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UNIT 1: -

NATURE AND SCOPE OF ECONOMICS

1.1 DEFINITION OF ECONOMICS

MEANING OF ECONOMICS

The word Economics originates from the Greek work Oikonomikos which can be divided into two parts:

(a) Oikos, which means Home, and

(b) Nomos, which means Management.

Thus, Economics means Home Management. The head of a family faces the problem of managing the unlimited
wants of the family members within the limited income of the family. In fact, the same is true for a society also. If
we consider the whole society as a family, then the society also faces the problem of tackling unlimited wants of
the members of the society with the limited resources available in that society. Thus, Economics means the study
of the way in which mankind organises itself to tackle the basic problems of scarcity. All societies have more wants
than resources. Hence, a system must be devised to allocate these resources between competing ends.

DEFINITIONS OF ECONOMICS

We have now formed an idea about the meaning of Economics. This at once leads to a general definition of
Economics. Economics is the social science that studies economic activities. This definition is, however, too broad.
It does not specify the exact manner in which the economic activities are to be studied. Economic activities
essentially mean production, exchange and consumption of goods and services. However, with the progress of
civilisation, the complexity of the production, exchange and consumption processes in society have increased
manifold. Economists at different times have emphasised different aspects of economic

Adam Smiths Definition

Classical economists like Adam smith and his distinguished followers J.S. Mill, F.A. Walker, David Ricardo, etc. define
economics as a science of wealth. Adam smith is the leader of classical school of economic thought. There were
many economists before the emergence of classical school of economic thought. However, the first definition was
given by Adam smith. He categorized economics as a separate science which was link with other subjects. For this
great contribution of smith in economic science, he is respected with the honor of father of economics. After the
publication of Adam smiths book (An enquiry into nature and cause of wealth of nation) in 1776 A.D, economics
got its independent identity. He defined economics as the science which studies about the nature and causes of
wealth of nation.

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According to him economics maintain the relationship between consumption and production of wealth. It is
concerned with the knowledge of earning money. Every individual of the society has a desire to earn wealth. So,
economics provides guidelines to the individual in earning more wealth. The main points or ideas in the definition
of Adam smith are:

1. Study of wealth of nation: Economics is the study of wealth of nation. It deals with consumption,
production, exchange and distribution of wealth.
2. Study of economic activities: Economics is only concerned with the activities of economic man, who is
involved in earning more wealth. But it is not a study of non-economic man, who is not involved in
earning wealth.
3. Main goal is to earn wealth: The main goal of human beings is to earn wealth because wealth is only the
means for satisfying human wants.
4. First place to wealth: Adam smith gave the first place to wealth and secondary place for man in the study
of economics. In other words, the subject matter of economics is wealth. He advocated that man is made
for wealth.
5. Only material goods constitute wealth: The definition has given emphasize only material goods
constitute wealth in society and there is no concern of economics with non-material goods or like free
goods: air, water, sunlight, water, etc. which do not play any role in creation of wealth in society.
6. Employed labour is the source of wealth: The source of wealth of nation is employed labour whose
productivity would be increased through the division of labour in production and distribution of goods
and services.

Criticism of of Adam Smiths Definition

1. Narrow meaning of wealth: Adam smith considered that economics is the science of wealth and
wealth includes only material goods. This is the narrow sense of defining wealth. In practice, wealth
includes both material and non- material goods. The human wants can be fulfilled by using non
material goods of services also.

2. Too much importance to wealth: Adam smith gave more importance to wealth than man. He had
given first place for wealth and secondary place for human beings. But according to Marshall, wealth is
only a means of satisfying human needs. Thus, economics must emphasize the study of man much
more than the study of wealth.

3. No meaning of human welfare: This definition gave no importance to the welfare of society. According
to Marshall, the main aim of economics is to increase the welfare of human beings not to obtain wealth
only.

4. Wrong assumption of economic man: According to Adam smith, Economic man is one who is involved
in earning wealth and this economic man is only the subject matter of economics. But no man can be
limited only with earning wealth. Because man is equally influenced by moral and spiritual thoughts
like love, self-esteem, sympathy, friendship, etc.

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5. Labour is not only the source of wealth: According to Adam smith, main source of wealth is employed
labour. In real, labour alone cannot produce anything. In production process, there are other factors of
production like land, capital, and organization including labour. Adam smith has ignored these aspects.

Marshalls Definition of Economics

Many economists have realized that there are serious mistakes in the Adam smiths definition. His definition of
economics made man selfish. People started thinking about the economics as a science of getting rich etc. In order
to save economics from this shiver criticism, Marshall, the leader of neo-classical economists, gave a new concept
about economics by publishing his book, Principles of economics in 1890 A.D. Marshall enlarged the scope of
economics by shifting the emphasis from wealth to man. Alfred Marshall also stressed the importance of wealth.
But he also emphasised the role of the individual in the creation and the use of wealth.

He wrote: Economics is a study of man in the ordinary business of life. It enquires how he gets his income and how
he uses it. Thus, it is on the one side, the study of wealth and on the other and more important side, a part of the
study of man.

Marshall, therefore, stressed the supreme importance of man in the economic system. Marshalls definition is
considered to be material-welfare centred definition of Economics

He said that people were not for wealth but wealth was made for the people. The objective of economics is to
increase human welfare. Wealth is not the end but it is only the means. So, Marshall gave primary place to man and
secondary place to wealth. Many economists like A.C. Pigou, Cannon, and Beverage etc. have supported the view
of Marshall. The main points or ideas in the definition of Marshall are as follows:

1. Primary Concern to mankind: - Economics is mainly concerned with the study of mankind in relation to
wealth. Wealth is for the benefit of mankind and secondary importance should be given to mankind and
secondary importance to wealth.
2. Study to ordinary man: - According to Marshall, economics is related to the behavior of ordinary man.
Ordinary men are those who are involved not only in accumulating more wealth but also try to
experience love, sympathy, good will etc. to make their social life more meaningful.
3. Study of material welfare: - Economics does not study the hole of human welfare but only part of it
called material welfare. Material welfare means satisfaction derived from the consumption of physical
goods. Any forms of goods of economic value that provide satisfaction are regarded as the subject
matter of economics. Non-material welfare is outside the scope of economics.
4. Study of social science: - Marshall explains that economics studies those people who live in society. It
does not study about an isolated people, not belonging to a society such as sadhu, priests, beggar,
monks, etc.

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Criticism of Marshalls Definition of Economics

The definition is not analytical.:- Alfred Marshall has divided human activities into economic and non economic,
material and non-material & ordinary and extra-ordinary. But he could not able to separate these terms clearly.
Therefore, his definition is only classificatory rather than analytical in nature.

1. Economics is human science not only social science.:- According to Marshall, economics studies the
economic activities of social man only. But in Robbinss view this idea is wrong. The man who lives
outside the society may be engaged in economic activities. Either the person lives in society or not, he
has to face various economic problems. Hence, economics is not only social science but it is a human
science also.
2. Focus on material activities only.:- According to Marshall, economics studies only material activities
which are the base of happiness. An ultimate goal of man is to increase material welfare. But in
Robbinss view, the non-material activities may also promote human welfare. Because of the services
provided by doctor, teacher, etc, there is possibility of promotion of human welfare.
3. All material goods may not provide welfare::- According to Marshall, material goods provides welfare
for person, but some of the goods like cigarette, alcoholic drinks etc. are not able to promote welfare
for the user. When harmful goods are used, welfare cant be achieved.
4. Difficult to separate material & non-material things.:- Marshall includes only material things within the
scope of economics and excludes all non-material things. But it is quite difficult to separate material and
non material things. For example: if a doctor services for fee, it is material and if he services for free,
it is non-material.

Lionel Robbins Definition

The next important definition of Economics was due to Prof. Lionel Robbins. In his book Essays on the Nature
and Significance of the Economic Science, published in 1932, Robbins gave a definition which has become one
of the most popular definitions of Economics. According to Robbins, Economics is a science which studies
human behaviour as a relationship between ends and scarce means which have alternative uses. A long line
of economists after Robbins, including Scitovsky and Cassel agreed with this definition and carried on their
analysis in line with this definition. It is a scarcity-based definition of Economics.

