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ECONOMICS FOR MANAGERS UNIT-I The word economy comes from the Greek word for one who manages a house-hold. We know that households and economies have much in common. A household faces many decisions. It must decide which members of the household do which tasks and what each member gets in return: Who cooks dinner? Who does the laundry? Who gets the extra dessert at dinner? In short, the household must allocate its scarce resources among its various members, taking into account each members abilities, efforts, and desires. Like a household, a society faces many decisions. A society must decide what jobs will be done and who will do them. It needs some people to grow food, other people to make clothing, and still others to design computer software. Once society has allocated people (as well as land, buildings, and machines) to various jobs, like a household, a society faces many decisions. A society must decide what it needs some people to grow food, other people to make clothing, and still others to design computer software. Once society has allocated people (as well as land, buildings, and machines) to various jobs will be done and who will do them. It needs some people to grow food, other people to make clothing, and still others to design computer software. Once society has allocated people (as well as land, buildings, and machines) to various jobs, it must also allocate the output of goods and services that they produce. Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Just as a household cannot give every member everything he or she wants, a society cannot give every individual the highest standard of living to which he or she might desire. Economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. For instance, they examine how the multitude of buyers and sellers of a good together determine the price at which the good is sold and the quantity that is sold. Finally, economists analyze forces and trends that affect the economy as a whole, including the growth in average income, the fraction of the population that cannot find work, and the rate at which prices are rising.

Although the study of economics has many features, the field is unified by several central ideas. But here we will concentrate on the ten principles of economics which help the individual in decision making.

PRINCIPLE #1: PEOPLE FACE TRADEOFFS: The first lesson about making decisions is summarized in the saying: There is no such thing as a free lunch. To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires trading off one goal against another. Consider a student who must decide how to allocate her most valuable resourceher time. She can spend all of her time studying economics; she can spend all of her time studying accountancy; or she can divide her time between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other. And for every hour she spends studying, she gives up an hour that she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money. When people are grouped into societies, they face different kinds of tradeoffs. The classic tradeoff is between guns and butter. The more we spend on national defense to protect our shores from foreign aggressors (guns), the less we can spend on consumer goods to raise our standard of living at home (butter). Another tradeoff society faces is between efficiency and equity. Efficiency means that society is getting the most it can from its scarce resources. Equity means that the benefits of those resources are distributed fairly among societys members. Efficiency refers to the size of the economic pie, and equity refers to how the pie is divided. Often, when government policies are being

designed, these two goals conflict and the government has to make decisions in such a way that both are achieved equity as well as efficiency. PRINCIPLE #2: THE COST OF SOMETHING IS WHAT YOU GIVE UP TO GET IT We know that people face tradeoffs (sacrifice), and therefore making decisions requires comparing the costs and benefits of alternative courses of action. In many cases, however, the cost of some action is not as noticeable as it might first appear. Consider, for example, the decision whether to go to college. The benefit is intellectual enrichment and a lifetime of better job opportunities. But there are many types of money costs i.e. the money you spend on tuition, books, and room. But this total does not truly represent what you give up to spend a year in college. The first problem here is that it includes some things that are not really costs of going to college. Even if you quit school, you would need a place to sleep and food to eat. Room and board (housing facilities) are costs of going to college only to the extent that they are more expensive at college than elsewhere. Indeed, the cost of room and board at your school might be less than the rent and food expenses that you would pay living on your own. In this case, the savings on room and board are a benefit of going to college. The second problem with this calculation of costs is that it ignores the largest cost of going to college your time. When you spend a year listening to lectures, reading textbooks, and writing papers, you cannot spend that time working at a job. For most students, the wages given up (sacrificed) to attend school are the largest single cost of their education. The opportunity cost of an item is what you give up to get that item. When making any decision, such as whether to attend college, decision makers should be aware of the opportunity costs that accompany each possible action. In fact, they usually are. College athletes who can earn millions if they drop out of school and play professional sports are well aware that their opportunity cost is very high. PRINCIPLE #3: RATIONAL PEOPLE THINK AT THE MARGIN One of the important principles is that rational (sensible) persons think at margin. It means that small adjustments that an individual makes in the existing plan of action. This helps in making good decisions. When exams are near, your decision is not between totally escaping from them or studying 24 hours a day, but whether to spend an extra hour reviewing your notes instead of watching TV. Economists use the term marginal changes to describe small incremental adjustments to an existing plan of action. Keep in mind that margin means edge, so marginal changes are adjustments around the edges of what you are doing. Another example, consider an airline deciding how much to charge passengers who fly

standby. Suppose that flying a 200-seat plane across the country costs the airline Rs. 100,000. In this case, the average cost of each seat is Rs. 100,000/200, which is Rs. 500. One might be tempted to conclude that the airline should never sell a ticket for less than Rs.500. In fact, however, the airline can raise its profits by thinking at the margin. Imagine that a plane is about to take off with ten empty seats, and a standby passenger is waiting at the gate willing to pay Rs.300 for a seat. Should the airline sell it to him? Of course it should. If the plane has empty seats, the cost of adding one more passenger is very small. Although the average cost of flying a passenger is Rs. 500, the marginal cost is merely the cost of the bag of peanuts and can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal cost, selling him a ticket is profitable. As these examples show, individuals and firms can make better decisions by thinking at the margin. A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. In short if MR>MC, it is advisable for a firm to make this decision. PRINCIPLE #4: PEOPLE RESPOND TO INCENTIVES Now we know that people make decisions by comparing costs and benefits and therefore their behavior may change when costs and benefits change. That is people respond to incentives. Incentives can be positive or negative. For example when the price of apple rises, then people decide to substitute by eating more pears and fewer apples. This is because the cost of buying apples is higher. Thus, it has positive effects on apple orchard owners. The apple orchard owners hire more workers and harvest more apples as the benefit of selling apples is higher. Public policy makers should never forget about incentives as incentives change the cost and benefits that people face and this will change their behavior. A tax on petroleum products, for example encourages people to drive smaller and more fuel efficient cars. It also encourages the use of public transportation. In short, people make decisions depending upon the incentives they receive. PRINCIPLE #5: TRADE CAN MAKE EVERYONE BETTER OFF: It is a fact that trade between the two countries can make each country better off. Trade facilitates each country to specialize in their respective products. And as the result they enjoy better variety of products and can buy the products at a cheaper rate. We know that china, U.S.A, U.K. is our competitors in the world market. But yet trade has made the countries better off. India can produce agricultural products at a lower cost than U.S.A. whereas U.S.A

