Term Paper on Micro Economics

8/3/2019 Term Paper on Micro Economics

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TERM PAPER ON

MICRO ECONOMICSBASED ON THE STUDY OF

LAW OF DEMAND

PREPARED FOR:

MOHAMMED BELAL UDDINLECTURER

DEPARTMENT OF ACCOUNTING

COMILLA UNIVERSITY

PREPARED BY:

OPTIMISTIC

CONSIST OF

ROLL NAME DESIGNATION

12 FARDUS MAHMUD GROUP LEADER

21 A. K. M. MAHMUDUL HASAN MEMBER 22 FARZANA SULTANA MEMBER

29 MD. MOSHIUR RAHMAN MEMBER

34 PRODYUT KANTI DAS MEMBER

45 UMME SALMA ASST.GROUP LEADER

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APRIL 29, 2008

MOHAMMED BELAL UDDINLECTURER

DEPARTMENT OF ACCOUNTINGCOMILLA UNIVERSITY

Dear Sir,Here is the report on the study of law of demand you asked us to conduct lastApril 15, 2008.By the grace of Almighty ALLAH, the most benevolent and merciful wehave been successful to complete this term report. Being prepared this report

I and my group member help us to meet up this report.

We have tried our best to make the report comprehensive and reliable withinthe given period. Nevertheless, some mistake might be occurred, pleaserectify these types of unconscious mistakes with sympathy.

Sincerely yours

Fardus MahmudOn behalf of Optimistic

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QUESTION PAGENO

Definition of demand 05 The law of demand 05 Forces behind demand curve 06 Why demand curve slope downward Consumers surplus

0708

Meaning of elasticity 09 Elasticity of demand 10 Price elasticity 11

Elastic demand 11 Inelastic demand 12 Unit elasticity of demand 13 Infinite elasticity of demand 13 Zero elasticity of demand 14

Cross elasticity 14 Income elasticity 15 Point elasticity 17 ARC elasticity 18 Indifference curve 18 Properties of indifference curve 22 Marginal rate of substitution 23 Diminishing marginal rate of substitution 25 Budget line 26 Shifting budget line 26 Distinguish between indifference curve & indifference

map27

Income effect 29 Substitution effect 30

Inferior good 31

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Giffen good 32

NO FIGURE NAME PAGE

01 Demand curve 0602 Substitution effect 0903 Consumers surplus 1004 Elasticity of demand 1105 Price elasticity of demand 11

06 Elastic demand 1207 Inelastic demand 1208 Unit elasticity 1309 Infinite elasticity 1410 Zero elasticity 1411 Cross elasticity 1512 Income elasticity 1613 Point elasticity 1814 ARC elasticity 1915 Indifference curve 2516 Marginal rater of substitution 2617 Diminishing marginal rate of substitution 2718 Budget line 2719 Shifting budget line 2920 Price effect 3021 Income effect 3122 Substitution effect 3223 Inferior good 3224 Giffen good 3325 Normal good 3426

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DEMAND:

The demand for anything at a given price is the amount of it, which will be brought per unit of time at the price. It is a multivariate relationship

determined by many factors simultaneously. Some of the mist importantdeterminates of the market demand for a particular product are its own

price, consumers testes, income, price of other commodities, incomedistribution, government policy, past levels of demand, past level of incomeetc.

THE LAW OF DEMAND:

According to the law of demand, at a given time period when other thingsremaining the same, quantity for a commodity fall as price rises & vice versa.it can be shown graphically below.

Y

p0

Demand curvePrice p1

p3

O X

q0 q1 q2

Quantity

Figure: Demand curve

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FORCES BEHIND DEMAND CURVE:

The graphical representation of the demand schedule is the demand curve. Ademand curve shows the relationship between the quantity demanded of a

good and its price when all other influences on consumers planned purchasesremain the same.Y

15Price

10

5

O X2 4 6

Quantity demanded

The forces behind the demand curve are given below:-

The average income:The average income of a consumer is the key determinants of demand. As

peoples income rise, individuals tend to buy more of almost everythingeven if prices do not change.

The size of market:

The size of market is measured by the population. It clearly affects themarket demand curve.

The price of availability of related goods:

The price and availability of related goods influence the demand for acommodity. Demand for good A tends to be low if the price of substitute

product A is low. Testes or preferences:

Testes represent a variety of cultural and historical influences. They mayreflect genuine psychological needs and they may include artificiallycontrived cravings.