The main points or ideas in the Robbinss definition are as follows:

1. Unlimited human wants or use.:- According to Robbinss, human wants are unlimited. These
unlimited wants are not possible to satisfy at a time. If one want is satisfied, another arises in our
mind immediately. Thus there is a chain of wants, one want chasing another. There are no ends of
human needs.
2. Limited resources. :- Human wants are unlimited but the means to satisfy them are limited
relatively. The wants are more times than means. We called such a resource as a limited whose
supply is less than demand. Limited resources mean time, money, wealth etc.

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3. Scarce resources have alternative use.: - Human wants are unlimited but the means to satisfy this
wants are scare but the scare means have alternative uses. For example: money can be used to buy
food, a book or to go to cinema.
4. All wants are not equally urgent.:- According to Robbinss, all wants are not equally urgent. They
differ in urgency. Some wants are more urgent than the other ones. So, more urgent wants need
more immediate satisfaction and others can wait. Current wants are more important than future
wants. For example: Medicine is more important than cosmetics for a sick girl.
5. Problems of choice:- Although human wants are unlimited, all the wants are not equally important
or urgent. More important wants have to be fulfilled immediately and less important wants have to
be fulfilled immediately and less important can be postponed. So, human beings make choice of
wants to derive maximum satisfaction. So, according to Robbinss, choice making is really an
economic problem.

Criticism of Robbins Definition of Economics

1. Hidden concept of welfare.:- Robbins has criticized the concept of Marshall but critics claimed that
his definition itself includes the concept of welfare through the back door. Robbinss definition of
economics is concerned with the choice between wants and allocation of resources for maximum
satisfaction. In fact, maximum satisfaction is sign of welfare.
2. Economic problem arises not only from society.:- According to Robbinss definition, economic
problem arises due to the scarcity of resources. But the problems like inflation, unemployment, etc.
arise due to the abundance of resources. The problem of unemployment is due to abundance of
manpower. So, it is not correct that economic problem arises due to scarcity only.
3. Confusion between means and end.:- Robin believes that means and end are easily separable. But
in practice, it is difficult to distinguish between means and end for example:- a M.A. student aims
getting M.A. degree. This is an end for him. Once he gets it, he uses it as a means to get employment.
Thus the same thing may be means in one situation and the end in another.
4. Wider scope than need.:- Robbinss definition includes the study of all human activities related to
the alternative uses in economics. Since all of the activities of human life are included, its scope is
being varied vastly. It makes difficult to draw the line of demarcation of economics.
5. It ignores the theory of economic growth.:- The theory of economic growth has recently become a
very important branch of economics but Robbinss definition does not cover it. Economics of growth
explains how an economy grows by increasing the national income and productive capacity of the
economy. But Robbins takes the resources as given and discusses only there allocation.

J.K. Mehta Definition on Economics

J.K. Mehta was a great scholar both in Economics and Philosophy. He made a positive contribution to the field of
economic theory for which he deserved credit and praise. His economic thinking is very much influenced by the
Indian way of life, religion and ethics and all the Gandhian philosophy.

Porf. J.K. Mehta-

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Economics is a science which studies human behaviour as a means to reach in a situation free of wants.

Mehta has dealt with the nature and scope of economics mainly from a philosophical viewpoint. Mehta developed
the theory of wantlessness as a counter to the Western economists theory of unlimited wants as the prime mover
of economic activity. According to him, wants to first emerge in the minds of people and subsequently surface more
freely as a source of pain when they are not able to satisfy them. Also, as soon as a want gets satisfied, a feeling
occurs in their mind for a recurrent satisfaction of the want and also generation of many other allied units. Thus,
the-satisfaction of a want gives birth to a new set of wants to lead to a new source of pain if the wants cannot be
satisfied. This cycle of satisfaction of one want to give rise to another want continues unendingly. Thus, the
satisfaction of a want does not close the circle of desire and pain.

The state of wantlessness, according to Mehta is one in which there is no pain and consequently no possibility of
getting pleasure. The feeling that one experiences in such a state of mind is best designated by the happiness, as
opined by Mehta. He made a distinction between satisfaction or pleasure and happiness. Happiness is not merely
the removal of pain; it is a state in which there is no pain. It (happiness) will be maximum when pain is reduced to
zero. Therefore, the end of human behaviour, as given by Mehta, is happiness, Pleasure, however, is only a means
to an end. According to him, economics is, therefore, the science that studies human behaviour as the effort to
minimise pain in the long run, or, in other words, as an endevour to gain freedom from wants and reach the state
of happiness. However, Mehtas wantless individual would have satisfied his elemental desires for necessities. The
problem arises when this bound is crossed or raised. New wants emerge for so called luxuries, which soon become
necessities for comforts and as newer luxuries emerge, there is perpetual disequilibrium. To overcome this, one has
to overcome imperfections, impurities and find ones true self.

Then one will not be a slave to his wants. To approach this state of wantlessness one has to discipline his bodily
existence, by understanding the temporary nature of satisfaction one gets from, the growing wants beyond their
basic necessities. Then the society will not have to generate more and more goods, which would in turn generate
scarcity of resources. In Mehtas wantlessness there is no room for scarcity as there is no room for unsustainable
resource use. His theory of wantlessness provides insights that help move towards sustainable development.

1.2 Nature of Economic Laws

Introduction

Like other social sciences, economics has its own laws. A law is a statement of what must happen given certain
conditions. Every cause has a tendency to produce some result. For example, in Physics, we study that things fall to
the ground because of gravitation. The law of gravitation is a statement of tendency. Similarly, the laws of economics
are statements of tendencies. For example, according to the law of demand, when there is fall in the price of a good,
the demand for it will expand. It means that there is a tendency among people to buy more when there is fall in the
price of a good. Similarly, if price rises, they will buy less. Laws operate under certain conditions. If these conditions
change, they will not operate. This is applicable to all sciences. When some economic laws do not operate, it means
that the conditions have changed.
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The term law means statements of general tendencies. Economic laws generalise the human behaviour
regarding economic activities. According to Professor Marshall, Economic laws or statements of economic
tendencies are those social laws which relate to bran ches of conduct in which the strength of the motives
chiefly concerned can be measured by a money price.

Characteristics of Economic Laws

1. Economic laws are statements of economic tendency: - Economic laws, like other laws establish relationship
between causes and their effect. As these laws are not cent per cent exact, so they are expressed in terms of
economic tendencies. In other words, these laws explain the likelihood of human behaviour under specific
conditions. For example, according to law of demand, the demand of a particular commodity will fall, if there
is an increase in its price. In real life, there are certain cases, when demand of the commodity may not fall even
after the increase in its price. Economic laws are not as exact as the laws of Physics and Chemistry.
2. Economic laws are hypothetical: - Economic laws simply indicate the general tendency of human behaviour.
These laws are not applicable in every situation. This is why, every economic law is associated with the phrase,
other things being equal or other things remaining the same. For example, the law of diminishing utility
explains that utility derived from the use of the successive units of a commodity goes on falling, but this law
will apply, when units are uniform, sufficient and there is always continuity in their use.
3. Economic laws are relative: - Economic laws are closely related to time, place and situations. Most of the
economic laws are not universal. Change of time, place and situations make then ineffective.
4. Economic laws are human laws: - Economic laws may be termed as human laws, because, they are based upon
human behavior. Laboratory testing of human behaviours cannot be made, as that of matters in physics and
salts in chemistry. This is why, economic laws are less exact. It is an accepted truth that every individual is
different from the other individual or there are individual differences, so laws regarding human behaviours can
never have universal application.
5. Certain universal laws:- Certain economic laws have universal application, such as problems of scarce means
and endless wants. It is equally true for every individual and economy. Marshall has compared the economic
laws with the law of tides. It shows that economic laws are less exact, seldom deficit and lack universal
application. Due to the use of statistical analysis and mathematical methods economic laws are approaching
towards exactness.

