Notes By: Ms.

Shweta Bhatia

NATURE AND SCOPE OF ECONOMICS

The term economics is derived from two words of Greek language, namely, Oikos (Household) and Nemein (to manage), meaning thereby Household Management. Definition of Economics It is difficult to give an accurate definition of economics. It has constantly been in the process of development. In order to facilitate the study of Economics, its definitions have been broadly classified into four parts: a) Wealth Definition: By Adam Smith b) Welfare Definition: By Marshall c) Scarcity Definition: By Robbins d) Growth Definition: By Samuelson

a) Wealth Definition
Economics is an enquiry into the nature and causes of wealth of Nations. By adam Smith Features i) Economics is a study of Wealth only: According to Adam Smith, the purpose of the study of economics is to increase the wealth of the nation. Its study includes the consumption, production, exchange and distribution of wealth. ii) Nature of Wealth: The term wealth here is used to signify those material goods, which are scarce. Material goods are those, which can be seen or touched. iii) Causes of Wealth: According to this definition, Economics seeks to investigate the causes that lead to increase of wealth.

b) Welfare Definition: In the words of Marshall, economics is a study of

mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of material requisites of well being. Features i) Importance to study of Man: This definition has accorded more importance to the study of man than to wealth. ii) Ordinary business of Life: By this, Marshall means those economic activities of a man that are mostly concerned with wealth-getting and wealth-spending. iii) Study of real man: Economics doesnt study any selfish man. It studies the real man who believes in social welfare. iv) Material Requisites: The term wealth here is used to signify those material goods, which are scarce. Material goods are those, which can be seen or touched. iv) Welfare: Economics studies those material means, which promote human welfare. v) Money is the measure of material welfare: Material welfare is that part of social welfare that can be directly or indirectly measured by money.

Notes By: Ms. Shweta Bhatia

c) Scarcity Definition: According to Robbins, Economics is a science that

studies human behaviour as a relationship between ends and scarce means which have alternative uses. Features i) Unlimited wants or Ends: By ends Robbins means wants. In economics we study those wants of man, which are concerned with goods and services. These are Economics Wants. There is no limit to these wants. ii) Limited or Scarce Means: Most of the means satisfying economic wants are scarce. Means may be material goods or non-material services. Thus, wants are greater than means. iii) Alternative Uses of Means: Economic problem arises because these scarce means have alternative uses. iv) Wants differ in urgency: Man has several wants, but at any time one of these wants may be more urgent than other wants. v) Economic Problem: when all the above four characteristics of human life become operative, there arises the problem of choice. One has to make a choice as to which want be satisfied first and by which means. Problem of choice-making is called Economic Problem. vi) Opportunity Cost: it is due to the problem of choice that in order to fulfill one want we have to forego another. The opportunity cost of a thing is always expressed in terms of the next best alternative foregone.

d) Growth-Oriented Definition: In the words of Prof. Samuelson, Economics

is the study of how people and society end up choosing with or without the use of money, to employ scarce productive resources that could have alternative uses , it produces various commodities over time and distributes them for consumption , now or in the future, among various persons and groups in society. It analyses costs and benefits of improving patterns of resource allocation. Features i) Economic Resources: According to this definition, economics is a study of economic resources. Economic resources refer to natural, human, and physical resources, which satisfy human wants but are scarce and have alternative uses. ii) Efficient Allocation of Resources; Choice-Making is the main problem of economics. Efficient allocation and use are the chief objectives of choicemaking. iii) Full-Utilization of Resources: Economics is not concerned with the allocation of resources but also with their full use and employment. iv) Increase in resources: This definition also underlines the fact that the objective of economics is to increase the quantum and productivity of resources in future. This results in the growth of economy, more employment and higher standard of living. Conclusion: Different economists have given different definitions of economics and any single definition will be in adequate. Thus, picking up the term wealth from the definition of Adam Smith, welfare from that of Marshall, scarcity from that of Robbins and economic growth from that of Samuelson, an acceptable definition of economics can be constructed in these words. 2

Notes By: Ms. Shweta Bhatia Economics is a subject that studies those activities of man which are concerned with the maximum satisfaction of wants or with the promotion of welfare and economic growth by the efficient consumption, production and exchange of scarce means having alternative uses. MICRO ECONOMICS The term Micro has been borrowed from the Greek word, Micros meaning Small. According to Bilas, The term micro in economics means division into small parts of such economic variables as consumption, investment, saving etc. we also study group in it. Foreg. Market demand curve, which is the aggregate of individual demand curves, is also a subject of study of micro-economics but we do not study in it large or national-level groups. Definition In the words of Shapiro, Micro economics deals with the small parts of the economy. Scope of Micro Economics: Microeconomics deals with the following problems: 1) Theory of Demand: It studies how demand for a commodity is determined and what is the law of demand. It refers to the demand of the consumer and his maximum satisfaction. 2) Theory of Production: Under this theory one studies production function and the laws governing production of goods. 3) Theory of Price Determination: Besides analyzing the conditions of demand and supply, theory of price determination seeks to explain how the price of goods produced under different market conditions, such as, perfect market, monopoly etc is determined. 4) Theory of Factor Pricing: Income received by the sale of goods produced with the help of different factors of production, is distributed among these very factors in the form of factor-price, viz., rent, wages, interest and profit. 5) Optimum Allocation of Resources: Micro-Economics also studies the conditions necessary for achieving equilibrium, that is, how efficiently the resources are distributed among the consumers and producers. 6) Welfare Economics: It deals with the welfare of people as consumers and producers. FUNCTIONS OF MICRO-ECONOMICS The study of micro-economics lies in the following: 1) Operation of an Economy; Micro-Economics explains the functioning of an economy. It tells whether different constituents of the economy, namely, consumers, firms etc. are functioning efficiently or not. 2) Prediction: Predictions are based on the basis of the theories of microeconomics. For eg. If demand increases prices are also likely to increase. 3) Economic Policies: Study of micro-economics helps in the formulation of economic policies. We can analyze those policies which influence an economy. 3

