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Economics is the social science that analyzes the production, distribution, and consumption of

goods and services. Economics is a study of human activity both at individual and national level.
The economists of early age treated economics merely as the science of wealth. The reason for
this is clear. Every one of us in involved in efforts aimed at earning money and spending this
money to satisfy our wants such as food, Clothing, shelter, and others. Such activities of earning
and spending money are called Economic activities.

Definition:
It was only during the eighteenth century that Adam Smith, the Father of Economics, defined
economics as the study of nature and uses of national wealth.

Reasons For Studying Economics:


1. It is a study of society and as such is extremely important.
2. It trains the mind and enables one to think systematically about the problems of business
and wealth.
3. From a study of the subject it is possible to predict economic trends with some
precision.
4. It helps one to choose from various economic alternatives.

Economics is the science of making decisions in the presence of scarce resources. Resources are
simply anything used to produce a good or service to achieve a goal. Economic decisions involve
the allocation of scarce resources so as to best meet the managerial goal. The nature of
managerial decision varies depending on the goals of the manager.

MICROECONOMICS: Microeconomics is the study of the economic actions of individuals


and small groups of individuals. This includes the study of particular firms, particular
households, individual prices, wages, income, individual industries and particular commodities.

MACROECONOMICS: Macroeconomics is that branch of economic theory which deals with


the study of the economy in the aggregates with specific focus on unemployment, inflation,
unemployment, business cycles, growth, monetary and physical policies.
DISTINCTION BETWEEN Macroeconomics
MICROECONOMICS AND
MACROECONOMICS Microeconomics

1- Microeconomics is generally the study of 1- Macroeconomics looks at higher up


individuals and business decisions. country and government decisions.
2- Microeconomics is the study of decisions 2- Macroeconomics, on the other hand, is
that people and businesses make regarding the field of economics that studies the
the allocation of resources and prices of behavior of the economy as a whole and not
goods and services. just on specific companies, but entire
3- Microeconomics focuses on supply and industries and economies.
demand and other forces that determine the 3- This looks at economy-wide phenomena,
price levels seen in the economy. For such as Gross National Product (GDP) and
example, microeconomics would look at how it is affected by changes in
how a specific company could maximize its unemployment, national income, rate of
production and capacity so it could lower growth, and price levels. For example,
prices and better compete in its industry. macroeconomics would look at how an
increase/decrease in net exports would
4- The bottom line is that microeconomics affect a nation's capital account or how GDP
takes a bottoms-up approach to analyzing would be affected by unemployment rate.
the economy 4- Macroeconomics takes a top-down
approach.

MANAGERIAL ECONOMICS: Managerial economics helps in decision-making as it


involves logical thinking. Moreover, by studying simple models, managers can deal with more
complex and practical situations.

CHARACTERISTICS OF MANAGERIAL ECONOMICS

i. Managerial Economics is micro-economic in character.


ii. Managerial Economics largely uses that body of economic concepts and principles, which is
known as 'Theory of the firm' or 'Economics of the firm'.
iii. Managerial Economics is pragmatic.
iv. Managerial Economics belongs to normative economics rather than positive economics (also
sometimes known as Descriptive Economics).
Nature Of Managerial Economics:

1. Managerial economics is concerned with the analysis of finding optimal solutions to decision
making problems of businesses/
firms (micro economic in nature).
2. Managerial economics is a practical subject therefore it is pragmatic.
3. Managerial economics describes, what is the observed economic phenomenon (positive
economics) and prescribes what ought to be (normative economics)
4. Managerial economics is based on strong economic concepts.(conceptual in nature)
5. Managerial economics analyses the problems of the firms in the perspective of the economy as
a whole ( macro in nature)
6. It helps to find optimal solution to the business problems (problem solving)

BASIC ECONOMIC CONCEPTS IN MANAGERIAL ECONOMICS:

It is useful and essential for better results to identify and understand the basic concepts. These
concepts or principles constitute the most significant contribution of economics to managerial
economics. The basic concepts or principles are as under:
I. Opportunity cost
II. Incremental principle
III. Principle of the time perspective
IV. Discounting principle
V. Equi-marginal principle
Opportunity Cost: - By the opportunity cost of a decision is meant the sacrifice of
alternatives required by that decision.

Ex. The opportunity cost of holding Rs. 1000 as cash in hand for one year is the 10% rate of
interest, which would have been earned had the money been kept as fixed deposit in bank.