Assumption of Economic Laws

Economic laws are the statements of human behaviours. This is why, these laws are not as exact as the laws of
natural sciences. Economist deals with human behaviours, which are never consant and exact as the behaviours of
natural bodies. In addition to this weakness, the human behaviour cannot be put to laboratory testing as the natural
bodies. Important assumptions are mentioned herewith:

1. Other Things Remaining the Same :- All the economic laws have the phrase, Other things being equal or other
things remaining the same. It shows that the law will apply at certain place and in certain situation. For example,
if the price of Cadbury chocolate falls its demand should increase considerably, but it may not increase because the
demand of chocolate is affected by other factors also. It is the income, tastes, preferences and the price of the
substitutes which will also affect the demand of Cadbury chocolates. In this case, the law of demand will apply only
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if the income of the consumers, their tastes, preferences and the price of substitutes do not change. This is why,
economist has to use the phrase, other things remaining the same.

2. Rationality of Human Conduct: - Economic laws presume that the consumers are rational. They will spend their
limited resources in such a way that they may get maximum satisfaction. It has been our experience that all the
consumers are not rational in their behaviour. There are certain consumers who visit a certain shop or certain type
of shops or shops in certain area, knowing well that these shops have been charging comparatively more price than
other shops. This extra-ordinary attitude of certain individuals makes economic laws inexact.

Types of Economic laws

(a) Universal Laws

Certain economic laws are relevant to almost all locations as well as all of the time. These types of laws are universal
in their application. They are in fact axiomatic in nature. The statements such as saving is a function of income,
human wants are unlimited and the like are commonly valid. Similarly, the law of demand and supply are
appropriate to pretty much all nations and at all the time.

(b) Relative Laws

Nevertheless, not all economic laws are like axioms and consequently not universally valid. For instance, the laws,
which happen to be valid in a capitalist economy may not be useful for a communist economy. Laws that are relevant
to developed nations, may not be employable in developing countries. Laws, which apply at certain occasions, may
not be useful during other situations. The samples of these kinds of laws are the laws of tariff, banking and
commerce etc. This set of laws is known as relative laws.

Importance of Economic Laws :-

Economic laws are of great importance in practical life. Some economic laws are applicable to all types of economic
systems. They have universal application. For example, we have the law of Diminishing Returns. There are other
important laws such as the law of diminishing marginal utility and the law of demand. Some economists believe that
the quantity theory of money is valid under all economic systems capitalism or socialism or mixed economy.

Let us take some important laws like the law of diminishing marginal utility, the law of demand, the law of
diminishing returns and the Malthusian Theory of population and discuss their significance. The law of diminishing
utility is based on actual experience. It tells that the more and more of a thing you have, the less and less you want
it. It explains the relationship between the price of a good and the satisfaction you get from it. During summer,
generally, there will be fall in the price of mangoes because they are available in plenty. So there is diminishing
utility. And as price is related to marginal utility, the price falls.

Progressive taxation is based on the law of diminishing utility. As the income increases, the Government ask the rich
to pay more taxes by increasing the rates of taxation for them. For it believes that as a man gets more and more
money, he will get diminishing utility from it. So even if he parts with more money, the sacrifice will not be much in
his case. The law of demand is based on actual experience. In practice we find that when price falls, demand

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increases. Price falls when supply is more. When there is increase in the supply of a good, its marginal utility
diminishes. A seller will try to sell more of his good by reducing its price slightly. The law of diminishing marginal
returns has universal application.

In agriculture, it means that we cannot double the output by doubling labour and capital. The law applies to
manufacturing industry also. The Malthusian theory of population tells that population increases at a faster rate
than food supply. It might not be an exact statement. But it was true in the case of most of the poor countries of
the world until the Green Revolution. The Green Revolution helped in increasing agricultural productivity. There is
the problem of over population in most of the poor countries of the world. That is why they spend huge amounts
on family planning to reduce population growth. So, most of the laws of economics are of great practical importance.

Limitation of Economics Law:-

Prof. Marshall says that economic laws are statements of tendencies. Generally, economic laws argue that under
specific circumstances some things would take place. Economic laws usually do not offer any assurance that they
must occur. Economic laws are merely likelihood and not certainties.

Physical and natural sciences are predictable. The law of gravitation indicates precisely how various things are
moved in a downwards direction by the power of gravity. Additionally, a particular volume of oxygen and hydrogen
would certainly provide us with water. On the other hand, this is not the situation in economics. To illustrate, the
laws of tides clarifies how you can find a surge and drop of waves twice a day under the impact of the sun and the
moon, and also how you can find robust waves on new and full moon times. Hence, the science of tides could
forecast when the tide will likely be the largest on any day at a specific area; however, its functionality could possibly
be hindered by numerous unexpected situations like extreme rainfall or intense winds. Likewise, in human activities
also, the anticipated course of action might not take place because of numerous unexpected instances.

Micro Economics

The term Micro Economics is derived from the Greek word mikros, meaning small. According to Prof. Boulding,
Microeconomics is the study of particular firms, particular households, individual price, wages, income, individual
industries and particular commodities. In Micro-Economics we study the economic behaviour of an individual, firm
or industry in the national economy. It is thus a study of a particular unit rather than all the units combined. It is
basically concerned with the mechanism of allocation of given resources. Further, it is a partial equilibrium analysis
as it seeks to determine price and output in an industry independent of those in other industries. We mainly study
the following in Micro-Economics:

1. Product pricing;
2. Consumer behaviour;
3. Factor pricing;
4. Economic conditions of a section of the people;
5. Study of firms; and
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6. Location of industry.

Thus, when we are studying how a producer fixes the prices of his products, we are studying Micro-Economics.
Similarly, when we are studying why an industry is located at a particular place, we are studying Micro-Economics.

Merits of Microeconomics

1. Individual Behaviour Analysis:- Micro economics studies behaviour of individual consumer or producer in
a particular situation.
2. Resource Allocation:- Resources are already scare i.e less in quantity. Micro economics helps in proper
allocation and utilization of resources to produce various types of goods and services.
3. Price Mechanization:- Micro economics decides prices of various goods and services on the basis of
'Demand-Supply Analysis'.
4. Economic Policy:- Micro economics helps in formulating various economic policies and economic plans to
promote all round economic development.
5. Free Enterprise Economy:- Micro economics explain operating of a free enterprise economy where
individual has freedom to take his own economic decisions.
6. Public Finance:- It helps the government in fixing the tax rate and the type of tax as well as the amount of
tax to be charged to the buyer and the seller.
7. Foreign Trade:- It helps in explaining and fixing international trade and tariff rules, causes of disequilibrium
in BOP, effects of factors deciding exchange rate, etc.
8. Social Welfare:- It not only analyse economic conditions but also studies the social needs under different
market conditions like monopoly, oligopoly, etc.

Demerits of Microeconomics

1. Unrealistic Assumptions:- Micro economics is based on unrealistic assumptions, especially in case of full
employment assumption which does not exist practically. Even behaviour of one individual can not be
generalised as the behaviour of all.
2. Inadequate Data:- Micro economics is based on the information dealing with individual behaviour,
individual customers. Hence, it is difficult to get correct information. So because of incorrect data Micro
Economics may provide inaccurate results.
3. Ceteris Paribus:- It assumes that all other things being equal (same) but actually it is not so.

Macro Economics

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The term Macro Economics is derived from the Greek word makros, meaning large. It is the study of overall
economic phenomena or the economy as a whole, rather than its individual parts.

According to McConnel, Macroeconomics examines the forest and not the trees. Thus it analyses and establishes
the functional relationship between large aggregates. Thus, in Macro-Economics, we study the economic behaviour
of the large aggregates such as the overall conditions of the economy such as total production, total consumption,
total saving and total investment. It includes:

1. National income and output;


2. General price level;
3. Balance of trade and payments;
4. External value of money;
5. Saving and investment; and
6. Employment and economic growth.

Thus, when we study why we continue to have balance of payments deficits, or why the value of rupee vis--vis
dollar is falling or why saving rates are high or low in a particular country, we are studying Macro-Economics.

Merits of Macroeconomics

1) To Understand the Working of the Economy: The study of macroeconomic variables is indispensable for
understanding the working of the economy. Our main economic problems are related to the behaviour of total
income, output, employment and the general price level in the economy.