Notes By: Ms. Shweta Bhatia 4) Economic Welfare: It informs us of the conditions of economic welfare. Study of micro-economics suggests how the welfare of an economy can be achieved. 5) Managerial Decisions; Business firms make use of micro-economics to take managerial decisions. They take these decisions on the basis of cost and demand analysis. Cardinal Utility Analysis According to this analysis utility can be measured in cardinal numbers like 1,2,3,4 etc. cardinal numbers are those numbers which can be added or subtracted. Fisher has used term util as a measure of utility. Want satisfying power of a good is called utility. Features: 1. Utility is subjective: A thing may have different utility for different persons i.e. peasants of Haryana get very little utility from coffee whereas peasants of Kerla derive lot of utility from its consumption. Utility is therefore subjective. 2. Utility is relative: Utility of a commodity never remains same. Coolers have utility in summer but not during the winter season. 3. Utility is not essentially useful: A commodity having utility need not to be useful. For example liquor is not useful but has utility for a drunkard. Concepts of utility: 1. Initial utility: The utility derived from the first unit of a commodity is called initial utility. It is always positive. 2. Total utility: The aggregates of utilities obtained from different units is called total utility. 3. Marginal utility: Marginal utility is also called additional utility. M.U. is net addition in total utility by consuming an extra unit. Marginal utility can be positive, negative and zero. Law of utility analysis: The founders of marginal utility analysis have developed two laws which occupy an important place in economic theory and have several applications and uses. These two laws are: 1. Law of diminishing marginal utility. 2. Law of equi. Marginal utility. Law of diminishing marginal utility Law of diminishing marginal utility is the foundation stone of utility analysis. According to Marshal, The additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has. Assumptions: 1. Utility can be measured in cardinal numbers. 2. Marginal utility of money remains constant. 3. Marginal utility of every commodity is independent. 4. There is continuous consumption of a commodity. 4

Notes By: Ms. Shweta Bhatia 5. No change in income of consumer. 6. No change in price of commodity and its substitute. 7. No change in taste fashions and habits. Explanation: Consider table in which we have presented the total and marginal utilities derived by a person from cups of tea consumed per day. Cups of tea consumed Total utility Marginal utility per day 1. 12 12 2. 22 10 3. 30 8 4. 36 6 5. 40 4 6. 42 2 7. 42 0 8. 40 -2 It is clear from the above table that as more and more units of tea are consumed, marginal utility from each successive unit goes on diminishing. At seventh cup marginal utility is zero and eight cup gives negative marginal utility. (A) Y T.U. O (B) Y +ve M.U. (zero) 0 1 2 3 4 5 6 7 MU 8 (-ve) Quantity 1 2 3 4 5 6 Quantity F G TU

In figure, A & B units of tea are shown on OX axis and total utility, marginal utility on OY axis. In figure A, curve TU represents total utility. It slope upwards up to point F. From point F to point G, TU is constant. After point G curve TU slops downwards. In figure B, curve MU represents marginal utility. It slope downwards from left to right. It shows that marginal utility of successive units goes on diminishing. Up to sixth unit MU is positive. At seventh unit MU curve touches OX axis means it is zero. In this situation TU is 5

Notes By: Ms. Shweta Bhatia maximum. After seventh unit MU intersects OX axis means here MU is negative. In this situation, TU begins to diminish. Exceptions: This law doesnt apply under the following situations. 1. Curious and rare things: Those persons who collect postage stamps, rare portraits, old and rare coins, etc, derive increasing marginal utility as the stock of these articles goes on increasing. So this law doesnt apply to rare and curious things. 2. Misers: This law doesnt apply to misers, who want to acquire more and more wealth. 3. Good book or poem: By reading a good book or listening a beautiful poem again and again, one gets more utility than before. So these are considered exceptions to this law. 4. Drunkards: In case of drunkards also this law does not apply. Causes of its application: Main causes of the application of the law of diminishing marginal utility are as under: 1. Commodities are imperfect substitutes: It means one commodity cannot always be used for another commodity. Thus, use of variable quantities of a commodity A with the fixed quantity of another commodity B, will cause the marginal utility of the additional units of commodity A to diminish. 2. Satiability of particular wants: There is hardly any particular want, which cannot be fully satisfied. Having reached the point of satiety, use of in more unit of the commodity will yield zero marginal utility. 3. Alternative uses: Each commodity has many alternative uses, some uses are more important while others is less. It is evident that as the quantity of a good go on increasing, it is put to less and less important use. Law of Equi-marginal utility Principle of equi. Marginal utility occupies an important place in utility analysis. It is through this principle that consumer equilibrium is explained. A consumer has given income, which he has to spent on various goods, he wants. Now the question is how he would allocate has income among various goods, that he would be in equilibrium position in respect of purchase of various goods. Consumer is assumed to be rational. Suppose there are only two goods X & Y on which a consumer has to spent a given income. The consumer behaviour will be governed by two factors. 1. Marginal utility of goods. 2. Price of two goods.

