Lecture -1

Business
A business is an economic activity. Transforming a set of inputs into a set of
output is the essence of economic activity. Through the process of
transformation, the value of the output generated must exceed the value of input
utilized. Creation of net value addition is the basic objective of all such
activities. On the input side we have reference to men, materials, management
etc. By output we have reference to various kinds of goods and services. Goods
can be consumer goods, public goods, merit goods, and non merit goods. The
purpose of any economic activity such as production and final consumption is
to create “Surplus” or profit. Some of the NGOs & NBOs (Non-Business
Organisations) may not aim at private profits, they aim at social benefits. All
organizations are organizing activities which are either commercially profitable
or socially desirable. For an economist, all these organizations represent
“economic enterprises”. We can say that business is an organized effort to
provide goods and services to make profit.

What is Economics all about:

Economics is the study and evaluation of economic problems. Each and every
economic problem is a problem of choice and valuation.

In business several decisions are to be taken. For example, a production unit has
to decide- what to produce? When to produce? for Whom to produce? Why to
produce?

1
In the same way, a finance enterprise dealing with funds confronts the issues –
when to raise finds? Where from? Where to direct the use of these funds? At
what Risk and Returns combinations funds are to be raised? What should be
maturity and other terms and conditions with regard to loans disbursed or
deposits mobilized?

In the same way a company has to decide – how many people are to be
recruited? For what post and position? Through direct recruitment or internal
promotion. To retire a person or replace? To train – develop existing employees
towards promotion and transfer
or to hire trained personnel?

In the same way, a marketing firm has to resolve whether to sell or market? At
what price? Whether to provide after sales service or not? What should be the
target group/territory? Should there be any price discount or not? Should
deferred payments be allowed or not? Should the focus be on domestic or
export market? Should the sales promotion be aggressive or defensive? Should
special efforts be made towards sales promotion or not?

In all of the above examples, the decision problems represent an area of

Choice?

The question of choice arises as and when means (resources) are adjusted to
ends (wants). The purpose of economic activity is to satisfy maximum possible
ends by sacrificing minimum possible resources.

Human wants have fundamental characteristics:

2
 1. Wants are unlimited
2. Wants can be graded in order of their intensity.

Resources’ fundamental characteristics are:

1. Resources are limited in supply.
2. Resources have alternative uses.

Unlimited ends and limited means together present the problem of choice.

Economic Concepts:
Concepts have references to terms like ‘Scarcity’, ‘activity’, optimality
‘Demand’, ‘Supply’ ‘Price’ ‘Costs’, ‘Profits” etc. Each concept has a specific
connotation in a specific context for example “Demand” in the context of a
market means buyers willingness and ability to purchase.

Economic Precepts:
Several concepts together can be built into a precept. Precept stands for
proposition, principle, policy, proscription.

A few precepts:-
(i) Scarcity lies at the root of every economic problem.
(ii) Demand is always at a price.
(iii) Optimal allocation of scarce resources is the essence of
management.
(iv) Supply is in response to the price prevailing in a market.
(v) Firm’s objective is to maximize profits.

3
What is Business Economics all about:
Based on the above, we can conclude logically that
(i) Economics as a discipline provides a set of concepts and
precepts.
(ii) The concepts and precepts together furnish us the tools and
techniques of analysis.
(iii) Economic analysis is used as an aid to understand business
practices and business environment
(iv) Such understanding facilitates business decision making.

Business Economics attempts to indicate how Business Policies are firmly

rooted in economic principles. Business economics tabes a pragmatic approach
towards facilitating and integration between economic theory (Principles) and
business practices (Policies).

Business Economics Uses:

(a) Microeconomic Analysis of the business unit.
(b) Macroeconomic Analysis of the business Environment

Business Economics is more comprehensive and broad based than managerial

Economics which is mostly microeconomics with high degree of analytic rigour
through sophisticated tools and techniques of Econometrics and operations
research

4
 Various forms of Economic Analysis

1. Micro V/s Macro Analysis:-

In micro economic analysis we focus on individual units like a consumer, a
producer, a firm, an industry, a single price or a single commodity. We analyse
the behaviour of one market variable at a time – it is step by step analyse. Such
an analysis helps us to understand behaviour of a single thing, “other things
remaining the same.”

