What is an indifference curve and what are its characteristics/properties? Use diagrams in your answer

 An indifference curve:

Definition: An indifference curve is a graph showing combination of two goods that give the consumer equal satisfaction and utility. Each point on an indifference curve indicates that a consumer is indifferent between the two and all points give him the same utility.

Description: Graphically, the indifference curve is drawn as a downward sloping convex to the origin. The graph shows a combination of two goods that the consumer consumes.

The above diagram shows the U indifference curve showing bundles of goods A and B. To the consumer, bundle A and B are the same as both of them give him the equal satisfaction. In other words, point A gives as much utility as point B to the individual. The consumer will be satisfied at any point along the curve assuming that other things are constant.

Characteristics/properties of an indifference curve:

Following are the indifference curve properties:

1. If two commodities are perfect substitute the indifference curve is a straight line.

 

2. When two commodities are not substitutable then the shape is represented by two vertical and horizontal lines.

3. In more typical cases, in which the two commodities can be substituted for each other but are not perfect substitutes, the indifference curve will be curved as

 

4. The more easily the two commodities can be substituted for each other the nearer will the curve approach straight line.

5. Indifference curves normally slope downward, the upward sloping portion of curve shown here s impossible. Basket A has more goods than basket B and therefore it could not be on the same indifference curve.  The indifference curves have normally negative slops – sloping downward.

6. The absolute value of the slope of an indifference curve at any point represents the ratio of the marginal utility of the good and on the horizontal axis to the marginal utility of the good on the vertical axis. The rate at which one good can be substituted for the other without gain or loss in satisfaction is called marginal rate of substitution.

7. Indifference curves are convex, that is, their slope decrease as one moves down and to the right along them. The implies that the ratio of the marginal utility of meat to the marginal utility of the ghee (cooking oil) also known as marginal ratio of substitution of meat for ghee (cooking oil) diminishes as one moves down and to the right along the curve.

8. Indifference curves can be drawn through the point that represents the basket of goods whatsoever.

a)      Explain with the help of an indifference curve analysis how a consumer reaches the highest level of satisfaction? (May’06,Nov’07,’10)

Consumer’s Equilibrium by Indifference Curve:

Consumer equilibrium refers to a situation, in which a consumer derives maximum satisfaction, with no intention to change it and subject to given prices and his given income. The point of maximum satisfaction is achieved by studying indifference map and budget line together.

Conditions of Consumer’s Equilibrium:

The consumer’s equilibrium under the indifference curve theory must meet the following two conditions:

(i) MRS_XY = Ratio of prices or P_X/P_Y

Let the two goods be X and Y. The first condition for consumer’s equilibrium is that

MRS_XY = P_X/P_Y

a. If MRS_XY > P_X/P_Y, it means that the consumer is willing to pay more for X than the price prevailing in the market. As a result, the consumer buys more of X. As a result, MRS falls till it becomes equal to the ratio of prices and the equilibrium is established.

b. If MRS_XY < P_X/P_Y, it means that the consumer is willing to pay less for X than the price prevailing in the market. It induces the consumer to buys less of X and more of Y. As a result, MRS rises till it becomes equal to the ratio of prices and the equilibrium is established.

(ii) MRS continuously falls:

The second condition for consumer’s equilibrium is that MRS must be diminishing at the point of equilibrium, i.e. the indifference curve must be convex to the origin at the point of equilibrium. Unless MRS continuously falls, the equilibrium cannot be established.

Thus, both the conditions need to be fulfilled for a consumer to be in equilibrium.

Let us now understand this with the help of a diagram:

In Fig. 2.12, IC₁, IC₂ and IC₃ are the three indifference curves and AB is the budget line. With the constraint of budget line, the highest indifference curve, which a consumer can reach, is IC₂. The budget line is tangent to indifference curve IC₂ at point ‘E’. This is the point of consumer equilibrium, where the consumer purchases OM quantity of commodity ‘X’ and ON quantity of commodity ‘Y.