2) In Economic Policies: Macroeconomics is extremely useful from the point of view of economic policy. Modern
governments, especially of the underdeveloped economies, are confronted with innumerable national problems.
They are the problems of overpopulation, inflation, balance of payments, general underproduction, etc.

3) In General Unemployment: The Keynesian theory of employment is an exercise in macroeconomics. The general
level of employment in an economy depends upon effective demand which in turn depends on aggregate demand
and aggregate supply functions.

4) In National Income: The study of macroeconomics is very important for evaluating the overall performance of
the economy in terms of national income. With the advent of the Great Depression of the 1930s, it became
necessary to analyse the causes of general overproduction and general unemployment.

5) In Economic Growth: The economics of growth is also a study in macroeconomics. It is on the basis of
macroeconomics that the resources and capabilities of an economy are evaluated. Plans for the overall increase in
national income, output, and employment are framed and implemented so as to raise the level of economic
development of the economy as a whole.

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6) In Monetary Problems: It is in terms of macroeconomics that monetary problems can be analysed and
understood properly. Frequent changes in the value of money, inflation or deflation, affect the economy adversely.
They can be counteracted by adopting monetary, fiscal and direct control measures for the economy as a whole.

7) In Business Cycles: Further macroeconomics as an approach to economic problems started after the Great
Depression. Thus its importance lies in analysing the causes of economic fluctuations and in providing remedies.

Demerits of Macroeconomics:

1) Misconception of Composition: In Macroeconomic analysis the fallacy of composition is involved, i.e.,


aggregate economic behaviour is the sum total of individual activities. But what is true of individuals is not
necessarily true of the economy as a whole.

2) To Regard the Aggregates as Homogeneous: The main defect in macro analysis is that it regards the aggregates
as homogeneous without caring about their internal composition and structure. The average wage in a country is
the sum total of wages in all occupations, i.e., wages of clerks, typists, teachers, nurses, etc.

3) Aggregate Variables may not be Important Necessarily: The aggregate variables which form the economic
system may not be of much significance. For instance, the national income of a country is the total of all individual
incomes. A rise in national income does not mean that individual incomes have risen.

The increase in national income might be the result of the increase in the incomes of a few rich people in the country.
Thus a rise in the national income of this type has little significance from the point of view of the community.

4) Indiscriminate Use of Macroeconomics Misleading: An indiscriminate and uncritical use of macroeconomics in


analysing the problems of the real world can often be misleading. For instance, if the policy measures needed to
achieve and maintain full employment in the economy are applied to structural unemployment in individual firms
and industries, they become irrelevant. Similarly, measures aimed at controlling general prices cannot be applied
with much advantage for controlling prices of individual products.

(5) Statistical and Conceptual Difficulties: The measurement of macroeconomic concepts involves a number of
statistical and conceptual difficulties. These problems relate to the aggregation of microeconomic variables. If
individual units are almost similar, aggregation does not present much difficulty. But if microeconomic variables
relate to dissimilar individual units, their aggregation into one macroeconomic variable may be wrong and
dangerous.

Managerial Economics: -

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Meaning of Managerial Economics: It is another branch in the science of economics. Sometimes it is
interchangeably used with business economics. Managerial economics is concerned with decision making at the
level of firm. It has been described as an economics applied to decision making. It is viewed as a special branch of
economics bridging the gap between pure economic theory and managerial practices. It is defined as application of
economic theory and methodology to decision making process by the management of the business firms. In it,
economic theories and concepts are used to solve practical business problem. It lies on the borderline of economic
and management. It helps in decision making under uncertainty and improves effectiveness of the organization. The
basic purpose of managerial economic is to show how economic analysis can be used in formulating business plans.

Definitions of Managerial Economics: In the words of Mc Nair and Merriam, ME consist of use of economic modes
of thought to analyze business situation. According to Spencer and Seigelman it is defined as the integration of
economic theory with business practice for the purpose of facilitating decision making and forward planning by the
management. Economic provides optimum utilization of scarce resource to achieve the desired result. MEs
purpose is to show how economic analysis can be used formulating business planning.

Managerial Economics = Management + Economics

Management deals with principles which helps in decision making under uncertainty and improves effectiveness of
the organization. On the other hand economics provide a set of preposition for optimum allocation of scarce
resources to achieve a desired result. Managerial Economics deals with the integration of economic theory with
business practices for the purpose of facilitating decision making and forward planning by management. In other
words it is concerned with using of logic of economics, mathematics, and statistics to provide effective ways of
thinking about business decision.

Objective of Managerial Economics: -

1. Integrating economic theory with business practice

2. Using economics tools to analyze business situations

3. Applying economic principles to solve business problems

4. Using economic ideas for crisis management

5. Facilitating demand analysis and demand forecasting

6. Allocating scarce resources for optimizing returns

7. Enabling risk taking and uncertainly bearing

8. Helping in profit maximization

9. Pursuing the larger objectives of the firm other than profit maximization

10. Formulating short-term and long-term business strategies

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BASIC PROBLEMS OF AN ECONOMY: -

Human wants are unlimited but resources to meet these wants are limited and scarce. These resources can also be
put to alternative uses. Satisfaction of unlimited wants with limited means creates problem of choice making. In
every economy, economic resources are limited, whereas demands are unlimited. This is why, every economy has
to face and solve the following basic problems :

A. Allocation of Resources

The available resources of the society may be used to produce various commodities for different

groups and in different manner. It requires that decisions regarding the following should be made :

1. What to produce ? (Types and amount of commodities to be produced) Land, labour, capital, machines, tools,
equipments and natural means are limited. Every demand of every individual in the economy cannot be satisfied,
so the society has to decide what commodities are to be produced and to what extent. Goods produced in an
economy can be classified as consumer goods and producer goods. These goods may be further classified as single
use goods and durable goods. It is undoubtedly the basic problem of the economy. If we produce one commodity,
it will mean that we are neglecting the production of the other commodity. We assume that all the factors of
production in the economy are fully absorbed, so if we want to increase the production of one commodity, we will
have to withdraw resources from the production of the other commodity. On the basis of our requirements goods
are further classified as goods for necessaries, comforts and luxuries. The economy is also faced with the problem,
how much goods should be produced for necessaries, comforts and luxuries.

2. How to produce ? (Problem of the selection of the technique of production-choice between labour-intensive and
capital-intensive techniques) After the decision regarding the goods to be produced is taken, next problem arises as
to what techniques should be adopted to produce commodity. Goods can be produced in large scale industries or
in small-scale village and cottage industries. The economy has to decide between automatic machines and
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handicrafts. Every method has got its own advantages and disadvantages. Mechanisation increases the quantity of
production. The quality is also improved. As it requires lesser number of workers, it results in unemployment.
Handicrafts reduce unemployment but the quantity of production is lesser. The economy has to decide about the
technique of production on the basis of the cost of labour and capital.

3. For whom to produce ? (Problem of distribution of income) Goods and services produced in the economy are
consumed by its citizens. The individuals may belong to economically weaker sections or rich class of people.
Actually this is a problem of distribution. In case of capitalism the decision is taken on the basis of the purchasing
power of the consumers.

Socialistic economy takes decision regarding goods and services to be produced on the basis of the requirements of
the individuals.

B. Fuller Utilisation/Employment of Resources (Efficient use)

Out means and resources are limited and scarce, so they should be properly used. There should not be the wastage
of these resources. The problem with the economy is how to use its available resources i.e., land, labour, capital
and other resources, so that maximum production with minimum efforts and wastages be made possible. Economic
development will suffer, if certain resources remain idle. Since 1930s after the great world depression we have
started thinking of fuller utilisation of limited resources. It has been accepted that the under-utilisation or
unemployment of resources is a waste, so the economy must ensure that the available resources are efficiently and
effectively utilised. Problems regarding fuller utilisation of resources and efficiency are studied under Welfare
Economics.

