Economics

Unit 1 – Introduction
1.1 Scarcity and basic economic problems; role of market/price mechanism in solving them.
1.2 Introduction to microeconomics.
1.1
Scarcity and basic economic problems
In view of the scarcity of means at our disposal and the multiplicity of ends we seek to
achieve, the economic problem lies in making the best possible use of resources so as to
get maximum satisfaction in the case of a consumer and maximum output or profit for a
producer.
1. What to produce, how much and at what price to sell?
Decision relates to the quantity and the range of goods to be produced and the price at
which they should be sold; e.g. consumer goods and capital goods. Since resources are
scarce(limited), no economy can produce as much of every good or service as desired by all
members of society. More of one good or service usually means less of others. Theory of
value/price theory determines the allocation of the economy’s scarce resources among
alternative uses which is done by the market mechanism in free market economy through
changes in price. In deciding the relative amounts of capital and consumer goods to be
produced, society is in fact weighing the relative merits of future, as opposed to current, want
fulfillment. The choice here is more now or much more later.
2. How to produce?
Theory of production studies by what methods are these products to be produced in order to
have efficient use of resources. Output can always be produced in more than one technical
possible way. Agriculture-extensive vs intensive-cultivation. Industry-labour or capital-
intensive. When making the choice of the combination of factors and the particular technique
to use in producing a good or service, society faces the problem of choosing the technique
which results in the least possible cost (in terms of resources used) to produce each unit of
the good or service it wants.
3. For whom to produce?
Division of national output among individuals is studied by the Theory of Distribution. This
means how to share the total commodities produced among all members of society. Since
resources, goods and services are scarce in every economy, no society can satisfy all the
want of its people. In short, the question is of how the total output is to be distributed among
households, businesses and government must be answered by society.
4. Are the resources economically used?
This is related to whether production and distribution is done in the most efficient manner
(Economics of Welfare). A society which seeks to maximise the immediate fulfillment of its
material wants must be willing to utilise its human and material resources to a very high
degree.
 5. Problem of full employment
This is dealt in Keynesian theory of employment. Every society must avoid the involuntary
idleness of its human and material resources. Involuntary idleness is the height of economic
inefficiency. To be efficient, any economic system must provide for high and stable levels of
employment.
6. Problem of growth and flexibility
This is related to economics of growth. To achieve the maximum fulfillment of society’s
material wants over time, the economy must be flexible and adaptable to change.
Role of market/price mechanism