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Special influences:

Finally, special influences will affect the demand for particular goods.thedemand for umbrellas is high in rainy Seattle but low in sunny phoenix.

These are some of the factors, which bring about changes in demandcurve. Why demand curve slope downward?

According to the law of demand, other things remaining unchanged, when theprice increase the quantity demand decreases, when the price decreases thequantity demand increases.That is,When, price Demand & when, price Demand

As a result the demand curve slopes downward to the right. These are thefollowing reasons for sloping downward of demand curve.

1. Law of diminishing marginal utility:

Law of diminishing marginal utility is the most important reason forsloping downward of demand curve. Marginal utility of money remainingconstant. When price decreases, the consumer increases his purchase ofgoods because the marginal becomes equal to the price after increasingthe purchase. Thus the quantity demanded increases after decreasing

price.

Price D

P2 Downward slopingOf demand curve

P

P1D

O X

Q2 Q Q1Quantity demanded

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2. Income effect:

If the price decreases the consumers real income increases, so theconsumer can purchase more than before. In this stage, the quantitydemanded increases, after decreasing price.

3. Substitution effect:

if the price of substitute goods remaining unchanged, when the price ofany good decreases than the consumer consumes that goods more &more instead of substitute goods. So the demand curve slopesdownward.

Y Y

p0 p0p1

p1

q0 q1 X O q0 q1 X

Quantity demand of beef Quantity demand of chicken

4. Afford to buy:When the price increases, the buying power of consumer decreasesthan before. so the consumer consumes less than before. Again whenthe price decreases the buying power of consumer increases. In thisstage, after decreasing price, the consumer consumes more than before.Thus when price decreases, quantity demand increases.

Consumer surplus:

The consumer surplus is a concept introduced by Marshall, who maintain thatit can be measured in monetary units & is equal to the difference between theamount of money that a consumer actually pays to buy a certain quantity ofcommodity X and the amount that he would be willing to pay for thisquantity rather than do without it.

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Px

A

p1

p2

p3

p4

q1 q2 q3 q4 B QxGraphically the consumers surplus may be found by his demand forcommodity x and the current market price which he cannot affect by his

purchases of this commodity. Assume that the consumers demand for x is astraight line AB and the market price is P. At this price the consumer buys qunits of x and pays an amount (a)(p) for it. However he would be willing to

pay p1 for q1, p2 for q2, p3 for q3 and so on. The fact that the price he wouldbe willing to pay for the initial units of x implies that his actual expenditure isless than he would be willing to spend to acquire the quantity q. This

difference is the consumers surplus, and is the area of the triangle PAC.

MEANING OF ELASTICITY:

A term widely used in economics to denote the responsiveness of onevariable to changes in another. Thus the elasticity of X with respect to Ymeans the percentage change in X for every 1 percent change in Y.Elasticity is defined as the percentage change in dependent variable divided

by the percentage change in independent variable.

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ELASTICITY OF DEMAND:

Elasticity of demand is the measure of the responsiveness of demand tochanging prices. The elasticity of demand is a measure of the relative change

in amount purchased in response to a relative change in price on a givendemand curve.

Here Q Ped= .

P Q%change in quantity demanded

=% change in price

hereQ = changes in quantity demandedP = change in priceP = original priceQ = original quantity

Y

10

5

25 50 X

here ed= 50-25/10-5 * 5/50= 25/5 * 5/50= =0.5

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PRICE ELASTICITY OF DEMAND:

When 1% changes in price leads to more than 1% change in quantity,we say that elasticity is greater than one. Then the good has elasticdemand.

Y

15Here, ed >1

10

ed

10 12 qFigure: Price elasticity of demand

1. ELASTIC DEMAND:

The change in demand is not always proportionate to the changein price. A small change in price may lead to a great change indemand. In that case the demand is elastic.

y

p1

p2

ed >1

q1 q2 q

Figure: Elastic demand

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2. INELASTIC DEMAND:

If a big change in demand is followed only by a small change indemand. It is said to be a case of inelastic demand.

y

p1

p2

ed < 1

O q1 q2 q

Figure: Inelastic demand

3. UNIT ELASTICITY OF DEMAND:

When 1% changes in price leads to 1% change in Quantity, wesay that elasticity is unit elasticity.

y

p1

p2

ed = 1

q1 q2 q

Figure: Unit elastic demand

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4. INFINITE ELASTICITY OF DEMAND:

When very small change in price leads to very large change inquantity, we say that is infinite elasticity.

ed =

Figure: Infinite elasticity of demand

5. ZERO ELASTICITY OF DEMAND:

When very large change in price leads to very insignificantchange in quantity, we say that elasticity is zero.

