📑 Topics on this page (Jump to Topic):
📌 1. Nature of Economics and Methods of Study
| Definition | By | Key idea |
|---|---|---|
| Wealth | Adam Smith (1776) | Nature and causes of the wealth of nations |
| Welfare | Alfred Marshall (1890) | Human activity linked to material welfare |
| Scarcity | Lionel Robbins (1932) | Unlimited ends and scarce means with alternative uses |
| Growth | Paul Samuelson | Choice of production and distribution over time |
| Method | How it works | Associated with |
|---|---|---|
| Deductive (abstract) | Logical reasoning from general assumptions to specific conclusions | Classical economists — Ricardo, Senior, J. S. Mill |
| Inductive (empirical) | General laws from observed facts and data | German Historical School (Schmoller) |
- Marshall: both deduction and induction are needed — "as the right and left foot are needed for walking".
- Positive economics — "what is" (facts, testable); normative — "what ought to be" (value judgements).
- Partial equilibrium (Marshall) — one market, other things equal (ceteris paribus); general equilibrium (Walras) — all markets together.
- Static analysis — one point in time; comparative static — compares two equilibria; dynamic — the path of change over time.
- Economics is both a science (cause-and-effect relations) and an art (practical solutions to problems).
⚠️ Exam Traps:
- Robbins's definition is about scarcity and choice, not welfare; the welfare definition is Marshall's.
- "The minimum wage should be raised" is normative; "a higher minimum wage reduced employment" is positive.
📌 2. Determinants of Demand and Supply
| Determinants of demand | Determinants of supply |
|---|---|
| Own price of the good | Own price of the good |
| Consumer's income | Prices of inputs (factors) |
| Prices of related goods (substitutes/complements) | State of technology |
| Tastes, fashion, advertising | Prices of other goods (alternatives in production) |
| Expected future price | Taxes and subsidies |
| Population and income distribution | Number of firms and their goals |
- A change in own price causes a movement along the curve (extension/contraction); a change in any other determinant shifts the curve (increase/decrease).
- When income rises, the demand curve of a normal good shifts right and that of an inferior good shifts left.
- A rise in the price of tea raises demand for coffee (substitute); a rise in car prices lowers demand for petrol (complement).
- Better technology or cheaper inputs shift the supply curve right; a higher excise tax shifts it left.
📌 3. Elasticity: Price, Income, Cross and Supply
| Elasticity | Formula | Interpretation |
|---|---|---|
| Price elasticity of demand (Ed) | % change in quantity demanded ÷ % change in price | |Ed| > 1 elastic; = 1 unitary; < 1 inelastic; 0 perfectly inelastic; ∞ perfectly elastic |
| Income elasticity of demand (Ey) | % change in quantity demanded ÷ % change in income | Ey > 1 luxury; 0 to 1 necessity; Ey < 0 inferior good |
| Cross elasticity (Exy) | % change in demand for X ÷ % change in price of Y | Positive — substitutes; negative — complements; zero — unrelated |
| Elasticity of supply (Es) | % change in quantity supplied ÷ % change in price | Straight line through origin: Es = 1; starting from the price axis: Es > 1; from the quantity axis: Es < 1 |
- Total outlay method (Marshall): if price falls and total expenditure rises → elastic; unchanged → unitary; falls → inelastic.
- Point method: on a straight-line demand curve Ed = lower segment ÷ upper segment; 1 at the midpoint, > 1 above, < 1 below.
- A unit-elastic demand curve is a rectangular hyperbola — total expenditure is the same at every point.
- Determinants of elasticity: availability of substitutes, necessity vs luxury, share of income spent, time period, number of uses.
Worked examples
| Problem | Solution | Result |
|---|---|---|
| Price ₹10 → ₹12, quantity 100 → 80 units | %ΔQ = −20%, %ΔP = +20% → Ed = −20/20 | |Ed| = 1, unitary |
| Income ₹20,000 → ₹25,000, quantity 10 → 14 units | %ΔQ = 40%, %ΔY = 25% → Ey = 40/25 | Ey = 1.6 > 1, luxury |
| Coffee ₹100 → ₹120, tea demand 50 → 55 | %ΔQ(tea) = 10%, %ΔP(coffee) = 20% → Exy = 10/20 | +0.5, substitutes |
| Price ₹5 → ₹6, supply 200 → 260 | %ΔQs = 30%, %ΔP = 20% → Es = 30/20 | Es = 1.5, elastic supply |
| Ed = −0.5; price rises 10% | %ΔQ = −0.5 × 10 = −5% | Demand falls 5%; total spending rises |
⚠️ Exam Traps:
- The sign of cross elasticity tells the relation: + substitutes, − complements. Negative income elasticity = inferior good.