In macro economic analysis we study the system as a whole, not the individuals
but the total. We focus on the form and functioning of the economy as an
aggregate system. Accordingly our variables are national income, national
consumption, expenditure, total investment expenditure, total money supply,
general price level, overall employment and output levels.

For understanding economic problems like unemployment, we find micro

economics very relevant

Microeconomics theory includes theory of demand, theory of production,

Theory of price determination, Theory of profit & capital budgeting .

Macroeconomic theories include theory of national income, theory of economic

growth, international trade and monetary mechanism, study of state policies and
their repercussion on the private business activities.
2. Positive V/s normative Economic Analysis:-
Economic analysis is the basis of an economic policy. Most of the business
polices of an economic unit, like a firm are based on micro economic principles.

5
Most are based on macro economic principals. However, neither the business
sector can overlook the impact of national and global economic policies of the
govt. nor the economy can overlook the impact of business policies framed by a
particular (individual or group) management. This implies that the distinction
between micro and macro analysis narrows down further as and when the
policy implication of various principles are worked out. To the extent economic
analysis (Positive Economics) and Economic Policy (Normative Economics)
are inseparable, micro and macro analysis must go together. Positive
Economics is “What is there” Normative economics is “What ought to be
there?’

3. Short Run V/s Long Run Economic Analysis:-

Economists analyse their problems with reference to objective & constraints.

In “Short Run” analysis, some constraints are variable while others are fixed. In
“Long Run Analysis” all the constraints are variable & adjustable.

4. Partial V/s General Equilibrium Analysis:-

Partial equilibrium analysis in economics means when at a time one part of the
system is being analysed, assuming that other parts to be constant parameters.
E.g. D = f (P, Pr, y, t.)

The assumption of “other things remaining constant” may be eventually relaxed

and then the inter dependence among consumers, among producers and between
consumers and producers is studied to derive the welfare implications of a
situation of balance of market forces. This is the system of “General
Equilibrium” analysis.

6
5. Static V/s Comparative Static V/s Dynamic Analysis:-

Both microeconomic analysis of partial or general type may be either static,

comparative static or dynamic. In static analysis, the reference is to an
adjustment at a point of time; preferences, techniques and resources are,
therefore, assumed constant.

In comparative static analysis, two or more static states i.e. shifting equilibrium
situations may be studied so as to identify the single process of adjustment. In
dynamic analysis, we study adjustment path followed over a period of time such
that successive changes in tastes, techniques and resources over ling run can be
taken care of.

Business Economics by
M.Adhikari.

7
 Lecture – 2

Definitions of Economics
“In its infancy, Economics was called political Economy.”

“The aim of political Economy is to show the way in which wealth is produced,
distributed and consumed.” J.B.Say

“Economics is the study of nature, causes and growth of national wealth” Adam
Smith

But Adam Smith paid too much attention to wealth as if wealth was every thing.
No attention was paid to man for whom wealth is really meant. No doubt,
wealth is the centre of all economic activities. But it is only a mean to an end,
the end being human welfare . Economics is thus regarded as a science of man
rather than of wealth.

Alfred marshall (1990) shifted emphasis from production of wealth to

distribution of wealth (welfare). According to him “Economics is a study of
man’s action in the ordinary business of life, it enquires how he gets his income
and how he uses it. Thus it is on one side a study of wealth and on the other a
more important side, a part of the study of man.”

Study of man occupies the prominent place in the Economics. However, we

confine our study to those of his action which relate to wealth i.e. how wealth is
produced and used. How it is exchanged and distributed in the community.
Thus it covers consumptions, production, Exchange- Distribution.