P

ed = 0

Figure: Zero elasticity of demand

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CROSS ELASTICITY:

Cross elasticity of demand is defined as the percentage change inquantity demanded of one commodity due to a percentage in price ofother related commodity.

Cross elasticity of demand for X & YProportionate change in purchase of commodity X=

Proportionate change in purchase of commodity Y

Eab= Qa/Pb * Pb/QaThis type of elasticity arises in the case of interrelated goods such assubstitutes and complementary goods.

Pb

substitute

10

5Eab= 10/5 * 5/10

=1

10 20 QaPb

Sugar 12 Eab= -5/2 * 10/20= -1.25

10

Complements isNegative

15 20 QaTea

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INCOME ELASTICITY:

Income elasticity is a measure of potential buyers to change in income.Income elasticity of demand is defined as the percentage in quantitydemanded of a commodity divided by the percentage change in income of the

consumer. It is equal to unit or one when the proportion of income spent ongood remains the same even though income has increased. It is said to begreater than unit when the proportion of income spent on a good increases asincome increases.

It is said to be less than unity when the proportion of income spent ona good decreases as income increases.

y=Q/y * y/Q

110 160

100 100

10 12 7 10

Normal goods inferior goods

Here, ey= 2/10 * 100/10 ey = -3/60 * 100/10= 2 =0.5+

ey > 0 ey < 0

It is zero income elasticity of demand when change in income makes nochange in our purchase and it is negative when with an increase in income theconsumer purchase less, in the case of inferior goods.

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DETERMINANTS OF PRICE ELASTICITY:

We know that the elasticity is relative. For one person or at one place, thedemand may be elastic, and for another person and at another place it may be

inelastic.Some determinants of price elasticity are given below. Availability of substitute:

The demand for a commodity is more elastic if there are close substitution forit. When the price of tea rises we may curtail its purchase and take to coffee,and vice versa. In a case like this a change in price will lead to expansion orcontraction in demand.

Nature of goods:

Luxury goods are price elastic while essential goods are price inelastic. It

stands to reason that lower in of the price of things like radio and TV sets.Refrigerators and artistic furniture will lead to more being bought, which isthe demand is elastic. On the other hand the change in price of wheat may beimmaterial for upper classes, but its consumption will certainly increaseamong the poor when price falls.

Time period:

The elasticity of demand is greater in the long run than in the short run for thesimple reason that the consumer has more time tom make adjustment in hisscheme of consumption.

Range of use:

The wider the range of use the more elastic the demand for the product islikely to be. When wheat becomes very cheap, it can be used even as cattlefeed. Hence, demand for a commodity having several uses in elastic.

Level of income:

The demand on the part of the poor people is sensitive to price changes. Inorder to derive maximum benefit from their marginal income, they must be

alert to vary their purchase in response to changes in prices. But rich peoplecontinue to bye practically the same quantities even though the price mayhave changed.

Level of prices:

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Elasticity of demand is great for high prices, & great or at least considerablefor medium prices, but it declines as the price falls, the gradually fades awayif the fall goes so far that stativity level is reached.

Postponement of use:

The demand of the goods the use of which can be postponed in more elasticthan the elasticity of those goods, the use of which can not be postponed ininelastic.

Proportion of total expenditure:

if a consumer absorbs goods only a small proportion of total expenditure suchas salt, the demand will not be much affected by a change in price. Hence itwill be in elastic.

Joint demand:

The demand for jointly determined goods is less elastic. For example, the

carriage becomes cheap but the prices of horses continue to rule high,demand for carriages will not extend much.

Market imperfections:

Owing to ignorance about market tends the demand for good may notincrease when its price falls for the simple reason that consumer thatconsumers may not be aware of the fall in price.

Technological factors:

Low price elasticity may be due to some technical reasons. For example

lowering of elasticity rates may not increase consumption because theconsumers are unable to bye the necessary electric appliance.

