Chapter 1

Definition of Economics

ADAM SMITH:

As we know when man was created and settled on earth, economic problems arise with him so the writer, philosophers, thinkers and social reformers discussed and wrote about economic problems. But there were no systematic writings about economic problems till the end of 18th century. It was ADAM Smith (a Scottish man) who wrote the first book "WEALTH OF NATIONS" in 1776 A.D. He described economics as the science of wealth or (An enquiry in to the nature and causes of wealth of nation).

Other economists of the classical school of thought like J.B say, Malthus, Ricardo, and TJ.S. Mill etc. followed him. They also considered economics as the science of wealth.Besides defining economics as the science of wealth the classical economists made the assumption of economic-man. They described economic-man whose economic struggle is motivated by wealth i.e. in economics we are concerned with that person who is making an economic activity. For example a mother nursing her own child, teacher teaches his own son is not performing an eco-activity because they are getting nothing in reward.

To define this definition we first define wealth and also its four aspects:

Wealth means, "Goods and services transacted with the help of money". It is our common observation that the transaction of goods and services take place in our daily life , for example transaction of computer, chair etc. it means that economics is a subject which deals with goods + services transacted with money that is why it is called a science of wealth.

Now the question arise how transaction will take place. For this purpose we will look in to the following four aspects of wealth.

1. Production of wealth

This explains as to how goods and services are produced by combining the four factors of production. For example. Mr. Ali wants to produce sugar, so he will combine four factors of production. First of all he gets/purchases land. Then machinery and raw material. He then employs labour and organizes the business. After combining four factors he produces sugar.

2. Exchange of wealth

Different producers produce different goods. Every producer produces more goods and services than his personal requirement. So every producer exchanges his surplus goods and services with the surplus good + services of other producer. This process of wealth exchange continues throughout the year and it enables every producer to satisfy his multiple wants.

3. Distribution of wealth

All the goods and services which are produced in a country in one year are called national income. Every individual or class gets his share from the national income during a year. This is called distribution of wealth. If one individual or class gets more share than the other. It will be called unequal distribution of wealth.

4. Consumption of wealth

When we use goods and services to satisfy our wants. It is called consumption. All the goods and services which we get are the result of distribution of wealth so consumption of wealth is the ultimate objective of production exchange and distribution.

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CRITICISM:

In the 17th and 18th centuries British society was a religious society and religious zeal of Christianity was strong in Europe. The religious minded people regarded wealth as mean object. In such an atmosphere it was but natural that economics as a science of wealth and even economics itself had to adverse reaction. Both the common people and scholars opposed the classical concept of economics. Even social reformers Ruskin and Carlyle condemned economics. It was regarded as the science of bread and butter. The science of selfishness, the science of mammonism and a dismal science. This sort of thinking created misconceptions about economics as a result the development of economics as science was adversely affected classical definition was criticized for variety of reasons.

1. Primary importance to wealth

This definition gives primary importance to wealth and secondary importance to man. But infect the study of man and its welfare is more important than the study of wealth.

2. Narrow Meaning of wealth

The word "wealth" in the classical definition means only material goods. It ignored the services which were more important. But wealth includes material as well as immaterial goods.

3. Concept of Economics Man

According to this definition, man works only for self-interest. Social interest is ignored. Marshall says that economics does not study a selfish man, but a common man.

4. Ignorance of Man's welfare

The definition ignores the importance of man's welfare. Wealth is not the best of all and the end all of all human activity.

5. It does not study Means

This definition lays emphasis on the earning of wealth as an end in itself. It ignores the means for the earning of wealth.

6. Narrow View and Controversial

In this definition wealth does not have a clear meaning, so it is controversial. It is regarded unscientific and has a narrow view.

ALFRED MARSHALL:

A British economist Alfred Marshall wrote a book in 1798 "Principles of economics" at this stage. He tried to remove the misconception and put economics on the road of development. He defines economics as below"Economics is the study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected and social action which is most closely connected with the attainment and use of the material requests of wellbeing"Marshall the founder of neo-classical school of thoughts or welfare school of economics and his followers are of the view that on the one hand economics is the study of wealth and on the other hand it is the study of man who is more important than wealth. Further they are of the view that materials welfare is the primary aim of economics. So economics is the study of material welfare.To elaborate Marshall's definition we discuss the main points:-

1. Study Of An Ordinary Man

According to Marshall Economics does study of an ordinary man who lives in society is not the subject of study of economics.

2. Wealth Is Not The Be All And End All Of All Human Activity

Economics does not regard wealth the be all and the end all of the human activity. Wealth is only a mean to the fulfilment of an end which is human welfare, so welfare and not wealth is, therefore of primary importance to man.

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3. Study of all Activity of Men

It does not study all activities of men people perform different activates while living in a society. There are different subjects to cover different activities i.e. Sociology for social activities, political science of political activities, physical education for sports activities. etc. but economics deals with the economic activities of human beings living in a society.

