Hello, welcome back to the lecture series
on microeconomics. We have been discussing
the core theme of microeconomics theory which
is price and markets . So, how price is determined
in market ? Back in 1776 Adam Smith worte
about ah very simple market model; where he
told us that even if there are millions of
buyers and sellers in the market , it may
seem like a cavos, but actually even through
a cavos the ah market will reach an equilibrium.
By equilibrium he means that the market will
clear . So, there will be a price at which
the quantity demanded will be equal to the
quantity supplied; and that is, market equilibrium
in Adam Smith's world
Now, what is equilibrium ? Equilibrium is
ah state of no change, this is kind of optimal
state. So, one can say that if a person an
economic agent or economic entity reaches
a situation which is based attainable given
the resource constant and the current conditions,
then there is no need to deviate from that
situation. Hence that situation would be called
un equilibrium
So, for we have seen the concept of price
equilibrium and market. Now let us look at
the working of price system or ah market mechanism
through a graphical illustration. It will
help us to understand how market works in
Adam Smith's world.
Adam Smith talked about invisible hands in
his book, what are this invisible hands? They
are the demand and supply functions in the
market. So, before we draw graph to explain
the simple market model proposed by Adam Smith,
let us have definition for demand and supply
. So, what do we mean by demand and supply?
Demand curve or demand function gives us the
relationship between quantity of a good demanded
by consumers and the price of that particular
good. And generally a demand curve is downward
sloping means that as the price goes up demand
for a commodity goes down.
By supply curve we mean a relationship between
the quantity that the producers are willing
to sale and price of that particular commodity.
And in general the relationship between these
2 variables is positive; that means, that
if we observe a higher price, then we also
observe a higher quantity ah put forward by
the sellers to sale in the market. So now,
let us draw a diagram with this invisible
hands and let see how market clears
Along the horizontal axis, I measure the quantity
brought and sold denoted by Q, and along the
vertical axis I measure the unit price of
the commodity which is denoted by P. From
the discussion on demand and supply we can
write a simple form of demand function; quantity
demanded as a function of it is own price
. Similarly, we can also write S as another
function quantity supplied as another function
of the market price that is observed .
Now, let us plot this 2 functions . So, we
have this downwards looking demand function
say, D D prime. And we have these upward sloping
supply functions S S prime. And Adam Smith
says that these are the invisible hands and
when markets clears, the market clearance
occurs at the intersection of the demand and
supply curve . So, basically at the intersection
of this 2 curves equilibrium price market
clearing price and quantity are obtained .
So, let us denote that equilibrium quantity
or market clearing quantity as Q star and
the prices P star . Now why P star and Q star
are equilibrium prices and quantity? Let us
check. So, we have to prove that the this
is that optimal state from where the either
the buyer or the seller has no incentive to
deviate. So, let us deviate from the optimal
price or equilibrium price P star and see
what happens .
. So, let us consider 2 cases where to start
with we assume a higher price P prime, and
let see what happens at this price . So, note
that at this higher price P prime there is
excess supply in the market of the magnitude
this. This is excess supply as there is lot
of supply in the market, this will create
a negative pressure or downward pressure on
the price, and the price will fall because
the seller will think that ok it is better
to reduce the price a bit and sale the quantity
or some of the quantity rather than selling
it not at all.
Now let us look at the other case where we
consider a price which is lower than the equilibrium
price say P double prime and let ah study
what will happen at a lower price . Here we
can see that at lower price P double prime
there is excess demand for the commodity in
the market . So, there is shortage of the
commodity . At price P double prime there
is excess demand in the market. And the buyers
are ready to pay more to have more units of
the good.
So, in that case there will be an upward pressure
on the price sellers will say this is a very
profitable situation for them because they
can charge higher price. So, in that case
they will raise the price. And finally, we
can see that although we have deviated to
P prime and P double prime, but in both cases
we are going to return to thus market equilibrium
price P star . And that is why we call that
this is an equilibrium from where deviation
is not profitable.
Let us now study how price system and market
mechanism helps an economy to take a call
on resource allocation problem. Let us start
with a simple case where the consumer consumes
only ah 2 goods. Suppose we are ah considering
rice and wheat. Now with time if there is
a change in taste and preference, then that
will be reflected through the demand function.
So, let us assume that ah with passage of
time the consumers in an economy ah .
let us assume that in an economy there are
consumers consuming both wheat and rice. Now
let us also assume that with time there is
a change in taste and preference, and the
consumers started preferring rice more over
wheat . Now in that case how the economy is
going to react? How the economy is going to
take a decision on resource allocation issues?
Let study through a diagram . So, in this
case we are going to study the case of rice.
So, I am denoting Q R as the quantity of rice
being brought and sold in the market, and
price of R rice P R denotes the price of rice.
So, there will be the demand function for
rice which is denoted by say D 1, and there
will be ah supply function 
which is denoted as S 1, this is like period
1.
Now, let us also draw the diagram for wheat
. So, along the horizontal axis, I am measuring
the quantity of wheat denoted as Q W . And
then along the vertical axis, I am measuring
the price of wheat which is P W. So, we have
plot the demand and supply curve again . So,
let us have the demand function , and that
is say D W 1, and let us call it D R 1. And
let us also superimpose the supply function
. Now let us call that supply of wheat denoted
by S 1 W .