8
According to Marshal the primary object and end of Economics is the
promotion of material welfare, which is part of human welfare. (Human welfare
also includes political, social, religious and other activities of mankind, not
amenable to quantitative measurements)

Criticism:

1. Marshall was concerned with the material goods. However non-material

goods are also equally important for the promotion of human welfare.
The services of teachers, doctors, lawyers, actors, singers etc are non-
material goods, which have been excluded by Marshall.
2. Marshall limited his study to those activities which increase human

welfare. He treats economics an normative science i.e. outcome can be

improved upon. He excluded the production of guns. Cigarettes, opium,
wine, poison- harmful drugs from the subject of economics. But these are
scarce in relation to demand for them. Economists have to study the
pricing problems & other aspects of such goods, whether they enhance
human welfare or not.

Scarcity Definition:
Man has unlimited wants
Resources are limited
Resources have alternative uses
Wants have hierarchy

9
According to Robin Economics studies the problems which have arisen because
of the scarcity of the resources. Robins believes that all human activities
whether it is the production of the commodities or services of teachers, doctors,
actors dancers, exhibit a clear relationship between ends and scare means.
According to him:

“Economics studies human behaviour as a relationship between ends and scarce

means which have alternative uses.”

“When time and means for achieving ends are limited and capable of alternative
application and the ends are capable of being distinguished in order of
importance, then behaviour necessarily assumes the form of choice i.e. it has
an economic aspect.

Robbins definition has broadened the scope of Economics narrowed down by

the welfare definition. Many other economists have also defined economics.

“Economy is a study of those principles on which the resources of a community

should be so regulated and administered as to secure communal ends without
waste.”
“Wichsteed”

“Economics is a social science concerned with the administration of scarce

resources.”
Scitovosky”

10
“Economics is the study of principales governing the allocation of scare means
among competing ends when the objective of allocation is to maximize the
attainment of the ends.”

Criticism
The idea of “welfare” is missing in the definition.

Growth Oriented Definition:

P.A. Samuelson gave a modified version of scarcity definition which is growth
oriented.

“Economics is the study of how man and society choose, with or without the
use of money, to employ scarce productive resources which have alternative
uses, to produce various commodities over time and distribute them for
consumption now and in the future among various people and groups of society.
It analyses the costs and benefits of improving patterns of resource allocation.
Managgerial Economics
by
D.D. Chaturveds
S.L. Gupta
Anand Mittel

11
Micro V/s Macro Economics

Micro is derived from the Greek word “micros” which means small. Thus micro
economics is the theory of small. It is the microscopic study of the economy.
The term ‘macro’ is derived from the Greek word “macros” which means large.
Macro economics also called “Income Theory” is concerned with the analysis
of the economy as a whole and its large aggregates or averages such as total
national income and output, total employment, aggregate demand and supply
and the general price level.

Importance of Macro Economics:

1. Formulation & Execution of Economic Policies:- Economic polices for

the removal of the poverty, the unemployment and the price instability
are based upon aggregate requirements.
2. Functioning of the Economy:- Macroeconomics gives us an idea of how

a complex economic system functions

3. Study the Economic Development
4. Study of welfare
5. Theory of Inflation & Deflation
6. International Comparisons.

Interdependence of Micro & macro Economics:-

Neither of the two is complete without the other. Demand of the product for
a firm or industry depends upon the total employment, income and demand
of the entire country for this product. The wages of the firm is related to and
depends upon wages to other firm in the industry. Therefore every price,
wage and income depends in some way or the other, upon the prices of all

12
other products, wages of all workers and income of all other individuals in
the country respectively. Prosperity and well being of individual economic
units can be ensured only if the performance of the whole economy is
excellent.

Difference between Micro macro Economics:-

In spite of very close relationship between two braches of economics, they
differ from each other fundamentally.
1. It is possible for an individual to become rich by finding bundles of
rupee notes but no nation can become richer by printing notes.
2. Savings may be virtue for an individual but if every body starts
savings, there will be deficiency of aggregate demand.
3. An individual can buy more of a commodity at a given price. But if
many individuals try to buy more, the price will shout up.

Business Economics
by
D.D. Chaturvedi
S.L.. Gupta
Sumitra Pal.