4. Study of material welfare

Economics only studies the ways in which man applies his knowledge and skill to the gift of nature for the satisfaction of this material welfare and ignores non-material aspects. According to Marshall's economics is the study of material welfare. He says each man applies his knowledge, uses his skill for the satisfaction of his material welfare and eco has nothing with immaterial thing.

CRITICISM:

1. Narrow Down The Scope Of Economics

According to Robbins when Marshall used the word "Material" in his definition considerably narrows down the scope of economics. There are many things in the world which are immaterial, but they are useful for promoting human welfare. I.e. the services of a doctor teacher, lawyer etc. which satisfy our wants and scarce in number (supply). If we exclude these services and include only material goods then the sphere of economics study will be very much restricted.

2. Relation Between Economics and welfare

The second objection by Robbins is on the establishment of relation between economics and welfare. He says there are many activities which do not promote human welfare, but they are regarded economic activities (e.g.) the production and sale of alcohol goods or opium, so he says we talk of welfare at all.

3. Welfare Is A Vague Concept

The third objection is welfare. He says welfare is vague concept. It is purely subjective. It varies from man to man, from place to place and from age to age. Robbins says what is the need of the use of such concept which cannot be measured quantitatively and on which two persons cannot agree as what is conductive to welfare and what is not.

4. It Involves Value Judgment

In this definition the word welfare involves value judgment (what is good and what is bad). According to Robbins, economists are forbidden to pass any judgment.

5. Impractical

Marshall's definition is theoretical in nature. It is not possible in practice to divide man's activities in to material and non-material.

LIONEL ROBBINS:

Different economists have different opinions regarding the subject matter of economics. Adam smith says economics is a science of wealth. According to Marshall Economics is the science of material welfare. He gave primary importance to man and secondary importance to wealth. But Robbins says that we have unlimited wants and limited resources which have alternative uses. Thus in spite of difference of opinion we say that:Economics is basically a science of wealth because it is only wealth which a man can use for human welfare and also to satisfy unlimited wants. There would be no concept without money. Robbins definition is most acceptable in the world these days.

1. Economics as a social science

In economics we study the human behaviour of the people who are living in  society, so economics is a social science for example  if a person goes to market and buys more commodity with higher price and less with lower price. The economist will see the aggregate behaviour of the people, not of that every single person. After judging the aggregate

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behaviour of the people, the economists will formulate a law that other things being equal with higher price les is purchased and with lower price more is purchased. So as the case of other laws of economics. They are all based on the action of the person taken in aggregate. Thus we concluded that economics is a social science.

2. Economics is a science or an ART

The question is whether economics is theoretical in nature or it has some practical side too. Science means a systematic body of knowledge relating to some aspect of nature and based on fact.In science we assemble some facts, then observe it and then experimented, from which certain laws, principles rules etc. are derived that are generally correct and are commonly followed in everyday life. According to this explanation economics is said to be science. So economics is well disciplined body of knowledge and based on facts. These facts are carefully collected observed and analyzed and from these facts economic laws principles are drawn. That happens to be correct and is followed in economic struggle. If we define science as a relationship between cause and effects, even then economics qualify to be a science i.e. when unlimited wants and limited resources (cause) economics problem. (Effect) is created to solve which a particular behaviour is adopted by man. Economics studies this very economic problem and behaviour.

ART:

When the laws principles, rules etc. of science are practically applied in everyday life, art comes into existence. For example: Agriculture and medical students so economics is science as well as an art. Its laws are practically applied. These economics laws are practically applied by individual and in all word.From this discussion it can be logically concluded that economics is science and art.

3. Economics as a positive (pure) or Normative science

This is difference of opinion that whether economic is positive or normative science.Robbins and Senior are of the view that economics is positive science. They argued it is based on facts and logic. Economics studies facts, observes it and analyses these facts and make principles. Malthus Pigno etc. say that economics is a normative science. They say that real function of science is to increase the well beings of human being. They have given suggestions in their theories to promote welfare i.e. Malthus suggestion for.Frazer says, economics is positive as well as normative science. He says economists should come forward to give suggestion to the people about the problems they are facing now days. I.e. inflation, unemployment, unequal distribution of wealth, birth rate etc.

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Chapter 2

Theory of Consumer Behaviour

Consumer Behaviour:

Consumer behaviour is the study of when, why, how, and where people do or do not buy product. It blends elements from psychology, sociology, social anthropology and economics. It attempts to understand the buyer decision making process, both individually and in groups. ORStudy of how people behave when obtaining, using, and disposing of products and services.ORThe behaviour of individuals when buying goods and services for their own use or for private consumption.

