Fundamentals of Economics

• The commodity market started with the barter system and eventually developed to the era of
electronic trading systems.

• In simple words, a market is defined as a meeting place for buyers and sellers to strike a deal.

• Microeconomics is the branch of economics that deals with how households or firms make
decisions and how they interact in the markets.

• The restructured power systems treat electric energy as a commodity rather than a service as in
vertically integrated systems.

• This chapter is aimed at providing some fundamental concepts associated with microeconomics
that are relevant to electricity market.
 Consumer Behavior

• Total Utility:- We begin with the notion that the consumer achieves
some satisfaction from consuming a product, electric energy in this
case. If this satisfaction is absent, the consumer would not demand it at
all.

• Marginal utility:- Marginal utility is the utility obtained from the last
unit consumed.
 Consumer Behavior…

No. of
Lamp Marginal utility Total utility
Lamps

L1 M1 L2 - 0 - 0
C 1 10 10
M1 2 9 19
M4 C M2
M2 3 8 27
M3 4 7 34
M4 5 6 40
L4 M3 L3
L1 6 5 45
L2 7 4 49
L3 8 3 52
L4 9 2 54

Figure 2.1 Room with lamp positions Table 2.1. Marginal and utility after putting the lamp ‘ON’
 Consumer Behavior…

Law of Diminishing Marginal Utility:-

The above pattern of marginal utility provided by sequence of putting

bulbs on is called as law of diminishing marginal utility. It states that
after consuming a certain amount of a good or service, the marginal
utility from it diminishes as more and more is consumed. This law is
quite natural and should hold for most of the products one consumes.
 Consumer Behavior…

Consumer Surplus:-

The person entering the room in the previous example would have been indifferent to the number
lamps to be put ON had electricity been for free. Then the person would not have bothered about the
marginal utility and the total utility. But as soon as the person is made to pay for the usage of electric
energy, he would start thinking and would rather make a judicious choice about how many lamps to
put on. The person then would have calculated how much utility he could have obtained if he had
spent same amount of energy on other usage, for example say, air conditioner. In other words, how
many lamps the person would have put ON depends not only on the marginal and total utilities but
also on the price of electricity.
 Consumer Behavior…

• The word equilibrium used in generic terms means the position of

balance.

Figure 2.2. Decision making based on marginal utility and net consumer surplus
 Consumer Behavior…
Market Demand Curve:-
The demand curve can be termed as marginal utility curve. If, instead of the discrete demand curve
as shown in Figure 2.2, a continuous function is established, the nature of the curve will be the one
with negative slope or downward sloping.

Figure 2.3: Demand function

 Consumer Behavior…
Demand Elasticity:- The price elasticity of demand becomes the ratio of relative
change in demand to the relative change in price. It is given as:
1. Self elasticity
Sr. No. Elasticity Range Type of Elasticity
𝑑𝑞 1 ε=0 Perfectly inelastic
𝑞 𝜋 𝑑𝑞 2 -1 < ε < 0 Inelastic
𝜀= =
𝑑𝜋 𝑞 𝑑𝜋 …………2.1 3 ε = -1 Unit elastic
𝜋 4 - ∞ < ε < -1 Elastic
5 ε=-∞ Perfectly elastic

Table2.2 Various cases of demand elasticity

Where ε depicts elasticity, π price and q the quantity.

The price elasticity of demand can be defined as a measure of how much the quantity demanded
of a good responds to a change in the price of that good, computed as the percentage change in
quantity demanded divided by the percentage change in price.
 Consumer Behavior…
2. Cross elasticity

• The elasticity of the demand for a commodity depends in large part on the
availability of substitutes.
• For example, the elasticity of the demand for coffee would be much smaller if
consumers did not have the option to drink tea.
• The concept of substitute products can be quantified by defining the cross-
elasticity between the demand for commodity i and the price of commodity j :

𝑑𝑞𝑖
𝑞 𝜋𝑗 𝑑𝑞𝑖
𝜀= 𝑖 = …………2.2
𝑑𝜋𝑗 𝑞𝑖 𝑑𝜋𝑗
𝜋𝑗
 Supplier Behavior….
Supply Function
Suppose there are many suppliers and they make use of different technologies and fuels to produce
electric energy. Thereby, these producers will have different marginal costs and will have different
power producing quantities at different price levels. If the amount supplied by a large number of
producers is aggregated, a smooth and upward sloping curve is obtained shown in fig 2.4.