Incremental principle: - It is related to the marginal cost and marginal revenues, for
economic theory. Incremental concept involves estimating the impact of decision alternatives on
costs and revenue, emphasizing the changes in total cost and total revenue resulting from
changes in prices, products, procedures, investments or whatever may be at stake in the
decisions.
Principle of the time perspective: - Managerial economists are also concerned with the short
run and the long run effects of decisions on revenues as well as costs.

The very important problem in decision making is to maintain the right balance between the long
run and short run considerations.

Discounting principle: - One of the fundamental ideas in Economics is that a rupee tomorrow
is worth less than a rupee today. Suppose a person is offered a choice to make between a gift of
Rs.100/- today or Rs.100/- next year. Naturally he will choose Rs.100/- today.
Equi-marginal principle: - This principle deals with the allocation of an available resource
among the alternative activities. According to this principle, an input should be so allocated that
the value added by the last unit is the same in all cases.

CONCEPTS, DECISION AREAS & OPTIMUM SOLUTIONS IN ME

The production department, marketing and sales department and the finance department usually
handle these types of decisions.

The scope of managerial economics covers two areas of decision making


a. Operational or Internal issues
b. Environmental or External issues

a. Operational issues:
Operational issues refer to those, which wise within the business organization and they
are under the control of the management. Those are:
1. Theory of demand and Demand Forecasting
2. Pricing and Competitive strategy
3. Production cost analysis
4. Resource allocation
5. Profit analysis
6. Capital or Investment analysis
7. Strategic planning
1. Demand Analyses and Forecasting:
A firm can survive only if it is able to the demand for its product at the right time, within the
right quantity. Understanding the basic concepts of demand is essential for demand forecasting.
Demand analysis should be a basic activity of the firm because many of the other activities of the
firms depend upon the outcome of the demand forecast. Demand analysis provides:
1. The basis for analyzing market influences on the firms; products and thus helps in the
adaptation to those influences.
2. Demand analysis also highlights for factors, which influence the demand for a product. This
helps to manipulate demand. Thus demand analysis studies not only the price elasticity but also
income elasticity, cross elasticity as well as the influence of advertising expenditure with the
advent of computers, demand forecasting has become an increasingly important function of
managerial economics.
2. Pricing and competitive strategy:
Pricing decisions have been always within the preview of managerial economics. Pricing policies
are merely a subset of broader class of managerial economic problems. Price theory helps to
explain how prices are determined under different types of market conditions. Competitions
analysis includes the anticipation of the response of competitions the firms pricing, advertising
and marketing strategies. Product line pricing and price forecasting occupy an important place
here.
3. Production and cost analysis:
Production analysis is in physical terms. While the cost analysis is in monetary terms cost
concepts and classifications, cost-out-put relationships, economies and diseconomies of scale and
production functions are some of the points constituting cost and production analysis.
4. Resource Allocation:
Managerial Economics is the traditional economic theory that is concerned with the problem of
optimum allocation of scarce resources. Marginal analysis is applied to the problem of
determining the level of output, which maximizes profit. In this respect linear programming
techniques has been used to solve optimization problems. In fact lines programming is one of the
most practical and powerful managerial decision making tools currently available.
5. Profit analysis:
Profit making is the major goal of firms. There are several constraints here an account of
competition from other products, changing input prices and changing business environment
hence in spite of careful planning, there is always certain risk involved. Managerial economics
deals with techniques of averting of minimizing risks. Profit theory guides in the measurement
and management of profit, in calculating the pure return on capital, besides future profit
planning.
6. Capital or investment analyses:
Capital is the foundation of business. Lack of capital may result in small size of operations.
Availability of capital from various sources like equity capital, institutional finance etc. may help
to undertake large-scale operations. Hence efficient allocation and management of capital is one
of the most important tasks of the managers. The major issues related to capital analysis are:
1. The choice of investment project
2. Evaluation of the efficiency of capital
3. Most efficient allocation of capital
Knowledge of capital theory can help very much in taking investment decisions. This involves,
capital budgeting, feasibility studies, analysis of cost of capital etc.
7. Strategic planning:
Strategic planning provides management with a framework on which long-term decisions can be
made which has an impact on the behavior of the firm. The firm sets certain long-term goals and
objectives and selects the strategies to achieve the same. Strategic planning is now a new
addition to the scope of managerial economics with the emergence of multinational corporations.
The perspective of strategic planning is global.
It is in contrast to project planning which focuses on a specific project or activity. In fact the
integration of managerial economics and strategic planning has given rise to be new area of
study called corporate economics.