Utility:

Utility is a concept used to denote the subjective satisfaction or usefulness attained from consuming goods and services. This concept helps to explain how consumers divide their limited income / resources among different choices of goods and services that help attain them satisfaction (utility) The issue however is how we are supposed to measure utility and how the value of utility derived from various choices can be quantified. Because of these issues, the consumer behaviour theory has been reformulated and utility is viewed as a way to describe preferences. It was recognized that all that mattered about utility is whether one combination of choice had a higher utility than another; by how much higher or lower didn't really matter

Preferences of consumers is the fundamental description important for analyzing choice while utility is just a simple way of describing preferences

Total utility:

The total satisfaction or fulfilment received by a consumer through the consumption of a goods or services or a combination of both is defined as Total utility. For instance if a person consumes five units of a commodity and derives U1, U2, U3, U4, U5 utility from the successive units of a good, his total utility will be,

Total utility increases with an increase in consumption, but as consumption rises, total utility grows at a diminishing rate.Every unit of a good or service has a marginal utility and the total utility is a

simple addition of all the marginal utilities of the units of goods or servicesAll consumers want to achieve the maximum possible total utility for their spending and thus they look to combine different bundles of goods and services. With their limited resources, consumers make various choices in order to increase their total utility with each additional unit of consumption.

Marginal utility:

As discussed above all consumers attempt to maximize their total utility from the goods and services they consume. This process of optimisation leads the consumers to consider the marginal utility of acquiring additional units of the product or service and of acquiring one product or service as opposed to another. Product characteristics and individual tastes and preferences apart from available resources (money) determine direct demand. Utility is maximised when products are bought at levels such that relative prices equal the relative marginal utility derived from consumption.

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TU = U1+ U2 +U3+ U4+ U5

The marginal utility of a good is the increase in total utility gained by consuming one additional unit of that good, for a given level of consumption of other goods

Law of diminishing marginal utility:

We have discussed earlier that with an increase in consumption total utility increases but at a slower and slower rate. Law of diminishing marginal utility explains this concept. The law of diminishing marginal utility says that as consumption rises the marginal utility of consuming the next unit is less than the previous one. Accordingly the marginal utility of good decreases as more and more units of that good are consumed as shown in the table and figure below:

Quantity of Good Total Utility (TU) Marginal Utility (MU)1 10 102 19 93 27 84 34 75 40 6

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Chapter 3

The Ordinal Utility Approach

Indifference Curve Analysis:

As we know that the consumer is able to rank bundles of goods and services based on the utility he derives from them. This makes possible joining together of all these bundles that give the consumer equal utility / satisfaction. The curve drawn on these bundles or combinations of goods and services is known as indifference curve.At all points across the indifference curve the consumer derives same level of utility. And thus the consumers are indifferent because they do not care which of the bundles on the indifference curve they have.

Compare the consumption bundles shown on the figure above. The indifference curve I1 tells us that Bundles A, B and C give the consumer equal satisfaction. Bundle E contains fewer bananas and fewer apples than Bundle B, and therefore Bundle B (and A and C) must be preferred to Bundle E. Similarly Bundle D contains more bananas and more apples than Bundle B, and therefore Bundle D must be preferred to Bundle B (and A and C). While bundle D should be on a higher indifference curves as it gives more utility to the consumer, E should be on a lower curves as it gives lesser utility. The indifference curves are convex to the origin as because to keep the consumers’ utility constant he must be compensated with increasingly larger amounts of good X for each additional unit of good Y he is giving up.

This concept stems from the fact of diminishing marginal utility and is explained below in Marginal rate of substitutionSlope of an Indifference curve is given by:

           

where MUA and MUB are marginal utility derived from the last unit consumed of good A and B respectively

All of the points along an indifference curve represent combinations of goods / services that are equally satisfying to the consumer

Marginal Rate of Substitution:

The amount of one unit of good that a consumer is prepared to forego for one extra unit of another good is known as the marginal rate of substitution. The marginal rate of substitution of good A for good B is the number of good A the consumer is willing to give up to gain another unit of good B without affecting total satisfaction. A diminishing marginal rate of substitution of good B for good A implies that the consumer is willing to give up diminishing quantities of good A to gain each additional good B. This means that if it takes, say, n extra units of good A to convince a consumer to give up one unit of good B, it will take more than another n extra good A to persuade her to give up yet another unit of good B.Suppose the following combinations of fruits give the consumer equal satisfaction:

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Marginal Rate of Substitution =

Apples Oranges20 115 211 38 4

The marginal rate of substitution of oranges for apples falls from 5 to 4 to 3, showing that the consumer is more willing to give up apples for an additional orange when the consumer has a lot of them.

Budget Line:

A consumer cannot decide to buy a particular combination of goods only on the basis of indifference curves. The indifference curves do not tell him, which combination will give him the most for his money. In order to study and predict the consumer behavior, two vital information are necessary besides the well defined preference pattern of the consumer (shown by the indifference "map), i.e., the income of the consumer (ability to buy the combinations of the commodities) and the prices of the commodities. These information’s are provided by the income price line or budget line. It shows all the combinations of the two commodities which the consumer can buy by spending his entire income for the given prices of the two commodities.