can produce technology at a lower cost. When trade takes place, it makes both the countries become better off. The idea of division of labour is based on trade. In an economy all families compete among themselves to buy goods at the cheapest price. But when the family isolates itself from the market, it will have to make its own food, clothing and shelter. This will make their life more difficult. Trade allows each person to specialize in the activities he or she does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost. PRINCIPLE #6: MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE ECONOMIC ACTIVITY: The fall down of communism in the Soviet Union and Eastern Europe has brought very important changes in the world during the last half century. The communist country worked on the assumption the Central planners were in the best position to guide the economic activity. The planners (Government) decided important questions such as what to produce? How to produce? For whom to produce? But today most of the countries have abandoned this system and are trying market economies. In market economy the decisions are taken collectively by millions of firms and households. In short, the market forces of demand and supply makes the important decisions for the economy. In 1776, Adam Smith published a book called, An inquiry into the nature and cause of wealth of nations. In this book he has mentioned that the Invisible hand that is the market forces will correct the problems of market. According to him price mechanism works like magic which solves the problems of the economy. Thus price is the instrument with which the invisible hand directs economic activity. The central planning system failed because they ignored the market economy or the invisible hand. Thus, we conclude that markets are usually a good way to organize economic activity. PRINCIPLE #7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET OUTCOMES: We know that markets are usually a good way to organize economic activity but this rule has many exceptions. There are two main reasons for government to intervene in the economy. One is to promote efficiency and another is to promote equity. We know that the invisible hand helps markets to efficiently allocate its resources. But many a times this does not work. Economists term them as market failure. Market failure refers to a situation in which the market on its own fails to allocate the resources efficiently. One of the reasons for market failure is externality. An externality is the impact of one persons actions on the well being of bystander (others). One very important example is pollution created by chemical factory. If Government intervene this problem by imposing environmental regulation, then it can force the chemical industry to undertake pollution abatement program. This will improve the

market outcome. Another possible cause of market failure is market power (monopoly). Market power refers to the ability of a single person (or small group of people) to unduly influence market prices. In case of monopoly, the seller increases the price for self-interest. Government intervene the problem by regulating the prices, this can increase the market efficiency. The invisible hand is even less able to ensure that economic prosperity is distributed fairly. A market economy rewards people according to their ability to produce things that other people are willing to pay for. The invisible hand does not ensure that everyone has sufficient food, decent clothing, and adequate health care. A goal of many public policies, such as the income tax and the welfare system, is to achieve a more equitable distribution of economic well-being. PRINCIPLE #8: A COUNTRYS STANDARD OF LIVING DEPENDS ON ITS ABILITY TO PRODUCE GOODS AND SERVICES: We have seen large changes in the standard of living in the citizens of the country. Also we have come across large differences in the standard of living among the countries. The explanation for these large differences in living standards is due to the differences in the countries productivity. Productivity is the amount of goods and services produced from each hour of workers time. It is observed that in nations where workers can produce more of goods and services per unit of time enjoy higher standard of living. And in nations where workers are less productive will have a lower standard of living. The growth rate of nations productivity determines the growth rate of its average income. There is a positive relationship between productivity and standard of living. The relationship between productivity and living standards has also deep impact on public policy. The relationship between productivity and living standards also has deep implications for public policy. To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods and services, and have access to the best available technology. PRINCIPLE #9: PRICES RISE WHEN THE GOVERNMENT PRINTS TOO MUCH MONEY: In Germany in January 1921, a daily newspaper cost 0.30 marks. Less than two years later, in November 1922, the same newspaper cost 70,000,000 marks. All other prices in the economy rose by similar amounts. This episode is one of historys most spectacular examples of inflation. What causes inflation? In almost all cases of large or persistent inflation, the culprit turns out to be the samegrowth in the quantity of money. When a government creates large quantities of the nations money, the value of the money falls. When government creates money and circulates in the market through let us say government expenditure the incomes of

the citizens increases which leads to increase in demand for goods and services. The supply of goods may not increase in same amount as demand and therefore it causes scarcity, which increases the price of the goods. PRINCIPLE #10: SOCIETY FACES A SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT:

We know that inflation has many negative impacts on the society. The question is why does policy makers find it difficult to get rid of this inflation. The reason this is that reducing inflation often leads to temporary rise in unemployment. A very popular economist called A. W. Phillips explained the relationship between unemployment and inflation. The curve that explains the relationship between inflation and unemployment is known as Phillips curve. This curve explains the inverse relationship between inflation and unemployment. According to a common explanation, it arises because some prices are slow to adjust. Suppose, for example, that the government reduces the quantity of money in the economy. In the long run, the only result of this policy change will be a fall in the overall level of prices. That is, prices are said to be sticky in the short run. Because prices are sticky, various types of government policy have short-run effects that differ from their long-run effects. When the government reduces the quantity of money, for instance, it reduces the amount that people spend. Lower spending, together with prices that are stuck too high, reduces the quantity of goods and services that firms sell. Lower sales, in turn, cause firms to lay off workers. Thus, the reduction in the quantity of money raises unemployment temporarily until prices have fully adjusted to the change. The tradeoff between inflation and unemployment is only temporary, but it can last for several years. The Phillips curve is, therefore, crucial for understanding many developments in the economy. In particular, policymakers can exploit his tradeoff using various policy instruments. By changing the amount that the government spends, the amount it taxes, and the amount of money it prints, policymakers can, in the short run, influence the combination of inflation and unemployment that the economy experiences.