POINT ELASTICITY OF DEMAND:

At first Joseph E. Stiglitz introduced the point elasticity method formeasuring elasticity of demand by geometric process. When the elasticity ismeasured at a certain point then the elasticity is called point elasticity.To be more exact,

The point elasticity of demand is defined s the proportionate change in thequantity demanded resulting from a very small proportionate change in price.By using this tactic we can measure elasticity of a specific point.

ep = Q/ P * P/QLower segment of the demand curve

ep =

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Upper segment of the demand curve

ARC ELASTICITY OF DEMAND:

The ARC elasticity is a measure of the average elasticity that is the elasticityat the mid points of the chord that connects two points on the demand curvedefined by the initial and the new price level. We use ARC elasticity ofdemand when price changes are significant or appreciable as distinguishedfrom point elasticity.

ARC elasticity

(p1+p2)/2ep = Q/ P * P

(Q1+Q2)/2 D

15 A= Q/ P * p1+p2/ Q1+Q2

= 2/5 * 10+15/18+20 10 RD

= 0.26

18 20 Q

INDIFFERENCE CURVE:

An indifference curve in the locus of point particular combination of bundleof goods which yield the same utility to the consumer so that he isindifference as to the particular combination he consumes.

An indifference curve represents satisfaction of a consumer from twocommodities. it is drawn on the assumption that for all possible points on anindifference curve the total satisfaction remains the same.

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Slope of indifference curve = -y/x= MRS xy

Y

y1 Ay2 B

y3 Cy4 D IC

x1 x2 x3 x4 XAssumption:

Rationality:

The consumer is assumed to be rational. He aims at the maximum of hisutility, given his income and market prices.

Ordinality:

The consumer can tank his preferences according to the satisfaction ofeach basket. He need not know precisely the amount of satisfaction. Heexpresses his preference for the various bundles of commodities.

Diminishing marginal rate of substitution:

Preference ranked in terms of indifference curves, which are assumed tobe convex to the origin. This implies that slope of indifference curve is calledthe marginal rate of substitution of the commodities.

Convex Concave

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Total utility of consumer:

The total utilities of the consumer depend on the quantities of thecommodities consumed.U = (q1, q2, q3, ............qx, qy,...........qn)

Consistency of choice:

The choice of consumer will be consistent.If A>B, then B>A

Transitivity of choice:

The consumers choice is characterized by transitivity.If A>B, and B>C, then A>C

Indifference schedule:

Combinations Apples Mangoes1 15 12 11 23 8 34 6 45 5 5

In the above schedule, the consumer obtains as much total satisfaction (totalutility) from 11 apples & 2 mangoes as from 8 apples & 3 mangoes and aswell as from other combination. In other words, our consumer feelsindifference whether he gets the1st combination (15A + 1M)2nd combination (11A + 2M)3rd combination (8A + 3M)

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4th combination (6A + 4M)5th combination (5A + 5M)The total satisfaction is the same in all these combination.

Y

A15

Apples B11

C8

6 D E5

IC

O 1 2 3 4 5 X

Mangoes

Mangoes are measured along the X-axis, their number increases from left toright. Apples are measured along Y-axis & their number increase upwards.if the consumer were at point on A the curve IC with 15 apples & 1 mango,he would be just as satisfied as at point B with 11 apples& 3 mangoes or at

point C with 8 apples& 3 mangoes or at point d with 6 apples & 4 mangoesand so on. These combinations give him same level of satisfaction. if we jointhe points A, B, C, D, & E, we get a continuous curve IC, each points on itshowing same level of or equal satisfaction or the indifference of theconsumer towards the various combinations.

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PROPERTIES OF INDIFFERENCE CURVE:

The diagram of an indifference curve given already is a typical one. it is clearwhy indifference curves normally have the shape. Besides we shall notice the

properties of typical indifference curves. There are three characteristics ofindifference curves,

Downward sloping to the right Non- intersecting Convex to origin Higher indifference curve, higher the level of satisfaction & vice

versa.

Downward sloping to the right:

To begin with indifference curves curveSlope downwards from left to right. It is

because when the consumer decides to havemore units of one of the two goods, he willhave to reduce the number of units of other IC1good. If he is to remain on the same levelof satisfaction.