Fig.shows the way budget line is drawn. Suppose, a consumer has $ 20 to be spent on two commodities 'X' and' Y'. If the price of commodity 'X' is $ 2 per unit and that of commodity' Y' is $ 1 per unit, he can buy 10 units commodity 'X' (given by OA in the figure), when the entire income is spent to purchase commodity 'X'. On the other hand, if the consumer spends his entire income to purchase commodity' Y', he can purchase 20 units of commodity 'Y' (OB in the figure).          

Fig.: Budget Line

The consumer can also choose any other combination on the line joining points 'A' and 'B', when he partly spends his income on one commodity (say, $ 5 to purchase 10 units of commodity 'X') and partly on the other (say, $ 5 to purchase 5 units commodity' Y'). Straight line AB is called the budget line. This line suggests that the consumer cannot choose any combination of commodities beyond this line (say, point 'C' in the figure), as his income does not permit him to do so. Any point, say, 'D', below this line indicates that his income is not fully spent. The budget line is also called as the consumption possibility line, as it represents the different possibilities of the two goods, the consumer can purchase with his given income. Sometimes, it is referred to as opportunity line, since it provides an opportunity of buying one combination rather than the other. Leftish calls it the line of attainable combinations. Friedman has also used the same term in his book, 'Price Theory'. The budget line can also be known as the menu of choices open to the consumer, given his money income and the prices of the goods.When the price of commodity 'X' changes (income of the consumer and price of other good remains constant), the budget line will shift only at its end touching the X-axis (Fig.). In case price of commodity 'X' decreases, the consumer can buy more of commodity 'X'. Here, the budget line shifts outward, increasing die intercept on X-axis. In the figure, the budget line shifts from AB to AB1. On the other hand, when the price of commodity 'X' rises, the consumer can purchase less of commodity 'X'. Therefore, the budget line shifts inward to AB2                                                      

               Fig: Shifts in Budget Line Due to Change in Price of Only One Commodity

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Consumer Equilibrium

Individuals (consumers in this case) make their choices about the quantity of goods and services to be consumed with the objective to maximize their total utility. But in maximizing total utility they face several constraints, the foremost being the individual’s income level and the prices of the goods and services that he desires to consume. These constraints as discussed above forms the budget line of the consumer. The consumer's effort to maximize total utility, subject to the budget line, includes decisions about how much he would consume of the goods and services and the combination of goods and services at which the consumer maximises its total utility is called consumer equilibrium.A consumer facing the budget line (fixed income and given market prices of goods) can come to a point (or equilibrium) of maximum satisfaction or utility only by acting in the following manner. Each product is demanded up to the point where the marginal utility for every unit of money spent on it is exactly the same as the marginal utility of the spent on any other good. This fundamental condition of consumer equilibrium can be written in terms of Marginal Utilities (MU) and Prices (P) of the different goods in the following compact way.

 = =  =  Common MU per unit of income. To maximise utility the consumers spread out their expenditures in such a way that the marginal rate of substitution is equal to the relative price of the good X as in the figure above. To represent it numerically:

 =

Thus combining the budget line with indifference curves, we can ascertain the consumption bundle which a consumer will choose. To further illustrate consider the earlier example of choice between apples and bananas and the figure below:

Now let assume that all income is spent. Since the bundle W lies on the highest achievable indifference curve, W will be chosen. At this point the consumer chooses to buy qa apples and qb bananas. Bundle F is unaffordable as it doesn’t touch the budget line and lies above it. Now though bundles such as G and H are affordable, but as they lie on a lower indifference curve and provide lower utility they will not be chosen. The bundle W maximises the consumer’s utility given the budget line and indifference curves.

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Chapter 4

The Theory of Demand

The Law of Demand:

(1). The law of demand states that when the price of a good rises, the amount demanded falls, and when the price falls, the amount demanded rises.(2). The law of demand states that, if all other factors remain equal, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded.

This law holds true because as the price of a goods increases the real income with the consumer declines and in order to avoid forgoing consumption of other important goods the consumer decides to consume lesser quantity of the good.

The above figure shows the demand relationship with the help of the demand curve. We can see that at point A when the price is highest at P1 quantity demanded is lowest at Q1. As price decreases from P1 to P2 and P3, the quantity demanded increases to Q2 and Q3 respectively as shown at the point B and C. The graph illustrates the demand relationship which explains that as P increases the demand at points (A, B and C) in the market decreases hence the Q decreases. This demonstrates a down-ward slope.

The Demand Curve:

We know that, the quantity demanded of a good usually is a strong function of its price. Demand is illustrated by the demand curve and the demand schedule. The term quantity demanded refers to a point on a demand curve.

By definition, the demand curve displays quantity demanded as the independent variable (the X axis) and price as the dependent variable (the Y axis). For basic analysis, the demand curve often is approximated as a straight line. A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve.