B. Environmental or External Issues:


An environmental issue in managerial economics refers to the general business environment in
which the firm operates. They refer to general economic, social and political atmosphere within
which the firm operates. A study of economic environment should include:
a. The type of economic system in the country.
b. The general trends in production, employment, income, prices, saving and investment.
c. Trends in the working of financial institutions like banks, financial corporations, insurance
companies
d. Magnitude and trends in foreign trade;
e. Trends in labor and capital markets;
f. Governments economic policies viz. industrial policy monetary policy, fiscal policy, price
policy etc.
The social environment refers to social structure as well as social organization like trade unions,
consumers co-operative etc. The Political environment refers to the nature of state activity,
chiefly states attitude towards private business, political stability etc. The environmental issues
highlight the social objective of a firm i.e.; the firm owes a responsibility to the society. Private
gains of the firm alone cannot be the goal. The environmental or external issues relate
managerial economics to macro-economic theory while operational issues relate the scope to
micro economic theory. The scope of managerial economics is ever widening with the dynamic
role of big firms in a society

DEMAND:Demand for a commodity refers to the quantity of the commodity which is


individual consumer or household is willing to purchase a particular price.
A product or service is said to have demand when three conditions are satisfied.
1. Desire of the customer to buy the product
2. His willingness to buy the product,&
3. Ability to pay the specified price for it.

Types of demand:
1. Demand for consumer goods vs producer goods: the different in these two types of demand
are that consumer goods are needed for direct consumption, while the producer goods are needed
for producing other goods. soft drink, milk, bread etc are the examples of consumer goods, while
the various types of machine, tools etc.
2. Autonomous demand vs derived demand: Autonomous demand refers to the demand for
products and services directly. The demand for the services of a super specialty hospital can be
considered as autonomous whereas the demand for the hotels around the hospital is called a
derived demand.
3. Demand for durable goods vs perishable goods: Here the demand for goods is classified
based on their durability. Durable goods are these goods which gives services relatively for a
long period. The use of perishable goods is very less may be in hours or days. Durable goods
meet the both the current as well as future demand, whereas perishable goods meet only the
current demand.
Example of perishable goods: milk, vegetables, fish etc
Example of durable goods: rice, wheat, sugar etc.
4. Firm demand vs industry demand:the firm is a single business unit whereas industry refers
to the group of firm carrying on similar activity.
The quantity of goods demanded by single is called firm demand and the quantity demanded by
industry as a whole is called industry demand.
5. Short run demand vs long run demand :The short run and long run cannot be clearly
defined other than in terms of duration of time. The demand for particular product /service in a
given region for a particular day can be viewed as long run demand.
6. New demand vs replacement demand: new demand refers to the demand of the new
products and it is the addition to the existing stock. In replacement demand, the item is purchased
to maintain the asset in good condition. The demand for cars in new demand and the demand
spare parts is replacement demand. Replacement demand may also refer to the demand resulting
out of replacing the existing assets with the new ones.
7. Totalmarket vs segment market demand:let us takethe consumption of sugar in a given
region. The total demand for sugar in the region is the total market demand. The demand for the
sugar from the sweet making industry from this region is the segment market demand. The
aggregate demand for all the segment market is called the total market demand.

FACTORS AFFECTING DEMAND/DEMAND DETERMINANTS:


There are factors on which the demand for a commodity depends. These factors are economic,
social as well as political factors. The effect of all the factors on the amount demanded for the
commodity is called Demand Function.
These factors are as follows:
1.Price of the Commodity:
The most important factor-affecting amount demanded is the price of the commodity. The
amount of a commodity demanded at a particular price is more properly called price demand.
The relation between price and demand is called the Law of Demand. It is not only the existing
price but also the expected changes in price, which affect demand.
2.Income of the Consumer:
The second most important factor influencing demand is consumer income. In fact, we can
establish a relation between the consumer income and the demand at different levels of income,
price and other things remaining the same. The demand for a normal commodity goes up when
income rises and falls down when income falls. But in case of Giffen goods the relationship is
the opposite.
3.Prices of related goods:
The demand for a commodity is also affected by the changes in prices of the related goods also.
Related goods can be of two types:
(i). Substitutes which can replace each other in use; for example, tea and coffee are substitutes.
The change in price of a substitute has effect on a commoditys demand in the same direction in
which price changes. The rise in price of coffee shall raise the demand for tea;
(ii). Complementary foods are those which are jointly demanded, such as pen and ink. In such
cases complementary goods have opposite relationship between price of one commodity and the
amount demanded for the other. If the price of pens goes up, their demand is less as a result of
which the demand for ink is also less. The price and demand go in opposite direction. The effect
of changes in price of a commodity on amounts demanded of related commodities is called Cross
Demand.
4.Tastes of the Consumers:
The amount demanded also depends on consumers taste. Tastes include fashion, habit, customs,
etc. A consumers taste is also affected by advertisement. If the taste for a commodity goes up,
its amount demanded is more even at the same price. This is called increase in demand. The
opposite is called decrease in demand.
5. Wealth:
The amount demanded of commodity is also affected by the amount of wealth as well as its
distribution. The wealthier are the people; higher is the demand for normal commodities. If
wealth is more equally distributed, the demand for necessaries and comforts is more. On the
other hand, if some people are rich, while the majorities are poor, the demand for luxuries is
generally higher.
6. Population:
Increase in population increases demand for necessaries of life. The composition of population
also affects demand. Composition of population means the proportion of young and old and
children as well as the ratio of men to women. A change in composition of population has an
effect on the nature of demand for different commodities.
7. Government Policy:
Government policy affects the demands for commodities through taxation. Taxing a commodity
increases its price and the demand goes down. Similarly, financial help from the government
increases the demand for a commodity while lowering its price.
8. Expectations regarding the future:
If consumers expect changes in price of commodity in future, they will change the demand at
present even when the present price remains the same. Similarly, if consumers expect their
incomes to rise in the near future they may increase the demand for a commodity just now.
9. Climate and weather:
The climate of an area and the weather prevailing there has a decisive effect on consumers
demand. In cold areas woolen cloth is demanded. During hot summer days, ice is very much in
demand. On a rainy day, ice cream is not so much demanded.
10. State of business:
The level of demand for different commodities also depends upon the business conditions in the
country. If the country is passing through boom conditions, there will be a marked increase in
demand. On the other hand, the level of demand goes down during depression.

LAW OF DEMAND
Law of demand shows the relation between p rice and quantity demanded of a commodity in the
market. In the words of Marshall , the Amount demand increases with a fall in price and
diminishes with a rise in price.
A rise in the price of a commodity is followed by a reduction in demand and a fall in price is
followed by an increase in demand, if a condition of demand remains constant.
The law of demand may be explained with the help of the following demand schedule.
Demand Schedule.

Price of Appel (In. Rs.) Qua ntity Demanded

10 1

8 2

6 3

4 4

2 5

When t he price falls from Rs. 10 to 8 quantity de mand increases from 1 to 2. I n the same w ay
as pri e falls, q uantity de mand incr eases on t he basis of the de mand schedul e we can dr aw
the de mand curve .

Assumptions:
Law is demand is based on certain assumptions:
1. This is no change in consumers taste and preferences.
2. Income should remain constant.
3. Prices of other goods should not change.
4. There should be no substitute for the commodity
5. The commodity should not confer at any distinction
6. The demand for the commodity should be continuous.
7. People should not expect any change in the price of the commodity
Exceptional demand curve:
Sometimes the demand curve slopes upwards from left to right. In this case the demand curve
has a positive slope.

When price increases from OP to Op1 quantity demanded also increases from to OQ1 and vice
versa. The reasons f or exceptional demand curve are as follows.

1. Giffen paradox :
The Giffen good or inferior good is an exception to the law of demand. When the price of an
inferior good falls, the poor will buy less an d vice versa. For example, when the price of maize
falls, the poor are willing to spend m ore on superior good s than on maize if the p rice of maize
increases, he has to increase the quantity of money spent on it. Otherwise he will have to face
starvation. Thus a f all in price is followed by reduction in quantity demanded and vice versa.
Giffen first explained this and therefore it is called as Giffens paradox

2. Veblen or Demonstration effect:


Veblan has explained the exceptional demand curve through his doctrine of conspicuous
consumption. Rich people buy certain good because it gives social distinction or prestige for
example diamonds are bought by the richer class for the prestige it possess. It the price of
diamonds falls poor also will buy is hence they will not give prestige. Therefore, rich people may
stop buying this commodity.

3. Ignorance:
Sometimes, the quality of the commodity is Judge by its price. Consumers think that the product
is superior if the price is high. As such they buy more at a higher price.

4. Speculative effect:
If the price of the commodity is increasing the consumers will buy more of it because of the fear
that it increase still further, Thus, an increase in price may not be accomplished by a decrease in
demand.