C. Growth of Resources (Economic development)

Increase in the population is the common feature of the economy. It becomes necessary that the rate of economic
development must be faster than the rate of increase in the population, so that the economic development may
take place and the reasonable standard of living of the citizens can be maintained. In this connection, the economy
has to decide about the rate of capital formation, investment and savings. Efforts are made for the economic
development of the society, so that it may be able to face the real challenges of time. Problems concerning the
growth of resources are discussed in the

Developmental Economics.

THE PRICE MECHANISM

This is a system in a free enterprise economy where prices in the market are determined by demand and supply and
prices are determined by the allocation of resources. In such cases, the economy is king/ there is consumer
superiority. When the consumers demand for a particular commodity increases, more resources are allocated to
the production of that commodity so its supply increases.

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When the consumers demand reduces, price falls so its not very worthwhile to produce that commodity so fewer
resources are devoted to it and as a result supply is reduced. This process of adjustment continues allowing for
changes in demand and supply in the economy.

ROLE OF PRICE MECHANISM

It helps in allocation of scarce resources to where prices are highest.


Price mechanism determines what to produce, when and how to produce.
The prices of factors of production determine how to produce and this depends on the relative costs.
Prices guide consumers choice. Consumers buy good at the cheapest price possible because their aim is to
maximize utility.
Helps to decide where to produce i.e. location of production units.
Helps in automatic adjustments between demand and supply in the market and establish an equilibrium
thereby equating supply and demand in the market.
It helps in the distribution of income between producers and individuals. Those whose resources are highly
demanded will get higher incomes compared to those who do not have many resources that are marketable.
The price mechanism determines the distribution of goods and services and for whom to produce. More
goods produced for the rich who can pay higher prices.
Promotes innovation. Producers try to look for new ways of producing goods and services to be able to
remain in production.
It provides impetus for economic growth. As prices of commodities increase producers in a bid to maximize
their profits increase their investment leading to increase in output of goods and services.
It provides a variety of goods on when to produce, when the demand is high and prices are high and rising.
It helps to harmonize profit maximization motive with producers and utility maximization motive of
consumers so that both fully benefit from the available factors of production.
Since there are many producers, they try to improve on the quality of their output so as to attract more
buyers.
The price mechanism is an indicator of change in wants when the people demand for more goods, prices
increases.

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UNIT -2 - DEMAND
B.COM- I NOTES COMPILED BY PROF.RUPESH DAHAKE AMV DHAMANGAON RLY COMMERCE DEPARTMENT
: 2.1 Law of Demand, Elasticity of Demand : 2.2 Concept, Importance and Measurement of Elasticity of Demand.
2.3 Determinants of Elasticity of Demand. 2.4 Average Revenue, Marginal Revenue and Elasticity of Demand. 2.5
Price income and cross Elasticities. 2.6 Concept and Characteristics of Indifference Curve.

MEANING OF DEMAND

The concept demand refers to the quantity of a good or service that consumers are willing and able to purchase at
various prices during a given period of time. It is to be noted that demand, in Economics, is something more than
desire to purchase though desire is one element of it. A beggar, for instance, may desire food, but due to lack of
means to purchase it, his demand is not effective. Thus, effective demand for a thing depends on (i) desire (ii) means
to purchase and (iii) willingness to use those means for that purchase. Unless demand is backed by purchasing power
or ability to pay, it does not constitute demand. Two things are to be noted about quantity demanded. One is that
quantity demanded is always expressed at a given price. At different prices different quantities of a commodity are
generally demanded. The second thing is that quantity demanded is a flow. We are concerned not with a single
isolated purchase, but with a continuous flow of purchases and we must therefore express demand as so much per
period of time one thousand dozens of oranges per day, seven thousand dozens oranges per week and so on.

In short By demand, we mean the various quantities of a given commodity or service which consumers would buy
in one market in a given period of time, at various prices, or at various incomes, or at various prices of related
goods.

LAW OF DEMAND

The law of demand is one of the most important laws of economic theory. According to law of demand, other things
being equal, if the price of a commodity falls, the quantity demanded of it will rise and if the price of a commodity
rises, its quantity demanded will decline. Thus, there is an inverse relationship between price and quantity
demanded, other things being same. The other things which are assumed to be equal or constant are the prices of
related commodities, income of consumers, tastes and preferences of consumers, and such other factors which
influence demand. If these factors which determine demand also undergo a change, then the inverse price-demand
relationship may not hold good. For example, if incomes of consumers increase, then an increase in the price of a
commodity, may not result in a decrease in the quantity demanded of it. Thus, the constancy of these other factors
is an important assumption of the law of demand.

Definition of the law of DemandP

Prof. Alfred Marshall defined the law thus: The greater the amount to be sold, the smaller must be the price at
which it is offered in order that it may find purchasers or in other words the amount demanded increases with a fall
in price and diminishes with a rise in price. The law of demand may be illustrated with the help of a demand
schedule and a demand

Demand Schedule : To illustrate the relation between the quantity of a commodity demanded and its price, we may
take a hypothetical data for prices and quantities of commodity X. A demand schedule is drawn upon the assumption
that all the other influences remain unchanged. It thus attempts to isolate the influence exerted by the price of the
good upon the amount sold.

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Demand schedule of an individual consumer

Price Quantity demanded


(`) (Units)
A 5 10
B 4 15
C 3 20
D 2 35
E 1 60

When price of commodity X is ` 5 per unit, a consumer purchases 10 units of the commodity. When the price falls
to ` 4, he purchases 15 units of the commodity. Similarly, when the price further falls, the quantity demanded by
him goes on rising until at price ` 1, the quantity demanded by him rises to 60 units. The above table depicts an
inverse relationship between price and quantity demanded; as the price of the commodity X goes on rising, its
demand goes on falling.

Demand curve: We can now plot the data from Table 1 on a graph with price on the vertical axis and quantity on
the horizontal axis. In Fig. 1, we have shown such a graph and plotted the five points corresponding to each price-
quantity combination shown in Table 1. Point A, shows the same information as the first row of Table 1, that at ` 5
per unit, only 10 units of X will be demanded. Point E shows the same information as does the last row of the
table, when the price is ` 1, the quantity demanded will be 60 units.

We now draw a smooth curve through these points. The curve is called the demand curve for commodity X. The
curve shows the quantity of X that a consumer would like to buy at each price; its downward slope indicates that
the quantity of X demanded increases as its price falls. Thus the downward sloping demand curve is in accordance
with the law of demand which, as stated above, describes an inverse price-demand relationship.

Market Demand Schedule : When we add up the various quantities demanded by the number of consumers in the
market we can obtain the market demand schedule. How the summation is done is illustrated in Table 2. Suppose
there are three individual buyers of the goods in the market. The Table 2 shows their individual demands at various
prices.
Table 2 : Market Demand Schedule
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Quantity demanded by
Price (`) P Q R Total market demand
5 10 8 12 30
4 15 12 18 45
3 20 17 23 60
2 35 25 40 100
1 60 35 45 140

When we add quantities demanded at each price by consumers P, Q and R we get the total market demand. Thus,
when price is ` 5 per unit, the market demand for commodity X is 30 units (i.e. 10+8+12). When price falls to ` 4,
the market demand is 45 units. At Re. 1, 140 units are demanded in the market. The market demand schedule also
indicates inverse relationship between price and quantity demanded of X.

Fig. 2 : Market Demand Curve

Market Demand Curve : If we plot the market demand schedule on a graph, we get the market demand curve.
Figure 2 shows the market demand curve for commodity X. The market demand curve, like individual demand
curve, slopes downwards to the right because
it is nothing but the lateral summation of
individual demand curves. Besides, as the
price of the good falls, it is very likely that new
buyers will enter the market which will
further raise the quantity demanded of the
quantity demanded of the good.