Determinants of demand:

Various factors affect the quantity demanded by a consumer of a good or service. A number of factors may influence the demand for products. The key determinants of demand are as follows:-

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Price of the good: This is the most important determinant of demand. The relationship between price of the good and quantity demanded is generally inverse as we will see later while studying law of demand.

Price of related goods:

o Substitutes: If the price of a substitute goes down than the quantity demanded of the good also goes down and vice versa.

o Complements: If the price of gasoline goes up the quantity demanded of automobiles will go down. An increase in the price of a complement reduces demand. Thus the price of complements has an inverse relationship with the demand of a good.

Income: Higher the income of the consumer the more will be quantity demanded of the good. The only exception to this will be inferior goods whose demand decreases with an increase in income level.

Individual taste and preferences: A preference for a particular good may affect the consumer’s choice and he / she may continue to demand the same even in rising prices scenario.

Expectations about future prices & income: If the consumer expects prices to rise in future he / she may continue to demand higher quantities even in a rising price scenario and vice versa.

Assumptions of the law:

Like every law, the law of demand also has its own limitation. We have mentioned, while stating the law of demand above, the assumptions that other things remaining same or unchanged. In real life this is not possible but for theoretical purposes and for analyzing the relationship between demand and price we take the assumption of all other things to be unchanged. Few of the key assumptions which we assume to be unchanged while stating the law of demand are:

1. Prices of other goods (substitutes & complements) remain unchanged.2. Tastes and preferences remain constant.3. Income level of the consumer does not increase or decrease.4. The commodity is a normal good and has no status value.5. Consumer expectations are neutral or they do not expect rise / fall in the price of the good.

Exceptions to the law of demand:

Unlike other laws, law of demand also has few exceptions i.e. there is no inverse relationship between price and quantity demanded for these goods. Few of them are as follows:

Giffen Goods : These are those inferior goods whose quantity demanded decreases with decrease in price of the good. This can be explained using the concept of income effect and substitution effect as discussed earlier. In case of such goods the positive income effect is higher than the negative substitution effect resulting is an overall positive (direct) relationship between price and quantity demanded.

As shown in the above figure, the substitution effect due to the decrease in price increase the quantity demanded from Q 2 to Q5, while the income effect gives more disposable income which leads to decrease in quantity demanded from Q 5 to Q4. So the net effect is a decrease in quantity demanded from Q2 to Q4.

Commodities which have snob value or regarded as status symbols: Expensive commodities like jewellery, AC cars, etc., are used to define status and to display one’s wealth. These goods doesn’t follow the law of demand and quantity demanded increases with price rise as more expensive these goods become, more will be their worth as a status symbol.

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Expectation of change in the price of the goods in future: If a consumer expects the price of a good to increase in future, it may start accumulating greater amount of the goods for future consumption even at the presently increased price. The same holds true vice versa.

Difference between movement or shifts along the demand curve:

Changes in demand for a commodity can be shown through the demand curve in two ways namely:

(1)- Movement along the demand curve. (2)- Shifts of the demand curve.

The change in the demand of a commodity due to change in its price leads to moving the demand curve upward or downward depending upon the change in price. When the price rises, the demand falls. And when the price falls the demand for that commodity rises leading to movement in the demand curve. Shift in the demand curve is the result of the price remaining constant but the demand changing due to several other factors such as, change in fashion, income, and population, etc.

Movement along the demand curve:

A movement along a demand curve is defined as a change in the quantity demanded due to changes in the price of a good will result in a movement along the demand curve. For instance, a fall in the price of apples from P1 to P2 causes an increase in the quantity demanded from Q1 to Q2.

In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.

Shifts in the demand curve:

A shift of the demand curve is referred to as a change in demand due any factor other than price. A demand curve will shift if any of these occurs:

1. Change in the price of other goods (complements and substitutes); leading to increase / decrease of real income.2. Change in the income level.3. Change in consumers’ taste and preferences.4. Change in expectations.

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Each of these factors tends the demand curve to shift downwards to the left or upwards to the right. While downward shift signifies decrease in demand, an upward shift of the demand curve shows an increase in the demand. For example, if there is a positive news report about FMCG products, the quantity demanded at each price may increase, as demonstrated by the demand curve shifting to the right. There are many factors may influence the demand for a product, and changes in one or more of those factors may cause a shift in the demand curve.

An outward (rightward) shift in demand increases both equilibrium price and quantity.

As shown in the demand curve if any of these changes factors changes, the demand curve will shift to D 2 from D1 and accordingly the price and quantity demanded will change. Movements along a demand curve is the result of increase or decrease of the price of the good, while the demand curve shifts when any demand determinant other than price changes.

