elasticity of demand for a good depends on

■ The closeness of substitutes
■ The proportion of income spent on the good
■ The time elapsed since the price change
The Elasticity of Supply

■ The elasticity of supply measures the responsiveness of the

quantity supplied to a change in the price of a good when all other
influences on selling plans remain the same. It is calculated by using the
formula:
The Factors That Influence the Elasticity of Supply

The elasticity of supply of a good depends on

■ Resource substitution possibilities
■ Time frame for the supply decision
INCOME ELASTICITY OF DEMAND

■ The coefficient of income elasticity of demand (eM) measures the

percentage change in the amount of a commodity purchased per unit time
(DQ/Q) resulting from a given percentage change in a consumer’s
income (DM/M). Thus
■ When eM is negative, the good is inferior. If eM is positive,
the good is normal. A normal good is usually a luxury if its eM
. 1, otherwise it is a necessity. Depending on the level of the
consumer’s income, eM for a good is likely to vary
considerably. Thus a good may be a luxury at “low” levels of
income, a necessity at “intermediate levels of income and an
inferior good at “high” levels of income.
Cross Elasticity of demand

■ The coefficient of cross elasticity of demand of commodity X with respect to

commodity Y(exy) measures the percentage change in the amount of X purchased
per unit of time (DQ x=Q x) resulting from a given percentage change in the
price of Y(DP y=P y). Thus

■ If X and Y are substitutes, exy is positive. On the other hand, if X and Y are
complements, exy is negative. When commodities are nonrelated (i.e., when
they are independent of each other), exy = 0
Average Cost

■ Average cost (AC) is the total cost of producing a unit of

output divided by the total number of units produced. In other
words, the total cost of producing all goods and services is
divided by the total quantity produced.
■ The formula for average cost is:
AC = TC/Q
■ Where: AC = Average cost TC = Total cost Q = Total quantity
produced
Marginal Cost

■ The cost of producing one more unit of a good or service is its

marginal cost. Marginal cost is the minimum price that producers
must receive to induce them to offer one more unit of a good or
service for sale. But the minimum supply-price determines supply.
A supply curve is a marginal cost curve.
Δ𝑇𝐶
Δ𝑄
■ MC =

■ Marginal Cost = Change in Total Cost / Change in Quantity

Fixed Cost

■ Fixed costs are expenses that remain constant, regardless of the

level of production or sales volume. These costs do not vary with
changes in the volume of output or sales, at least in the short run. In
other words, they are costs that a business incurs regardless of
whether it produces or sells any goods or services.
■ Examples of fixed costs include rent, property taxes, salaries and
wages of permanent employees, insurance premiums, and loan
repayments. The business must pay these expenses, regardless of
the level of activity or revenue.
■ Fixed costs remain constant over a wide range of activities,
but variable costs vary in total with the volume of output.
Consumer surplus

■ We don’t always have to pay as much as we are willing to pay. We

get a bargain. When people buy something for less than it is worth to
them, they receive a consumer surplus. Consumer surplus is the
excess of the benefit received from a good over the amount paid for
it. We can calculate consumer surplus as the marginal benefit (or
value) of a good minus its price, summed over the quantity bought.
Marginal Cost

■ Firms are in business to make a profit. To do so, they must sell their
output for a price that exceeds the cost of production. Let’s
investigate the relationship between cost and price.
■ Firms make a profit when they receive more from the sale of a good
or service than the cost of producing it. Just as consumers
distinguish between value and price, so producers distinguish
between cost and price. Cost is what a firm gives up when it
produces a good or service and price is what a firm receives when it
sells the good or service.
■ The cost of producing one more unit of a good or service is its
marginal cost. Marginal cost is the minimum price that
producers must receive to induce them to offer one more unit
of a good or service for sale. But the minimum supply-price
determines sup ply. A supply curve is a marginal cost curve.
Producer surplus