Notes By: Ms. Shweta Bhatia The law of equi. marginal utility states that consumer will distribute his money income between goods in such a say that utility derived from the last rupee spent on each good is equal. According to Samuelson, A consumer gets maximum satisfaction when the ratio of marginal utilities of all commodities and their price is equal. MUx / Px = MUy / Py = MUz / Pz If prices of commodities are equal then, MUx = MUy = MUz Assumptions: 1. Cardinal measurement of utility is possible. 2. Consumer is rational. 3. Price of commodities remains constant. 4. Income of consumer remains constant. 5. Marginal utility of money remains constant. Rupees spent 1. 2. 3. 4. 5. MU of X 12 10 8 6 4 MU of Y 10 8 6 4 2

Suppose income is rupees 5 only. He wants to spent it on X & Y. Let us suppose that price of both goods is rupee 1 per unit. He wants to allocate this income between X and Y in such a manner that his total utility is maximized. It is clear from table that MUX / PX = 8 utils, when consumer purchases 3 units of good X. MUy / Py is equals to 8 utils, when he purchase two units of good Y. There fore consumer will be in equilibrium when he is buying 3 units of X and 2 units of Y and will be spending rupees 5 on them. Thus in equilibrium position, MUx / Px = MUy / Py. Y (M.U. of x) 12 10 8 A Marging 6 B Utility Line 4 2 0 D C X 1 2 3 4 Rupee Spent 12 10 8 E F 6 Gain X 5 4 2 0 H G Loss 1 2 3 4 5 Rupee Spent Equi Y (M.U. of y)

Notes By: Ms. Shweta Bhatia Suppose consumer spends 1 rupee more on X and 1 rupee less on Y. By spending 1 rupee more on X he will gain 6 utils as shown by ABCD area. But by spending 1 rupee less on Y he will loose 8 utils as shown by EFGH area. So total utility is less by 2 utils as shown in figure. Criticism: 1. Consumer is not fully rational. 2. Cardinal measurement of utility is not possible. 3. Marginal utility of money changes. 4. Change in fashion, custom and habit. Indifference curve Analysis: The ordinal utility theory According to this analysis, utility cant be expressed in cardinal numbers because utility is a psychological feeling. This analysis has adopted the concept of ordinal utility, which is expressed in terms of first, second, third etc. What is an indifference curve? An indifference curve is a locus of all such points, which shows different combinations of two commodities, which yield equal satisfaction to the consumer. Combination of Good X Good Y Good X an Y A. 1 30 B. 2 24 C. 3 19 D. 4 15 E. 5 12 Y Units of good y B D E 0 1 2 3 4 I.C5 Units of good x C A

A table which lists all such combinations to which consumer are indifferent is known as indifference schedule. When these combinations are represented graphically and joined together with the help of a curve, we get an indifference curve. There are as many indifference curves as there are utility levels. The family of indifference curve is known as indifference map. In the indifference map a higher indifference curve refers to a higher level of utility.

Notes By: Ms. Shweta Bhatia Y Good y 1C1 X Good x In this figure points on IC2 represents more of one or both the goods X & Y compared to corresponding combinations on IC1. Marginal rate of substitution (MRSxy): MRS of X is defined as the amount of Y, the consumer is just willing to give up to get one more unit of X and maintain the same level of satisfaction. Combination of Good X an Y A. B. C. D. E. Good X 1 2 3 4 5 Good Y 30 24 19 15 12 MRSxy 6:1 5:1 4:1 3:1 1C3 1C2

Law of Diminishing Marginal of rate of Substitution According to this law, as a consumer gets more and more units of X, he will be willing to give up less and less units of Y. In other words, the marginal rate of substitution of X for Y will go on diminishing while the level of satisfaction remains the same. Above table shows that consumer will give up 6 units of good Y for getting second unit of good X, 5 units good Y for getting third unit of X and so on. In other words, MRSxy goes on diminishing. Assumptions of IC analysis: 1. Rational consumer: Consumer aims to get maximum satisfaction out of his total income so he will behave rationally. 2. Ordinal utility: Utility can be expressed in terms of ordinal numbers like first, second etc. 3. Diminishing MRS: IC analysis assumes that MRS diminishes. 4. Non-satiety: A bigger bundle is preferred to smaller bundle means consumer doesnt reach the level of satiety. He prefers more quantity of good to less quantity. 5. Consistency in selection: It means that if at any given time consumer prefers A combination to B, then at another time he will not prefer B to A combination. 9

Notes By: Ms. Shweta Bhatia 6. Transitivity: If consumer prefers A combination to B and B to C, he prefers A combination to C. Properties of IC: 1. IC is downward sloping: This property implies that IC has a negative slope means when the amount of one good in the combination is increase, the amount of other good is reduced. This must be so if the level of satisfaction is to remain the same on an IC. If an IC doesnt slope downwards then it can either be vertical, horizontal or upward sloping. A Good y B 1C

Good x 2. Convex to origin: An IC will be convex to origin this property is based on the law of diminishing marginal rate of substitution.

Good y

10
B

7 5 4 0 1
C D 1C

Diagram shows MRSxy is means as the consumer gets more and more of X as he parts with less and less units of Y. 3. Two IC never cuts each other: In figure IC1 & IC2 cuts each other at point C. But it is not possible. Take pt. A on IC2 & pt. B on IC1. Since an IC represents equal satisfaction so combination A & C on IC2 will give equal satisfaction likewise combination B & C will also give equal satisfaction because both lies on same IC that is IC1. If A=C And B=C Then A will be equal to B in terms of satisfaction. But it is not true, because A contains more of good Y while amount of good X is same in both combinations. C A IC2 B 10 IC
1

2 3 4 Good X diminishing it

Notes By: Ms. Shweta Bhatia Good y

Good x

4. Higher IC represents high level of satisfaction: It is clear from diagram that IC2 represents Higher level of satisfaction because combination B on IC2 represents more of X than point A on IC1.