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Chapter 5

The Theory of Elasticity of Demand

Elasticity Of Demand

Meaning of price elasticity of demand

Price elasticity of demand can be defined as responsiveness or sensitivity of the quantity demanded to price changes. Most goods have a downward-sloping demand curve and therefore have a negative price elasticity of demand. However there can be exception to this and demand curve of goods (Giffen goods) can have a positive price elasticity of demandDemand for goods for which a change in price causes a more than proportionate change in the quantity demanded are said to elastic, in cases where the change in prices causes exactly proportionate change in quantity demanded the demand is said to be unit elastic and lastly the demand is said to be inelastic when a change in price causes a less than proportionate change in the quantity demanded

Demand is said to be “elastic” when the (own price) elasticity of demand is more negative than –1Demand is said to have “unit elasticity” when the (own price) elasticity of demand is –1Demand is said to be “inelastic” when the (own price) elasticity of demand is less negative than –1

Kinds of price elasticity of demand

The elasticity of demand changes along the length of a demand curve. As we move along the demand curve from left to right, the percentage change in quantity demanded (calculated as change in quantity divided by original quantity) falls and the percentage change in price (calculated as the percentage change in price divided by original price) rises. Therefore elasticity decreases as we move from left to right.The figure above shows how elasticity changes along a straight-line demand curve. We can infer the following from the figure:

elasticity falls as we move from left to right i.e. elasticity decreases as the price falls and the quantity demanded increases

at the midpoint of the demand curve the demand is unit elastic the demand is elastic above the midpoint the demand is inelastic below the midpoint demand is perfectly elastic where the quantity demanded is zero demand is perfectly inelastic where the price is zero

Measurement methods

Total outlay method or Revenue method

Total outlay method of measuring elasticity of demand was developed by Marshall. This method tries to measure change in total expenditure of the consumer or revenue of a firm due to change in the price of a good.

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Total outlay or total revenue is calculated as the multiplication of price and quantity demandedThis method expresses elasticity in three ways:

Unitary elastic (E=1): Total revenue (outlay) remains unchanged as a result of price change Elastic (E>1): Total revenue (outlay) increases with fall in price and vice versa Inelastic (E<1): Total revenue (outlay) increases with rise in price and vice versaPrice(rs)

Quantity demanded (units)

Total outlay (price x quantity) Elasticity

5 50 2506 45 270 Inelastic (E<1)7 40 280 Inelastic(E<1)8 35 280 Unitary(E=1)9 30 270 Elastic(E>1)10 25 250 Elastic(E>1)

Income elasticity of demand

Income elasticity of demand is defined as the change in quantity demanded of a good due the change in the income of the consumer.

Income elasticity of demand of good “i” is A normal good is a good for which the income elasticity of demand is positive. So the quantity demanded increases as income increases.

Normal goods can be categorised as follows:

Income Inelastic normal good is also know as necessity. A necessity is a good for which the income elasticity of demand is less than 1. So a smaller proportion of a person’s income is spent on the good as income rises.

Income Elastic normal good also known as luxury goods. A luxury is a good for which the income elasticity of demand is greater than 1. So a greater proportion of a person’s income is spent on the good as income rises.

 

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Income Unit elastic normal good. The demand for these goods increase in the same proportion of the increase in the income level i.e. X% increase in the income leads to X% rise in the quantity demanded

An inferior good is a good for which the income elasticity of demand is negative. So the quantity demanded falls as income increases.                                      

Cross elasticity of demand

Cross elasticity of demand measures the sensitivity of the price change of a good to the quantity demanded of the other good (complement or substitute) all other things remaining same i.e. it tries to measure that if the price of a good increase (decreases) what is the percentage change in the quantity demanded of the other goodGoods can be classified as follows

Complementary goods: These goods are jointly consumed, like petrol and car. These goods have negative cross elasticity of demand. For instance if the price of petrol increases the demand of cars will come down

Substitute goods: These goods are alternatives to each other and the consumer can choose in between them. For instance a Toyota car and a Honda car. They tend to have positive cross price elasticity of demand. So if price of a Toyota car increases the demand for a Honda car would increase and vice versa.

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Determinants of price elasticity of Demand

As discussed earlier price elasticity measures the responsiveness of the quantity demanded to a change in price of a product/goodThe factors influencing the magnitude of the elasticity of demand are:

Closeness of substitutes: The closer the substitute/alternative for the product, the higher elasticity of the demand will be for it

Broadness of the product definition: It is easier to find substitutes for the product which is narrowly defined. For instance the demand for food is inelastic as there is virtually no substitute for food but Bread can be a substitute for meat

Time elapsed since price change / length of the time considered: the longer the time has passed since the price change, the more elastic will be the demand. It is easier to find and make use of a substitute in the long run than in the short run. For example, if the price of domestic gas increases, the quantity demanded may fall a little as people try to use less gas for cooking and heating, but it may only be after a number of years, when people have had a chance to switch to electric cookers and, say, oil-fired central heating, that the full fall in the quantity demanded will occur

The degree of brand loyalty / addiction: Some products have very strong brand loyalty, for example tickets to see an India – Pakistan cricket tie. Watching Australia-England match is not much of a substitute for an India/Pakistan fan! Some people are addicted to tobacco and are unlikely to reduce their demand for cigarettes very much if the price increases

Proportion of the Income spent on the good: Other things remaining same, the greater the income spent on the good the more elastic is the demand for it.  For instance if the price of a soap increase from $1 to $1.2 there will be hardy any fall in the demand of the same while if the price of a car increase from $5,000 to $6,000 there will be a significant fall in the price of that car

The degree of necessity/luxury of the good: If the price of a necessity item such as milk or toothpaste increases there would be very little change in quantity demanded because consumers cannot do without these products and there is no real alternative. Some products are bought as treats such as bubble bath or boxes of chocolates and consumers would be inclined to go without or reduce their demand for this sort of product if the price increases and to treat themselves in some other way.