■ When price exceeds marginal cost, the firm receives a

producer surplus. Producer surplus is the excess of the
amount received from the sale of a good or service over the
cost of producing it. It is calculated as the price received minus
the marginal cost (or minimum supply-price), summed over
the quantity sold.
Average Revenue
■ In economics, average revenue is the total revenue generated
by a business divided by the quantity of goods or services
sold. It is also known as the revenue per unit of output.
Average revenue is calculated by dividing the total revenue by
the quantity sold, using the following formula:
■ Average Revenue = Total Revenue / Quantity Sold
■ For example, if a company generates $10,000 in revenue
by selling 500 units of a product, the average revenue per
unit would be:
■ Average Revenue = $10,000 / 500 = $20
■ Therefore, the average revenue per unit for this company is
$20.
■ Average revenue is an important concept in economics as it
helps businesses understand the relationship between the
quantity of goods or services sold and the revenue generated.
By analyzing their average revenue, businesses can
determine the optimal price and quantity of products to sell in
order to maximize their profits.
 Marginal Revenue
■Marginal revenue is the additional revenue generated by selling
one additional unit of a product or service. It is the change in total
revenue that results from producing and selling one more unit of output.
The formula for calculating marginal revenue is:
■
■ Marginal Revenue = Change in Total Revenue / Change in Quantity
Sold
■ In other words, marginal revenue is the slope of the total revenue curve
at a given point.
■ For example, suppose a company sells 1,000 units of a product for
$10 each, generating a total revenue of $10,000. If the company
sells an additional unit for $10, its total revenue increases to
$10,010. The marginal revenue of that additional unit would be:
■ Marginal Revenue = Change in Total Revenue / Change in
Quantity Sold
■ Marginal Revenue = ($10,010 - $10,000) / (1 unit)
Marginal Revenue = $10
■ Therefore, the marginal revenue of selling the additional unit is $10
■ Marginal revenue helps businesses determine the optimal
quantity of output to produce and sell in order to maximize
their profits. Businesses can use marginal revenue to
determine whether producing an additional unit of output will
increase their total revenue or not.
Total Revenue, Total Cost, and Profit

■ Economists normally assume that the goal of a firm is to maximize

profit, and they find that this assumption works well in most cases.
What is a firm’s profit? The amount that the firm receives for the sale
of its output (cookies) is called its total revenue. The amount that the
firm
pays to buy inputs (flour, sugar, workers, ovens, and so forth) is called its
total cost. A producer gets to keep any revenue that is not needed to
cover costs. Profit is a firm’s total revenue minus its total cost:
Profit = Total revenue − Total cost.
Cost Curves and Their Shapes
■ The horizontal axis measures the quantity the firm produces, and the
vertical axis measures marginal and average costs. The graph shows
four curves: average total cost (ATC), average fixed cost (AFC),
average variable cost (AVC), and marginal cost (MC)
The Relationship between Marginal Cost
and Average Total Cost
■ Whenever marginal cost is less than average total cost,
average total cost is falling. Whenever marginal cost is greater
than average total cost, average total cost is rising.
■ The marginal-cost curve crosses the average-total-cost curve
at its minimum. Why? At low levels of output, marginal cost
is below average total cost, so average total cost is falling.
Typical Cost Curves
■ we have studied so far, the firms have exhibited diminishing
marginal product and, therefore, rising marginal cost at all
levels of output. This simplifying assumption was useful
because it allowed us to focus on the key features of cost
curves that are useful in analyzing firm behavior. Yet actual
firms are usually more complicated than this. In many
firms, marginal product does not start to fall immediately
after the first worker is hired.
■ Figure 5 shows the cost curves for such a firm, including
average total cost (ATC), average fixed cost (AFC), average
variable cost (AVC), and marginal cost (MC). At low levels of
output, the firm experiences increasing marginal product, and
the marginal-cost curve falls. Eventually, the firm starts to
experience diminishing marginal product, and the marginal-
cost curve starts to rise. This combination of increasing then
diminishing marginal product also makes the average-variable-
cost curve U-shaped.
What is Utility
■ Utility refers to the satisfaction or enjoyment that a consumer
derives from consuming a good or service. It is a measure of
how much a consumer values a good or service, and it is
usually represented by a numerical value.
■ Utility is subjective and varies from person to person,
depending on their preferences, tastes, and other factors. It is
also not directly observable, but it can be inferred from the
choices that consumers make when deciding between different
goods and services.
Indifference Curves

■ An indifference curve shows the various bundles of

consumption that make the consumer equally happy. In this
case, the indifference curves show the combinations of pizza
and Pepsi with which the consumer is equally satisfied.
Marginal rate of substitution