Figure 2.4: Supply function

 Supplier Behavior….
Suppliers' surplus
• Suppliers' surplus can be explained on similar lines to the consumer surplus.
• The entire supply of commodity is traded at the market price .
• The horizontal line depicts the market price.
• The shaded portion shows producers' net surplus.
• Eventually, net surplus is the area between
supply curve and horizontal line depicting
market price.
• The supplier whose opportunity cost is equal
to the market price is called as marginal producer.

Figure 2.5: Suppliers' net surplus

 Supplier Behavior….
Supplier's Equilibrium
The supplier has a threshold price in mind below which it will not sell
its commodity. There are two reasons for deciding this threshold price.
• First of course is that the total revenue will be less than total cost of
producing that commodity.
• Second and important reason could be that the supplier could make
use of same resources required to produce the commodity under
consideration to produce some other commodity that would fetch more
money.
In other words, the supplier will sell the commodity at a price at
which the opportunity cost of production is equal or lesser.
 Supplier Behavior….
Supply Elasticity
An increase in the price of a commodity encourages suppliers to make larger
quantities of this commodity available. The price elasticity of supply quantifies this
relation. The supply elasticity can be defined in a similar fashion to the demand
elasticity. Only difference is to replace supply curve by demand curve.
𝑑𝑞
𝑞 𝜋 𝑑𝑞 Elasticity
𝜀= = ……..2.3 Sr. No.
Range
Type of Elasticity
𝑑𝜋 𝑞 𝑑𝜋
𝜋 1 ε=0 Perfectly inelastic
2 -1 < ε < J Inelastic
3 ε = -1 Unit elastic
4 - ∞ < ε < -1 Elastic
5 ε=-∞ Perfectly elastic
Table2.2 Various cases of supply elasticity
 Market Equilibrium
Now we consider how the consumers and suppliers would
interact with each other at the marketplace.
The market equilibrium is achieved at a price called market
clearing price such that the quantity that the suppliers are
willing to sell is equal to quantity that the consumers wish to
obtain. In other words, market equilibrium is a state of zero
excess demand and zero excess supply.

Thus,π* and q* mark the price and quantity at equilibrium,

respectively. The equilibrium situation in a competitive
market is said to be Pareto efficient. An economic situation
is Pareto efficient if the benefit derived by any of the parties
can be increased only be decreasing benefit enjoyed by one of Figure 2.6: Market equilibrium
the other parties.
 Global Welfare
• Global welfare is the sum of net consumer surplus and net producer surplus.

• It is the quantification of the overall benefit that arises from trading.

• Global welfare is maximized when market is settled at the intersection of supply and
demand curves.

• The global welfare is also termed as social welfare and social surplus. In this figure 2.7,
sum of the areas DS1, DS2 and DW2 represents the consumer surplus while sum of areas
SS1, SS2 and DW1 represents the producer surplus. The total area consisting of areas
DS1, DS2, SS1, SS2, DW1 and DW2 represents the global welfare.

• It is clear from the figure 2.7 that if the price is set to any infra-marginal value rather than
the equilibrium price, there is a reduction in the global welfare.
 Deadweight Loss
What happens when the price is forcefully set at some value other than the
equilibrium price?
It leads to reduction in global welfare and creation of deadweight loss.

Case 1.Suppose the price is set at π2 due to some intervention by say, the government, as shown in
Figure 2.11. In this case, the consumers reduce their consumption from q* to q. The consumer
surplus then becomes equal to area DS1, while producers' surplus is the sum of areas DS2, SS1 and
SS2.
Case2. Similarly, if price is set at π1 , the suppliers reduce their production to q from q*. The net
consumer surplus is the sum of areas DS1, DS2 and SS2, while producers' surplus is area SS1.

Thus, these interventions while setting price have undesirable effect of reducing the
global welfare by an amount equal to the sum of areas DW1 and DW2. The amount
equivalent to this area is called as the deadweight loss.
Global Welfare and Deadweight Loss

Figure 2.7: Global welfare and deadweight loss