Rationale of the Law of Demand : Why does demand curve slope downwards?
Different economists have given different explanations for the operation of law of demand.
These are given below.
(1) Law of diminishing marginal utility : According to Marshall people will buy more quantity
at lower price because they want to equalize the marginal utility of the commodity and its
price. So a rational consumer will not pay more for lesser satisfaction. He is induced to
buy additional units in order to maximize his satisfaction or utility. The diminishing marginal
utility and equalizing it with the price is the cause for the downward sloping demand curve.
(2) Substitution effect : Hicks and Allen have explained the law in terms of substitution
effect and income effect. When the price of a commodity falls, it becomes relatively cheaper
than other commodities. It induces consumers to substitute the commodity whose price
has fallen for other commodities which have now become relatively expensive. The result
is that the total demand for the commodity whose price has fallen increases. This is called
substitution effect.
(3) Income effect : When the price of a commodity falls, the consumer can buy the same
quantity of the commodity with lesser money or he can buy more of the same commodity
with the same amount of money. In other words, as a result of fall in the price of the
commodity, consumers real income or purchasing power increases. This increase in the
real income induces him to buy more of that commodity. Thus, demand for that commodity
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(whose price has fallen) increases. This is called income effect. Due to the operation of
income effect and substitution effect, price effect operates or law of demend holds.
(4) Arrival of new consumers : When the price of a commodity falls, more consumers start
buying it because some of those who could not afford to buy it previously may now afford
to buy it. This raises the number of consumers of a commodity at a lower price and hence
the demand for the commodity in question.
(5) Different uses : Certain commodities have multiple uses. If their prices fall they will be
used for varied purposes and demand for such commodities will increase. When the price
of such commodities are high, rises they will be put to limited uses only. Thus, different
uses of a commodity make the demand curve slope downwards reacting to changes in price.
Exceptions to the Law of Demand : According to the law of demand, more of a
commodity will be demanded at lower prices than at higher prices, other things being equal.
The law of demand is valid in most cases; however there are certain cases where this law does
not hold good. The following are the important exceptions to the law of demand.
(i) Conspicuous goods : Articles of prestige value or snob appeal or articles of conspicuous
consumption are demanded only by the rich people and these articles become more
attractive if their prices go up. Such articles will not conform to the usual law of demand.
This was found out by Veblen in his doctrine of Conspicuous Consumption and hence
this effect is called Veblen effect or prestige goods effect. Veblen effect takes place as some
consumers measure the utility of a commodity by its price i.e., if the commodity is expensive
they think that it has got more utility. As such, they buy less of this commodity at low
price and more of it at high price. Diamonds are often given as example of this case.
Higher the price of diamonds, higher is the prestige value attached to them and hence
higher is the demand for them.

(ii) Giffen goods : Sir Robert Giffen, an economist, was surprised to find out that as the price
of bread increased, the British workers purchased more bread and not less of it. This was
something against the law of demand. Why did this happen? The reason given for this is
that when the price of bread went up, it caused such a large decline in the purchasing
power of the poor people that they were forced to cut down the consumption of meat and
other more expensive foods. Since bread, even when its price was higher than before, was
still the cheapest food article, people consumed more of it and not less when its price went
up.
Such goods which exhibit direct price-demand relationship are called Giffen goods.
Generally those goods which are considered inferior by the consumers and which occupy
a substantial place in consumers budget are called Giffen goods. Examples of such goods
are coarse grains like bajra, low quality rice and wheat etc.
(iii) Conspicuous necessities : The demand for certain goods is affected by the demonstration
effect of the consumption pattern of a social group to which an individual belongs. These
goods, due to their constant usage, have become necessities of life. For example, in spite of
the fact that the prices of television sets, refrigerators, coolers, cooking gas etc. have been
continuously rising, their demand does not show any tendency to fall.
(iv) Future expectations about prices : It has been observed that when the prices are rising,
households expecting that the prices in the future will be still higher, tend to buy larger
quantities of the commodities. For example, when there is wide-spread drought, people
expect that prices of foodgrains would rise in future. They demand greater quantities of
foodgrains as their price rise. But it is to be noted that here it is not the law of demand
which is invalidated but there is a change in one of the factors which was held constant
while deriving the law of demand, namely change in the price expectations of the people.
(v) The law has been derived assuming consumers to be rational and knowledgeable about
market-conditions. However, at times consumers tend to be irrational and make impulsive
purchases without any rational calculations about price and usefulness of the product
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and in such contexts the law of demand fails.
(vi) Demand for necessaries: The law of demand does not apply much in the case of necessaries
of life. Irrespective of price changes, people have to consume the minimum quantities of
necessary commodities.
Similarly, in practice, a household may demand larger quantity of a commodity even at a
higher price because it may be ignorant of the ruling price of the commodity. Under such
circumstances, the law will not remain valid.
(vii) Speculative goods: In the speculative market, particularly in the market for stocks and
shares, more will be demanded when the prices are rising and less will be demanded
when prices decline.
DEMAND EXPANSION AND CONTRACTION OF DEMAND
The demand schedule, demand curve and the law of demand all show that when the price of
a commodity falls, its quantity demanded increases, other things being equal. When, as a result
of decrease in price, the quantity demanded increases, in Economics, we say that there is an
expansion of demand and when, as a result of increase in price, the quantity demanded
decreases, we say that there is contraction of demand. For example, suppose the price of apples
at any time is ` 100 per kilogram and a consumer buys one kilogram at that price. Now, if
other things such as income, prices of other goods and tastes of the consumers remain same
but the price of apples falls to ` 80 per kilogram and the consumer now buys two kilograms of
apples, we say that there is a change in quantity demanded or there is an expansion of demand.
On the contrary, if the price of apples rises to ` 150 per kilogram and consumer buys only half
a kilogram, we say that there is a contraction of demand.

The phenomena of expansion and contraction of demand are shown in Figure 3. The figure
shows that when price is OP quantity demanded is OM, given other things equal. If as a result
of increase in price (OP), the quantity demanded falls to OL, we say that there is a fall in
quantity demanded or contraction of demand or an upward movement along the same
curve. Similarly, as a result of fall in price to OP, the quantity demanded rises to ON, we say
that there is expansion of demand or a rise in quantity demanded or a downward movement
on the same demand curve.

INCREASE AND DECREASE IN DEMAND

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In case of expansion and contraction of demand, we have seen that the change takes place as a result of
changes in price, all other factors remaining constant. When all the other factors influencing demand also
change, there is an increase or decrease in demand and the demand curve shifts either to its right or left. If
the income of a consumer rises, he would be able to purchase the commodities which he earlier could not
afford. This would result in an increase in demand and therefore, the demand curve shifts to the right. If, on
the other hand, the goods are out of fashion, the demand of that good will decline, resulting in the shift of
the demand curve to the left.

Demand may also increase and decrease due to the following reason

Rise in income
Rise in the price of substitutes
in demand Fall in the price of a complement
Favourable change in tastes of a good
(A shift in the demand curve towards the right) Increase in population
Goods in fashion

Rise in income
Rise in the price of substitutes
Decrease in demand Fall in the price of a complement
Favourable change in tastes of a good
(A shift in the demand curve towards the left) Increase in population
Goods in fashion

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ELASTICITY OF DEMAND
Till now we were concerned with the direction of the changes in prices and quantities demanded.
Now we will try to measure these changes, or to say, we will try to answer the question by
how much?
Consider the following situations :
(1) As a result of a fall in the price of radio from ` 500 to ` 400, the quantity demanded
increases from 100 radios to 150 radios.
(2) As a result of fall in the price of wheat from ` 20 per kilogram to ` 18 per kilogram, the
quantity demanded increases from 500 kilograms to 520 kilograms.
(3) As a result of fall in the price of salt from ` 9 per kilogram to ` 7.50, the quantity demanded
increases from 1000 kilogram to 1005 kilograms.
What do you notice? You notice that as a result of a fall in the price of radios, the quantity
demanded of radios increases. Same is the case with wheat and salt. Thus, we can say that
demand for radios, wheat and salt all respond to price changes. Then, where is the difference?
The difference lies in the degree of response of demand which can be found out by comparing
percentage changes in prices and quantities demanded. Here lies the concept of elasticity.
Definition : Elasticity of demand is defined as the responsiveness of the quantity demanded of
a good to changes in one of the variables on which demand depends or we can say that it is the
percentage change in quantity demanded divided by the percentage in one of the variables on
which demand depends.
These variables are price of the commodity, prices of the related commodities, income of the
consumers and other factors on which demand depends. Thus we have price elasticity, cross
elasticity, elasticity of substitution and income elasticity. It is to be noted that when we talk of
elasticity of demand, unless and until otherwise mentioned, we talk of price elasticity of demand.
In other words, it is price elasticity of demand which is usually referred to as elasticity of
demand.
Price Elasticity : Price elasticity of demand expresses the response of quantity demanded
of a good to a change in its price, given the consumers income, his tastes and prices of all other
goods. In other words, it is measured as percentage change in quantity demanded divided by
the percentage change in price, other things remaining equal. That is

price and quantity are inversely related (with a few exceptions) price elasticity is negative. But, for the sake of

convenience, we ignore the negative sign and consider only the numerical value of the elasticity. Thus if a 1%
change in price leads to 2% change in quantity demanded of good A and 4% change in quantity demanded of good
B, then we get elasticity of A and B as 2 and 4 respectively, showing that demand for B is more elastic or
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responsive to price changes than that of A. Had we considered minus signs, we would have concluded that the
demand for A is more elastic than that for B, which is not correct. Hence, by convention, we take the absolute
value of price elasticity and draw conclusions.