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Chapter 6

The Theory of Supply

Law of supply

The law of supply sass that the quantity of a good offered or willing to offer by the producer/owners for sale increase with the increase in the market price of the good and falls if the market price decreases, all other things remaining unchangedAn increase in price will increase the incentive to supply which means that supply curves will slope upwards from left to right. Supply curves can be curves or straight linesConsider the supply of labour as in the figure below:

                                              The above supply curve shows the hours per week at job by the labour on the X axis and hourly wages on the Y axis. As we can see that as the hourly wages increases the hours spent on job also increases. Thus the supply curve is a left to right upward sloping curve

Determinants of supply

Quantity supplied of a good/ service is affected by various factors. Several key factors affecting supply are discussed as below:

Price of the product: Since the producer always aims for maximising his returns/profit, so the quantity supplied changes with increase or decrease I the price of the good.

Technological changes: Advanced technology can yield more quantity and at lesser costs. This may result in the   producer to be willing to supply  more quantity of the goods

Resource supplies and production costs: Changes in production costs like wage costs, raw material cost and energy costs might impact the producers’ production and eventually the supply. An increase in such cost might result in lesser quantities produced and thus lesser quantities supplied and vice versa

Tax or subsidy: Since the producer aims to minimise costs and expand profit, an increase in tax will increase the total cost, thereby decreasing the supply. Similarly a subsidy might incentivise the producer to supply more of that goods in order to maximise his profits. Tax and subsidy are two important tools used by central government to control supplies of certain goods. For example an increase in tax can be used to reduce the supply of cigarettes, while and increase in subsidy can be used to increase the supply of fertilizers

Expectations of prices in future: An expectation that the prices of goods will fall in future might lead to lessen the production by the producer an dthereby decrease the supply and vice-versa.

Price of other goods: A producer might have several options to produce. Since the money to invest is limited with the producer he would decide to produce the good which offers him the maximum profit. Thus if the producer is currently producing good A and the price of good B increases than he might switch to producing good B as this would result in better returns for him.

Number of producers in the market: This is a very important factor or determinant of supply. If there are large number of producers or sellers in the market willing to sell goods than the supply of good will increase and vice versa

Movement along and shifts in supply curve

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Changes in the determinants of the supply cause movement along the supply curve or shifts in the supply curve. We will discuss these two phenomenons in detail as below:

Movement along the supply curve

Movement along the supply curve happens due to change in the price of the good and resulting change in the quantity demanded at that price. For instance, an increase in the price of the good from P1 to P2 in the figure below results in an increase of quantity supplied of the good from Q1 to Q2. This movement from point A to point B on the supply curve S due to change in price of the good all other factors of supply remaining unchanged is called movement along the supply curve.

Shifts in the supply curve

Shift in the supply curve is also sometimes referred as a change in supply. This happens due to changes in factors of supply other than that of price of the goodFor example, if the price of a factor of a related good increases the supply curve shifts. Similarly changes in technology and government tools like tax and subsidy tends to shift supply curve.                       The supply curve can shift to the right or left as shown in the figure below. A shift towards the right i.e. from S1 to S2 curve denotes an increase in supply of the good at all levels of prices. Similarly a shift in the supply curve from S1 to S3 denotes a decrease in supply of the good at all levels of pricesAs seen in the figure above a rightward shift in the supply curve from S1 to S2 increases supply from Q1 to Q2 while the price of the good remains same at P1. Similarly a leftward shift from S1 to S3 decreases supply from Q1 to Q3 whilst the price remaining unchanged at P1A shift in supply will occur if either of the following changes:

the (opportunity) cost of resources needed to produce the good the technology available to produce the good.

Either factor could cause the supply curve to shift to the left (a decrease in supply) or to the right (an increase in supply).

