MICROECONOMICS

AADESH GUPTA, IIM MUMBAI

DEMAND & SUPPLY
INTRODUCTION TO DEMAND & SUPPLY
• Demand: The quantity of a good that consumers are both willing and able to purchase at various price levels during a
specific time period.
Example: If the price of coffee drops from ₹100 to ₹80, more consumers may choose to buy coffee, increasing the quantity
demanded.
• Supply: The quantity of a good that producers are both willing and able to offer for sale at various price levels during a
specific time period.
Example: If the price of mangoes rises from ₹50 to ₹80 per kg, farmers are likely to supply more mangoes to the market to
maximize profits.
 LAW OF DEMAND & SUPPLY
•Law of Demand: Ceteris paribus (all other factors being constant), as the price of a good decreases, the quantity
demanded increases, and vice versa.
Example: When the price of movie tickets drops from ₹200 to ₹150, more people are likely to go to the movies, increasing
the quantity demanded.
•Law of Supply: Ceteris paribus (all other factors being constant), as the price of a good increases, the quantity supplied
increases, and vice versa.
Example: If the price of wheat rises from ₹25 to ₹40 per kg, farmers may increase wheat production to earn higher profits.
 DETERMINANTS OF DEMAND & SUPPLY
Factors Influencing Demand
•Income: Higher income increases demand for normal goods (e.g., luxury cars) and decreases demand for inferior goods
(e.g., instant noodles).
•Prices of Related Goods:
• Substitutes: Higher tea prices may increase coffee demand.
• Complements: Lower printer prices increase demand for cartridges.
•Consumer Preferences: Trends like rising demand for electric cars due to environmental concerns.
•Population/Demographics: Larger populations or specific age groups influence demand (e.g., healthcare for aging
populations).
•Future Expectations: Expected fuel price hikes may boost current demand.

Factors Influencing Supply

•Production Technology: Advancements (e.g., automation) increase supply by lowering costs.
•Input Costs: Higher raw material prices (e.g., steel) reduce supply.
•Government Policies: Taxes decrease supply; subsidies (e.g., on solar panels) increase it.
•Number of Sellers: More sellers increase market supply.
•Natural Events: Disasters (e.g., droughts) reduce supply, especially in agriculture.
 ELASTICITY OF DEMAND & SUPPLY
Elasticity: Measuring Responsiveness
•Price Elasticity of Demand (PED): Measures the responsiveness of quantity demanded to changes in the price of a good.
• Elastic Demand: When quantity demanded responds significantly to price changes (e.g., luxury items like high-
end electronics).
• Inelastic Demand: When quantity demanded changes only slightly with price changes (e.g., necessities like salt
or medicine).
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
Factors Influencing Price Elasticity of Demand (PED):
•Substitutes: More substitutes = higher elasticity (e.g., tea vs. coffee).
•Necessity vs. Luxury: Necessities are inelastic; luxuries are elastic (e.g., medicine vs. designer bags).
•Time Period: Elasticity increases over time (e.g., fuel prices and public transport).
•Income Proportion: Higher cost goods = more elastic (e.g., cars vs. gum).

Cross Elasticity of Demand (XED):

•Substitutes: Positive XED (e.g., tea demand rises when coffee prices increase).
•Complements: Negative XED (e.g., fuel demand drops if car prices rise).

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴

𝐶𝑟𝑜𝑠𝑠 𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐵

Cross Elasticity of Demand (XED):

•Positive (Substitutes): Tea demand rises when coffee prices increase.
•Negative (Complements): Fuel demand falls when car prices increase.
Income Elasticity of Demand (YED):
•Measures how demand changes with consumer income.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
MARKET EQUILIBRIUM
 MARKET EQUILIBRIUM
•A situation where the market price balances the quantity supplied and quantity demanded.
•At equilibrium, there is no surplus or shortage in the market.
 SURPLUS & SHORTAGE
Surplus vs. Shortage
•Surplus: Occurs when quantity supplied exceeds quantity demanded, leading to downward pressure on prices.
• Example: An excess of unsold winter coats at the end of the season.
•Shortage: Occurs when quantity demanded exceeds quantity supplied, leading to upward pressure on prices.
• Example: A sudden spike in demand for face masks during a health crisis.
 GOVERNMENT INTERVENTIONS
• Price Ceiling: A legal maximum on the price at which a good can be sold

• Price Floor: A legal minimum on the price at which a good can be sold
 WELFARE
Consumer Surplus: The amount a buyer is willing to pay for a good – The amount buyer actually pays for it

Producer Surplus: The amount a seller receives – The sellers minimum willing to sell amount