All other points on the budget line to the left or right of point ‘E’ will lie on lower indifference curves and thus indicate a lower level of satisfaction. As budget line can be tangent to one and only one indifference curve, consumer maximizes his satisfaction at point E, when both the conditions of consumer’s equilibrium are satisfied:

(i) MRS = Ratio of prices or P_X/P_Y:

At tangency point E, the absolute value of the slope of the indifference curve (MRS between X and Y) and that of the budget line (price ratio) are same. Equilibrium cannot be established at any other point as MRS_XY > P_X/P_Y at all points to the left of point E and MRS_XY < P_X/P_Y at all points to the right of point E. So, equilibrium is established at point E, when MRS_XY = P_X/P_Y.

(ii) MRS continuously falls:

The second condition is also satisfied at point E as MRS is diminishing at point E, i.e. IC₂ is convex to the origin at point E.

What do you mean by price Elasticity of demand? Distinguish between elastic and inelastic demand

 Price Elasticity of demand:

A measure of the relationship between changes in the quantity demanded of a particular good and a change in its price. Price elasticity of demand is a term in economics often used when discussing price sensitivity. The formula for calculating price elasticity of demand is:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price 

If a small change in price is accompanied by a large change in quantity demanded, the product is said to be elastic (or responsive to price changes). Conversely, a product is inelastic if a large change in price is accompanied by a small amount of change in quantity demanded.

Price elasticity of demand measures the responsiveness of demand to changes in price for a particular good. If the price elasticity of demand is equal to 0, demand is perfectly inelastic (i.e., demand does not change when price changes). Values between zero and one indicate that demand is inelastic (this occurs when the percent change in demand is less than the percent change in price). When price elasticity of demand equals one, demand is unit elastic (the percent change in demand is equal to the percent change in price). Finally, if the value is greater than one, demand is perfectly elastic (demand is affected to a greater degree by changes in price).

For example, if the quantity demanded for a good increases 15% in response to a 10% increase in price, the price elasticity of demand would be 15% / 10% = 1.5.

The main differences between an elastic demand and an inelastic demand have been explained in details as follows:
     Elastic Demand:

·         When a small change in price brings about more than proportionate change in demand, it is known as the elastic demand.

·         The demand curve is flatter.

·         Luxuries and comforts have elastic demand.

·         Examples of elastic demand are Color T.V. sets, Prestige goods, etc.

·         Perfectly elasticity of demand is not practical, while relative elasticity is seen in case of moderately priced goods.

·         The coefficient of elasticity of demand is greater than 1, that it ed >

 

Inelastic Demand:

·         When a big change in price brings about less than proportionate change in demand, it is known as inelastic demand.

·         The demand curve is steeper.

·         Necessary items can be termed as inelastic demand.

·         Examples of Inelastic demand are salt, rice, food grains, etc.

·         Perfectly inelasticity of demand is seen in the demand of necessary goods, while relative inelasticity is seen in case of very expensive goods.

·         The coefficient of elasticity of demand is less than 1, that is ed < 1.

What are the main objectives of a firm in the private sector

 Basically the main key objective of the private sector is to get the highest profit as much as they can get. The profit is the Earning before interest and tax. Taxes are government sanctioned and the private sector tries to give a great cushion to EBIT against interest and tax. To achieve this aim, the companies in the private business produce, where their total revenues are far higher than total costs. This creates high reserves for the stockholders.

This indicates that the private sector has to accomplish the goals and desires of the shareholders and it will always aim to fulfil their satisfaction. Another objective of companies in the private sector is to raise their market shares to get a sustainable competitive advantage. Companies involved in the private sector also strive to improve their corporate image by showing social responsibility. In addition, the private sector is highly involved in sponsoring and participating in social and community events because they know that such events can make their positioning and image better in the market

What are the Practical difficulties with Profit Maximization

  In economics, profit maximization is the short run or long run process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenue–total cost perspective relies on the fact that profit equals revenue minus cost and focuses on maximizing this difference, and the marginal revenue–marginal cost perspective.

Problems with the 'maximization of profits' objective: Firstly, there are quantitative difficulties associated with profit. Maximization of profits as a financial objective requires the profit to be defined and measured accurately, and that all the factors contributing to it are known and can be taken into account. It is very doubtful that this requirement can be met on a regular basis. E.g- If 5 auditors go into the same company; it is very likely that each will come out with a completely different profit figure.

