1.

Ans: Economics is science which studies human behavior as a relationship between ends and
scarce means which have alternative user- Lionel Robbins 1932

2. In a simplified economy with only two types of economic agents,

households or consumers and business firms, the circular flow of
economic activity is shown in Figure 10. Consumers and firms
are linked through the product market where goods and services
are sold. They are also linked through the factor market where
the factors of production are sold and bought.
3. Consumers and firms have a dual role, and exchange
with one another in two distinct ways:

4.
5. (1) Consumers or households own all the factors of production,
that is, land, labour, capital and entrepreneurship, which are also
called productive resources. They sell them to firms for
producing goods and services.
6. In the diagram, the sale of goods and services by firms to
consumers in the product market is shown in the lower portion
of the inner circle from left to right; and the sale of their services
to firms by households or consumers in the factor market is
shown in the upper portion of the inner circle from right to left.
 These are the real flows of goods and services from firms to
consumers which are linked with productive resources from
consumers to firms through the medium of exchange or barter.
7. ADVERTISEMENTS:
8. (2) In a modem economy, exchange takes place through financial
flows which move in the reverse direction to the “real” flows. The
purchase of goods and services in the product market by
consumers is their consumption expenditure which becomes the
revenue of the firms and is shown in the outer circle of the lower
portion from right to left in the diagram.
9. The expenditure of firms in buying productive resources in the
factor market from the consumers becomes the incomes of
households, which is shown in the outer circle of the upper
portion from left to right in the diagram.

The income effect
The income and substitution effect can also be used to explain why the demand curve
slopes downwards. If we assume that money income is fixed, the income effect
suggests that, as the price of a good falls, real income – that is, what consumers can
buy with their money income – rises and consumers increase their demand.
Therefore, at a lower price, consumers can buy more from the same money income,
and, ceteris paribus, demand will rise. Conversely, a rise in price will reduce real income
and force consumers to cut back on their demand.

The substitution effect
In addition, as the price of one good falls, it becomes relatively less expensive.
Therefore, assuming other alternative products stay at the same price, at lower prices
the good appears cheaper, and consumers will switch from the expensive alternative to
the relatively cheaper one.
It is important to remember that whenever the price of any resource changes it will
trigger both an income and a substitution effect.

Exceptions
It is possible to identify some exceptions to the normal rules regarding the relationship
between price and current demand.

Ans: 5- Consumer surplus

Consumer surplus is derived whenever the price a consumer actually pays is less than
they are prepared to pay. A demand curve indicates what price consumers are prepared
to pay for a hypothetical quantity of a good, based on their expectation of private
benefit.

For example, at price P, the total private benefit in terms of utility derived by consumers
from consuming quantity, Q is shown as the area ABQC in the diagram.
The amount consumers actually spend is determined by the market price they pay, P,
and the quantity they buy, Q – namely, P x Q, or area PBQC. This means that there is a
net gain to the consumer, because area ABQC is greater that area PBQC. This net gain is
called consumer surplus, which is the total benefit, area ABQC, less the amount spent,
area PBQC. Hence ABQC – PBQC = area ABP.

Declining consumer surplus

Consumer surplus generally declines with consumption. One explanation for this is
the law of diminishing marginal utility, which suggests that the first unit of a good or
service consumed generates much greater utility than the second, which generates
greater utility than the third and subsequent units. A very thirsty consumer will be
prepared to pay a relatively high price for their first soft drink, but, as they drink more,
less utility is derived and the price they would be prepared to pay falls. Therefore, in the
above diagram, as consumption rises from zero, at C, to Q, marginal utility falls. As
utility falls, the price that consumers are prepared to pay declines, causing the demand
curve to slope down from A to B.

Some firms can capture this consumer surplus by charging the highest price that
consumers would be prepared to pay, rather than charge price P for all units consumed.

See also: price discrimination.

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Producer surplus
Producer surplus is the additional private benefit to producers, in terms of profit, gained
when the price they receive in the market is more than the minimum they would be
prepared to supply for. In other words they received a reward that more than covers
their costs of production.

The producer surplus derived by all firms in the market is the area from the supply curve
to the price line, EPB.

See also: profits

Economic welfare
Economic welfare is the total benefit available to society from an economic transaction
or situation.
Economic welfare is also called community surplus. Welfare is represented by the area
ABE in the diagram below, which is made up of the area for consumer surplus, ABP plus
the area for producer surplus, PBE.

In market analysis economic welfare at equilibrium can be calculated by adding

consumer and producer surplus.

Welfare analysis  considers whether economic decisions by individuals, organisations,

and the government increase or decrease economic welfare.