Non- intersecting:

Y

No two such curves will ever cut each otherif they did, the point of their intersectionwould imply two different level of satisfaction

. BA

. C i

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iiO

X

Convex to origin: Y

Third property of indifference curves is thatthey are normally convex to the origin. The

implication of this convexity rule is that aswe have more & more & more of good X &less & less of Y. the marginal rate ofsubstation of X for Y goes on falling.

IC

O X

Higher indifference curve, higher the Ylevel of satisfaction & vice versa.

IC3IC2

IC1O X

MARGINAL RATE OF SUBSTITUTION:

The marginal rate of substitution shows how much of one commodity issubstituted for how much of another or at what rate a consumer is willing tosubstitute one commodity for another in his consumption pattern.

In Hichks word we may define marginal rate of substitution of X for Y

as the quantity of Y which would just compensate the consumer for the

loss of the marginal unit of X.

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combination apple mangoes MRS xy1 15 1 ----2 11 2 4:13 8 3 3:14 6 4 2:15 5 5 1:1

Let us suppose that the consumer decides upon the forth combination. Where

terms of our diagram means that he chooses the combination represented by apoint on IC. Now the marginal unit of mangoes is the third mangoes, toacquire which he has had to forego two apples.

It is common observation that, as we come to have more & more of one good,we shall be prepare to forego less & less of the other since our desire for theformer becomes less & less intense with more & more of it.In technical language, it will be said that the marginal rate of substitution ofX for Y will fall as we have more of X & less of Y.

The principle is that as X is substituted for Y so as to keep the consumer atthe same level of satisfaction, the marginal rate of substitution X for Ydiminishes.

So we can say thatThe marginal rate of substitution shows how much one commodity issubstituted for how much of another.

The marginal rate of substitution of X for Y is defined as the number of unitsof commodity Y that must be given up in exchange for an extra unit ofcommodity X so that the consumer maintains the same level of satisfaction.

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DIMINISHING MARGINAL RATE OF SUBSTITUTION:

Y

AGood Y B

C

D

E IndifferenceCurve

O XGood X

When the consumer slides down the curve A to B, he forgoes Y of good Y

to obtain X of good X. here the slope of indifferencecurve=MRSxy=Y/X. as the consumer slides down, Y becomes shorter &shorter while X remains the same. when a consumer moves from A to B, Bto C, C to D and so on, he is prepared to forego less and less of Y for a unit ofX. the reason for diminishing marginal rate of substitution are:

Since a particular want is satiable. The edge of want for a good isblunted as the consumer has more and more of it.

The goods are imperfect substitutes for one another. Thats why as onecommodity and decrease in that of the other would make no difference.

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The marginal rate of substitution of one good for another will notdiminish if the want satisfying power of the other good has increased atthe same time.

BUDGET LINE:

A line indicating the combination of commodities that a consumer can buywith a given income at a givenset of prices. Y

20 y/py

15 .

Budget line10 .

5 .y/px

. . . . .O 5 10 15 20 25 X

SHFTING BUDGET LINE:

1. 2.

Y Y

Py Py

O X O X

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Px Px1 Px1 Px Px Py remain constant Px Py remains constant

3. 4.Y Y

Py1 Py

Py Py1

O X O XPx Px

Px remains constant Py Px remains constant Py 5. 6.

Py1 Py

Py Py1

Px Px1 Px1 Px

Px & Py constant Y Px & Py constant Y

DISTINGUISHES BETWEEN INDEFFERENCE CURVE &INDIFFERENCE MAP:

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An indifference curve is the locus of points representing all combination oftwo market baskets that provides the same level of satisfaction.

An indifference map is a set of indifference curves that describes the

consumers preferences among various combination of market basket.Indifference curve No Indifference mapAn indifference curve is the locusof points representing allcombination of two market

baskets that provides the samelevel of satisfaction.

01 An indifference map is aset of indifference curvesthat describes theconsumers preferencesamong variouscombination of market

basket.

. A

. B. C

Indifference curve

02

. A .B . Ciii

iii

Indifference mapAs we attain any upper point of

indifference curve the total utilitydoes not change.

03 As we attain any points

which is on the upperindifference curve the totalutility of consumer increased.

It can be drawn without the help ofindifference map.

04 The indifference map cannot be drawn without thehelp of indifference curveas indifference map isnothing but a combinationof indifference curves.