5. Fear of shortage:
During the times of emergency of war People may expect shortage of a commodity. At that time,
they may buy more at a higher price to keep stocks for the future.
5. Necessaries:
In the case of necessaries like rice, vegetables etc. people buy more even at a higher price.
ELASTICITY OF DEMAND

Elasticity of demand: Elasticity of demand is a quantitative relative measurement of the change


in demand on account of a given change in demand determinants.
Elasticity of demand explains the relationship between a change in price and consequent change
in amount demanded. Marshall introduced the concept of elasticity of demand. Elasticity of
demand shows the extent of change in quantity demanded to a change in price.Elastic demand:
A small change in price may lead to a great change in quantity demanded. In this case, demand is
elastic.
In-elastic demand: If a big change in price is followed by a small change in demanded then the
demand in inelastic.

Types of Elasticity of Demand:


There are four types of elasticity of demand:
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand
4. Advertisement elasticity of demand

1. Price elasticity of demand:


Marshall was the first economist to define price elasticity of demand. Price elasticity of demand
measures changes in quantity demand to a change in Price. Price elasticityis always negative
which indicates that the consumer buy more with every fall in the price.It is the ratio of
percentage change in quantity demanded to a percentage change in price.

(Q2-Q1)/Q1
Edp= ---------------
(P2-P1)/p1
Where
Q1=Quantity demanded before price change
Q2=Quantity demanded after price change
P1=price before change
P2=price after change
There are five cases/measurements of price elasticity of demand
A. Perfectly elastic demand :when any quantity can be sold at a given price, and when
there is no need to reduce price, the demand is said to be perfectly elastic.

Figure reveals that the quantity demanded increases from 0Q to 0Q1, from 0q1 to 0Q2 even
though there is no change in price. Price is fixed at 0P.

B. Perfectly Inelastic Demand


The demand is said to be perfectly inelastic when there is no change in the quantity demanded
even though there is a big change in price.

When price increases from O P to OP, the quantity demanded remain s the same. In other
words the response of demand to a change in Price is nil. In this ca se E=0.

C. Relatively elastic demand:


Demand changes more than proportionately to a change in p rice. i.e. a small change in price
loads to a very big change in the quantity demanded. In this case E > 1. This demand curve will
be flatter
When price falls from OP to OP, amount demanded increase from OQ to OQ1 which is
larger than the change in price.

D. Relatively in-elastic demand.


Quantity demanded changes less than proportional to a change in price. A large change in price
leads to s mall change in amount demanded. Here E < 1. Demanded curve will be steeper.

When price falls from OP to OP1 amount demanded increases from OQ to OQ1, which is
smaller than the change in price.

E. Unit elasticity of demand:


The change in demand is exactly equal to the change in price. When both are equal E=1 and
elasticity if said to b e unitary.

When price falls from OP to OP1, quantity demanded increases from OQ to OQ1. Thus a
change in price has resulted in an equal change in quantity demanded so price elasticity of
demand is equal t o unity.
2. Income elasticity of demand:
Income elasticity o f demand shows the change in quantity demanded as a result of a change in
income. Income elasticity is normally positive, which indicates that the consumer tends to buy
more and more with every increase in income. Income elasticity of demand may be slated in t he
form of a formula.

(Q2-Q1 )/Q1
Edi= ---------------
(I2-I1 )/I1

Income elasticity of demand can be classified in to five types.

A. Zero income elasticity:


Quantity demanded remains the same, even though money income increases.
Symbolically, it can be expressed as Ey= 0. It can be depicted in the following way:

As income increase s from OY to OY1, quantity demanded never changes.

B. Negative Income elasticity:


When income increases, quantity demanded falls . In this case, income elasticity of demand is
negative. i.e., Ey< 0.
When income increases from OY to OY1, demand falls from O Q to OQ1.

C. Unit income elasticity:


When a n increase in income brings about a proportionate increase in quantity demanded, and
then income elasticity of demand is equal to o ne. Ey = 1
When income increases from OY to OY1, Quantity demanded also increases from O Q to OQ1.

D. Income elasticity greater than unity:


In this case, an increase income bring s about a more than proportion ate increase in quantity
demanded. Symbolically it can be written as Ey> 1.

It shows high-income elasticity of demand. When income increases from OY to OY1, Quantity
demanded increases from OQ to O Q1.

E. Income elasticity leas than unity:


When income increases quantity demanded also increases but less than proportionately. In this
case E < 1

An increase in income from OY to OY, brings what an increase in quantity demanded from OQ
to OQ1, But the increase in quantity demanded is smaller than the increase in income. Hence,
income elasticity of demand is less than one.