Good y 5 A B IC1 O 5 Good X 10 IC2

Price line or budget line Understanding the concept of price line is essential for understanding the theory consumers equilibrium. The price line shows combinations of goods that can be purchased if the entire money income is spent. Income Good X Good Y 50 0 10 50 1 8 50 2 6 50 3 4 50 4 2 50 5 0 Suppose our consumer has got income of Rs. 50 to spend on goods X & Y. Let the price of good X is Rs. 10 per unit. And that of Y be Rs. 5 per unit. If the consumer spends his whole income on good X, he would buy 10 units of Y. If a straight line joining 5X & 10Y is drawn we get 11

Notes By: Ms. Shweta Bhatia price line. Consumer can buy other combinations also such as 10Y & 0X , 8Y & 11X, 6Y & 2X, 4Y & 3X. Now what happens to price line if either the price of goods changes or the income changes. 1. Due to change in price of one commodity: If income of consumer & price of one commodity (good Y) remains unchanged, price of other commodity (good X), changes than due to fall in price of X, PL shifts to PL. suppose price of good X rises, PL shifts to PL. Y Good y

Good x L X 2. Due to change in income:L consumers income increases but If L price of both goods X & Y remains unchanged, Price line shifts upward say PL and is parallel to original price line PL. This is because with increased income he will be able to purchase more of both X & Y. On the other hand if income of consumer decreases, price line shifts downward say PL but remains parallel to original price line PL. Y Good y P P P

L L L X Good Consumers equilibrium: A consumer Xshall be in equ. When he maximizes his utility. In other words where the IC and price line are tangent to each (their slopes are equal), the consumer will attain equilibrium. MRSxy = Px / Py Slope of IC = Slope of price line Y P C D E F O X IC4 IC3 G L IC2 IC1 12

Notes By: Ms. Shweta Bhatia Figure shows that E is equ. point having OX & OY of goods X & Y respectively. Any other point like C,D,F, G etc. cant be considered as optimum point because it lies in lower IC than IC3. fLAW OF DEMAND Meaning of demand: Demand refers to the quantities of a commodity that the consumers are able and willing to buy at each possible price during a given period of time. Demand in economics implies both the desire to purchase and the ability to pay for a good. Merely desire for a commodity doesnt constitute demand for it, if it is not backed by the ability to pay. Demand for a good is determined by several factors such as tastes of consumer, income of consumer, price of related goods, substitutes or complements. When there is change in any of these factors, demand of the consumer for a good also changes. Dx = f (Px, Py,Y, etc.) Dx = demand of good X Px = price of good X Py = price of related goods Y = consumers income Law of demand: This law of demand expresses the functional relationship between price and quality demanded. According to law of demand, other things being equal, if the price of a commodity falls, the quantity demanded for it will rise and if price of commodity rises, its Q.D. will decrease. So according to this law, there is negative relationship between price and Q.D., other things remains same. Assumptions: 1. There should be no change in the price of related goods. 2. There should be no change in the income of the consumer. 3. There should be no change in the tastes and preferences of consumer. 4. The consumer doesnt expect any change in the price of the commodity in the near future. The law of demand can be explained through a demand schedule and through a demand curve. Demand schedule: Demand schedule is table that shows different prices of a good and the quantity of that good demanded at each of these prices. It has two aspects. 1. Individual demand schedule: it shows different amount of the commodity that a individual consumer is ready to buy at different possible prices.

13

Notes By: Ms. Shweta Bhatia 2. Market demand schedule: Market demand schedule shows the different amount of the commodity which all consumers are ready to buy at different prices. Demand curve: Demand curve is a graphical representation of demand schedule it can be two types: 1. Individual demand curve: It refers to demand for a commodity by an individual in the market. Y D

Price O D X Q.D The demand curve slopes downwards from left to right, meaning thereby that when price is high demand is low and when price is low, demand is high. 2. Market demand curve: It refers to demand for a commodity by all consumers in the market. Consumer A Consumer B Market demand (A+B) Y Y Y P Price P1 11 O X Q Q1
DA

P P1 11 X O R
DB

P
P1

D O (A+B)

R1 S S1 Q.D Q.D Market demand curve is a horizontal summation of all consumers curve. Its slope is also negative. OQ+OR=OS OQ+OR=OS It is clear from above that at price OP, individual A wishes to buy OQ of good, B wishes to have OR of good. The total quantity of good that all the consumers plan to buy at price OP is therefore OQ+OR which is equal to OS. So OQ1+OR1=OS1 Why does demand curve slope downwards: 1. Law of diminishing marginal utility: Law of diminishing marginal utility states that as more and more commodity is consumed, the utility derived from each successive unit goes on diminish. Hence more is purchased only at lower price. 14

2. 3.

4. 5.

Notes By: Ms. Shweta Bhatia Income effect: When price of a commodity decreases, real income of consumer will increase. So more is purchased with fall in prices. Substitution effect: Substitute goods are those that can be used in place of each other like tea and coffee when price of commodity X reduces, it becomes cheaper in relation to commodity Y. So more of X is purchased in place of Y. Additional buyers in a market: When price of a commodity falls, more people can afford to buy it. So demand increases. Alternative uses of commodity: Some goods have more than one use. When price of such type of commodity reduces, it can be put to its various sources of alternative. So demand increases.