8 Government takes policy measures to reduce price level by reducing the quantity of money

price level does not change immediately or the prices remain sticky in the short run

At high prices but less amount of money people make less purchases

The firms shut down the business as less quantity of the goods are sold and this makes the workers unemployed

UNIT-III CONCEPT OF PRICE ELASTICITY Q1. Define Price elasticity of demand and explain the methods of measuring price elasticity of demand. ANS: The law of demand explains that changes in price will cause changes in demand but it does not tell us by how much the demand changes. Price elasticity of demand explains by how the demand will change due to the change in price. The proportion of change in demand due to the change in price is called price elasticity. Some economists have defined price elasticity of demand in the following manner. According to Alfred Marshall, Price elasticity of demand means the ratio of relative change in quantity demanded to a relative change in its price. According to Mrs. Joan Robinson, The proportion of changes in demand due to small change in price is divided by the quantity of changes. The index thus derived at is called price elasticity of demand. According to Stonier and Hague, The proportion of change in demand that takes place due to reduction in price is technically indicated through price elasticity is demand. Methods of Measuring Price Elasticity There are three methods of measuring price elasticity. They are explained below; 1. Point method: To find out the elasticity of demand at a single point on the demand curve, we use the point method. The point method can be studied in two ways: a. Mathematical method: The mathematical method to study price elasticity is explained with the help of the following formula.


Thus by rearranging the term we get,

This method is also known as the percentage method to measure price elasticity. The price elasticity of demand range between 0 to , we can find out the price elasticity by using the percentage method. 2. Arc Method: The arc method to measure elasticity can be used when there are two points on the demand curve. Elasticity of demand on a certain part of demand curve is called arc elasticity. Arc elasticity is the average elasticity; the diagram shows the use of arc elasticity.







Quantity demanded X


From the above diagram we find that there are two points on the demand curve A and B. At point A we have price P1 and quantity Q1 and at point B, the price P2 and quantity Q2. Now we determine the elasticity between the two points with the help of the following formula:

Where ep = elasticity of demand q = change in quantity demanded p = change in price q= original quantity p = original price But now to find arc elasticity, the average of both the quantities and prices are taken, which is explained with the help of the following formula:

We also know that we get

and p = p1-p2, now substituting this in the above equation

The negative sing indicates the inverse relationship between price and quantity demanded but for simplicity purpose we ignore the negative sign.

3. Total Expenditure method: This method is used to measure the elasticity of demand, according to this method we can determine the elasticity on the basis of total expenditure done by the consumer on a particular good. The explanation is given below with the help of an example. a. Unit elastic demand: (E = 1) When there is a change in the price of a good but the total expenditure done by the consumer remains the same or constant, it is called unit elastic demand.


Price Quantity Demanded Total Expenditure Rs.10 8 Rs.80 Rs.8 10 Rs.80 Rs.4 20 Rs.80 From the above example, we conclude that whether the price rises or falls, the total expenditure remains constant. This indicates that the good has unit elastic demand. b. Elastic demand: ( E > 1) When the price of the good falls and the expenditure rises or when price rises and expenditure falls, it is known as relatively elastic demand. For example: Price Quantity Demanded Total Expenditure Rs.10 8 Rs.80 Rs.8 9 Rs.72 Rs.4 10 Rs.40 From the above table, the conclusion can be drawn that if price reduces and total expenditure rises or if price increases and total expenditure falls, the demand for the good is greater than 1. This indicates that the demand for the good is elastic in nature. Luxurious goods have elastic demand. c. Inelastic demand: ( E < 1) If the price reduces the total expenditure also reduces or when price increases the total expenditure rises on the good then the good will have relatively inelastic demand. This is explained form the table below. Price Quantity Demanded Total Expenditure Rs.10 8 Rs.80 Rs.8 15 Rs.120 Rs.4 40 Rs.160


From the above table we conclude that price and expenditure are rising or falling at the same time. Therefore the goods will have inelastic demand. Necessaries will have inelastic demand. This method is helpful to know whether the demand is elastic or inelastic but the exact measurement of elasticity cannot be done.

Q2. Explain the different types of elasticity of demand with the help of suitable diagram. OR The price elasticity of demand determines whether the demand curve is steep or flat-How? You also need to explain all five cases of price elasticity. Remedial Exam (April-2010). ANS: Price elasticity means the degree of responsiveness of quantity demanded to the change in price of a good. Mathematically, it can be written as:

There are five types of elasticity of demand. They are explained below with the help of diagrams. a. Perfectly inelastic demand, (e=0): With the change in price, if there is no change in quantity demanded, then elasticity is equal to zero. This means perfectly inelastic demand. This is explained with the help a demand schedule and a diagram: Price Quantity Demanded (Rs.) (units) 5 10 10 10 15 10
Y Price 15 10 5 (e = 0, perfectly Inelastic demand)


From the above diagram, we conclude that when e = 0, the demand curve is a vertical line. This explains that with the change in price there is no change in demand. b. Relatively Inelastic demand, (e<1): With the change in price, if there is relatively smaller change in quantity demanded, then it is known as relatively inelastic demand. Normally necessaries will have inelastic demand. Goods such as salt, wheat rice etc will have inelastic demand. This is explained with the help a demand schedule and a diagram: Price Quantity Demanded (Rs.) (units) 5 10 10 9 15 8
Y Price 15 10 5 (e<1, Inelastic demand) Steeper curve

8 9 10 Quantity demanded X

From the above diagram, we conclude that when the elasticity is less elastic or e < 1, then the demand curve will be downward sloping but steeper. c. Unit Elastic demand, (e = 1): When there is proportionate change in quantity demanded and price, the elasticity is equal to one, (e=1). This is known as unit elastic demand. This can be explained with the help a table and a diagram.