Welfare = Producer Surplus + Consumer Surplus

Deadweight Loss: Loss of total welfare due to market distortions like taxes, subsidies, or price controls.
UTILITY ANALYSIS
 CARDINAL & ORDINAL
Utility: The satisfaction or pleasure a consumer
derives from consuming a good or service.
Cardinal Utility: Assumes utility can be measured
numerically in units (e.g., utils). Example: Eating
a chocolate gives 10 utils, while drinking coffee
gives 8 utils.
Ordinal Utility: Assumes utility can only be
ranked, not measured. Example: A consumer
prefers tea over coffee but cannot quantify how
much more satisfying tea is.
Law of Diminishing Marginal Utility (LDMU): As
more units of a good are consumed, the
additional satisfaction (marginal utility) from
each extra unit decreases. Example: Eating the
first slice of pizza is highly satisfying, the second
less so, and by the fourth slice, the satisfaction
might drop significantly.
 CARDINAL & ORDINAL
Indifference Curves (ICs): Represent combinations of two
goods that provide the same level of satisfaction. They are
downward-sloping and convex to the origin.
Budget Line (BL): Represents the combinations of two
goods a consumer can afford based on their income and
the prices of the goods.
Marginal Rate of Substitution (MRS): The rate at which a
consumer is willing to substitute one good for another
while maintaining the same level of satisfaction.
Diminishing MRS: As more of one good is consumed, the
willingness to give up the other good decreases.
Consumer Equilibrium: Achieved where the Indifference
Curve is tangent to the Budget Line, indicating the
optimal consumption bundle for maximum satisfaction
within the budget.
PRODUCTION & COSTS
 PRODUCTION FUNCTION
Production Function
•Describes the relationship between inputs (labor, capital) and output.
• General Form: 𝑄 = 𝑓(𝐿, 𝐾), where Q = output, L = labor, K =
capital.
Short Run: At least one input is fixed (e.g., capital).
•Law of Diminishing Returns: Adding more of a variable input (e.g.,
labor) to a fixed input (e.g., land) eventually decreases the marginal
product of the variable input.
• Example: Adding more workers to a small factory leads to
overcrowding, reducing efficiency.

Long Run: All inputs are variable.

•Returns to Scale:
• Increasing: Output grows faster than input increases.
• Constant: Output grows proportionally to inputs.
• Decreasing: Output grows slower than input increases.
•Economies of Scale: Cost advantages from larger production (e.g., bulk
buying raw materials).
•Diseconomies of Scale: Higher costs due to inefficiencies at very large
scales (e.g., communication issues in large firms).
 COSTS
Types of Costs
•Fixed Costs (FC): Costs that remain constant regardless of
output level.
• Example: Rent, insurance, or salaries of
permanent staff.
•Variable Costs (VC): Costs that vary directly with the level
of output.
• Example: Raw materials, packaging, or utility
costs for production.

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡𝑠 (𝑇𝐶): 𝑇𝐶 = 𝐹𝐶 + 𝑉𝐶

• Marginal Cost (MC): Cost of producing an additional

unit

𝑀𝐶 = ∆𝑇𝐶
∆𝑄
MARKET STRUCTURES
 Monopolistic
Features Perfect Competition Monopoly Competition Oligopoly

Number of Firms Many One Many Few

Unique (no close Homogenous or

Nature of Product Homogenous substitutes) Differentiated Differentiated

Considerable
Significant (Price Limited (Due to product
Pricing Power None (Price Taker) (interdependence
Maker) differentiation)
exists)

Barriers to Entry None High Low High

Supernormal Profits or
Profit in the Short Run Losses Supernormal Profits Supernormal Profits Supernormal Profits

Supernormal Profits (if

Profit in the Long Run Normal Profits Supernormal Profits Normal Profits collusion exists)

Indian Railways,
Examples Agricultural Markets Google Fast Food Chains Telecom Industry
PRICING STRATEGIES
 PRICE DISCRIMINATION
Importance of Pricing Strategies
•Revenue and Profit Maximization: Helps achieve financial goals.
•Market Adaptability: Adjusts to changing conditions and customer needs.
•Differentiation: Distinguishes products and firms in competitive markets.

What is Price Discrimination?

•Charging different prices to different customers for the same product.

Types of Price Discrimination

•First-Degree: Charging each customer their maximum willingness to pay.
• Example: Auction-based pricing.
•Second-Degree: Offering discounts based on quantity purchased.
• Example: "Buy 1 Get 1 Free" offers in supermarkets.
•Third-Degree: Charging different prices to different groups based on demand elasticity.
• Example: Student discounts or senior citizen tickets.
 BUNDLING, PREDATORY PRICING, DYNAMIC PRICING
What is Bundling? - Selling multiple products as a single package.
Types of Bundling:
• Pure Bundling: Products only sold together (e.g., software suites).
• Mixed Bundling: Products sold individually or as a package (e.g., meal combos).
Advantages:
• Increases sales volume.
• Captures consumer surplus.
• Reduces competition on individual items.

What is Predatory Pricing? - Setting prices below cost to eliminate competitors.

Strategy Objective:
• Gain market share by driving competitors out.
• Raise prices later to recoup losses.
Legal Implications:
• Considered anti-competitive and often regulated.
Example: Amazon - Allegations of predatory pricing in online retail.