13
 Lecture -3

Contribution and Application of Business Economics to Business

Business Economics is useful in decision making by business firms regarding

the least cost input mix, product mix, production technique, level of output,
price for the product, investment decisions, amount of advertising out lay etc. It
involves, tools, techniques, principles and theories by business firms for
decision making and forward planning by establishing plans for the future.

“Business Economics consists of the use of economics modes of thought to

analyse business situations.” It is applied economics to solve decision problems
at the firm level.

Scope of Business Economics

Demand
Cost & Production
Analysis &
Analysis
forecasting
Profit Analysis (Input-output
(Demand
Profit Decisions)
Decisions)
Maximization
Alternative
Theories

Risk &
Investment
Uncertainty Market Structure
Analysis
Analysis, Pricing Policies
(Project Appraisal
Economic (Price-output
& Investment
Forecasting & Decisions)
Decisions)
Planning

14
 Lecturer – 4
Opportunity Cost

Opportunity Cost is the income foregone which a businessman could expect

from the second best alternative use of his resources. For example if an
entrepreneur uses his capital in his own business he foregoes interest which he
might earn by purchasing debentures of other companies or by depositing his
money with joint stock companies for a period. Further more if an entrepreneur
uses his labour in his own business he foregoes his income (salary) which he
might have earned by working as a manager in another firm.

Similarly by using productive assets (Land & Building) in his own business he
sacrifices his market rent. These foregone incomes- interest, salary and rent are
called opportunity Costs or Transfer Costs.
Also opportunity cost in called Implicit cost or Imputed Cost
Accounting Profit = Total Revenue – Explicit Cost

or A.F. = T.R - (W + R + I + M)

Wages Rent Interest Materials Cost.

Pure Profit/ Economic Profit
= Total Revenue - (Explicit Cost + Implicit Cost)

If a machine can produce either ‘X’ or ‘Y’ the opportunity cost of producing a
given quantity of ‘X’ is therefore the quantity of ‘Y’ which it would have
produced. If that machine can produce 10 units of X or 20 units of Y, the
opportunity cost of IX is 2Y.

15
In macrosense, the opportunity cost of more guns in an economy is less butter.
Continued diversion of funds to defense spending amounts to a heavy tax on
alternative spending on growth & development.

Managerial Economics
By
D.N. Divedi

16
 Lecturer – 5
Time Value of Money

One of the fundamental ideas in economics is that a Rupee tomorrow is worth

less than a Rupee today. This is because of two reasons.

(i) The future is uncertain

(ii) The interest rate – inflation

Todays Rs.100= 00 can be invested at 8% interest so that one year after today
Rs100 will become Rs.108= 00. Another way of saying the same thing is that
Rs.100 one year hence is not equal to Rs.100 = 00 of today, but less than that.
But how much money today is equal to Rs.100 one year hence. To find it out
we shall have to find out the relevant rate of interest which one would earn if
one decides to invest the money.

Suppose the rate of interest is 8%. Then we shall have to discount Rs.100 at 8%
in order to ascertain how much money today will become Rs.100 one year after.
The formula is
P.V. = Rs100
1+i
Where P.V. = Present Value & I = Rate of interest.
In our case
P.V. = 100 = 100 = Rs. 92.59
1 + .08 1 + .08

As a cross check Rs. 92.59 x 1.08 = Rs.100 = 00

i.e. Rs. 92.59 deposited at 8% today will become Rs. 100 = 00 after one year.

17
The same reasoning applies to longer periods. A sum of Rs. 100 = 00 two years
from now is worth
P.V. = 100 = 100 = 100 = Rs. 85.73
(1 + i)2 (1 +08)2 1.1664

This time value of money in called ‘Discounting Principle”

If a decision affects costs and revenues at future dates, it is necessary to

discount those costs and revenues to present values before a valid comparison
of alternatives is possible.