Price Quantity Demanded (Rs.) (units) 5 10 10 5

Y Price (e=1, unit elastic demand) 10 5

10 Quantity demanded X

From the above diagram, we conclude that the demand curve is downward sloping curve which indicates that the price and quantity demanded changes in the same proportion. The shape of the demand curve is downward sloping from left to right. It is a rectangular hyperbola. d. Relatively Elastic demand, (e>1): With a small change in price, if there is a proportionately larger change in quantity demanded, then the good will have elastic demand. Luxurious goods such as expensive cars, televisions etc will have elastic demand. The same can be explained with the help of a table and a diagram. Price Quantity Demanded (Rs.) (units) 5 10 6 5 7 1

16 Y Price 7 6 5 (e>1, relatively elastic demand) Flatter curve

0 X

10 Quantity demanded

From the above diagram, we conclude that for elastic demand, the demand curve is downward sloping but a flatter curve. e. Perfectly elastic demand, (e=): When there is an extremely small change in the price but infinitely large change in quantity demanded, then the elasticity is perfectly elastic. This is not practically possible in the real life but with the help of the following table and a diagram, we can explain perfectly elastic demand. Price Quantity Demanded (Rs.) (units) 10 10 9.99
Y Price 10 (e=, perfectly elastic demand)

10 Quantity demanded X


From the above diagram we conclude that for a perfectly elastic demand the demand curve is a horizontal line parallel to X-axis and perpendicular to Y-axis. Q3. Explain the main factors affecting elasticity of demand. OR Explain price elasticity of demand and income elasticity of demand. Also explain the determinants of price elasticity of demand. (Feb-2011) ANS: There are several factors which affect the elasticity of demand. These factors make the demand for goods more elastic or less elastic. They are explained below: 1. Availability of substitutes: If the goods have close substitutes in the market then the demand for the good concerned will have elastic demand. For examples commodities like butter, coca-cola, cars have close substitutes and therefore if the price of the good changes, the demand for the product will change in greater proportion making the demand more elastic. Where as, if the good has less substitutes or no substitutes then the good will inelastic demand. For example demand for common salt is inelastic because a good substitute for salt is not available. 2. Position of a commodity in consumers budget: The greater the proportion of income spent on a commodity, the greater will be its elasticity of demand. The demand for goods such as salt, match-box, buttons etc tends to be inelastic because a household would spend only a small position of their income on them. 3. Nature of the need that a commodity satisfies: In general, luxury goods have elastic demand where as necessaries has inelastic demand. This is due to the reason that people cannot do without using necessaries where as one can postpone the use of luxury goods. For example salt will have inelastic demand where as televisions will elastic demand. 4. Number of uses to which a commodity can be put: The more the possible uses of a commodity, the greater will be its price elasticity. For example milk has several uses. If its price falls, it can be used for variety of purposes like preparation of curd, cream, ghee and sweets. But if the price increases, its use will be restricted only to essential purposes like feeding the children and sick persons. But if the product has one or less uses the demand for the product may turn inelastic. 5. The time period: The longer the time period one has more completely one can adjust. For example, if the price of petrol increases then one can make fewer trips by car but in


the long run the consumer can purchase a car which is more fuel efficient. In short, longer the time period faced by the consumer, elastic will be the demand for the product. 6. Consumers habit: If a consumer has formed a habit of using a particular commodity then with the change in the price the demand for the commodity will be inelastic. 7. Tied demand: The demand for the goods which are tied to the other goods will generally inelastic. For example the demand for cement is tied with the demand for buildings and construction. Therefore, if buildings are in demand, cement will be definitely required. This makes the demand for cement inelastic. 8. Price range: Goods which are in very high price range or very low price range have inelastic demand but those in the middle range will have elastic demand.

Q4. Explain the uses of elasticity of demand. ANS: The concept of elasticity of demand is very useful in practice. Some of the important uses are explained below: 1. Useful to government: The concept of elasticity of demand is very useful to the finance minister of the country. The finance department will consider the elasticity of demand for every commodity while imposing taxes on goods. If the demand for the commodity is inelastic, it can be necessity items, therefore government will imposes low tax rates. Whereas if the demand for the good is elastic in nature it may be luxurious goods, thus government will impose high taxes. 2. Helpful to monopolist: A monopolist will analyze the elasticity of demand for the product before determining the price of the product. If the demand for good is inelastic, the monopolist can charge higher prices whereas if the demand for the goods is elastic, the monopolist can charge a lower price. 3. For international trade: The elasticity of demand will help to determine the prices of the goods to be exported. If the demand is inelastic in the international market, we can charge a high price for exports. But if the demand for export is elastic, lower price can be charged for exports to become more competitive. Devaluation of the currency is done on the basis of elasticity of demand for imports and exports. 4. Helpful to producers of joint products: The producers who produce joint goods have to decide the price of joint products. The producer considers the elasticity of demand in fixing the price of the joint products. For example, cotton and cotton seeds are joint


products, if the demand for cotton is inelastic the producer can charge a high price for cotton and if cotton seeds have elastic demand, then he can charge lower price for seeds. Thus, we conclude that elasticity of demand is of great importance in making business decisions. Q5. Explain the income elasticity of demand with the help of suitable examples and diagrams. ANS: Income elasticity of demand means the degree of responsiveness of quantity demanded of goods to the change in income of consumers. The formula for income elasticity is as under:

Where Ey= Income elasticity, q= change in quantity, y=change in income of the consumers. Normally, income elasticity will have a positive sign because there is a positive relationship between quantity demanded and change in consumers income. We know that higher the income, higher is the quantity demanded, where as lower the income, lower is the quantity demanded, assuming other factors remaining constant. Positive income elasticity can be due to normal goods. Normal goods can be classified into necessity items and luxurious items. Types of income elasticity The types of income elasticity are explained below: 1. Positive Income Elasticity: We know that as the income of the consumers increases the quantity demanded for the goods will also increase, that means there is a positive relationship between quantity demanded and the income of the consumers. Generally, normal goods will have positive income elasticity. Normal goods are classified into two: a. Luxurious goods: Income elasticity greater than 1 (ey>1): the demand increases more than the proportion of income, this income elasticity is greater than 1. Luxurious goods will have elastic demand.


b. Necessity goods: Income elasticity less than 1, (ey<1): If the demand increases in less proportion to the rise in income, it is called inelastic demand. Necessity items will have inelastic demand.
Y Income (Positive Income Elasticity)

0 Quantity X The above demand curve is upward sloping from left demanded to right because there is a positive relationship between income and quantity demanded.