■ The slope at any point on an indifference curve equals the rate

at which the consumer is willing to substitute one good for
the other. This rate is called the marginal rate of substitution
(MRS). In this case, the marginal rate of substitution
measures how much Pepsi the consumer requires to be
compensated for a one unit reduction in pizza consumption.
Four Properties of Indifference Curves
■ Property 1: Higher indifference curves are preferred to lower
ones. People usually prefer to consume more goods rather than
less. This preference for greater quantities is reflected in the
indifference curves. As Figure 2 shows, higher indifference curves
represent larger quantities of goods than lower indifference curves.
Thus, the consumer prefers being on higher indifference curves.
■ Property 2: Indifference curves are downward sloping. The
slope of an indifference curve reflects the rate at which the
consumer is willing to substitute one good for the other. In
most cases, the consumer likes both goods. Therefore, if the
quantity of one good is reduced, the quantity of the other
good must increase for the consumer to be equally happy. For
this reason, most indifference curves slope downward.
■ Property 3: Indifference curves do not cross. To see why this
is true, suppose that two indifference curves did cross, as in
Figure 3. Then, because point A is on the same indifference
curve as point B, the two points would make the consumer
equally happy. In addition, because point B is on the same
indifference curve as point C, these two points would make
the consumer equally happy. But these conclusions imply that
points A and C would also make the consumer equally happy,
even though point C has more of both goods. This contradicts
our assumption that the consumer always prefers more of both
goods to less. Thus, indifference curves cannot cross.
■ Property 4: Indifference curves are bowed inward. The slope of an
indifference curve is the marginal rate of substitution—the rate at
which the consumer is willing to trade off one good for the other.
The marginal rate of substitution usually depends on the amount of
each good the consumer is currently consuming. In particular,
because people are more willing to trade away goods that they
have in abundance and less willing to trade away goods of which
they have little, the indifference curves are bowed inward. As an
example, consider Figure 4
Perfect Substitutes

■ Two goods with straight line indifference curves. A perfect

substitute refers to a product or service that can be easily
replaced with another product or service, without any
change in the consumer's utility or satisfaction level.
Perfect Complements

■ Two goods with right angle indifference curves. Perfect

compliments are a type of goods where the consumption of
one good is entirely dependent on the consumption of another
good. In other words, the two goods are used together, and the
consumer's satisfaction level depends on the proportion in
which they are consumed. Perfect compliments are also called
"jointly consumed goods."
The Consumer’s Optimal Choices
■ The consumer's optimal choices refer to the decisions that a
consumer makes to maximize their utility or satisfaction
from the goods and services they consume, given their
income and the prices of the goods and services.
■ Consumers make choices based on their preferences, which
are represented by their indifference curves. An indifference
curve shows all the combinations of two goods that give the
same level of utility to the consumer. The slope of the
indifference curve represents the rate at which the consumer is
willing to trade one good for another, given their level of
satisfaction.
■ To find the consumer's optimal choices, we need to analyze
their budget constraint, which represents the combination of
goods that the consumer can afford given their income and
the prices of the goods. The budget constraint is represented
by a straight line on a graph, with the slope equal to the ratio
of the prices of the two goods.
■ The optimal choice depends on the prices of the goods and the
consumer's income. If the prices of the goods change, the
budget constraint will shift, and the optimal choice will
change as well. Similarly, if the consumer's income changes,
the budget constraint will shift, and the optimal choice will
also change.
The Budget Constraint: What the Consumer
Can afford
■ The limit on the consumption bundles that a consumer can
afford is called a budget constraint.
■ Notice that the slope of the budget constraint equals the
relative price of the two goods—the price of one good
compared to the price of the other. A pizza costs five times as
much as a liter of Pepsi, so the opportunity cost of a pizza is 5
litres of Pepsi. The budget constraint’s slope of 5 reflects the
trade-off the market is offering the consumer: 1 pizza for 5
liters of Pepsi.
■ Figure 6 shows the consumer’s budget constraint and three of her
many indifference curves. The highest indifference curve that the
consumer can reach (I2 in the figure) is the one that just barely
touches her budget constraint. The point at which this indifference
curve and the budget constraint touch is called the optimum. The
consumer would prefer point A, but she cannot afford that point
because it lies above her budget constraint. The consumer can afford
point B, but that point is on a lower indifference curve and, therefore,
provides the consumer less satisfaction. The optimum represents the
best combination of pizza and Pepsi available to the consumer.
Link of Utility and Indifference Curve
■ Indifference curves and utility are closely related. Because the
consumer prefers points on higher indifference curves, bundles of
goods on higher indifference curves provide higher utility.
Because the consumer is equally happy with all points on the same
indifference curve, all these bundles provide the same utility. You
can think of an indifference curve as an “equal-utility” curve.
■ the marginal rate of substitution between two goods depends on
their marginal utilities. Utility analysis provides another way to
describe consumer optimization. recall that, at the consumer’s
optimum, the marginal rate of substitution equals the ratio of prices.
that is
■ this equation has a simple interpretation: at the optimum, the
marginal utility per dollar spent on good X equals the
marginal utility per dollar spent on good Y. (Why? If this
equality did not hold, the consumer could increase utility by
spending less on the good that provided lower marginal utility
per dollar and more on the good that provided higher marginal
utility per dollar.)
 Changes in Equilibrium
■ The equilibrium price and quantity depend on the position of the supply
and demand curves. When some event shifts one of these curves, the
equilibrium in the market changes, resulting in a new price and a new
quantity exchanged between buyers and sellers.
■ When analyzing how some event affects the equilibrium in a market, we
proceed in three steps. First, we decide whether the event shifts the
supply curve, the demand curve, or, in some cases, both curves.
■ Second, we decide whether the curve shifts to the right or to the left.
■ Third, we use the supply-and-demand diagram to compare the initial and
the new equilibrium, which shows how the shift affects the equilibrium
price and quantity.
How Changes in Income Affect the
Consumer’s Choices
How Changes in Prices Affect the Consumer’s
Choices
Income and Substitution Effects
Do All Demand Curves Slope Downward?
■ Normally, when the price of a good rises, people buy less of
it. This usual behavior called the law of demand, is reflected
in the downward slope of the demand curve.
■ Economists use the term Giffen good to describe a good that
violates the law of demand. (The term is named for
economist Robert Giffen, who first noted this possibility.
■ Giffen good: a good for which an increase in the price
raises the quantity demanded
How Do Wages Affect Labor Supply?
■ People spend some of their time enjoying leisure and some of
it working so they can afford to buy consumption goods. The
essence of the time-allocation problem is the trade-off
between leisure and consumption
How Do Interest Rates Affect Household Saving?
Price-Demand Relationship