Suppose a firm is going to receive Rs.40,000 per year for next three years and
firm can earn 10% from fixed Deposits. Then the Present Value can be
computed as
P.V. = B1 + B2 + B3
(1+0.10) (1 + 0.10)2 (1+.10)3
.= 40,000 + 40,000 + 40,000
1.10 1.21 1.301
= 36360.40 + 33058.0 + 30,052.40

Marginalism v/s Instrumentalism

Incremental Analysis stresses on total costs and total revenue resulting from
changes in prices, products, processes, investments etc. Incremental costs and
incremental revenue are the two basic concepts in this analysis. Incremental
cost is the changes in total cost resulting from a decision.

18
The Decision criteria according to this concepts is “Accept a particular decision
if it increase revenue more than it increases cost as assessed from the point of
view of the total enterprise.”

Incremental cost = New Total Cost – Old Total Cost

= Change in Cost
I.C. = C2- C1 = C

The difference between old & new revenue is incremental revenue.

Incremental Revenue = New Total Revenue – Old Total Revenue

= Change in Revenue
I.R. = R2- R1 = R
Incremental concept has some relationship with marginal concept of economics.
(a) Marginal Analysis is more useful when the cost and revenue

functions are curvilinear. To find out small changes, marginal

analysis is more appropriate than the incremental concept.
(b) Incremental concept is not associated with a single unit change. It
can be associated with a change in any member of units. But
marginal analysis is related only to a unit change.
(c) In selecting best product mix, least cost input mix, optimum input

level & optimum maturity of assets, marginal analysis is superior

to incremental reasoning.
(d) But incremental reasoning in more useful in linear functions.
Marginal analysis is a special case of incremental reasoning.

19
As implied by incremental reasoning a decision is sound if it
increases revenue more than the costs or reduces costs more than
the revenue.

Principles of Managerial Economics by

Dr. B. Prabhakra Shishib

20
 Lecture - 6
RISK, RETURN & PROFITS
RI
R
18 D
16 RII
14 C
12 C"
Rate of Return 10 B
7.5
8 A
6
4
2
0
3.5 6 9 Risk

Risk – Return trade off function or Indifference curve R indicates that the
manager or investor is indifferent among 7.5% rate of return with Risk = 0;
10% return on an investment with Risk = 3.5 (Pt.B), 14% return on an
investment with Risk = 6 (Point C) and 18% Return on an investment with
Risk = P (Point)

Thus Risk Premium at Point ‘B’ is 2.5% (10 -7.5) Risk Premium at Point ‘C’ is
6.5% (14-7.5%) and at Point D is (18-7.5) 10.5% A more risk averse manager
or Investor (Curve R′ ) requires a higher premium while a less risk averse one
(with Curve R") requires a smaller Risk Premium for each level of Risk.

The higher the Risk, the higher the return. If an investor invests Rs.100 in the
Bank in F.D. he will get Rs.110 after one year (Assuming interest rote to be

21
10%). But if he invests in the stock market Rs.100, he may get Rs.200 after one
year (higher returns) but he may totally loose his principal amount even.

Market Forces & Equilibrium

At O P Price, demand of the buyers is OL, while sellor are ready to sell ok
quantity. (OK>OL) i.e. There is excess supply. In this situation there will be a
competition among the sellers. On the contrary at 0T prices demand will be ON
units where as supply will be OM units. In this case demand will be more than
supply & prices will tent to increase.

At Point ‘E’ there will be equilibrium of Demand supply. This will be

equilibrium price.

22
 Lecture -7

Cardinal Utility Approach

Utility is a property common to all commodities and services desired by a
person. It has no physical or material existence and so it is not inherent in a
commodity. As long as a commodity has some use i.e. a capacity to satisfy
consumer want, it has utility. Thus utility can be defined as the want satisfying
power of the commodity. It relates to inner sentiments and emotions and resides
in the mind of the consumer. Utility is subjective in nature.