3. Cross elasticity of Demand:


A change in the price of one commodity leads to a change in the quantity demanded of another
commodity. This is called a cross elasticity of demand. The formula for cross elasticity of
demand is:
(Q2-Q1)/Q1
Edc= ----------- ----
(P2Y-P1Y)/P1Y
a.In case of substitutes, cross elasticity of demand is positive. Eg: Coffee and Tea When t he
price of coffee increases, Quantity demanded o f tea increases. Both are substitutes.

B .In case of compliments, cross elasticity is negative. If increase in the price of one commodity
leads t o a decrease in the quantity demanded of another and vice versa.

When p rice of car goes up from OP to O P!, the quantity demanded of petrol decreases from OQ
to OQ!. T he cross-demanded curve has negative slop e.

c. In case of unrelated commodities, cross elasticity of demanded is zero. A change in the p


rice of one commodity will not affect the quantity demanded of another.
4. Advertising elasticity of demand: It refers to increase in the sales revenue because of
change in the Advertising expenditure. Advertising elasticity is always positive

(Q2-Q1)/Q1
Eda= ------------------
(A2-A1)/A1

Factors influencing the elasticity of demand

Elasticity of demand depends on many factors.


1. Nature of commodity:
Elasticity or in-elasticity of demand depends on the nature of the commodity i.e. whether a
commodity is a necessity, comfort or luxury, normally; the demand for Necessaries like salt, rice
etc is inelastic. On the other band, the demand for comforts and luxuries is elastic.

2. Availability of substitutes:
Elasticity of demand depends on availability or non-availability of substitutes. In case of
commodities, which have substitutes, demand is elastic, but in case of commodities, which have
no substitutes, demand is in elastic.

3. Variety of uses:
If a commodity can be used for several purposes, than it will have elastic demand. i.e. electricity.
On the other hand, demanded is inelastic for commodities, which can be put to only one use.

4. Postponement of demand:
If the consumption of a commodity can be postponed, than it will have elastic demand. On the
contrary, if the demand for a commodity cannot be postpones, than demand is in elastic. The
demand for rice or medicine cannot be postponed, while the demand for Cycle or umbrella can
be postponed.

5. Amount of money spent:


Elasticity of demand depends on the amount of money spent on the commodity. If the consumer
spends a smaller for example a consumer spends a little amount on salt and matchboxes. Even
when price of salt or matchbox goes up, demanded will not fall. Therefore, demand is in case of
clothing a consumer spends a large proportion of his income and an increase in price will reduce
his demand for clothing. So the demand is elastic.
6. Time:
Elasticity of demand varies with time. Generally, demand is inelastic during short period and
elastic during the long period. Demand is inelastic during short period because the consumers do
not have enough time to know about the change is price. Even if they are aware of the price
change, they may not immediately switch over to a new commodity, as they are accustomed to
the old commodity.

7. Range of Prices:
Range of prices exerts an important influence on elasticity of demand. At a very high price,
demand is inelastic because a slight fall in price will not induce the people buy more. Similarly at
a low price also demand is inelastic. This is because at a low price all those who want to buy the
commodity would have bought it and a further fall in price will not increase the demand.
Therefore, elasticity is low at very him and very low prices.

Importance of Elasticity of Demand:

The concept of elasticity of demand is of much practical importance.

1. Price fixation:
Each seller under monopoly and imperfect competition has to take into account elasticity of
demand while fixing the price for his product. If the demand for the product is inelastic, he can
fix a higher price.

2. Production:
Producers generally decide their production level on the basis of demand for the product. Hence
elasticity of demand helps the producers to take correct decision regarding the level of cut put to
be produced.

3. Distribution:
Elasticity of demand also helps in the determination of rewards for factors of production. For
example, if the demand for labour is inelastic, trade unions will be successful in raising wages. It
is applicable to other factors of production.

4. International Trade:
Elasticity of demand helps in finding out the terms of trade between two countries. Terms of
trade refers to the rate at which domestic commodity is exchanged for foreign commodities.
Terms of trade depends upon the elasticity of demand of the two countries for each other goods.
5. Public Finance:
Elasticity of demand helps the government in formulating tax policies. For example, for
imposing tax on a commodity, the Finance Minister has to take into account the elasticity of
demand.

6. Nationalization:
The concept of elasticity of demand enables the government to decide about nationalization of
industries.