Budget line

05 incomeconsumption

curve

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. Optimal choice

INCOME EFFECT:Income effect is the effect on the quantity demanded exclusively as a result ofchange in money income, all prices remaining constant. What will happen tothe consumers equilibrium and the amount of the two commodities bought inhis income were to change while prices of the commodities remain the same.Obviously, as a result of change in income, his satisfaction will eitherincrease or decrease, for he has spent now a large or small income to spend.The result of this type if change is described in technical language as income

effect.Y

L4Amount ofCommodity Y L3 ICC

L2

p4

L1 p3p2

p1 c4c3

c2c1

O M1 M2 M3 M4 XAmount of commodity X

With price income line L1M1, the consumer is in equilibrium point P1. Nowsuppose the income of the consumer increase so that his new price incomeline is L2M2. As a result of this increase in income, the consumer will moveto a new equilibrium position at the point P2 on a higher indifference curveC2 and will be buying OH2 of commodity X and OQ2 of commodity Y. thus

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the consumer will get on to a higher level of satisfaction as a result of anincrease in income.If his income increase still further, so that the new price income line becomesL3M3 he will be in equilibrium at the point P3 on as indifference curve C3

and so on for further increase in income.If the points P1, P2, P3, and P4 etc are joined together by a line passing fromthe origin, we get, what is called income consumption curve.The income consumption curve shows how the consumption of twocommodities is affected by change in income when prices of both goods aregiven and constant.

Total Effect:

Total effect is nothing but summation of substitution effect and

income effect. Total effect or= Substitution effect+ Income effect

SUBSTITUTION EFFCT:

The substitution effect is the increasing in the quantity bought as the price ofthe commodity falls after adjusting income so as to keep the same as before.This adjustment in income is called compensating variation and is showngraphically by a parallel shift of the new budget line until it becomes tangent

to the initial indifference curve.The propose of the compensating variation is to allow the customer to remainon the same level of satisfaction as before the price change.

P

Commodity Y A in case of Normal goods

QT R

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OM K L R B H

Commodity XThe substitution effect can be easily explained with the help of the graph.

In this figure, the consumer is in equilibrium at point Q where the given priceis PL is tangent to indifference curve C1. When the price of X falls and theprice of Y remain the same, the price line will shift to PH (because now moreof X is purchased) and the consumer will be in equilibrium at R. where thenew price line PH touches the indifference curve C2. To find the substitutioneffect, we draw a hypothetical price line AB parallel to the price line PH sothat it should touch the indifference curve C1. Slope of AB or PH shows thechanged relative prices of X & Y. in terms of this diagram, BH or AP is theamount of money income that should be taken away from the consumer so

that the gain in real income which results from the fall in the price of X iscancelled out. with the price line AB the consumer is in equilibrium at pointT, he gets the same level of satisfaction as at Q, because both Q & T aresituated on the same indifference curve C1 is due to only the relative fall inthe price of X, at the point T, the consumer buy MK of X than at Q as X isnot relatively cheaper. This MK is the substitution effect which involvesmovement from Q to T.

Inferior goods:

YSubstitution effect negative

Income effect positiveP

ba

iic

i

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O Xx1 x2 x3 P P1

Movement from a to b is due to total effect = x1x2 (price effect) Movement from a to c is due to substitution effect = x1x3 Movement from c to b is due to income effect = - x3x2

Total effect = substitution effect + income effectx1x2 = x1x3 + (-x2x3)

= x1x3 x2x3= x1x2 Giffen goods:

Giffen goods are special type of inferior goods. Quantity demanded of giffengoods as price rise and vice versa.

Y Substitution effect = negative

Income effect = positive

b

ii

ac

iO X

x2 x1 x3 p p1

Movement from a to b is due to total effect = - x1x2 Movement from a to c is due to substitution effect = x1x3 Movement from c to a is due to income effect = - x2x3

Total effect = Substitution effect + Income effect

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-x1x2 = x1x3 + (-x2x3)= x1x3 x2x3= - x1x2

Normal Good:

If the consumer increases of his purchases of goods due tothe increase in income, then the effect is called positive income effect. Thegood whose income effect is positive is called normal good. So in case

positive income effect, income consumption curve is upward sloping.Y

P

a bc

i ii

x1 x2 x3 P P1 X

In the figure, there are three indifference curves. IC1,IC2 and IC3 indifference map and PL, P1L1, P2L2 are the price lines. Icc is the incomeconsumption curve in case of normal goods. Point E is the initial equilibrium

point. when the income increases, the consumer income increases hispurchase of good at new equilibrium point E1. Again when the incomedecreases, the price line shifted P2L2 and the consumer purchase less than

before at new equilibrium point E2. By adding points E1, E, E2, incomeconsumption curve is found. It is upward sloping because it is normal goods.

