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Managerial Economics Assignment NAME:- BHAVNA MAHESH NIRBAN Roll No :- 27 SEM V Submitted to :Submitted by :-

[email protected] University Of Mumbai Law Academy YEAR: T.Y. B.B.A. LLB. (HONS.)

NAME:- BHAVNA MAHESH NIRBAN

The Consumption Function: Many different factors, including tastes and preferences, income and interest rates, determine consumption. For example, if the income of one household is greater than the income of another, the former is likely to consume more. Even if their incomes are the same, however, they will spend different amounts on consumption if their attitudes toward thrift differ. Similarly, households vary their consumption in response to changes in interest rates. Although many factors affect consumption, aggregate income in the most important by far. Consequently, we shall concentrate on the relationship between consumption and income, called the consumption function. In Keynesian consumption function, consumption is assumed to vary directly with income. Specifically, consumption is assumed to increase with income, with the increase in consumption being less than the increase in income. The consumption function is expressed as: C = a + bY (a > 0, 0 < b < 1). where C and Y represent real consumption and real income, respectively. The equation indicates that consumption is a linear function of income. In the equation, ‘a’ and ‘b’ are constants, called parameters. Consumption, C, and income, Y, are variables. The parameter b, called the marginal propensity to consume or MFC, is the slope of the consumption function. If ΔY denotes a change in income and ΔC denotes the change in consumption associated with the change in income, b, the MPC, equals ΔC/ΔY. For example, if income increases by Rs 200 crores and, as a result, consumption increases by Rs 150 crores, the MPC is Rs. 150 crores divided by Rs. 200 crores or 0.75. In postulating his consumption function, J.M. Keynes assumed that consumption increases as income increases, but by a smaller amount. Thus, implies that b, the MPC, must lie between 0 and 1. The parameter a is the portion of consumption which does not vary with income, i.e., a represents the consumption which would occur if income were 0. Short-run studies of the consumption function show that a is positive. The consumption function may be shown graphically by specifying various levels of income, determining the corresponding levels consumption, and then plotting the combinations of income and consumption. To illustrate, suppose the consumption function is C = 100 + 0.75Y. If Y equals Rs 100 crores, C equals Rs 700 crores, obtained by solving the equation C = 100 + 0.75 (800). This combination of Y and C is plotted as a point on the consumption function C = 100 + 0.75Y in Fig. 1. Other points on the consumption function can be obtained in the same way.

An alternative way to plot the consumption function is to recognise that ‘a’ is the intercept and b the slope. Once the intercept and slope are specified, a straight line is completely determined. For example, if ‘a’ equals 100 and ‘b’ equals 0.75, the function will start at a = 100 and have a slope, ‘b’ equal to 0.75. If ‘a’ changes, the consumption function will shift so that the new function is parallel to the old. If ‘b’ changes, the function will change its slope. It may become flatter or steeper.

The Saving Function: Since the decision on how much income to consume implies a decision on how much to save, a saving function may be derived with the aid of the consumption function. With no government and foreign trade sectors, income equals, by definition, consumption plus, saving, S: Y = C + S But C is equal to a + bY. Consequently, after substituting, the saving function is found to be S = -a + (1 – b) Y (0 < 1 – b < 1) where S and Y represent real saving and real income, respectively. The parameter 1 – b, referred to as the marginal propensity to save or MPS, is the slope of the saving function. If ΔY denotes a change in income and ΔS denotes the change in saving associated with the change in income, 1 – b, the MPS, equals ΔS/ΔY.

For example, if income increases by Rs 200 crores and, as a consequence, saving increases by Rs. 50 crores, the MPS is Rs 50 crores divided by Rs 200 crores or 0.25. Since ‘b’, the MPC, is assumed to be between 0 and 1, 1 – b, the MPS, is also between 0 and 1, which implies that saving increases as income increases, but by a smaller amount. The saving function may be plotted in the same manner as the consumption function. To show the relationship between the consumption and saving functions, however, we may consider an alternative approach. Suppose, in Fig. 2, income is plotted on both axes and that a 45° line is drawn through the origin.

At all points on the 45°-line, income on the vertical axis is equal to income on the horizontal axis. Given the 45° line and the consumption function, we can now derive the saving function graphically. Since income equals consumption plus saving, saving is the difference between income and consumption. Therefore, to find saving at each level of income, consumption is subtracted from income. Graphically, saving is the vertical distance between the income line, the 45° line, and the consumption function, saving being positive (negative) when income is greater (less) than consumption. Consider income Y 0 in Fig. 2. At income Y0, consumption equals C 0; consequently, saving equal S 0, obtained by subtracting C0 from Y0. Therefore, one point on the saving function is the point Y = Y0, S = S0. Let us select another level of income, say, Y 1 where the consumption function intersects the 45° line. At that level of income, consumption equals C 1, which also equals Y1. Therefore, at