SUPPLY
Supply of a commodity refers to the various quantities of the commodity which a seller is willing
and able to sell at different prices in a given market at a point of time, other things remaining the
same. Supply is what the seller is able and willing to offer for sale. The Quantity supplied is the
amount of a particular commodity that a firm is willing and able to offer for sale at a particular
price during a given time period.
Supply Schedule: is a table showing how much of a commodity, firms can sell at different
prices.
Law of Supply: is the relationship between price of the commodity and quantity of that
commodity supplied. i.e. an increase in price will lead to an increase in quantity supplied and
vice versa.
Supply Curve: A graphical representation of how much of a commodity a firm sells at different
prices. The supply curve is upward sloping from left to right. Therefore the price elasticity of
supply will be positive. Graph - Supply curve

Determinants Of Supply:
1. The cost of factors of production: Cost depends on the price of factors. Increase in factor
cost increases the cost of production, and reduces supply.
2. The state of technology: Use of advanced technology increases productivity of the
organization and increases its supply.
3. External factors: External factors like weather influence the supply. If there is a flood,
this reduces supply of various agricultural products.
4. Tax and subsidy: Increase in government subsidies results in more production and higher
supply.
5. Transport: Better transport facilities will increase the supply.
6. Price: If the prices are high, the sellers are willing to supply more goods
to increase their profit.
7. Price of other goods: The price of other goods is more than X then the
supply of X will be increased.
Elasticity of Supply: Elasticity of supply of a commodity is defined as the responsiveness of a
quantity supplied to a unit change in price of that commodity.
Qs / Qs
Es = ------------
P /P

Qs = change in quantity supplied


Qs = quantity supplied
P = change in price
P = price

Factors Influencing Elasticity Of Supply


1. Nature of the commodity: If the commodity is perishable in nature then the elasticity of
supply will be less. Durable goods have high elasticity of supply.

2. Time period: If the operational time period is short then supply is inelastic. When the the
production process period is longer the elasticity of supply will be relatively elastic.

3. Scale of production: Small scale producers supply is inelastic in nature compared to the
large producers.

4. Size of the firm and number of products: If the firm is a large scale industry and has more
variety of products then it can easily transfer the resources. Therefore supply of such
products is highly elastic.

5. Natural factors: Natural calamities can affect the production of agricultural products so
they are relatively inelastic.

6. Nature of production: If the commodities need more workmanship, or for artistic goods
the elasticity of supply will be high.

Why Demand Curve Slpes Dowmward?


Price has inverse relationship with demand leads the demand curve to slope downwards. The
demand and supply curves are graphical expressions of the behaviors of a market following
individual demands.
The mangers use the demand graph to measure demand schedules and future consumption
patterns in a competitive market. When they intersect the demand graph with a supply graph,
they find equilibrium price on which equilibrium supply can maximize the profits. We know
consumers are ready to pay equilibrium price for equilibrium supply which can be produced
without any surplus or shortage.

The obvious reason behind demand graph sloping downward is inverse relation between demand
and price. The price is displayed at Y-axis and demand at X-axis. When we draw a demand
graph we show that consumers purchase more on decrease in price less on increase. Besides this
basic assumption, the economists agree on some other reasons as well which force the demand
curve to slope downwards including income effect, substitution effect, number of consumers,
law of diminishing marginal utility and multiple uses of goods.

Income Effect

With decrease in price of a product the consumers can purchase more goods. Whatever money he
saves from purchase of that particular good is considered an increase in his real income. This
adds up to his purchasing power as well. Now he can buy more quantity of the same product or
allocate than he was used to do previously. When price of a product increases, the real income of
the consumers decreases and they will purchase less of its less quantity. This phenomenon is
called income effect and when we put it in graphical expression we find demand curve slopping
downwards. J.R. Hicks and Allen support this point of view.

Substitution Effect

When price of a product decrease the consumers shift their resources to this product. This results
in less consumption of the price substitutes. This phenomenon is called as substitution effect.
J.R. Hicks, Allen and other modern economists take substitution effect as one of the reasons
behind demand curve slopping downwards.
Number of Consumers

When price of a product goes down the number of consumers of that product rises. Similarly,
when price of a product goes up, the consumers shift towards cheaper substitutes. The number of
consumers impacts the demand graph and make curve slope downwards.

Law of Diminishing Marginal Utility

Consumption of products provides satisfaction. However, this satisfaction or utility decreases


with every next unit of item to be consumed. It is called law of diminishing marginal utility.