Exceptions to the law of demand: Law of demand is generally believed to be valid in most of the situations. However there are some exceptions: 1. Articles of distinction: This exception to law of demand is associated with name the economist Veblen. According to him, some consumers measure the utility of a commodity entirely by its price. For them greater the price of a commodity. The greater its utility. Diamonds are often given example in this case. 2. Ignorance: Many a time, consumer due to ignorance or poor judgment consider a commodity to be of low quality if its price is low and of high quality if its price is high. 3. Giffen goods: Law of demand doesnt hold good in case of giffin goods. Giffin goods are those inferior goods whose demand falls even when there price falls. 4. Expectation of rise or fall in price in future: If prices are likely to increase more in the future, then even at higher price, people may demand more. Contrary, if prices are likely to fall in future, then even at the existing lower price, people may demand less units of the commodity.

Demand function: Demand of a consumer for a particular commodity is determined by following factors: 1. Price of commodity: Other things being equal, there is inverse relationship between price and quantity demand. X D P P1 O Q Q1 15 D Y

Notes By: Ms. Shweta Bhatia 2. Price of related goods: Related goods can be of two types: a) Substitute goods: Substitute goods are those goods which can be substituted for each other like tea and coffee, limca and cola etc. there is positive relationship between price of one good and demand for other good. D P1 Price of Limca P D Q Q1 Demand for Coke b) Complementary goods: Complementary goods are those which are jointly demanded to satisfy one want like car & petrol, pen & ink etc. there is negative relationship between price of one good and demand for other. P1 Price of Car P Demand of Petrol Q1 Q 3. Income of consumer (Y): Relationship between income of consumer and demand for a good is generally positive means increase in income leads to increase in demand and vice versa. Generally this relationship is discussed with reference to: a) Normal Goods: These are those goods, whose demand increase with increase in income & vice versa. So in case of normal goods, there is positive relationship between consumers income & Q.D. D Y1 Income Y D X Q Q1 b) Inferior goods: There is negative relationship between income & Q.D. This occurs because with increase in income, the consumer shifts from inferior to superior goods. 16 D

Notes By: Ms. Shweta Bhatia D Y1 Y Q1 Q D X

4. Size of population: Increase in population leads to more demand and decrease in population leads to less demand. 5. Taste and preference : Other things being equal, demand for those goods increases for which consumers develop tastes. 6. Expectations: If consumer expects that price will rise in future, he will buy more goods in present even when price is high and vice versa. Movement along demand curve: Other things being equal when Q.D. changes due to change in price only, then this change is shown by different points on same demand curves called movement along a demand curve. In this case fall in price is followed by extension of demand and rise in price is followed by contraction in demand. 1. Extension of demand: It refers to increase in Q.D. as a result of fall in price, other things remaining same. P 10 5 Q.D 5 10 D P P1 Q Q1 A B D

Movement from A to B downwards on same demand curve DD shows extension of demand. 2. Contraction of demand: It refers to fall in Q.D. as a result of rise in price, other things being same. P 5 10 Q.D 10 5 D P1 P Q1 B A D Q

Movement from A to B upwars on same demand curve DD shows contraction of demand. Shifting of demand curve: When demand changes due to changes in, other things being equal, then this change is shown by shifting of 17

Notes By: Ms. Shweta Bhatia demand curve. So a change in any determinant of demand other than price will shift the entire demand curve to the right or to the left. 1. Increase in demand: When more is demanded at same price or same is demanded at more price then demand curve shifts right to original demand curve. Y Same Price More Demand D1 5 5 D 5 6 P D1 D X Q Q1 So it is clear that due to increase in demand, demand curve shifts to right from DD to D1D1. 2. Decrease in demand: When less is demanded at same price or same is demanded at less price, then demand curve shifts left to the original demand curve. Same Price Less Demand 5 5 5 D1 D 3 P D1 Q1 Q D

So it is clear that due to decrease in demand, demand curve shifts to left from DD to D1D1

ELASTICITY OF DEMAND
The elasticity of demand measures the responsiveness of quantity demanded of a good, to change in its price, price of other goods and changes in consumers income. In the words of Dooley PRICE Elasticity of Demand: It is a measurement of percentage change in demand due to percentage change in price. Thus, Elasticity=% change in quantity demanded\% change in price NOTE: The coefficient o elasticity is always negative because of opposite relation between price and demand. Degrees of Price Elasticity of Demand: 18

Notes By: Ms. Shweta Bhatia 1) Perfectly Elastic: Here, Ed =Infinity. It refers to a situation when demand is infinite at the prevailing price. Here, a minute change in price will cause the demand to fall to curve is parallel to x-axis showing perfect elasticity of demand.