Y = Y1, S1 equals 0, since S1 equals Y1 – C1 and C1 equals Y1. Consequently, another point on the saving function is the point Y = Y1, S = 0. Finally, suppose income is 0. At that level of income, consumption equals a. Hence, saving equals -a, obtained by subtracting C = a from Y = 0. Thus, a third point on the saving function is the point Y = 0, S = -a. Other such points may be obtained by considering other levels of income. In Fig. 5, saving is positive at income levels greater than Y 1, since income exceeds consumption at those levels of income. Saving is negative at income levels less than Y 1 since consumption exceeds income. Negative saving, dissaving, occurs if individual households consume more than their income. They may do so by spending part of their savings or by borrowing. For society as a whole, dissaving is unlikely.

Perfect competition Perfect competition is a market structure where many firms offer a homogeneous product. Because there is freedom of entry and exit and perfect information, firms will make normal profits and prices will be kept low by competitive pressures.

Features of perfect competition 1. 2. 3. 4.

Many firms. Freedom of entry and exit; this will require low sunk costs. All firms produce an identical or homogeneous product. All firms are price takers, therefore the firm’s demand curve is perfectly elastic. 5. There is perfect information and knowledge.

Diagram for perfect competition

• • •

The industry price is determined by the interaction of Supply and Demand, leading to a price of Pe. The individual firm will maximise output where MR = MC at Q1 In the long run firms will make normal profits.

What happens if supernormal profits are made? If supernormal profits are made new firms will be attracted into the industry causing prices to fall. If firms are making a loss then firms will leave the industry causing price to rise

The features of perfect competition are very rare in the real world. However perfect competition is as important economic model to compare other models. It is often argued that competitive markets have many benefits which stem from this theoretical model.

Changes in long run equilibrium 1. The effect of an increase in demand for the industry.

If there is an increase in demand there will be an increase in price Therefore the demand curve and hence AR will shift upwards. This will cause firms to make supernormal profits. This will attract new firms into the market causing price to fall back to the equilibrium of Pe 2. An increase in firms costs • The AC curve will increase therefore AR< AC • Firms will now start making a loss and therefore firms will go out of business. This will cause supply to fall causing prices to increase.

Efficiency of perfect competition • • • • •

Firms will be allocatively efficient P=MC Firms will be productively efficient. Lowest point on AC curve. Firms have to remain efficient otherwise they will go out of business. (Xefficiency) Firms are unlikely to be dynamically efficient because they have no profits to invest in research and development. If there are high fixed costs, firms will not benefit from efficiencies of scale.

Examples of perfect competition In the real world, it is hard to find examples of industries which fit all the criteria of ‘perfect knowledge’ and ‘perfect information’. However, some industries are close. 1. Foreign exchange markets. Here currency is all homogeneous. Also, traders will have access to many different buyers and sellers. There will be good information about relative prices. When buying currency, it is easy to compare prices 2. Agricultural markets. In some cases, there are several farmers selling identical products to the market, and many buyers. At the market, it is easy to compare prices. Therefore, agricultural markets often get close to perfect competition. 3. Internet related industries. The internet has made many markets closer to perfect competition because the internet has made it very easy to compare prices, quickly and efficiently (perfect information). Also, the internet has made barriers to entry lower. For example, selling a popular good on the internet through a service like e-bay is close to perfect competition. It is easy to compare the prices of books and buy from the cheapest. The internet has enabled the price of many books to fall in price so that firms selling books on the internet are only making normal profits.

The concept of equilibrium generally relates to all types of situations and economic models, not just the demand and supply model currently being discussed. • Equilibrium - An equilibrium generally means that when one is at the equilibrium then no force exists that will move one away from the equilibrium. • Stable Equilibrium - A stable equilibrium is a specific type of equilibrium. It has the characteristic described above, which is true of all equilibria, of having no tendency to move away from the equilibrium once it is attained. However, it has one important additional characteristic. When not at the equilibrium some force exists that will cause a move back to the equilibrium. (An unstable equilibrium has the opposite characteristic.) Generally, equilibria in economic models are stable.

How does the market attain equilibrium? Putting together the demand and supply curves in the same model, what is the equilibrium in the market? Most students are not surprised to learn that equilibrium occurs as shown in Graph 1, where the demand and supply curves intersect. Formally, this occurs at the price (PE) where quantity demanded (QE) equals quantity supplied (QE). Although this is the equilibrium in the demand and supply model, it remains important to understand why it is the equilibrium. That is, how does the equilibrium meet the characteristics defined above that must exist for something to be a stable equilibrium? We must essentially show that the equilibrium has three characteristics: • When the

actual price exceeds the equilibrium price some force exists that moves the market back to the equilibrium price.

