Part A Micro Economics

Unit 1: Basic Concept of Market Economy

Basic Concept of demand
Supply and demand is perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy. Demand refers to how much (quantity) of a product or service is
desired by buyers. The quantity demanded is the amount of a product people are willing to buy at
a certain price.

A. LAW OF DEMAND

A. The Law of Demand

The law of demand states that, if all other factors remain equal, the higher the price of a good,
the less people will demand that good. In other words, the higher the price, the lower the quantity
demanded. The amount of a good that buyers purchase at a higher price is less because as the
price of a good goes up, so does the opportunity cost of buying that good. As a result, people will
naturally avoid buying a product that will force them to forgo the consumption of something else
they value more. The chart below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation
between quantities demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1
and the price will be P1, and so on. The demand relationship curve illustrates the negative
relationship between price and quantity demanded. The higher the price of a good the lower the
quantity demanded (A), and the lower the price, the more the good will be in demand (C)
b) Derivation of Individual and market demand curve

Formal DERIVATION OF DEMAND CURVE

We all face a variety of potential goods and services to consume. The

choice of how much and which goods/services to consume can be thought
of as consisting of two parts:

our preferences (what we like and dislike) and

Our budget (constraints on our preferences -- we cant buy
everything we want).

Indifference curves represent an individuals preferences. For simplicity, assume

that the consumer has the choice of consuming just two goods. An indifference
curve shows all combinations of the two goods that yield the same level of utility.
Utility is constant along the indifference curve. All points along the curve are
equally satisfying. The consumer does not prefer one combination of goods to any
other along the curve.
The indifference curve below represents a consumers monthly preference for
steak and pizza. The indifference curve shows that 8 steaks and 3 pizzas per
month yield the same level of satisfaction as 2 steaks and 7 pizzas per month.

Indifference Map
Note that an indifference curve shows various combinations of goods that
yield the same utility, but different indifference curves show different
levels of utility. For instance, the green indifference curve on the graph
below indicates a higher level of utility than the red or the blue
indifference curves. Economists assume that people want to attain the

highest level of utility possible (I3 is better than I2 which is better than
I1 )
There are an infinite number of indifference curves in the indifference
map, and each persons indifference map is unique to that person.

Characteristics of Indifference Curves

Downward sloping to the right: if a consumer gives up a unit of one

good, he/she must have more of the other good to maintain the
same level of utility
Convex to the origin (bowed inward)
Cannot intersect

As one moves along the indifference curve (from left to right), each
additional x-axis good will replace fewer y-axis goods than the previous
one to maintain the same level of utility. This is the diminishing marginal
rate of substitution (MRS). MRS is the rate at which one good can be
substituted for another without changing the consumers total utility.
Goods substitute for one another at a diminishing marginal rate because
of diminishing marginal utility for each.

To see the diminishing marginal rate of substitution, start with consuming

8 units of good Y and 3 units of good X. To increase consumption of good
X by one unit, this consumer is willing to trade-off (decrease)
consumption of good Y by 3 units (8 5) in order to maintain a constant
level of utility. But notice what happens when more of good X is
consumed, say increasing consumption of good X from 6 to 7. Now this
consumer is only willing to sacrifice one unit of good Y to get one more
unit of good X (remaining at the same level of satisfaction). The rate at
which people are willing to trade-off good Y for X diminishes as additional
units of X is consumed (The good Y is becoming more dear as we consumer
more and more of good X)

MRS is the slope of the indifference curve, and can be measured as the
ratio of marginal utilities of the two goods.

MRSx,y = MUx / MUy

The Budget Constraint
Consumers have a limited amount of money (income, I) to spend on the
two goods (X and Y). Each good has a price (Px and Py). The budget line
shows (if spending entire income only on some combination of the two

goods, X and Y) all combinations of the goods that the consumer could
afford . The slope of the budget line is the ratio of the prices.

Slope = (I / Py) / (I / Px) = (Px / Py)

Example: Jan Consumer has $100 to spend. Good X costs $5 per unit.
Good Y costs $10 per unit. If Jan spent all of her income on X, she could
purchase 20 units (100 / 5) of X. If she spent all of her income on Y, she
could purchase 10 units (100 / 10) of Y. She could also afford to buy
different combinations of the two goods. For example, she could buy 6
units of X and 7 units of Y, or 10 units of X and 5 units of Y, or 14 units
of X and 3 units of Y. The budget line shows all combinations of the goods
that Jan can afford. The slope of Jans budget line is 0.5 ( Px / Py =
5/10 ).
Jans budget line is shown below:

Consumer Choice
Equilibrium is determined by combining the consumers preferences with
the consumers budget line.

To maximize utility, the consumer tries to achieve the highest

indifference curve (highest utility), given the budget constraint.
Therefore, the consumer should maximize utility subject to the budget
constraint, or

Max U s.t. BC
Utility maximization occurs where the marginal rate of substitution (the
slope of the indifference curve) equals the price ratio (the slope of the
budget line).

MUx / MUy = Px / Py
At the point of utility maximization, the marginal utility per dollar spent
on each good is equal.

MUx / Px = MUy / Py
Utility maximization occurs where the budget line is tangent to the
indifference curve. Suppose the graph below represented Jans budget
line and preferences. According to the information shown on the graph,
Jan would consume 5 units of good Y and 10 units of good X. Given her
budget constraint (purple line), the highest level of utility she can achieve
is the red indifference curve (she cannot afford any combination of goods
X and Y represented on the green (a higher indifference curve).

Effect of Price Changes

Assume Jans income remains the same ($100), but the price of good X
increases from $5 to $10 per unit. Note how the budget line changes. The
increase in price of good X reduces Jans purchasing power, so she can no
longer achieve a utility level associated with the red indifference curve.
The highest level of utility Jan can now achieve is associated with the
blue indifference curve. With the higher price of good X, Jan now
consumes only 6 units of good X and 4 units of good Y.

The demand curve for a good can be derived by determining how

consumer choices change when the price of that good changes, all else
held constant. Returning to the Jan example, we now have two points on
Jans demand curve for good X. The price of good X was originally $5 and
Jan consumed 10 units of X. When the price increased to $10, Jan's
consumption fell to 6 units of X (see graph below).

Market Demand
Market demand is the horizontal summation of all individual demand
curves for the good. The market demand shows the quantity of a good
that all consumers are willing to purchase at different prices (for that
good).

Effect of Price Changes

Assume Jans income remains the same ($100), but the price of good X
increases from $5 to $10 per unit. Note how the budget line changes. The
increase in price of good X reduces Jans purchasing power, so she can no
longer achieve a utility level associated with the red indifference curve.
The highest level of utility Jan can now achieve is associated with the
blue indifference curve. With the higher price of good X, Jan now
consumes only 6 units of good X and 4 units of good Y.