■ As the selling price per unit (p) is increased, there will be less demand
(D) for the product, and as the selling price is decreased, the demand will
increase. The relationship between price and demand can be expressed
as the linear function

■ where a is the intercept on the price axis and −b is the slope. Thus, b is
the amount by which demand increases for each unit decrease in p.
Both a and b are constants.
The Total Revenue Function

■ The total revenue, TR, that will result from a business venture during a
given period is the product of the selling price per unit, p, and the number
of units sold, D thus,

■ If the relationship between price and demand as given in previous Equation is used
Perfect Competition

■ Perfect competition occurs in a situation in which any given

product is supplied by a large number of vendors and there
is no restriction on additional suppliers entering the market.
■ Perfect competition may never occur in actual practice,
because of a multitude of factors that impose some degree of
limitation upon the actions of buyers or sellers, or both.
However, with conditions of perfect competition assumed, it
is easier to formulate general economic laws.
Monopoly
■ Monopoly is at the opposite pole from perfect
competition.A perfect monopoly exists when a unique
product or service is only available from a single supplier
and that vendor can prevent the entry of all others into the
market.
■Perfect monopolies rarely occur in practice, because
■(1) few products are so unique that substitutes cannot be
used satisfactorily, and
■(2) governmental regulations prohibit monopolies if they
are unduly restrictive.
 Cost, Volume, and Breakeven Point
Relationships

■ Fixed costs remain constant over a wide range of activities, but variable
costs vary in total with the volume of output. Thus, at any demand D,
total cost is

■ where CF and CV denote fixed and variable costs, respectively. For the
linear relationship assumed here,

■ where cv is the variable cost per unit.

In order for a profit to occur, based on Equation (2-9), and to
achieve the typical results depicted in Figure 2-4, two conditions
must be met:
1. (a − cv) > 0; that is, the price per unit that will result in no
demand has to be greater than the variable cost per unit.
(This avoids negative demand.)
2. Total revenue (TR) must exceed total cost (CT) for the
period involved.
■ To ensure that we have maximized profit (rather than minimized it), the sign
of the second derivative must be negative. Checking this, we find that
Breakeven Point

■ An economic breakeven point for an operation occurs when total

revenue equals total cost. Then for total revenue and total cost, as used in
the development of Equations (2-9) and (2-10) and at any demand D,
revenue, cost and profit function
BREAK-EVEN ANALYSIS
■ The main objective of break-even analysis is to find the cut-off
production volume from where a firm will make profit. Let
s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production
The total sales revenue (S) of the firm is given by the following formula:
S=s Q
The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost = v Q + FC
■ For any production quantity which is more than the break-even
quantity, the total revenue will be more than the total cost. Hence, the
firm will be making profit.
Profit = Sales – (Fixed cost + Variable costs)
= s Q – (FC + v Q)
The formula to find the break-even quantity and break-even sales quantity
■ The contribution is the difference between the sales and the
variable costs. The margin of safety (M.S.) is the sales over
and above the break-even sales. The formula to compute
these values are