Supply

PE

Equilibrium

Demand

QE

Quantity

Consumer surplus Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price they do pay. If a consumer is willing to pay more for a unit of a good than the current asking price, they are getting more benefit from the purchased product than they would if the price was their maximum willingness to pay. They are receiving the same benefit, the obtainment of the good, with a smaller cost as they are spending less than they would if they were charged their maximum willingness to pay. An example of a good with generally high consumer surplus is drinking water. People would pay very high prices for drinking water, as they need it to survive. The difference in the price that they would pay, if they had to, and the amount that they pay now is their consumer surplus. The utility of the first few litres of drinking water is very high (as it prevents death), so the first few litres would likely have more consumer surplus than subsequent litres. The maximum amount a consumer would be willing to pay for a given quantity of a good is the sum of the maximum price they would pay for the first unit, the (lower) maximum price they would be willing to pay for the second unit, etc. Typically, these prices are decreasing; they are given by the individual demand curve, which must be generated by a rational consumer who maximizes utility subject to a budget constraint. Because the demand curve is downward sloping, there is diminishing marginal utility. Diminishing marginal utility means a person receives less additional utility from an additional unit. However, the price of a product is constant for every unit at the equilibrium price. The extra money someone would be willing to pay for the number units of a product less than the equilibrium quantity and at a higher price than the equilibrium price for each of these quantities is the benefit they receive from purchasing these quantities. For a given price the consumer buys the amount for which the consumer surplus is highest. The consumer's surplus is highest at the largest number of units for which, even for the last unit, the maximum willingness to pay is not below the market price. Consumer surplus can be used as a measurement of social welfare, first shown by Willig (1976). For a single price change, consumer surplus can provide an approximation of changes in welfare. With multiple prices and/or income changes, however, consumer surplus cannot be used to approximate economic welfare because it is not single-valued anymore. More modern methods are developed later to estimate the welfare effect of price changes using consumer surplus. The aggregate consumers' surplus is the sum of the consumer's surplus for all individual consumers. This can be represented graphically as shown in the above graph of the market demand and supply curves. It can also be said to be the maxim of satisfaction a consumer derives from particular goods and services.

Calculation from supply and demand The consumer surplus (individual or aggregated) is the area under the (individual or aggregated) demand curve and above a horizontal line at the actual price (in the aggregated case: the

equilibrium price). If the demand curve is a straight line, the consumer surplus is the area of a triangle:

CS = ½ Qmkt (Pmax Pmkt) where Pmkt is the equilibrium price (where supply equals demand), Qmkt is the total quantity purchased at the equilibrium price and Pmax is the price at which the quantity purchased would fall to 0 (that is, where the demand curve intercepts the price axis). For more general demand and supply functions, these areas are not triangles but can still be found using integral calculus. Consumer surplus is thus the definite integral of the demand function with respect to price, from the market price to the maximum reservation price (i.e. the price-intercept of the demand function):

where this shows that if we see a rise in the equilibrium price and a fall in the equilibrium quantity, then consumer surplus falls.

Measuring Consumer Surplus With a Demand Curve The demand curve is a graphic representation used to calculate consumer surplus. It shows the relationship between the price of a product and the quantity of the product demanded at that price, with price drawn on the y-axis of the graph and quantity demanded, drawn on the x-axis. Because of the law of diminishing marginal utility, the demand curve is downward sloping. Consumer surplus is measured as the area below the downward-sloping demand curve, or the amount a consumer is willing to spend for given quantities of a good, and above the actual market price of the good, depicted with a horizontal line drawn between the y-axis and demand curve. Consumer surplus can be calculated on either an individual or aggregate basis, depending on if the demand curve is individual or aggregated. Consumer surplus always increases as the price of a good falls and decreases as the price of a good rises. For example, suppose consumers are willing to pay $50 for the first unit of product A and $20 for the 50th unit. If 50 of the units are sold at $20 each, then 49 of the units were sold at a consumer surplus, assuming the demand curve is constant. Consumer surplus is zero when the demand for a good is perfectly elastic. But demand is perfectly inelastic when consumer surplus is infinite.

KEY TAKEAWAYS Consumer surplus happens when the price consumers pay for a product or service is less than the price they're willing to pay. Consumer surplus is the benefit or good feeling of getting a good deal. Consumer surplus always increases as the price of a good falls and decreases as the price of a good rises. Real World Example of a Consumer Surplus

Consumer surplus is the benefit or good feeling of getting a good deal. For example, let's say that you bought an airline ticket for a flight to Disney during school vacation week for $100, but you were expecting and willing to pay $300 for one ticket. The $200 represents your consumer surplus. However, businesses know how to turn consumer surplus into producer surplus or for their gain. In our example, let's say the airline realizes your surplus and as the calendar draws near to school vacation week, they raise their ticket prices to $300 each. The airline knows there'll be a spike in demand for travel to Disney during school vacation week and that consumers will be willing to pay higher prices. So by raising the ticket prices, the airlines are taking consumer surplus and turning into producer surplus or additional profits....