Price

2 O

X 1 5 Units 2) Perfectly Inelastic Demand:- In this case, change in prices causes no change in the quantity demanded. Here elasticity = 0.Here, the curve is parallel to y-axis, showing inelasticity of demand. Y D 2 Price 1 O X Units 3) Unitary Elastic Demand:- It is a situation when change in quantity demanded in response to change in price is such that total expenditure remains constant. That is percentage change in demand = percentage in price. Here, elasticity=1(unit elastic). Y D p1 Price p D O q1 q Units 4) Greater Than Unit Elastic:- When change in quantity demanded in response to change in price is such that total expenditure increases when price decreases & vice- versa. That is percentage change in demand is more than percentage in change in price. Here, elasticity is more than one (>1 unit elastic). X

19

Notes By: Ms. Shweta Bhatia Y D p p1 price D

q units

q1

5) Less than unit elastic:- When change in quantity demanded in response to change in price is such that total expenditure decreases when price decreases & vice-versa that is percentage change in demand is less than percentage in price. Elasticity is less than one (<1 unit elastic) Y D p Price p1 D O q q1 units MEASUREMENT OF PRICE ELASTICITY OF DEMAND Methods of measuring are:1) 2) 3) 4) 5) Total Expenditure Method Proportionate Method Point Elasticity Method Arc Elasticity Method Revenue Method X

1)Total expenditure method:- Also known as total outlay method was evolved by doctor Marshall. Here, total expenditure of a purchaser is compared both after& before the change in price& it can be known when his demand is elastic, unity or less elastic. Total expenditure=Price * quantity demanded. S.no. Price T.E Relation Elasticity 1 Falls Rises Inverse & More than One 20

2 3

Rises Falls Rises Falls Rises

Falls Unchanged Unchanged Falls Rises

Notes By: Ms. Shweta Bhatia Negative [No Effect] One Zero Direct & positive Less than one

Y E P5 P4

PRICE

P3 P2 P1 P T O Q5 Q Q4 Q1 Q2 TOTAL EXPENDITURE X

i. ii. iii. 2)

E<1 = Between points D&C showing positive & direct relation between P&T.E. Here, the curve is upward sloping from left to right. E=1 = Between points B&C showing that change in price has no effect on T.E. Here, the curve is || to Y-axis. E>1 = Between points B&A showing a negative & inverse relation between price & T.E. Here, the curve is downward sloping from left to right. Proportionate or Percentage Method: This method was also given by Dr. Marshall as per this method; proportionate changes in demand & price are compared to know Ed.

Ed = (-) Proportionate changes in DD of good-x / Proportionate changes in price of good-x 21

Notes By: Ms. Shweta Bhatia Ed= Change in qty DD / Initial DD / Change in price / Initial Price = (-) Q1-Q / Q / P1-P / P = (-) DQ / Q / DP / P Ed= (-) DQ / Q * P / DP i. ii. iii. = (-) DQ / DP * P / Q

If Ep=1, Elasticity is unity. If % D in demand > % change in P, Ep>1 If % D in demand < % change in P, Ep<1

3) Point Elasticity of Demand: It refers to price elasticity of demand at any point on demand curve. Ep is different at different points on a given demand curve. a) When demand curve is Linear: Here, the Ed = Lower portion of DD curve / Upper portion of DD curve i. ii. iii. iv. v. Ed at N = O / MN = 0 Ed at C = CN / CM = E < 1 Ed at T = TN / TM = E = 1 Ed at A = AN / AM = E > 1 Ed at M = MN / 0 = E = Infinite

b) Non-Linear DD Curve : In this case, a tangent is drawn to non-linear demand curve to Ep. This point (where DD curve is tangent) will divide the line in 2 parts, Lower & Upper segment Ep at point P = PN / PM. 4) The Arc Method: When elasticity is measured between 2 points on the sane demand curve it is known as Arc Elasticity. Any 2 points on a DD curve make an arc. Here the Ep is measured as: Ep = DQ / (q1+q2) / DP /(P1+P1) = DQ / q1+q2 * P1+P2 / DP Ep = DQ / DP * (P1+P2) / (q1+q2)

5) Revenue Method:Here Ep is measured using AR & MR curves. T.R = P * Quantity sold A.R = T.R / Units M.R = T.Rn T.Rn-1 Ep = A / A-M Where A = A.R, M = M.R Here, A.R = PM & M.R = LM so Ep = PM / PM- LM INCOME ELASTICITY OF DEMAND 22

Notes By: Ms. Shweta Bhatia Income elasticity measures the change in quantity demanded by a consumer due to change in his income:Ed = % Change in Quantity demanded / % Change in Income = DQ / Q / DY / Y =DQ / Q * DY / Y = DQ / DY * Y / Q Where, D = change, Q = Quantity Demanded, Y = Income Ed can be POSITIVE, NEGATIVE or ZERO. Depending on nature of the commodity. 1. NORMAL GOODS: Here Ed is positive, so here increase in income leads to increase in demands of the goods. Here, the demand curve is upward sloping showing the direct and positive relation between Income and Quantity demanded of the commodity. INFERIOR GOODS: Here Ed is negative, so here consumer will decrease the quantity demanded due to increase in his Income. Here, the demand curve is downward sloping showing the opposite and inverse (-ve) relation between Income and Quantity demanded of the goods. NECESSITY GOODS: Here Ey is Zero, so here increase and decrease in Income does not change the Quantity demanded of the good. Here, the demanded curve is || to Y-axis i.e. Inelastic showing the there is no or zero relation between Income and Quantity demanded of such goods.

2.

3.

CROSS ELASTICITY OF DEMAND It is the relation between % changes in the Quantity demanded of a good to the % change in the Price of a related good. Thus cross elasticity between good x & y: Exy = % Change in Quantity of x / % Change in Price of y Or = DQx / Qx / DPy / Py = DQx / Qx * Py / DPy = DQx / DPy * Px / Qx Where Qx = Quantity of good x, Py = Price of good y, D = Change. Cross elasticity may be positive, negative or zero depending on the nature of relation between x & y good. This may be substitutes, complementary or unrelated goods. 1. SUBSTITUTE GOODS: If x & y are substitutes a decrease in Price of good will decrease in Quantity demanded of good x & vice-versa. Here, cross elasticity of x & y is positive given the price of x, change in price of y will lead to change in Quantity demanded of x. COMPLEMENTARY GOODS: If 2 goods are complementary (jointly demanded) increase in price of one leads to a decrease in demand for other & vice-versa. Here, cross elasticity is negative. Price and demand change in opposite directions. UNRELATED GOODS: If 2 goods are unrelated a fall in price of good y has no effect on demand of good x. Here, cross elasticity is ZERO. Price change has no effect on demand. 23

2. 3.