- With inelastic demand a price rise increases total spending (seller revenue) — that is why taxes on salt or medicines raise more revenue.
📌 4. Revenue Concepts and Price Determination in Perfect Competition
- Total revenue TR = P × Q; average revenue AR = TR/Q = P; marginal revenue MR = ΔTR/ΔQ.
- Firm equilibrium (every market): MR = MC and MC cuts MR from below (MC rising).
- Perfect competition: very many buyers and sellers, homogeneous product, free entry and exit, perfect knowledge. Price is set by industry demand = supply; the firm is a price taker, so AR = MR = P (a horizontal line).
- Short run: a firm may earn supernormal profit, normal profit or a loss; if P < minimum AVC it shuts down.
- Long run: free entry and exit leave only normal profit — P = MR = MC = minimum LAC (optimum scale).
Worked example
Market demand Qd = 100 − 2P, supply Qs = 20 + 2P. Equilibrium: 100 − 2P = 20 + 2P → 4P = 80 → P = ₹20, Q = 60. The firm accepts this ₹20: selling 10 units gives TR = 200, AR = 20, and the MR of the 11th unit is also 20. If the firm's MC equals 20 at the 15th unit, it sells 15 units.
📌 5. Price Determination under Monopoly
- One seller, no close substitute, barriers to entry; firm = industry; the firm is a price maker.
- The AR (demand) curve slopes down; MR lies below it. If AR = a − bQ, then MR = a − 2bQ (twice the slope).
- Equilibrium at MR = MC; price is read from AR, so P > MC. Relation: MR = AR (1 − 1/|e|) → for MR > 0, |e| > 1, so a monopolist produces on the elastic part of demand.
- A monopolist has no supply curve; supernormal profit can persist in the long run.
- Price discrimination (Pigou's three degrees): different prices in different markets — conditions: separate markets, no resale, different elasticities; the higher price is charged where demand is less elastic.
Worked examples
- Demand P = 100 − 2Q, MC = ₹20. TR = 100Q − 2Q² → MR = 100 − 4Q. MR = MC: 100 − 4Q = 20 → Q = 20; P = 100 − 40 = ₹60 (P > MC).
- AR = ₹40, |e| = 2 → MR = 40 (1 − 1/2) = ₹20. If |e| = 1, MR = 0 (total revenue is maximum).
📌 6. Monopolistic Competition and Oligopoly
- Monopolistic competition (Chamberlin, 1933): many sellers, product differentiation (brands), selling costs (advertising), free entry. Demand slopes down but is fairly elastic. Short run: profit or loss at MR = MC; long run: AR is tangent to LAC on its falling part → only normal profit and excess capacity.
- Joan Robinson also published "The Economics of Imperfect Competition" in 1933.
- Oligopoly: a few large sellers, mutual interdependence, entry barriers. Main pricing models:
- Kinked demand curve — Sweezy (1939): rivals do not follow a price rise but follow a cut → a gap in MR → price rigidity.
- Cartel — firms jointly fix price/output to maximise joint profit (e.g. OPEC); price leadership — a dominant firm sets the price and others follow.
- Cournot's duopoly model (1838); game theory is used to study oligopoly.
| Feature | Perfect competition | Monopoly | Monopolistic competition | Oligopoly |
|---|---|---|---|---|
| Sellers | Very many | One | Many | Few |
| Product | Homogeneous | No close substitute | Differentiated | Homogeneous or differentiated |
| Control over price | None (taker) | High (maker) | Some | Interdependent |
| AR curve | Horizontal (perfectly elastic) | Downward, less elastic | Downward, more elastic | Kinked (Sweezy) |
| Long-run profit | Normal | Supernormal possible | Normal | Supernormal possible |
⚠️ Exam Traps:
- Selling costs (advertising) mark monopolistic competition; perfect competition needs no advertising.