What is Dynamic Pricing? - Prices change based on real-time demand and supply.
Applications:
• E-commerce platforms (e.g., Amazon).
• Surge pricing for ride-hailing services (e.g., Uber).
Advantages:
• Captures real-time value.
• Maximizes revenue during high demand.
GAME THEORY
 WHAT IS GAME THEORY?
• The study of strategic interactions where the outcome depends on the actions of all participants.

Key Concepts
• Players: Decision-makers in the scenario.
• Strategies: Choices available to players.
• Payoffs: Outcomes based on chosen strategies.

What is Nash Equilibrium?

• A situation where no player can improve their payoff by changing their strategy, assuming others stick to their strategies.

Example
Pricing in an Oligopoly: Two companies decide whether to set high or low prices. Both achieve equilibrium when neither can benefit
from
deviating.

Payoff Matrix Example:

Two firms (A and B) with strategies: High Price (H) and Low Price (L).

Firm B (H) Firm B (L)

Firm A (H) 8, 8 4, 10

Firm B (L) 10, 4 6, 6

 PRISONER’S DILEMMA
What is a Dominant Strategy?
•A strategy that yields the best payoff for a player, regardless of the opponent's actions.

Prisoner’s Dilemma:
•A scenario where two prisoners must choose between confessing or staying silent.
• Dominant Strategy for Both: Confess, as it maximizes individual payoff irrespective of the other's decision.
• Outcome: Both confess, leading to a worse collective outcome than if both remained silent.

Prisoner B: Silent Prisoner B: Confess

Prisoner A: Silent -1, -1 -10, 0

Prisoner A: Confess 0, -10 -5, -5

EXTERNALITIES &
MARKET FAILURE
 WHAT ARE EXTERNALITIES
What are Externalities?
Externalities refer to the unintended costs or benefits that affect third parties who are not directly involved in an
economic transaction.
Types of Externalities:
•Positive Externalities: These are beneficial effects on third parties, such as the social benefits of education or
vaccinations.
•Negative Externalities: These are detrimental effects, like pollution, that impose costs on individuals or communities
not directly involved in the activity.
 WHAT ARE PUBLIC GOODS?
Public Goods
Public goods are characterized by being non-
excludable and non-rival in consumption.
•Non-Excludability: It is impossible to prevent
others from using the good.
•Non-Rivalry: One person's use of the good
doesn't diminish its availability for others.
Examples: National defense, street lighting,
public parks.

Common Resources
Common resources are non-excludable but rival
in consumption.
•Non-Excludability: Everyone has access to the
resource.
•Rivalry: One person's consumption reduces the
availability of the resource for others.
Examples: Fisheries, grazing land, water bodies.
 TRAGEDY OF COMMONS
Tragedy of the Commons
The tragedy of the commons occurs when a shared resource
is overused and depleted because individual incentives
outweigh the collective benefits.
Cause: Lack of ownership or regulation.
Solutions:
•Government Intervention: Implementing regulations,
quotas, or taxes.
Example: Fishing limits to prevent overfishing.
•Privatization: Assigning ownership rights to individuals or
firms.
•Community Management: Encouraging collective
agreements for sustainable usage.
Example: Local communities managing forests.
•Tradable Permits: Allowing the exchange of permits for
resource use.
Example: Carbon credits for pollution control.
WELFARE ECONOMICS
 SOCIAL WELFARE
Social Welfare Economics
Social welfare economics is the study of how the allocation of resources affects social welfare.
Key Objectives:
•Maximizing total surplus in society.
•Analyzing efficiency and equity in resource allocation.
Pareto Efficiency
Pareto efficiency refers to a situation where no one can be made better off without making someone else worse off.
Key Points:
•All resources are optimally allocated.
•Does not guarantee equity (fairness).
Types of Social Welfare
•Utilitarian: Maximizing the sum of individual utilities.
Example: Progressive taxation to reduce income inequality.
•Rawlsian: Maximizing the welfare of the least well-off.
Example: Government safety nets for the poor.
 ASYMMETRIC
INFORMATION
 SOCIAL WELFARE
• A situation where one party in a transaction has more or better information than the other.

Examples

Used car markets (sellers know more about the car than buyers). – LEMON’S
MARKET Health insurance (customers know more about their health risks than
insurers).

Types of Asymmetric Information

1. Adverse Selection: Hidden information leads to high-risk participants entering the market
disproportionately. Example: In insurance: Only people with higher health risks buy insurance.
2. Moral Hazard: Hidden actions where one party takes on higher risks because they do not bear the full consequences.
Example: Insured drivers may drive recklessly since they have insurance coverage.
3. Signalling and Screening:
Signalling: Actions taken by the informed party to reveal information (e.g., a job applicant sharing educational
qualifications). Screening: Actions taken by the uninformed party to elicit information (e.g., insurers offering discounts for
driving records).