Notes By: Ms. Shweta Bhatia FACTOR EFFECTING PRICE ELASTICITY OF DEMAND I. NATURE OF COMMODITY: Necessary goods like salt, kerosene oil etc have inelastic (<1) demand. Luxuries likes ACs, costly furniture etc have >1 elasticity, change in price has greater impact on demand. Comforts like milk, fans coolers etc have neither very elastic nor very inelastic demand. II. AVAILABILITY OF SUBSTITUTES: Commodities which has substitutes (e.g. tea and coffee) are relatively more elastic. Commodities having no substitutes like cigarettes etc have inelastic demand. III. DIFFERENT USES OF A COMMODITY: If a good can be put to variety of uses, it has elastic demand and vice-versa. IV. POSTPONEMENT OF THE USE: Demand will be elastic for goods whose consumption can be postponed and inelastic for those whose use can be postponed. V. INCOME OF CONSUMER: People whose incomes are very high or very low, have inelastic demand because, rise or fall in price will have little effect on their demand and vice-versa. VI. HABIT OF THE CONSUMER: Goods to which a person becomes accustomed or habitual will have inelastic demand like tea, tobacco etc. It is so, because a person cannot do without them. VII. PROPORTION OF INCOME SPENT ON A COMMODITY: Goods on which a consumer spends a very small proportion of his income will have inelastic demand & vice-versa. VIII. PRICE LEVEL: Elasticity of demand will be high at higher level of price and low at lower level of price. IX. TIME PERIOD: Demand is inelastic in short period but elastic in long period. It is so because in long run, a consumer can change his habits more conveniently than in the short period. X. JOINT DEMAND: Goods demanded jointly have inelastic demand, e.g.:- car & petrol, pen & ink etc. Rise in price of petrol may not decrease the demand if there is no fall in the demand for cars.

THEORY OF SUPPLY
MEANING By SUPPLY is meant the quantities of a commodity or service that a seller is willing and able to offer for sale at various prices during a given period of time. The higher the price, the greater will be the supply and vice-versa. Therefore, the relation between price and quantity supplied is Direct and Positive.

Supply It refers to the quantities of a commodity that the producers are willing & able to sell at alternative prices during the given period of time.

Quantity Supplied It refers to a specific quantity sold against the specific price.

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Notes By: Ms. Shweta Bhatia SUPPLY SCHEDULE The table relating to price & quantity supplied is called the Supply Schedule It has 2 types: 1) Individual Supply Schedule: It refers to the quantities of a given commodity, which a producer will sell at all possible prices, at a given moment. Price (Rs) 1 2 3 4 Quantity Supplied 1 2 3

2) Market Supply Schedule: It is the one that shows total supply of all the producers in the market at different prices of the commodity. Market Supply Schedule Price (Rs) As Supply 1 1 2 2 3 3 4 4 Bs Supply 2 3 4 5 Market Supply (A+B) 1+2=3 2+3=5 3+4=7 4+5=9

SUPPLY CURVE: Graphic Representation of supply schedule expressing the relationship between different quantities supplied at different prices of a commodity. It also has two types: 1) Individual Supply Curve: It is the one that represents different quantities of a commodity produced by a producer at different prices. Y S 2 PRICE 1

O 2) Market Supply Curve:

1 2 UNITS

25

Notes By: Ms. Shweta Bhatia It is the horizontal summation of the individual supply curves i.e. it is the one that represents total of quantities supplied by all the producers in the market at different price. As Curve Bs Curve Market Supply Curve y Price SB 5 SA 4 3 2 1 O 1 2 3 4 x 5 4 3 2 1 O1 2 3 4 5 Units 5 4 3 2 1 O 1 2 3 4 5 6 7 8 9 x y y SA+B

Factors Affecting Supply or Determinants of Supply: a) Price of the Commodity: Price & Quantity supplied are directly (positively) related. b) Price of Other Commodities: A change in the price of other commodity also affects the supply of a commodity. c) Price of Factors: If price of any one factor of production (i.e. labour and capital) increases, its cost will also increase. As a result, its output will fall and supply will be reduced and vice-versa. d) Goals of the Producers: If a producer aims at maximizing profit, he will produce less of the commodity that involves large risk. A producer who aims at maximizing his sales will produce and sell more. e) Tax Rate: High tax rate means, higher cost of production and low supply & viceversa. f) Availability of Credit: If credit is available at cheap rates, supply will increase & viceversa. g) State of Technology: If new and improved methods of production are used, they tend to increase the supply of the commodities. LAW OF SUPPLY The Law of Supply states that other thing remaining constant; quantity supplied of a commodity increases with a rise in price and diminishes when price decreases. Its Assumptions: 26

Notes By: Ms. Shweta Bhatia i) Price of other commodities remains constant. ii) Prices of factors of production remain fixed. iii) State of technology doesnt change. iv) Goal of the producers is to maximize the profit. Price (Rs) 1 2 3 4 Quantity Supplied 1 2 3 4 Y 2 PRICE 1