Now, as there is a change in preference, the
consumer he had started to demand more for
rice at the given price. So, then what will
change in this particular diagram ? So, let
us first mark the equilibrium price and quantity
, that is the initial condition to start with
. 
Now at these equilibrium price P star R suppose
the consumers have started demanding more
rice because there is a change in taste and
preference. If that is the case, then we are
talking about a parallel shift in the demand
function , and let us have this new demand
function denoted by D R 2. So, of course,
we can see here that there is some excess
demand in the market, and hence there will
be an upward pressure in the market of rice
and the equilibrium price will raise
So, the new equilibrium price will be at the
new intersection point P 2 in the new demand
curve and the original supply curve , right
? Now what will happen in the case of wheat
? So, let us first look at the equilibrium
price and quantity figures to start with . 
Q star w is the equilibrium for market clearing
quantity, and then P W star is the equilibrium
price to start with .
Now, in this case what will happen at the
equilibrium price? There will be ah decrease
in demand for wheat because of the taste and
preference change. So, in that case the demand
function will parallelly shift downward, and
let us call this new demand function D W 2
. So, what will happen now ? There is some
excess supply of wheat in the market, and
of course, there will be some downward pressure
due to a clot of wheat supply in the market
do there will be a fall in the equilibrium
price. So, the new equilibrium price will
be obtained at the new intersection between
the new demand curve and the original supply
curve , right?
As the prices of this 2 commodities change,
this will send signal to the factors markets
as well, why? Because now the farmers will
see that the cultivation of rice more profitable
than the cultivation of wheat. So, land river
and all other agricultural resource inputs
will now flow from the wheat sector to the
paddy sector. Let us now discuss another related
concept called circular flow of market economy
. These discussion is very important to understand
the concept of general equilibrium in microeconomic
theory. This discussion will show you how
markets are interrelated.
So, as of now there are 2 boxes I have drawn.
So, this is the lower box , and this signifies
the producers or the forms in the economy,
and there is this upper box which denotes
the households which are basically consumers,
but note that they are also the owners of
the resources. By resources I mean, that ah
it can be labor it can be capital. The households
will supply this resources labor capital etcetera
to the ah firm , and this is called supply
of factor inputs . Why they will approach
firm or produces obvious reason because the
producer of the firms needs to produce some
outputs and for that they need this resources
or factor inputs.
So, of course, there is this earn which represents
the demand for factor inputs . And this is
flowing from the producerer firms box to the
household's box . So, this is 
demand for factor inputs . As the household
or the consumer supplies this this resources
to the firm or the producers in return they
earn income. So, for labor ah the worker receives
wage , the persons who has saved and invested,
the capital to the ah firm he earns rate of
interest etcetera. So, these are the factor
earnings.
Now what will the household of the consumer
do with this factor earnings? Of course, they
need to consume, and they will now demand
for goods and services. Now a critical question
arises how these returns to factor inputs
it resources are determined. So, these are
determined through a market, and that market
is called the factor input market; where this
demand for factor inputs meets the supply
of factor inputs and equilibrium price and
quantities are figured out.
So, this link box you can call this ad factor
market . So, there will be a flow of factor
earning from the producer box to the house
hold box and this is called factors earnings
or income . 
Now with this income the household they are
going to start demanding for final goods and
services to consume. So, there will be a flow
of demand , 
and there will be another flow which will
denote the supply because the producer after
producing some final goods and services of
course, has to sale it to earn some money
and he will sale this to the house hold or
the consumer sector . So, this will be the
supply of final consumption goods .
So now the income which goes to the household
from the producer or firm box now comes back
to the form again . And this is to the expenditure
root . 
Now there is a market called factor market,
where this demand and supply for factor inputs
interact with each other . There will be another
such market which is for the final goods and
services , and it is there where this demand
for this finished final goods meet the supply
of this finished final goods and the equilibrium
price or the market clearing price is obtained.
So, this market is called the goods market
. 
With this discussion we conclude the theme
prices markets and equilibrium. Now let us
move to a different theme, the next theme
is theory and models. What is a theory theory
is a set of explanations and predictions regarding
real life objects that will be observed around
us? Often theories are represented through
simplified models. What is a model?
So, model is an abstraction which permits
scientists to study a real life phenomenon
in a simplified setting .
now a theoretical economic model has 4 components.
And let us have a look at this 4 components
. The first component is called data , the
second component is called postulates . Third
components is assumptions , 
and the last component is decision variable
. Let us now explain this 4 components one
by one. What is data? Data is exogenous parameter
used in the modeling exercise. These are held
fixed so that the economic agents cannot tampered
with the magnitude of this factors.
What is postulates? Postulate is universal
type statements on the behavior of the constructed
abstract objects . What is assumption? Assumption
is basically the link between the real life
object and the constructed object . Now the
last one is decision variable. What is the
decision variable? Decision variables are
the variables of the interest to this constructed
economic objects and the economists. So, an
economic agent or a constructed object basically
tries to optimize given the resource constraints
and the person or the economic entity is basically
looking for the optimized value of this variables
and so are the economists.
So, these are basically the control variable
in a model. So, with this let us ah finish
for today. We will continue with the discussion
in the next lecture . We will continue with
the discussion on themes of microeconomics
in the next lecture .