A second problem concerns the timescale over which the profit should be maximized.
Should profit be maximized in the short term or the long term?? Given that profit considers one year at a time, the focus is likely to be on short-term profit maximization at the expense of long-term investment, putting the long term survival of the company into doubt.

There are many examples of companies going into liquidation shortly after declaring high profits. Check out - Polly Peck Plc's dramatic failure in 1990!

The third problem is that profit does not take account of or make any allowance for risk! It would be inappropriate to concentrate efforts on maximizing accounting profit when this objective does not consider one of  the key determinants of shareholder wealth.

So the 'maximization of profit' is not a suitable core objective for a company. That is not to say that a company does not need to pay attention to its profit figures, since falling profits of profit warnings are taken by the financial markets as a sign of financial weakness.

Instead these sorts of profit targets/objectives should can serve a useful purpose in helping a company to achieve short-term or operational objectives within its overall strategic plan.

How does a private sector firm maximize its profits

 In economics, profit maximization is the short run or long run process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenue–total cost perspective relies on the fact that profit equals revenue minus cost and focuses on maximizing this difference, and the marginal revenue–marginal cost perspective is based on the fact that total profit reaches its maximum point where marginal revenue equals marginal cost.

The proprietors of those private firms, treat their staff professionally Provide a conductive working environments for their staff to work in comfort. Regard their marketing departments and their sales persons as important personnel, to bring in business for the various departments of their firms to process and turn those business and services into finished goods or services to sell or provide to their customers so that profits can be made.

 

Discuss the importance of multiplicity of wants and scarcity of resources in the study of Economics.

 importance of multiplicity of wants and scarcity of resources in the study of Economics.

Explain the terms “Want” and “Scarcity” as understood in Economics.

 The basic concept or elements of economics are:

 Wants:

Want may be defined as an insatiable desire or need by human beings to own goods or services that give satisfaction. The basic needs of man include; food, housing and clothing. Human needs are many.

They include tangible goods like houses, cars, chairs, television set, radio, e.t.c. while the others are in form of services, e.g. tailoring, carpenter, medical; e.t.c. Human wants and needs are many and are usually described as insatiable because the means of satisfying them are limited or scarce.

There are four essential elements of human wants. i. Scarcity of things

ii. Desire to get the scarce things

iii. Sufficient amount of money to satisfy the desire.

iv. Willingness to spend the money to get the desired things.

 

Human wants are unlimited, varied and diverse. They encourage people to undertake economic activity. Satisfactions of wants through production and exchange of goods and services is the basic aim of economic activity.

 

Wants may be classified into two broad categories.

1. Primary or basic wants e.g., food, clothing and shelter which are common to all persons;

and

2. Secondary or non‐basic wants e.g., education, travelling, etc., which differ from person to person.

A person first of all tries to satisfy his primary wants at all costs. Secondary wants are satisfied as and when the necessary resources become available.

Scarcity:

Scarcity can be defined as a situation in which human wants are greater than the capacity of available resources to provide for those wants. In other words, it means that people want more than is available. Economic resources are limited, but human needs and wants are infinite. Indeed the development of society can be described as the uncovering of new wants and needs - which producers attempt to supply by using the available factors of production.
Making choices Because of scarcity, choices have to be made on a daily basis by all consumers, firms and governments.

When a product is scarce, consumers are faced with conducting their own cost-benefit analysis, since a product in high demand but low supply will likely be expensive. This means that the consumer should only take action and purchase the product if he or she sees a greater benefit from having the product than the cost associated with obtaining it.

Briefly state the differences between micro-economics and macro-economics

 