Utility is not usefulness. Alcohol may be harmful for health, but, it is paid for
since it possesses utility. Concept of utility is legally, morally, socially and
ethically neutral. Utility is expected satisfaction and satisfaction is realised
utility. When a consumer plans the purchase of a commodity he actually
compares the price he is going to pay and the utility he is expecting from it.
Utility can exist without consumption but satisfaction will necessarily come
only after actual consumption. However for most of the goods expected
satisfaction is nearly same as realized satisfaction hence utility & satisfaction
are mostly used synonymously.

Measurement of Utility
The nineteenth century economists believed that utility was measurable just as
the weight, height and temperature of objects. The consumer was assumed to
possess a cardinal measure of utility. In this approach, utility is considered to be
objectively measurable. A psychological unity of measuring utility was used
called “Util”.

23
Because util can not be taken as a standard unit for measurement, as it will vary
from individual to individual, hence Marshall suggested the measurement of
utility in terms of monetary units.

Marginal Utility
Marginal Utility is the utility of last unit or the addition to total utility by the
consumption of one additional unit of the commodity for example the total
utility of consuming ten units of some commodity is the total satisfaction that
those ten units provide. The marginal utility of the tenth units consumed is the
satisfaction added by the consumption of that unit. It is the difference in total
utility between consumption of ten units and nine units.

Symbolically
Mu10 = Tu10 – Tu9
or In general
Mun = Tun – Tun-1
Where Mun is the marginal utility of nth unity. Tun = Total utility of ‘n’ units.
Tu n-1 = Total utility of (n-1) units.
Marginal utility can also be defined as increase in total utility (∆Tu), when the
quantity of the commodity is increased by a small amount (∆Q).
Mu = ∆Tu
∆Q
When change in quantity of the commodity is 1, the above formula reduces to
Mu = ∆Tu
Or Mun = tun – Tun-1

24
Initially marginal utility of a commodity is positive due to a feeling of an urge
for the commodity. However as the process of consumption is continued, a
point of saturation is reached. Consequently, marginal utility becomes zero.
Thereafter marginal utility will become negative.

Total Utility

Total utility (Tu) presents the sum of numbers of units consumed. It is the sum
of the marginal utilities associated with the consumption of successive units. If
the consumer derives utility worth Rs.100, Rs.90 & Rs.80 from the first second
& third unit of the commodity, the total utility of the commodity for the
consumer = Rs.270

Tun = Mu1 + Mu2 +…………Mun.

= ∑Mu.

25
Average Utility

Anis obtained by dividing total utility by the number of units of the commodity.

Au = Tu
Q

Relationship among Total Utility, Marginal Utility & A.U.

No. of Total Utility Marginal Utility Average Utility
Units (Tu) (Mu) (Au)
1 10 10 10
2 18 8 9
3 24 6 8
4 28 4 7
5 30 2 6
6 30 0 5
7 28 -2 4
8 24 -4 3

When the total utility reaches its maximum value, marginal utility become zero.
(Point of satiety). When consumption is expanded beyond the point of satiety,
the total utility starts falling because marginal utility turns negative.

26
 Relationship among Total Utility, Marginal Utility &
A.U.

35
30
25
20
Series1
15
Series2
10
Series3 Tu
5
0
-5 1 2 3 4 5 6 7 8 9

-10

AU

Mu

Unlike marginal utility, average utility is always positive, since it is a ration of

two non-negative values Tu & Q.

27
 Lecture -8

When average utility attains maximum value, it is equal to marginal utility.

Law of Diminishing Marginal Utility

It is a general human behavior that as one gets more and more units of the same
commodity, the utility from the successive units (marginal utility) goes on
diminishing. If the consumer continues with the consumption he will develop a
dislike for the commodity. Law “The utility which a consumer derives from the
consumption of each additional unit of a commodity keeps decreasing with
every increase in the stock of the commodity which he already has”

Assumption
1. Rationality :- Consumer is rational and he aims at the maximization of
his utility subject to the constraint imposed by his given income.

2. Cardinal Utility :- Utility is measurable and it can be quantified. It can

be added, subtracted, multiplied & divided.

3. Independence of Utility:- Utilities of different commodities are

independent of one another.