A numerical example for price elasticity of demand:

The price of a commodity decreases from ` 6 to ` 4 and quantity demanded of the good increases rom 10 units to
15 units. Find the coefficient of price elasticity.

Solution : Price elasticity = (-) q / p p/q = 5/2 6/10 = (-) 1.5

There are five cases of Elasticity of Demand in which it responds:

Perfectly elastic demand

Perfectly inelastic demand

Relatively elastic demand

Relatively inelastic demand

Unitary elastic demand

Perfectly elastic demand: The demand is said to be perfectly elastic when a very insignificant change in price
leads to an infinite change in quantity demanded. A very small fall in price causes demand to rise infinitely. Likewise
a very insignificant rise in price reduces the demand to zero. This case is theoretical which is never found in real life.
The demand curve in such a situation is parallel to X-axis. Numerically, elasticity of demand is said to be equal to
infinity. (Ed = )

Perfectly inelastic demand: The demand is said to be perfectly inelastic when a change in price produces no
change in the quantity demanded of a commodity. In such a case quantity demanded remains constant regardless
of change in price. The amount demanded is totally unresponsive to change in price. The demand curve in such a
situation is parallel to Y-axis. Numerically, elasticity of demand is said to be equal to zero. (Ed = 0)

Relatively elastic demand: The demand is relatively more elastic when a small change in price causes a greater
change in quantity demanded. In such a case a proportionate change in price of a commodity causes more than
proportionate change in quantity demanded. For example: If price changes by 10% the quantity demanded of the
commodity changes by more than 10%. The demand curve in such a situation is relatively flatter. Numerically,
elasticity of demand is said to be greater than 1. (Ed > 1)

Relatively inelastic demand: It is a situation where a greater change in price leads to smaller change in quantity
demanded. The demand is said to be relatively inelastic when a proportionate change in price is greater than the
proportionate change in quantity demanded. For example: If price falls by 20% quantity demanded rises by less
than 20%. The demand curve in such a case is relatively steeper. Numerically, elasticity of demand is said to be less
than 1. (Ed < 1)

Unitary elastic demand: The demand is said to be unit when a change in price results in exactly the same
percentage change in the quantity demanded of a commodity. In such a situation the percentage change in both
the price and quantity demanded is the same. For example: If the price falls by 25%, the quantity demanded rises

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by the same 25%. It takes the shape of a rectangular hyperbola. Numerically, elasticity of demand is said to be equal
to 1. (Ed = 1)

Fig. 2.14 Types of Price Elasticity


Fig 2.14 shows various demand curves, where X-axis shows
quantity demanded and Y-axis shows prices.
Different types of price elasticity discussed above can be shown in
E>1 a diagram.

DD1 Perfectly Elastic Demand

DD2 Elastic Demand

DD3 Unitary Elastic Demand

DD4 Inelastic Demand

DD5 Perfectly Inelastic Demand

METHODS OF MEASURING PRICE ELASTICITY OF DEMAND

Price elasticity of demand can be measured through three popular methods. These methods are:

Percentage Method or Arithmetic Method

Total Expenditure Method

Graphic Method or Point Method

1. Percentage Method

According to this method, price elasticity is estimated by dividing the percentage change in quantity demanded by
the percentage change in price of the commodity. Thus, given the percentage change of both quantity demanded
and price; the elasticity of demand can be derived. If the percentage change in quantity demanded is greater that
the percentage change in price, the elasticity will be greater than one.

If percentage change in quantity demanded is less than percentage change in price, the elasticity is said to be less
than one. But if percentage change of both quantity demanded and price is same, elasticity of demand is said to
be unit.

2. Total Expenditure Method

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Total expenditure method was formulated by Alfred Marshall. The elasticity of demand can be measured on the
basis of change in total expenditure in response to a change in price. It is worth noting that unlike percentage
method a precise mathematical coefficient cannot be determined to know the elasticity of demand.

By the help of total expenditure method, it is determined whether the price elasticity is equal to one, greater than
one, less than one. In this method, the initial expenditure before the change in price and the expenditure after the
change in price are compared.

Total Outlay/ Expenditure = Price x Quantity Demanded

If, with a fall in price, it is found that the expenditure remains the same, elasticity of demand is said to be one (Ed =
1), if the total expenditure increases the elasticity of demand is said to be greater than one (Ed > 1), if the total
expenditure diminishes with the fall in price, elasticity of demand is less than one (Ed < 1), and vice-versa.

TABLE: 2.8 TOTAL OUTLAY AND EXPENDITURE METHOD


Price Total Expenditure Elasticity of
Demand
Increases Less than 1

INCREASES Remains Same Equal to 1


Falls More than 1

Falls Less than 1

FALLS Remains Same Equal to 1


Increases More than 1

Total Expenditure or Total Outlay method has certain drawbacks. Firstly, it is not able to give us an exact numerical
measure of elasticity of demand. It only tells us whether the elasticity is equal to, less than, or more than one.
Therefore, this method fails to compare demand elasticities of different goods. Secondly, it is not possible to use
this method in measuring demand elasticity when demand changes in the same direction as the price, as in the case
of giffen goods.

Fig. 2.15 : Price Elasticity of Demand using Total Outlay Method


In Fig 2.15, demand for commodity X is unitary elastic over the
price range OP1 to OP2 because total outlay or expenditure does
not change with change in price. Demand is inelastic over the
price range O to OP1 because total expenditure increases or
decreases with increase or decrease in prices respectively.
Demand is elastic over the price range OP2 to OP3 because total
outlay increases with decrease in prices and decreases with
increase in prices.

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3. Graphic Method

Graphic method is otherwise known as Point Method or Geometric Method. According to this method, elasticity of
demand is measured on different points on a straight line demand curve. The price elasticity of demand at a point
on a straight line is equal to the lower segment of the demand curve divided by upper segment of the demand curve
at that point. Thus, at mid point on a straight-line demand curve, elasticity will be equal to unity; at higher points
on the same demand curve, but to the left of the mid-point, elasticity will be greater than unity, at lower points on
the demand curve, but to the right of the midpoint, elasticity will be less than unity.

At a corner point on demand curve where there is no lower segment, elasticity of demand is equal to zero (Ed = )
and where there is no upper segment on demand curve, elasticity of demand is equal to infinity, (Ed = )

Fig. 2.16: Point Elasticity of Demand on a Straight Line Demand Curve


In Fig. 2.16, if the demand curve is a straight line and meets (or is
extended to meet) X-axis and Y-axis at points B and A respectively,
then elasticity of demand at point P on the demand curve is given by
the ratio:

Segment of demand curve from point P to X-


axis

Segment of demand curve from point P to Y-


axis

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

Price elasticity of demand is dependent upon a number of factors as follows:

(a) Price Level: The demand is elastic for moderate priced goods but, the demand for very costly and very cheap
goods is inelastic. The rich do not bother about the prices of the goods that they buy. Very costly goods are
demanded by the rich people and hence their demand is not affected much by changes in prices. For example,
increase in the price of maruti car from Rs. 3,00,000 to Rs. 3,20,000 will not make any noticeable difference
in its demand. Similarly, the changes in the price of very cheap goods (such as salt) will not have any effect
on their demand, for their consumption which is very small and fixed.