2. Negative Income Elasticity: If the income increases but as the result the demand for the commodity decreases, it is called negative income elasticity. The demand for inferior goods such as jowar and bajra will have negative income elasticity. The diagram below explains the same.

Y Income (inferior goods) Negative income elasticity

Quantity demanded X

The above diagram explains that there is a negative relationship between quantity demanded and income in case of inferior goods. It explains that when income increases consumers will


demand lesser amounts of inferior goods Zero Income Elasticity: When income changes but there is no change in the quantity demanded, then income elasticity is equal to Zero. (Ey=0). The diagram below explains zero income elasticity.
Y Income (Zero income elasticity)

Quantity demanded X

Zero income elasticity will have a vertical straight line demand curve indicating that there is no change in quantity demanded with the change in income. Q6. Explain the concept of cross elasticity of demand with the help of suitable diagram. ANS: Most of the goods are connected with other goods in the form of substitute goods or complementary goods. Tea and coffee, ink pen and ball pen are examples of substitutes goods. Where as ink and ink pen, sugar and tea are examples of complementary goods. Cross elasticity of demand helps us to understand the relationship between two goods. Cross elasticity of demand can be defined as, Cross elasticity of demand means the ratio of percentage change in demand of substitute good or complementary goods as a result of percentage change in the price of the commodity. The following is the formula to find out the cross elasticity.

Types of cross elasticity 1. Positive cross elasticity: When two goods are substitute goods, the cross elasticity will have a positive sign. This can be explained with the help of an example. Let us assume


that there are 2 goods tea and coffee and changes in the price of coffee will lead to changes in quantity demanded for tea. Tea Coffee Price of coffee Quantity demanded Quantity demanded ` 5 3 5 7 1 7 The diagram for the same is explained on the next page.
Y Price Of coffee 7 5

7 Quantity demanded of Tea X

From the above diagram and an example we conclude that there is a positive relationship between quantity demanded of tea and price of coffee. 2. Negative cross elasticity: When two goods complimentary goods, the cross elasticity will have a negative sign. This can be explained with the help of an example. Let us assume that there are two goods ink and ink pen and changes in the price of ink will lead to changes for ink pens. Ink Ink pens Price of Ink Quantity demanded Quantity demanded ` 2 3 10 1 2 15

23 Y (Negative cross elasticity) (Complimentary goods) 10 5

Quantity demanded of ink pens

From the above diagram we conclude that the demand curve for complementary goods is a downward sloping curve. 3. Zero cross Elasticity: When two goods are not related goods, then the cross elasticity will be zero. For example there is no relationship between a ceiling fan and a car. Therefore the cross elasticity will be zero indicating that with the change in the price of ceiling fans, there will be no change in the quantity demanded of cars. The demand curve is a vertical line. This is explained with the help of a diagram.
Y Price of Ceiling Fans

Quantity demanded of cars X


COST ANALYSIS The term cost has wide variety of meanings in economics but the normal concept used is the mon cost of production i.e. the expenditure incurred by the company on wa ges, salary, raw materia power, light, fuel, transportation etc. Money cost therefore refers to money expenditure by a firm produce or sell a product. Business managers use this cost figures to determine prices of the produ purchase of a new technology and profits for a firm. Therefore, it is essential to know the different types of cost involved in a firm. Some important costs are recorded below: 1. Accounting cost and Economic cost 2. Short run cost and Long run cost 3. Incremental cost and Sunk cost 4. Traceable cost and Common cost 5. Fixed cost and Variable cost 1. Accounting cost and Economic cost: The cost incurred for accruing or producing good or service is called accounting cost as these costs can be recorded in the books of accounts for e.g. power, light, fuel, wages, salary, insurance, rent etc. These costs are also known as Absolute costs or outlay costs. Where as opportunity cost is the revenue sacrificed by not making the best alternative use. For e.g. a company can produce 1000 units of X, 900 units of Y, and 800 units of Z. If the company decides to produce X, he makes a sacrifice of 900 units of Y and 800 units of Z. According to the modern economist, opportunity cost is applicable to all factors of production. While economic cost is a wide concept as it includes both the accounting Cost as well the economic cost. i.e. Economic cost = Accounting cost + Opportunity cost. The accounting costs are important for managing the taxation needs as well as calculating profit or loss for the firm where as economic costs relate to future. Since the only costs that matter for business decisions are the future costs, economic costs are more used in decisionmaking. A modern business firm should not only look at the accounting cost while making a decision but also take into account the opportunity or implicit costs because actual profitability of production can only be measured if the sacrifices actual costs are taken into account.


2. Short run and Long run Cost: In the short run, we know that to increase the level of output, a firm cannot purchase new factors of production like land, capital and set up a new enterprise as it requires a long term planning. Therefore, in the short run certain factors remain constant while labour can only be managed. The costs that change with the output or sales in the short run are called short run cost. While in the long run i.e. (10 to 15years), after the long term, planning all the factors of production can be changed to produce more output. Therefore, all the costs are variable in the long run. Long-term decisions can be regarding setting up of a new plant. The cost involved in the long-term to expand the business is called the long-run cost. 3. Incremental (or, Avoidable or, differential) cost and Sunk cost: Incremental cost is the additional cost, which arises due to the change in the business activity. The changes can take place in several forms for e.g. addition of a new product line, replacing the old machine by a new one, expansion of market etc. Incremental cost will not occur when new business is set up. Incremental cost only arises when changes in the existing business takes place. In addition, incremental cost will be different in cases of different alternatives. These costs can be avoided by not bringing about any change in the business activity; the incremental costs are also called avoidable costs or escapable costs. On the other hand, sunk cost is the cost, which does not change with the change in the level of business activity. It remains fixed or same irrespective of the alternatives selected. Thus to a manager incremental costs are more important than sunk costs. Sometimes sunk cost is also known as fixed cost. For e.g. a manager has to make a choice between hiring a machine and buying a machine. The costs associated with this machine are as under: (a) Acquisition cost. (b) Service and maintenance cost (c) Operating cost (labour, power, fuel).