4. Continuous Consumption Process :- The law assumes that there is no

time gap between the consumption of two successive units of the
commodity. It there is a discontinuity in the consumption, the intensity of
want get revived.

28
5. Homogenous Units of Commodity :- If a delicious ripe mango, is eaten
after consuming an unripe mango, the second mango may give greater
utility.
6. No. Change in Personal, Social & Mental Conditions of Consumer:-
His income, tastes, fashions & habits should not change.

7. Constancy of Marginal Utility of Money ;- I.e. marginal utility of

money is constant. If the unit of measurement itself varies, then it will
give different results in different circumstances for the same quantity of
good.

Importance of Law

1. Basis of Law of Demand :

The price which a consumer is prepared to pay for a commodity depends

upon the marginal utility and not on the total utility. He would like to by
additional units of the commodity only at a lower price. Thus a consumer
is ready to pay higher price for the initial units and lessor for the
additional ones.

2. Explanation of Diamond/ Water Paradox :-

Since water is available in plentiful quantity its marginal utility is low or

even zero. Therefore its price is very low, yet it is essential for human
existence. On the other hand, diamond being a scarce commodity
commands a higher price due to its higher marginal utility, though not
essential for human existence.

29
Suppose the quantity of Diamond available is OQD and that of water in
OQw. Now Diamond will command a Price PD QD with total utility equal to
OA PD QD . Water will command a price of Pw Qw with total utility equal
to OBPw Qw. Water will command a price PwQw.

Hence the price a consumer would be willing to pay for diamond is high,
but, it has lower total utility vis-à-vis water. Price reflects marginal utility
while total utility determines the use-value of the commodity.

30
 Consumer Equilibrium (One Commodity)

If the commodity consumed by the consumer is available free of cost, he will

carry on consuming the commodity upto the point, where his total utility from
that commodity is maximum. He stops the consumption of the commodity at
the point of satiety i.e. where the marginal utility is equal to zero.

When a consumer pays price for the utility he derives from the additional unit
of commodity with the utility he scarifies in terms of the price paid for that unit
of commodity. Thus consumer is in equilibrium when marginal utility & price
are equal.

31
 Lecture - 9

Law of Equi- marginal utility (Consumer Equilibrium for more than one
commodity.)

A consumer spends his income on many goods & services. How he should
distribute his total income among these goods and services, so that he may be in
equilibrium. (He attains maximum possible level of utility). Let the prices of
two goods A & B be PA & PB respectively.

From law of diminishing M.U. it can be deducted that the consumer is in

equilibrium, when the quantity of the commodity is purchased in such a way
that M.U. derived from it is equal to the price paid for it multiplied by the
marginal utility of money to the consumer.

MUA = ∝ PA -------------- (1)

MUB = ∝ PB -------------- (2)

Where ∝ = marginal utility of money to the consumer

MUA = PA
MUB PB
If price of good ‘A’ is twice that of good ‘B’ MU A has to be twice MUB.
Marginal utilities of all the commodities should be proportional to their
respective prices.
From (1) ∝ = MUA ∝ = MUB
PA PB

32
 ∴∝ = MUA = MUB
PA PB

Thus equilibrium condition can also be stated as :

The consumer is in equilibrium when the marginal utility of money to the

consumer (∝ ) is equal to the ratios of marginal utilities of two commodities &
their respective prices. Now if MUA/ PA is greater than MUB/ PB, the consumer
will substitute good ‘A’ for good ‘B’. As a result of increase in the quality of
‘A’ and decrease in the quality ‘B’, MUA/ PA will fall and MUB/ PB will go up.
The consumer will continue the substitution till MUA/PA becomes equal to
MUB/PB when he will be in equilibrium.

The Consumer spends his money income in such a way that the last rupee spent
on each commodity gives him equal amount of utility. But this does not mean
spending of equal amount of money on each commodity. This only means that
marginal utilities of commodities and their respective prices are proportional.
MUA = MUB = MUc = MUm
PA PB PC

Also MUA = PA
PA MUB PB

33
34