1 2 UNITS

EXCEPTIONS TO THE LAW OF SUPPLY There are, however, certain exceptions to the Law of Supply: 1) When prices are expected to fall much, sellers will sell more in order to clear the stocks. This is so in the short-run. 2) Over the long-run, the supply is influenced by changes in costs which are, in turn, affected by changes in technology. 3) Changes in habits, tastes, fashions, weather etc. also affect the supply of the commodities. Change Quantity Supplied Movement along the Supply Curve Extension of Supply Contraction of Supply Increase in Supply in & Change supply in

Shifts in Supply Curve Decrease in Supply

Caused by Increase in Price of Same Good

Caused by decrease in Price of Same Good

Caused by Factors other than the Price of the Good

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Notes By: Ms. Shweta Bhatia MOVEMENT ALONG THE SUPPLY CURVE 1) Extension of Supply Other things being equal, when price of a Commodity increases, its quantity supplied Increases, and this is called Extension of Supply. P Q 5 1 1 5 5 Price 1 Thus, when price increases quantity supplied Increases. S Expansion of supply

1 Units

2) Contraction of Supply Other things being equal, when price of a Commodity decreases, its quantity supplied Decreases, and this is called Contraction of supply. P Q 5 5 1 1 Thus, when price decreases quantity supplied Decreases.

Y 5 1 O

Contraction of Supply curve S

1 5 Units

SHIFTS IN SUPPLY CURVE 1) Increase in Supply: This implies that at given price, a larger amount is supplied due to change in factors other than price of the commodity. P Q 3 4 3 5 Increase in supply S Y S 3 PRICE

4 5 UNITS

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Notes By: Ms. Shweta Bhatia Forward or Rightward shift in Supply curve shows increase in Supply. # Causes of increase in Supply: i) Price of the other good decreases. ii) Price of factors of production decreases. iii) Goal of the producer shifts to maximizing of sales not to maximize the profits. iv) Future price is expected to decrease. v) Increase in number of suppliers. vi) State of technology has improved.

2) Decrease in Supply: This implies that at a given price a smaller amount is supplied due to change in factors other than price of the same good. P Q 3 5 3 4 Decrease in supply S Y S 3 PRICE

4 5 UNITS

Backward or Leftward shift in Supply curve shows decrease in Supply. #Causes of Decrease in Supply i) Price of the other good increases. ii) Price of factors of production increases. iii) Goal of the producer shifts to maximizing of profits not to maximize the sales. iv) Future price is expected to increase. v) Decrease in number of suppliers. vi) State of technology has become outdated.

ELASTICITY OF SUPPLY
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Notes By: Ms. Shweta Bhatia The elasticity of supply measures the responsiveness of quantity supplied of a good, to change in its price.

Price Elasticity of Supply: It is a measurement of percentage change in supply due to percentage change in price. Thus, Elasticity=% change in quantity supplied\% change in price NOTE: The coefficient o elasticity is always positive because of direct relation between price and supply. Degrees of Price Elasticity Supply: 1)Perfectly Elastic: Here, Ed =Infinity. It refers to a situation when supply is infinite at the prevailing price. Here, a minute change in price will cause the supply to fall to curve is parallel to x-axis showing perfect elasticity of supply. X

Price

2 O 1 5 Units

S X

2) Perfectly Inelastic Supply:- In this case, change in prices causes no change in the quantity supplied. Here elasticity = 0.Here, the curve is parallel to y-axis, showing inelasticity of supply. Y S 2 Price 1 O Units 3) Unitary Elastic Supply:- It is a situation when change in quantity supplied in response to change in price is Equal. That is percentage change in supply = percentage in price. Here, elasticity=1(unit elastic). X

y S 30

Notes By: Ms. Shweta Bhatia p1 Price p O q Units q1 X

4)Greater Than Unit Elastic: - When change in quantity supplied in response to change in price is greater. That is percentage change in supply is more than percentage in change in price. Here, elasticity is more than one (>1 unit elastic). y S p1 Price p O q Units q1 X

5)Less than unit elastic:- When change in quantity supplied in response to change in price is less that is percentage change in supply is less than percentage in price. Elasticity is less than one (<1 unit elastic) y S P1 Price P O q q1 Units X

MEASUREMENT OF PRICE ELASTICITY OF SUPPLY Proportionate or Percentage Method: This method was also given by Dr. Marshall as per this method; proportionate changes in supply & price are compared to know Es. Es = Proportionate changes in SS of good-x / Proportionate changes in price of good-x Es= Change in qty SS / Initial SS / Change in price / Initial Price 31

Notes By: Ms. Shweta Bhatia = Q1-Q / Q / P1-P / P = DQ / Q / DP / P

ES= DQ / Q * P / DP = DQ / DP * P / Q 1. If Es=1, Elasticity is unity. 2. If % change in supply > % change in P, Es>1 3. If % change in supply < % change in P, Es<1 4. If % change in supply=0 in spite of change in price, Es=0 FACTOR EFFECTING PRICE ELASTICITY OF SUPPLY NATURE OF COMMODITY: If a commodity is perishable, its supply is inelastic. This is because its supply cannot be increased or cut by a rise or fall in price. On the other hand, the supply of a durable good is elastic as its supply can be changed with change in its price. TIME PERIOD: The longer the time period, the more elastic will be the supply of a commodity. The shorter the time period, the more inelastic will be the supply of a commodity. COST OF PRODUCTION: If the per unit cost of production increases at a faster rate than the rise in price, the supply will be inelastic and vice-versa. PRODUCERS EXPECTATION: If a producer expects a rise in the price in near future, he will cut down the present supply and vice-versa.

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Notes By: Ms. Shweta Bhatia

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