(d) Space occupancy. (Depreciation, taxes, insurance) From this we realize that acquisition cost and service and maintenance cost is incremental cost as they change with the decision while operating cost and space occupancy are sunk cost. 2.Traceable and common cost: A direct or traceable cost is one, which is easily identified with a unit of operation for e.g. the salary of the divisional manager is the direct cost when the division is the costing unit. In other words, direct costs are the ones that have direct relationship with the unit of operation like a product, a process, or a department of the firm. Since all the costs are linked to a particular product, process or department they vary with the changes in them and therefore direct cost is variable costs. Traceable costs are important when a company is engaged in multiple products. On the other hand, indirect costs or the nontraceable may or may not be variable. Common costs are the indirect cost that are not traceable with the final product for e.g. electric power for operating machine, raw material, labour are the traceable costs while salary of the administrative department, electricity bill, interest, and insurance are common costs. A rational producer will try to find out the different types of cost incurred by the firm especially if it is a multi-product firm. The knowledge of different types of cost can give the idea to the manager on how to maximize the production and profit by making some changes in the costs. Thus, the traceability of the costs is quite important in decisions involving additions and subtraction from a product line, product pricing, product marketing, changes in processes etc. (Q). Explain the cost output relationship in the short run. Cost and output are correlated. If the producing unit increases the level of output, the cost will also be affected. The study of cost is divided into two: (a) The cost output relationship in the short run. (b) The cost output relationship in the long run. (a) The cost output relationship in the short run: In the short run if a firm decides to produce and sell more output in the market, the only thing it can do is adjust the labour to increase the level of output. This is because in the short run it is not possible to for the firm to buy or introduce new plant, machinery, land, capital etc. Therefore, in the short run certain cost is fixed while some are variable. The cost incurred on land, plant, machinery is fixed while that on labour is variable. In the short run total cost of production will be Total cost = Total fixed cost + Total variable cost.


TC = TFC + TVC. The cost output relationship in the short run can be studied in terms of 1. 2. 3. 4. Average fixed cost. Average variable cost Average total cost. Marginal cost Average total cost = Average fixed cost + Average variable cost ATC = AFC + AVC 1. Average fixed cost: As the total fixed cost remains constant or fixed, with the change in the in output average fixed cost will fall with the increase in output for e.g. No. of units TFC AFC 100 200 500 5000 5000 5000 50 25 10

From the above table we mark that greater the level of output, lower will be the fixed cost. The shape of the average fixed cost curve will be downward sloping because there is an inverse relationship between total number of units and average fixed cost.
AFC 50 (Downward sloping AFC Curve) 25

10 0 100 200 UNITS units 500


2. Average variable cost: Average variable cost will first rise then fall as more and more units are produced. This is because in the short run law of variable proportion is applicable i.e. till the time we have underutilized capacity the output will rise but the cost will fall but once the capacity is fully utilized extra output can be increased only at an extra cost i.e. if more output is produced by hiring more and more labour the laborers will be more in number then the machines and the cost would rise sharply. Average Variable Cost (AVC=TVC/Q) 500 5 750 3.75 800 2 1500 3 TVC

Units 100 200 400 500

AVC 5 Average Variable cost U shaped

3.7 5 3 2

100 200

400 500


3. Average total cost: Average total cost is the total cost of production i.e. the sum of average fixed cost and the average variable cost. The ATC curve is a U shaped curve because it is affected by both AVC and AFC curves. Initially both the curves are falling and therefore will slope downwards further AFC curve fall but AVC curve rises, the rise in the AVC curve is more


powerful than the fall in AFC curve. The shape of the ATC curve will be affected by the AVC curve and therefore the AVC curve shoots up suddenly. This is explained in the diagram below. Units AVC 100 200 300 500 600
ATC 55 Average Total Cost U shaped

AFC 50 25 16.66 10 8.33

ATC=AVC+AFC 55 28.75 18.66 13 16.33

5 3.75 2 3 8

28.75 18.66 16.33 13 100 200 300 400 500 600 units

4. Marginal cost: Marginal cost is the addition made to the total cost by producing one more unit of output. The law of variable proportion in the short run also affects the marginal cost. However, marginal cost is independent of the fixed cost. The marginal cost curve first falls down and later it rises steeply and it intersects the average variable cost curve at its minimum point. This can be explained with the help of a table and diagram.


The above table explains the relationship between fixed cost variable cost and marginal cost. It states that: (a) Fixed cost remains same or constant i.e. it does not change with the level of output. Therefore the average fixed cost falls down with the increase in the in the output. (b) Variable cost increases with the level of output but not proportionately. (c) Marginal cost is the cost of an additional unit produced. This cost also falls down as the output level increases.




Relationship between Average and Marginal Cost and Output The relationship between average, marginal and output are explained in the diagram below. It states that (1) As the result of increase in output the average cost falls, marginal cost is less than average cost. (MC < AC) (2) As the result of increase in output the average cost is at its minimum, marginal cost is equal to average cost. (AC = MC) (3) As the result of increase in output the average cost is increasing, marginal cost is more than average cost. (AC>MC) DIAGRAM




Q) Explain the Cost output relationship in the long run.

In the long run all the cost are variable because to increase the output in the long run we can change all the factors of production. In the long run, the producer can Change or construct a new plant size to suit to the level of output. To explain this let us assume three plants of different sizes. Corresponding to this plant size, we will have three average short run cost curves, SAC 1, SAC2, SAC3, respectively. Where plant 1is a small plant, plant 2 is a medium sized plant, while plant 3 is a large sized plant. This can be explained with the help of a diagram.


Now if the producer wants to produce OA, it should select plant size 1 as the cost of production on plant size 1 is less than the cost of production on plant size 2, similarly If he wishes to increase the output to OB, he should select plant size 2 and for OC level of output plant size 3 is the best choice. To derive a long run average cost curve (LAC curve), a tangential line should be passed through various SAC curves. This will give an envelope shaped LAC curve and the optimum level of output for a firm is ON because the cost of production at this point is minimum. If a producer produces more than ON level of output, the cost of production rises as the plant is over utilized and if the producer produces less than ON, the plant in the long run will be over utilized. This is shown in the diagram.