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Substitution Effect:The income of consumer remaining constant, when the

quantity demanded of two goods is changed proportionately after change inprice, and then it is generally known as substitution effect.

Professor Hichs analyses this substitution effect throughindifference curve.

In the figure good x and good y are measured along the ox axis and oy axisrespectively. The consumer at first reaches in equilibrium at point A. At point

A, the consumption of good x and good y is on. Now the budget line isshifted to PL, from PL when the price of good X decreases. As a result theconsumers real income is increased. To remain the real income unchanged,

price line p2l2 is tangent to the same indifference curve. IC at point B. at thepoint B the consumption at good X is OM1 and good Y is ON1. In this case,the consumer consumes excess MM1, amount of good X instead of

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consuming NM1, amount of good Y. this change is known as substitutioneffect.

CONSUMERS EQUILIBRIUMWhen the consumer attains a position of maximum satisfaction & would haveno further incentive to make any change in the quantity of the commodity

purchased.

Equilibrium with one commodity purchased:The law of diminishing marginal utility tells us the position of consumersequilibrium in the case of one commodity purchase. If price fall consumer

buy more until successive units & the marginal utility will come down to the

level of price. That means equality between marginal utility & price indicatesthe position of consumers equilibrium when only commodity is being

purchase and consumed.

Equilibrium with two commodity purchased:In this case the position of the equilibrium will be determined according tothe law of equi-marginal utilities. A consumer derives maximum satisfactionwhen the marginal utilities of two commodities are equal. In case they are notequal. Adjustment will be made in the matter of quantities purchased. That is

buying more of the commodities with higher marginal utilities and buyingless the lower marginal utility commodity.He purchased till the marginal utilities of two commodities are equalized.This is a position of maximum satisfaction.

The position of maximum satisfaction, the consumer considers two factors. The marginal utilities of two goods and their price Given his money income that he has to spend on the two commodities.

From above, we can derive a formula for a consumers equilibrium in respectof two goods X & Y.MUx = MUyPx Py

that is marginal utility of good X divided by the price of X, must be equal tomarginal utility of Y divided by the price of Y. it means that it is giving theconsumer maximum satisfaction.

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We can show the consumers equilibrium with the help of table & diagram.Units MUx MUx/Px MUy MUy/Py1 33 11 36 92 30 10 32 83 27 9 28 74 24 8 24 65 21 7 20 56 18 6 16 4

Here Px = 3

Py = 4

Explanation of the table:With the given income, suppose a consumers marginal utility of money isconstant at Re. 1 = 8 utilities. From the above table, it will be seen thatMUx/Px = 8 units when the hypothical consumer buys four units of X goodsand MUy/Py = 8 when he byes two units of Y goods. This consumer will thus

be inequilibrium when he is buying four units of X goods and two units of Ygoods and he will be spending 20 taka on these two goods.

Diagramic representation:

Y

PriceMUy

MUx PyPx

E

E

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DO B

F F G G XFigure: Consumers equilibrium by using principle of equi-marginal utility.

ACKNOWLEDGEMENTS

Nothing can be created successfully by itself of individually. One needs

help of others too. I am very thankful to my group members who worked

with me with concentration and good understanding.

We want to give special thanks to our honorable

Course teacher for his Constant and individual advice.

We appreciate the helpful suggestions of the following

reviewers.

Mohammed Belal Uddin

Lecturer

Department of Accounting

Fardus Mahmud

Student of Accounting Dept.

Group leader of Optimistic

Umme Salma


Md. Moshiur RahmanStudent of Accounting Dept.

Proudhut Kanti Das


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Farzana Sultana


A. K. M. Mahmudul Hasan

Student of Accounting Dept

For making this term paper information has collected from thesefollowing sources.

Lecture of course teacher.

Modern Micro Economics (2nd edition )Koutsoyaunic

Modern Economic Theory

K. K. Dewett. Economics

Paul Samuelson & William D. Nordhaus

Documents

Term Paper on Micro Economics