Microeconomics	Macroeconomics
1. It is that branch of economics which deals with the economic decision-making of individual economic agents such as the producer, the consumer, etc	1. It is that branch of economics which deals with aggregates and averages of the entire economy, e.g., aggregate output, national income, aggregate savings and investment, etc.
2. It takes into account small components of the whole economy.	2. It takes into consideration the economy of any country as a whole.
3. It deals with the price-determination in case of individual products and factors of production.	3. It deals with general price-level in any economy.
4. It is known as price theory (since it explains the process of allocation of economic resources along alternative lines of production on the basis of relative prices of various goods and services).	4. It is also known as the income theory (since it explains the changing levels of national income in any economy during any particular time period).
5. It is concerned with the optimisation goals of individual consumers and producers (e.g., individual consumers are utility-maximisers, while individual producers are profit-maximisers).	5. It is concerned with the optimisation of the growth process of the entire economy.
6. It studies the flow of economic resources or factors of production from any individual owner of such resources to any individual user of these resources, etc.	6. It studies the circular flow of income and expenditure between different sectors of the economy (say, between the firm sector and household sector).
7. Microeconomic theories help us in formulating appropriate policies for resource allocation at the firm level.	7. Macroeconomic theories help us in formulating appropriate policies for controlling inflation (i.e., rising price-level), unemployment, etc.
8. It takes into account the aggregates over homogeneous or similar products (e.g., the supply of steel in an economy).	8. It takes into account the aggregates over heterogeneous or dissimilar products (say, the Gross Domestic Product of any country during any year.

Discuss the importance of the study of Economics

 Importance of the study of Economics: The Importance /advantages/ Objectives of the study of economics are as under:

(1) Intellectual Value: The knowledge of Economics is very useful as it broadens our outlook, sharpens our intellect, and inculcates in us the habit of balanced thinking. The study of Economics makes us realize that we as human beings are dependent upon one another for our daily needs. This feeling creates in us the intelligent appreciation of our position and the spirit of co-operation with others.

(2) Practical Advantages: The practical advantages of Economics are much more important than its theoretical advantages. These advantages can be looked at from the individual and community point of view.

(3) Personal Stake in Economics: From personal point of view, the study of Economics is useful as it enables each of us to understand better and appreciate more intelligently the nature and significance of our money earning and money spending activities. With the knowledge of Economics, the consumer can better adjust his expenditure to his income. The study of Economics is also useful to a producer. It suggests him the ways of bringing about the most economical combinations of the various factors of production at his disposal. It also helps in solving the various intricacies of exchange. From the study of Economics, one can easily judge as to why the prices have risen or fallen. The knowledge of Economics also explains us as to how the reward of various factors of production is determined. Thus, we find that every’ individual can rightly hope to become a better and more efficient consumer, producer and businessman, if he has the working knowledge of economics.
(4) Economics for the Leader: The study of economics is not only helpful from the individual point of view but it is also very useful for the welfare of the community. It enables a statesman to understand and better grasp the economic and social problems facing the country. Every government has to tackle different kinds of economic problems such as unemployment, inflation, over production, under-production, imposition of tariffs and control, problem of monopolies, etc. the statesman can successfully solve these problems, if he has thorough knowledge of the subject of Economics. The knowledge of Economics for a finance minister is also indispensable. He has to raise revenue by imposing taxes on the incomes of the people for meeting the necessary expenditure of the government. Economics here comes to his rescue and guides him as to how the taxes could be levied and collected.
(5) Poverty and Development: The greatest advantage of Economics is that it helps in removing traces of poverty from the country. Take the case of Pakistan; we in Pakistan are confronted with different kinds of problems. For example, low-per capita income, low productivity of agriculture, slow development of industries, fast increase in population, under-developed means of communication and transport, etc. The study of Economics helps in devising ways and means and suggesting practical measures in solving these problems.

(6) Economics for the citizen: Such being, the importance of study of Economics, it is rightly remarked by Wooten that “you cannot be in real sense a citizen unless you are also in some degree an economist”. He is perfectly right in giving the statement. The world is so fast changing that we are completely now living in a world dominated by economic forces and economic ideas. If the people of any country do not have the working knowledge of an economic system; then the government of that  country can easily hoodwink citizens have knowledge of Economics, then the government will be very vigilant and spend the money in a wise manner.

The importance of the study of Economies can also be judged from this fact that the daily newspapers cannot be understood without some knowledge of Economics. The newspapers often describe complicated economic problems such as inflation, balance of payment, balance of trade, imperfect markets, dumping, co-operative farming, sub-division and fragmentation of holdings, mechanization of agriculture, if you do not have working knowledge of Economics, you cannot understand these diverse problems.

From brief discussion, we conclude, that the knowledge of Economics is very useful. As such it is necessary that every citizen, bankers, worker, administrator, consumer, etc., should have at least working knowledge of it. In the words of Sir Henry Clay: “Some study of Economics is at one a practical necessity and a normal obligation”.