- Price rigidity = kinked demand (oligopoly); excess capacity = monopolistic competition.
💡 Memory Tip: "MR = MC in every market; P = MC only in perfect competition; P > MC in all the others."
📌 7. Practice MCQs
📝 Practice MCQs (prepared by SF Prep — not PYQs)
Q1. "Economics studies human behaviour as a relationship between ends and scarce means which have alternative uses" — whose definition is this? Practice
Correct answer: (A)
Robbins (1932) — the scarcity definition.
Robbins (1932) — the scarcity definition.
Q2. Reasoning from general assumptions to specific conclusions is the: Practice
Correct answer: (B)
The abstract method of the classical economists.
The abstract method of the classical economists.
Q3. Which school strongly supported the inductive method? Practice
Correct answer: (C)
Schmoller and others stressed observed facts.
Schmoller and others stressed observed facts.
Q4. "The government should cut the tax on petrol" is a: Practice
Correct answer: (C)
"Should" = a value judgement.
"Should" = a value judgement.
Q5. General equilibrium analysis is associated with: Practice
Correct answer: (D)
Marshall — partial equilibrium.
Marshall — partial equilibrium.
Q6. When income rises, the demand curve of an inferior good: Practice
Correct answer: (A)
Demand for an inferior good falls as income rises.
Demand for an inferior good falls as income rises.
Q7. A change in the good's own price causes: Practice
Correct answer: (B)
Other determinants shift the curve.
Other determinants shift the curve.
Q8. When price rises from ₹10 to ₹12, demand falls from 100 to 80 units. Absolute price elasticity is: Practice
Correct answer: (A)
−20% ÷ 20% = −1.
−20% ÷ 20% = −1.
Q9. When income rises 25%, demand for a good rises 40%. The good is a: Practice
Correct answer: (C)
Ey = 40/25 = 1.6 > 1.
Ey = 40/25 = 1.6 > 1.
Q10. Two goods have a cross elasticity of −0.8. They are: Practice
Correct answer: (D)
Negative cross elasticity = complements.
Negative cross elasticity = complements.
Q11. A straight-line supply curve through the origin has elasticity: Practice
Correct answer: (B)
Es = 1 at every point.
Es = 1 at every point.
Q12. If total expenditure is unchanged when price falls, demand is: Practice
Correct answer: (B)
Total outlay method (Marshall).
Total outlay method (Marshall).
Q13. Under perfect competition, the firm's demand (AR) curve is: Practice
Correct answer: (C)
The firm is a price taker; AR = MR = P.
The firm is a price taker; AR = MR = P.
Q14. The long-run equilibrium condition under perfect competition is: Practice
Correct answer: (D)
Only normal profit.
Only normal profit.
Q15. Market demand Qd = 100 − 2P and supply Qs = 20 + 2P. Equilibrium price: Practice
Correct answer: (A)
100 − 2P = 20 + 2P → P = 20.
100 − 2P = 20 + 2P → P = 20.
Q16. A monopolist faces P = 100 − 2Q with MC = ₹20. Profit-maximising price: Practice
Correct answer: (D)
MR = 100 − 4Q = 20 → Q = 20; P = 60.
MR = 100 − 4Q = 20 → Q = 20; P = 60.
Q17. If AR = ₹40 and elasticity of demand is 2, MR is: Practice
Correct answer: (A)
MR = AR(1 − 1/e) = 40 × 1/2.
MR = AR(1 − 1/e) = 40 × 1/2.
Q18. A monopolist produces on the part of the demand curve that is: Practice
Correct answer: (B)
MR must be positive to equal MC > 0, so |e| > 1.
MR must be positive to equal MC > 0, so |e| > 1.
Q19. "Excess capacity" in the long run is a feature of: Practice
Correct answer: (C)
AR touches LAC on its falling part.
AR touches LAC on its falling part.
Q20. The model explaining price rigidity under oligopoly is the: Practice
Correct answer: (C)
The gap in MR keeps price stable.
The gap in MR keeps price stable.