To simplify the idea suppose you are fasting. In the evening when you take first sip of water it is
the most satisfying. However, every next sip loses its utility and after taking a couple of glasses
of water you no more need water. Eventually, the utility falls to zero.

Talking in terms of price, if you have to pay from 1-10 dollars for every sip of water as a unit
you will be ready to pay $10.00 for the first sip. However, as you continue drinking more water,
a time will come when you will not be ready to pay a single penny for the next sip. The utility of
water diminishes with every sip.

Due to the phenomenon of law of diminishing marginal utility, the demand curve slopes
downwards.

Multiple Uses of Goods

Some economists suggest that if a product has many uses and its price falls down, the consumers
shall continue to purchase more of that product for other uses besides the basic one. It has been
observed that when subsidy is offered on flour in Pakistan, the consumers continue purchasing it
their basic needs are satisfied. They purchase it to replace a bit costlier fodder for animals. This
kind of attitude shows that when price decreases, the people purchase more of that product not
only for their own consumption but also for other uses

Why do supply curves slope upwards?


There are a number of explanations of this relationship, including the law of diminishing
marginal returns.

The Law of diminishing returns

The law of diminishing marginal returns explains what happens to the output of products when a
firm uses more variable inputs while keeping a least one factor of production fixed. Real capital,
such as buildings, machinery, and equipment, is usually the factor kept fixed when
demonstrating this principle.

Economic theory predicts that, when employing these extra variable factors, such as labour,
the marginal returns (additional output) from each extra unit of input will eventually diminish.
Take, for example, a hypothetical firm that has a factory in which computers are assembled. The
machinery is fixed, and extra workers can be hired to increase the output of assembled
computers. At first, the addition of extra workers creates a significant benefit because it becomes
possible to divide up the labour, and for workers to specialise in undertaking one task. Initially,
there are increasing marginal returns to each additional worker.

However, marginal returns will eventually fall because the opportunity to divide labour and to
specialise must eventually dry up. Gradually, each additional worker contributes less than the
one before so that total output of computers continues to rise, but at a decreasing rate. The falling
marginal returns from each successive worker leads to a rise in the cost of using them.

Diminishing returns and increasing costs

Firms need to sell their extra output at a higher price so that they can pay the highermarginal cost
of production. Hence, decisions to supply are largely determined by the marginal cost of
production. The supply curve slopes upward, reflecting the higher price needed to cover the
higher marginal cost of production. The higher marginal cost arises because of diminishing
marginal returns to the variable factors.

Shifts in Demand:
Shift of the demand curve occurs when the determinants of demand change. When tastes and
preferences and incomes are altered, the basic relationship between price and quantity demanded
changes (shifts). This shifts the entire demand curve upward (rightward) and is called as increase
in demand because more of that commodity is demanded at that price. The downward shift
(leftward) is called as decrease in demand. The new demand curves D1D1 and D0D0 can be seen
in the Graph below.

Therefore we understand that a shift in a demand curve may happen due to the changes in the
variables other than price. The movement along a demand curve takes place (extension or
contraction) due to price rise or fall.

Extension And Contraction Of Demand Curve:


When with a fall in price, more of a commodity is bought , then there is an extension of the
demand curve. When lesser quantity is demanded with a rise in price, there is a contraction of
demand
From the above graph we can understand that an increase in prices result in the contraction of
demand. If the price increases from P2 to P then the demand for the commodity fall from OQ2 to
OQ. Therefore the demand curve DD contracts from b to a on the other hand when there is a
fall in price, it results in the extension of demand. Let us assume that the price falls from P2 to
P1 then the quantity demanded OQ2 increases to OQ1 and the demand curve extends from point
b to c

DEMAND FUNCTION

Demand function is a function that describe how much of a commodity will be purchased at the
prevailing prices of that commodity and related commodities, alternative income levels, and
alternative values of other variables affecting demand.
A change in demand occurs when one or more of the determinants of demand change and it is
expressed in the following equation.

Qd X = f (Px, Pr, Y, T, Ey, Ep, Adv.)


Where,
Qd X = quantity demanded of good X
Px = the price of good X
Pr = the price of a related good
Y = income level of the consumer
T = taste and preference of the consumers
Ey = expected income
Ep = expected price
Adv = advertisement cost

The above mentioned demand function expresses the relationship between the demand and other
factors. The quantity demanded of commodity X varies according to the price of commodity
(Px), income (Y), the price of a related commodity (Pr), taste and preference of the consumers
(T), expected income (Ey) and advertisement cost(Adv) spent by the organization.