N Now if the producer wishes to produce less than ON level of output i.e. OM then he underutilizes his plant size and the cost of production increases to EM and if he produces more than ON level of output i.e. OP level of output the cost of production increases to GP and therefore a rational producer will produce at minimum cost in the long run and therefore he will select ON level of output. Thus, we derive a long run average cost curve with the help of the short run average cost curve. CHARACTERISTICS OF LONG RUN AVERAGE COST CURVE
i. LAC Curve is U shaped; ii. The LAC covers all the SACs; iii. The LAC is tangential to all the SACs; that is LAC can never intersect the



iv. The LAC is also known as Envelope Curve as its arms envelope all the

SACs. v. LAC shows minimum cost of any level of output. Hence, no SAC can cut and lie below LAC. vi. When LAC is falling, it touches the descending portion of SAC and when it is rising, it touches the ascending portion of SAC. vii. The LAC curve is also known as Planning curve as it helps management in planning its business operations. MANAGERIAL USES OF LAC CURVE The firm is interested in producing the given level of output at minimum cost and not interested in getting the minimum cost output in a given plant. The LAC curve helps a firm to decide to buy that level of plant size for a given level of output to minimize the cost. If the plant is underutilized then the cost increased because the business manager has to incur maintenance charge to keep the machine in running condition. It is observed that if a firm wishes to produce little less output compared to optimum level then it is economical to under use a slightly bigger plant operating at less than its minimum cost output then to overuse a smaller plant. On the other hand, at output beyond the optimum level that is when the firm experiences decreasing returns to scale it is more economical to overuse a slightly smaller plant than to underuse a lightly larger one. Q) Discuss the Factors Affecting Cost. Cost of any product is a function of many variables. In other words, cost is determined by many factors they are also known as determinants of cost. Symbolically it can be expressed as: CX = F (OX, T, I, Q, G)

OX = output of product x T = Technology I = Input prices Q = Input Quality G = Government Policy


1. Output of X: Cost of production depends upon the level of output, higher the level of output lower will be per unit cost because the fixed cost is divided between many units. Thus the we can say that the fixed cost such as rent, insurance premium, interest payment etc can be among many units. 2. Technology: Technology is another important determinant of cost. A firm to reduce the cost of production and improve the quality of the product though the cost of installation may be high adopts usually new technology. 3. Input Prices: The inputs like raw materials of various prices, labour, transport, insurance, capital etc. are required to produce goods. If the cost of such goods increases the total cost of production increases and if the input prices are lower than the cost of production decreases. 4. Input Quality: It the quality of input is poor or inferior in nature then the cost of production will increase because of loss of raw material during production. Where as the better quality of the raw materials reduce the cost of production. 5. Government policy: Nowadays government controls and regulates the business and industry. Government policy pertaining to taxation, subsidy, wage fixation, export-import, licences etc. affects the cost structure of industry largely. If the tax rates were high, cost of production would swell to that extent. 6. Location: According to Dr.Vishweshvaria, the firm should take into considerations the nine Ms before making any decisions with respect to any decision regarding location of a new unit. The Nine Ms are men, material, market, machinery, motive power, management, means of transportation, money etc. The success of a firm depends up on the selection of a suitable site. 7. Transportation: Every manufacturing industry requires cheap and efficient means of transportation for the movement of both raw materials from the source of supply to the factory and finished products from the factory to the markets or the centers of consumption. The location of the plant, should therefore, be at a place where adequate transport facilities are available at cheaper rate. 8. Finance: No productive activity is possible without the availability of adequate capital. Banks, stock exchange and other similar institutions help in capital formation and expansion of industry by providing financial help to it from time to time. 9. Size: The success and efficiency of the firm also depends on its suitable size. The size of the firm should be optimum as to ensure maximum profitability. The optimum size of the firm is that point which results in the lowest production cost and maximum efficiency. This optimum size of the firm keeps on changing from time to time depending upon the improvement made by the firms in production techniques and managerial expertise.


10. Climatic conditions: Certain industries require a special type climate. For e.g. cotton, textile industries require humid climate while the photographic climate require dry climate. Climatic conditions also require affect the working capacity.

No. of units 100 200 300 400 500 TVC

AFC 50 25 16.66 12.5 10


TC 51

0.75 25.75 1 2 3 17.66 14.50 13

No. of units


100 200 300 400 500

100 150 300 800 1500

1 0.75 1 2 3



39 MEASURING NATIONAL INCOME Q) Describe the four components of GDP and give examples of each. ANS: We know that one of the most important things in macro economics is the measurement of national income. GDP is one of the ways of estimating national income. GDP is the most closely watched statistics as it is considered as the best single measure of societys well-being. Economy as a whole is the collection of many households and firms interacting in the markets. It is known facts that total expenditure is equal to the total national income and total national production. Total national income= Total national expenditure= Total national production This is because one mans expenditure is equal to another man income is equal to the market value of total national production. Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period of time. This definition might seem simple enough. But, in fact, many subtle issues arise when computing an economys GDP. Lets therefore consider each phrase in this definition with some care. GDP is the market value: It means that GDP adds together many different kinds of products into a single measure of the value of economic activity. To do this, it uses market prices. Because market prices measure the amount people are willing to pay for different goods, they reflect the value of those goods. Of all goods and services: It includes all goods and services produced in the economy. It is a comprehensive measure. GDP adds together many different kinds of products into a single measure of the value of economic activity. To do this, it uses market prices. Because market prices measure the amount people are willing to pay for different goods, they reflect the value of those goods. GDP excludes items produced and sold illicitly, such as illegal drugs. It also excludes most items that are produced and consumed at home and, therefore, never enter the marketplace. Vegetables you buy at the grocery store are part of GDP; vegetables you grow in your garden are not. Final: The word final goods and services mean that it includes the value of only final finished product and not the value of intermediate or semi-finished goods or services. For example the value of cotton, yarn, and textile would already be included in the market value of ready-made shirts. So if intermediate goods are taken into consideration then there would be problem of double counting. An important exception to this principle is when an intermediate good is produced and, rather than being used, is added to a firms inventory of goods to be used or sold at a later date. In this case, the intermediate good is taken to be final for the moment, and its value as inventory investment is added to GDP. When the inventory of the intermediate good is later used or sold, the firms inventory investment is negative, and GDP for the later period is reduced accordingly. GOODS AND SERVICES: GDP includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, and doctor visits). When you buy a CD by your favorite singing group, you are buying a good, and the