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Chapter 8

The Theory of Price Determination

MARKET EQUILIBRIUM:

Equilibrium means a state of equality or a state of balance between market demand and supply . Without a shift in demand and/or supply there will be no change in market price. In the diagram above, the quantity demanded and supplied at price P1 are equal. At any price above P1, supply exceeds demand and at a price below P1, demand exceeds supply. In other words, prices where demand and supply are out of balance are termed points of disequilibrium. Changes in the conditions of demand or supply will shift the demand or supply curves.  This will cause changes in the equilibrium price and quantity in the market. Demand and supply schedules can be represented in a table. The example below provides an illustration of the concept of equilibrium. The weekly demand and supply schedules for T-shirts (in thousands) in a city are shown in the next table:

1. The equilibrium price is £5 where demand and supply are equal at 12,000 units2. If the current market price was £3 – there would be excess demand for 8,000 units3. If the current market price was £8 – there would be excess supply of 12,000 units

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Price per unit (£) 8 7 6 5 4 3 2 1Demand (000s) 6 8 10 12 14 16 18 20Supply (000s) 18 16 14 12 10 8 6 4

Chapter 10

The Theory of Firm’s Behaviour

Isoquants

Isoquants are those combination of inputs or factors of production which provides an equal or same quantity of output. Isoquant curves are also called Equal product or isoproduct curve.  For a production function which denotes isoquant:Q=F(L,K), Q is fixed level of production L = labour and K = Capital are variableThe table below shows different combinations of labour and capital required to produce 100 shirts

.

Labour (L)

Capital (K)

Output (Shirts)

10 90 10020 60 10030 40 10040 30 10050 20 100

Different resources/ inputs are required for production of goods. Same number of outputs can be produced using different input combinations. Isoquant is the combination of all such combination of inputs which produces same output. Thus we have an isoquant curve for every level of output. Since the quantity produced will remain unchanged on an isoquant, the producer is indifferent for different input combinations. In the figure below the producer will be indifferent on points A, B and C since they are on the same isoquant. Also he cannot move to D without increasing both the inputs and would not produce at E due to inefficiency:                                                     Similar to Indifference curve as one move to the right of the isoquant, one reaches a higher level of production.

Marginal Rate of Technical substitution: (MRTS) :

MRTS is the rate at which the factors can be substituted at the margin without changing the level of output. Or the loss of certain units of X factor which will just be compensated for by Additional units of factor Y at that point.

Producer's Equilibrium:

There are number of combinations of factors which can yield a given level of output, the producer has to choose one combination out of these which yield a given level of output with least possible cost. The least cost combination of factor for any level of output is that where the iso product curve is tangent to an iso cost curve.The producer is said to be in equilibrium when the following conditions are satisfied: 1. The isoquant must be convex to the origin. 2. The slope of isoquant and isocost must be equal to each other.

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Chapter 17

Equilibrium of Firm under Perfect Competition

Perfect Competition:

Perfect competition market form is a highly competitive market in which an optimal allocation of resources is achieved. Even if the strict assumptions of the theory are rarely, if ever, held in reality, the model still provides a benchmark by which other more realistic market structures can be judged.

Perfect competition describes an industry where each firm faces a horizontal demand curve. This will typically occur if there are a large number of firms producing an identical product.A horizontal demand curve means that demand is infinitely elastic. In particular, if a firm raises its price above the going market price it will lose all its sales. This contrasts with monopoly, oligopoly and monopolistic competition (collectively known as “imperfect competition”) where each firm faces a downward-sloping demand curve. Imperfectly competitive firms have some freedom to alter their prices whereas perfectly competitive firms do not. A firm in perfect competition is a “price taker”, taking the market price it faces as given, whereas imperfectly competitive firms are price setters.

Short-run Equilibrium

The diagram below shows a short-run equilibrium position for a firm in perfect competition

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Suppose an individual firm has the following cost structure:

At price p1, the firm produces where MC = MR, i.e. Q1. At this price, the firm makes supernormal profit since price exceeds average cost.

At price p2, the firm produces where MC = MR, i.e. Q2. At this price, the firm makes normal profit since price is equal to average cost.

At price p3, the firm produces where MC = MR, i.e. Q3. At any price between p2 and p3, the firm makes less than normal profit, but it carries on in the short run because price exceeds AVC.

At prices below p3, the firm will supply nothing, since the price does not even cover its average variable cost.Thus, the MC curve above minimum AVC is the firm’s short-run supply curve. At prices below minimum AVC, the firm will supply nothing.

Long-run Equilibrium

In the long run all factors are variable. Since there are no barriers to entry or exit, firms can enter the industry or they can leave.If supernormal profits were being earned in the short run, then new firms (with cost curves such that they could make at least normal profit) would be tempted to enter the industry in the long run. The output of the new firms would increase the total

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industry supply and hence reduce the market price and the level of profit. The process would continue as long as supernormal profits were being earned.The following diagram shows the long-run equilibrium position for the perfectly competitive firm.The shape of the long-run industry supply curve will reflect the way that the costs experienced by firms change as total output changes. If increased output does not increase factor costs, then additional new firms will be attracted to the industry and the long-run supply curve will be horizontal. If the additional demand for factors of production pushes up their cost, then the long-run supply curve will slope upwards, reflecting additional output from existing firms and also, possibly, new entrants.However, the long-run supply curve may even be downward sloping. This would occur if the additional demand allowed firms to operate in a more efficient manner (including reduced costs for factors of production that could be supplied more efficiently).

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