(b) Availability of Substitutes: If a good has close substitutes, the price elasticity of demand for a commodity
will be very elastic as some other commodities can be used for it. A small rise in the price of such a commodity
will induce consumers to switch their consumption to its substitutes. For example gas, kerosene oil, coal etc.
will be used more as fuel if the price of wood increases. On the other hand, the demand of such commodities
is inelastic which have no substitutes such as salt.

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(c) Time Period: A typical consumer finds it difficult to adjust his consumption of a good in the short run. He
needs time to adjust to the changed situation. Therefore, demand elasticity of a good tends to increase in
the long run.

(d) Proportion of Total Expenditure Spent on the Product: Elasticity of demand for a good is also dependent
upon the proportion of a consumers budget spent on it. On account of a price rise of a good, a consumer
feels more concerned if he is spending a large proportion of his budget on it. The extent of change in demand
by the consumer is not significant in the case of those goods on which the consumer spends a very small
proportion of his monthly budget. In the former case elasticity of demand is higher, while in the latter cases,
it is low.

For example out of total monthly expenses of Rs10,000, the amount spent on multiplex tickets is Rs500,
then a change in the price to Rs600 will not matter and there will be no change in demand.

(e) Habits: Some products which are not essential for some individuals are essential for others. If individuals are
habituated of some commodities the demand for such commodities will be usually inelastic, because they
will use them even when their prices go up. A smoker generally does not smoke less when the price of
cigarette goes up.

(f) Nature of the Commodities: The demand for necessities is inelastic and that for comforts and luxuries is
elastic. This is so because certain goods which are essential will be demanded at any price, whereas goods
meant for luxuries and comforts can be dispensed with easily if they appear to be costlier.

(g) Various Uses: A commodity which has several uses will have an elastic demand such as milk, wood etc. On
the other hand, a commodity having only one use will have inelastic demand. The consumer finds it easier to
adjust the quantity demanded of a good when it is to be used for satisfying several wants than if it is confined
to a single use. For this reason, a multiple-use good tends to have more elastic demand.

(h) Postponing Consumption: Usually the demand for commodities, the consumption of which can be
postponed has elastic demand as the prices rise and are expected to fall again. For example, the demand for
v.c.r. is elastic because its use can be postponed for some time if its price goes up, but the demand for rice
and wheat is inelastic because their use cannot be postponed when their prices increase.

CROSS PRICE ELASTICITY OF DEMAND

The change in the demand of a good x in response to a change in the price of good y is called cross price elasticity
of demand. Its measure is
Ed = Change in Quantity Demanded of Good X

Change in Price of Good Y


Symbolically, = ( Dx / Py) / (Dx /Py)

Cross price elasticity may be infinite or zero.

Cross price elasticity is infinite if the slightest change in the price of good Y causes a substantial change in the
quantity demanded of good X. It is always the case with goods which are perfect substitutes.

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Cross price elasticity is positive if the change in the price of good Y causes a change in the quantity demanded
of good X in same direction. It is always the case with goods which are substitutes.

Cross price elasticity is negative if the change in the price of good y causes a change in the quantity demanded
of good X in opposite direction. It is always the case with goods which are complements of each other.

Cross price elasticity is zero, if a change in the price of good Y does not affect the quantity demanded good
X. In the case of goods which are not related to each other, cross elasticity of demand is zero.

INCOME ELASTICITY OF DEMAND

According to Stonier and Hague: Income elasticity of demand shows the way in which a consumers
purchase of any good changes as a result of change in his income. It shows the responsiveness of a consumers
purchase of a particular commodity to a change in his income. Income elasticity of demand means the ratio of
percentage change in the quantity demanded to the percentage change in income.
Ey = Percentage Change in Quantity Demanded of Good X
Percentage Change in Real Income of Consumer

Symbolically, Ey = ( Dx / Y) / (Dx /Y) Where, Y denotes income of the


consumer
It is noteworthy that sign of income elasticity of demand is associated with the nature of the good in question

INDIFFERENCE CURVES:
An indifference curve is a curve which represents all those combinations of two goods which give same satisfaction
to the consumer. Since all the combinations on an indifference curve give equal satisfaction to the consumer, the
consumer is indifferent among them. In other words, since all the combinations provide the same level of
satisfaction the consumer prefers them equally and does not mind which combination he gets.

To understand indifference curves, let us consider the example of a consumer who has one unit of food and 12 units
of clothing. Now, we ask the consumer how many units of clothing he is prepared to give up to get an additional
unit of food, so that his level of satisfaction does not change. Suppose the consumer says that he is ready to give up
6 units of clothing to get an additional unit of food. We will have then two combinations of food and clothing giving
equal satisfaction to consumer : Combination A which has 1 unit of food and 12 units of clothing, and combination
B which has 2 units of food and 6 units of clothing. Similarly, by asking the consumer further how much of clothing
he will be prepared to forgo for successive increments in his stock of food so that his level of satisfaction remains
unaltered, we get various combinations as given below :

Table 7 : Indifference Schedule

Combination Food Clothing MRS


A 1 12
B 2 6 6
C 3 4 2
D 4 3 1
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Now, if we draw the above schedule we will get the following figure.
an indifference curve IC is drawn by plotting the various combinations of the indifference schedule. The quantity of
food is measured on the X axis and the quantity of clothing on the Y axis. As in indifference schedule, the
combinations lying on an indifference curve will give the consumer the same level of satisfaction. The indifference
curve is also called Iso-Utility curve.

(A Consumers Indifference Curve)

Indifference Map: An Indifference map represents a


collection of many indifference curves where each curve
represents a certain level of satisfaction. In short, a set of
indifference curves is called an indifference map. An
indifference map depicts the complete picture of consumers
tastes and preferences. In an indifference map of a consumer
is shown which consists of three indifference curves. We have
taken good X on X-axis and good Y on Y-axis. It should be
noted that while the consumer is indifferent among the
combinations lying on the same indifference curve, he certainly prefers the combinations on the higher indifference
curve to the combinations lying on a lower indifference curve because a higher indifference curve signifies a higher
level of satisfaction. Thus, while all combinations of IC1 give him the same satisfaction, all combinations lying on IC2
give him greater satisfaction than those lying on IC1.

ASSUMPTIONS UNDERLYING INDIFFERENCE


CURVE APPROACH
1. The consumer is rational and possesses full information
about all the relevant aspects of economic environmentin which he
lives.

2. The consumer is capable of ranking all conceivable


combinations of goods according to the satisfaction hederives.
Thus, if he is given various combinations say A, B, C, D, E he can
rank them as first preference, second preference and so on.

3. If a consumer happens to prefer A to B, he can not tell quantitatively how much he prefers A to B.

4. If the consumer prefers combination A to B, and B to C, then he must prefer combination A to C. In otherwords,
he has consistent consumption pattern behaviour.

5. If combination A has more commodities than combination B, then A must be preferred to B.

PROPERTIES OF INDIFFERENCE CURVES


The following are the main characteristics or properties of indifference curves :
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(a) Indifference curves slope downward to the right: This property implies that when the amount of one
good in combination is increased, the amount of the other good is reduced. This is essential if the level of
satisfaction is to remain the same on an indifference curve.
(b) Indifference curves are always convex to the origin: It has been observed that as more and more of
one commodity (X) is substituted for another (Y), the consumer is willing to part with less and less of the
commodity being substituted (i.e. Y). This is called diminishing marginal rate of substitution.
(c) Indifference curves can never intersect each other: No two indifference curves will intersect each
other although it is not necessary that they are parallel to each other. In case of intersection the relationship
becomes logically absurd because it would show that higher and lower levels are equal which is not possible.
(d) A higher indifference curve represents a higher level of satisfaction than the lower
indifference curve: This is because combinations lying on a higher indifference curve contain more of
either one or both goods and more goods are preferred to lesS.

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Compiled By Prof.Rupesh R. Dahake Department of Commerce, Adarsha Mahavidyalaya Dhamangaon Rly