40 purchase price is part of GDP. When you pay to hear a concert by the same group, you are buying a service, and the ticket price is also part of GDP. PRODUCED: GDP includes goods and services currently (In that financial year) produced. It does not include transactions involving items produced in the past. When General Motors produces and sells a new car, the value of the car is included in GDP. When one person sells a used (second hand) car to another person, the value of the used car is not included in GDP. WITHIN A COUNTRY: GDP measures the value of production within the geographic confines of a country. When a Canadian citizen works temporarily in the United States, his production is part of U.S. GDP and therefore it is recorded . When an American citizen owns a factory in Haiti, the production at his factory is not part of U.S. GDP. (It is part of Haitis GDP.) Thus, items are included in a nations GDP if they are produced domestically, regardless of the nationality of the producer. IN A GIVEN PERIOD OF TIME: GDP measures the value of production that takes place within a specific interval of time. Usually that interval is a year. GDP measures the economys flow of income and expenditure during that interval. It should be apparent that GDP is a sophisticated measure of the value of economic activity. In advanced courses in macroeconomics, you will learn more of the subtleties that arise in its calculation. But even now you can see that each phrase in this definition is packed with meaning. COMPONENTS OF GDP Now we know that total expenditure of the economy is equal to total national income of the economy. So the statistician measures the total national expenditure of the economy. GDP includes all of these various forms of spending on domestically produced goods and services. To do this, GDP (which we denote as Y) is divided into four components: consumption (C), investment (I), government purchases (G), and net exports (NX): Y = C+I+G+NX Consumption spending: It is the spending by households on goods and services, with the exception of purchases of new housing. The circular flow in income as shown below explains how households spend on various goods and services to satisfy their wants. The households may buy food, clothing, shelter and various other things of comforts and luxuries and this all is included in consumption spending. C (consumption) is normally the largest GDP component in the economy, consisting of private (household final consumption expenditure) in the economy. These personal expenditures fall under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but do not include the purchase of new housing.

41 Investment spending: Firms as well as household do for investment spending. Investment spending on capital

equipment, inventories, and structures, including household purchases of new housing is included in this category. I (investment) include business investment in equipments for example and do not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in Investment. In contrast to its colloquial meaning, 'Investment' in GDP does not mean purchases of financial products. Buying financial products is classed as 'saving', as opposed to investment. This avoids double-counting: if one buys shares in a company, and the company uses the money received to buy plant, equipment, etc., the amount will be counted toward GDP when the company spends the money on those things; to also count it when one gives it to the company would be to count two times an amount that only corresponds to one group of products. Buying bonds or stocks is a swapping of deeds, a transfer of claims on future production, not directly an expenditure on products. Government purchases: It is the spending on goods and services by local, state, and Central governments. G (government spending) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits. Net exports spending: Spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports)

42 Q) Difference between Real and Nominal GDP. Q) Why do economists use real GDP rather than nominal GDP to gauge economic wellbeing? ANS: We now know that GDP measures the total spending on goods and services in all markets in the economy. If total spending rises from one year to next, then two reasons are responsible. a. The economy is producing a larger output of goods and services. Or b. Goods and services are being sold at higher prices. We can separate these two effects, when we want to understand the changes over time. In particular, we want a measure of the total quantity of goods and services the economy that is produced is not affected by changes in the prices of those goods and services. To do this economists use the Real GDP. Real GDP answers a hypothetical question: What would be the value of the goods and services produced this year if we valued these goods and services at the prices that prevailed in some specific year in the past (current year and base year)? By evaluating current production using prices that are fixed at past levels, real GDP shows how the economys overall production of goods and services changes over time.

To sum up: Nominal GDP uses current prices to place a value on the economys production of goods and services. Real GDP uses constant base-year prices to place a value on the economys production of goods and services. Because real GDP is not affected by changes in prices, changes in real GDP reflect only changes in the amounts being produced. Thus, real GDP is a measure of the economys production of goods and services. Our goal in computing GDP is to gauge how well the overall economy is performing. Because real GDP measures the economys production of goods and services, it reflects the economys ability to satisfy peoples needs and desires. Thus, real GDP is a better gauge of economic well being than is nominal GDP. When economists talk about the economys GDP, they usually mean real GDP rather than nominal GDP. And when they talk about growth in the economy, they measure that growth as the percentage change in real GDP from one period to another.

43 THE GDP DEFLATOR As we have just seen, nominal GDP reflects both the prices of goods and services and the quantities of goods and services the economy is producing. By contrast, by holding prices constant at base-year levels, real GDP reflects only the quantities produced. From these two statistics, we can compute a third, called the GDP deflator, which reflects the prices of goods and services but not the quantities produced. The GDP deflator is calculated as follows: GDP deflator = Because nominal GDP and real GDP must be the same in the base year, the GDP deflator for the base year always equals 100. The GDP deflator for subsequent years measures the rise in nominal GDP from the base year that cannot be attributable to a rise in real GDP. The GDP deflator measures the current level of prices relative to the level of prices in the base year. To see why this is true, consider a couple of simple examples. First, imagine that the quantities produced in the economy rise over time but prices remain the same. In this case, both nominal and real GDP rise together, so the GDP deflator is constant. Now suppose, instead, that prices rise over time but the quantities produced stay the same. In this second case, nominal GDP rises but real GDP remains the same, so the GDP deflator rises as well. Notice that, in both cases, the GDP deflator reflects whats happening to prices, not quantities.