1.2
Introduction to microeconomics

Unit 2 – Demand and Supply Analysis

2.1 Concept of utility, cardinal measure of utility, ordinal measure, law of diminishing
marginal utility.
2.2 Concept of individual and market demand and their determinants, law of demand.
2.3 Elasticity of demand: types and usefulness.
2.1
Concept of utility
Utility maybe defined as the power of a commodity or service to satisfy human wants. It is
essentially a subjective or introspective concept which resides in the minds of the
consumers. The same commodity may have different degrees of utility for different
individuals. Utility cannot be equated with usefulness. A commodity may not useful, yet it
may have utility for a particular person, e.g. liquor is considered harmful for health yet it has
a high degree of utility for an alcoholic. Utility also carries no moral or legal significance. E.g.
it is illegal to possess a gun without a licence, but the gun has immersed utility for a dacoit.
Utility implies expected satisfaction, whereas satisfaction means realised satisfaction, so
there are not the same. A consumer thinks of utility when he is contemplating the purchase
of a commodity, but he secures satisfaction only after having consumed the commodity.
Utility can be measured indirectly i.e. in the form of price paid for the commodity, but the
satisfaction cannot be measured directly or indirectly.
Cardinal measure of utility
According to the concept of cardinal utility, it is possible to measure & compare the utilities of
two commodities, e.g. an apple may yield to the consumer a utility of 20 units whereas an
orange yields only utility of 10 units. The cardinalists hold that a person can express the
utility he desires from a commodity in quantitative cardinal terms. The units of utility can be
measured in imaginary units called ‘utils’. Dr. Marshall advocated the cardinal approach to
utility.
Ordinal measure
According to the concept of ordinal measure, utility derived from the consumption of a
commodity cannot be measured but compared. The ordinalists maintain that quantities of
utilities are non-measurable theoretically, conceptually and practically. According to the
ordinal utility hypothesis, the consumer may not be able to indicate the exact amount of
utility that he derives from a commodity but is capable of judging whether the satisfaction
obtained from a good is equal, lower or higher than another.
Law of diminishing marginal utility
The LDMU is the basic law of consumption. Producers change the design, pattern &
packaging of goods keeping in mind the LDMU. It is well known that the use of the same
good makes the consumer feel bored and its utility diminishes. The consumer wants variety
in various consumer goods like soaps. The LDMU enables in bringing in a variety in
consumption and production.
Price discrimination –
LDMU helps to explain the phenomenon in the value. Theoretically, the price of a commodity
falls when its supply increases, this is because with an increase in the stock of a commodity,
its MU diminishes.
The Diamond-Water Paradox of Thrift is explained with the help of this law. Due to their
relative scarcity diamonds possess high MU and high price. Since water is relatively
abundant it possesses low MU and hence low price even though its TU is high. Thus, water
has low price as compared to diamonds.
Taxation –
The principle of progression in taxation is based on the LDMU. As a person’s income
increases, the rate of tax rises because the MU of money to him falls with a rise in income.
The redistribution of income through imposing income tax on the rich and spending the tax
proceeds on social services for the poor. The concept of DMU demonstrates that transfer of
income from the rich to the poor will increase the economic welfare of the community.
It is seen that loss of utility of the rich as a result of decline in income by HH1 is equal to the
area HDCH1 and the gain in utility by increase of an equivalent amount of income LL1 for the
poor is LABL1.
2.2
Concept of individual and market demand
According to Prof. J Harvey “demand in economics is the desire to possess
something/commodity and the willingness and ability to pay a certain price for it.”
Demand constitutes the characteristics:
i. Price – demand at a particular price and if a person is willing to pay.
ii. Time – demand per unit of time; per day, per week, per month, per year.
iii. Market – means the contract between buyers and sellers. No need for a definite
geographical area.
iv. Amount – demand is quantity specific. It is not an approximation and is to be
expressed numerically.
Individual demand –
The quantity of the goods that the individual is willing and able to buy at each specific price
during some time period.
Market demand –
In a market, there are many consumers. Market demand means the demand of all the
consumers for a good at a price.
Thus, demand is the desire to purchase backed by ability to pay for a good. Demand is
always at a price and for a period. Demand means the various quantities of a given
commodity which the consumers would buy in one market in a given period of time at
various prices.
Determinants of demand Dx=f(Px, Y, PR, T, E, C, N, A, ID, S, B, TP, G)
The effect of all the factors on the amount demanded Q for a commodity X over a given
period of time can be expressed in the form of a demand function (A relationship between
two or more variables/factors on which demand, production or cost depends).
The determinants of demand provide analysis of consumer behaviour. They affect both the
direction and proportion of change in demand.
1) Price of a commodity –
The quantity demanded of a commodity is greatly influenced by the price. The demand for a
good varies inversely with its own price. Price low = demand high. Price high = demand low.
Dx=f(Px) ceteris paribus. Price is the cause variable and demand is the effect variable
(independent and dependent).
2) Income of the consumers –
An increase in consumers’ incomes leads to an increase in the demand of various
commodities assuming that their prices remain unchanged. Consumers’ incomes act as a
constant variable. Excluding savings, a consumer spends all his income on goods & services
he consumes. With an increase in income he can buy more commodities and after a while
his preference shifts to superior quality products and his demand for superior goods
increases.
3) Prices of related goods –
Goods & services have 2 kinds of relationships (i) substitutes (ii) complementary substitute
goods are those that satisfy the same wants of a consumer. They are alternatives, e.g. tea
and coffee are substitutes. Whereas a car and petrol are complementary goods. When tea
becomes expensive, less tea and more coffee will be consumed. But for complementary
goods, an increase in price of cars will result in a decrease in demand for petrol.
4) Tastes & preferences –
Favourable taste = demand rises
Unfavourable taste = demand decreases
5) Expectations –
The demand for durable & non-durable goods depends upon consumers’ expectations about
their prices, income and availability. The consumer expects:
Prices to fall in future = current demand will be less. Prices to increase in future = current
demand is high (prompts them to buy now).
Rising income = consumers become more liberal in their current spending. Falling income =
decrease the current demand for products.
Shortage in future = present demand goes up. Production of product increases in future =
present demand goes down.
6) Climate –
It has direct influence on demand. E.g. In winter, there is a greater demand for woollen
clothing.
7) Population –
An increase in population results in an increase of consumers in the market. Furthermore,
more spread of consumers over regions i.e. urban and rural areas & their composition in
terms of children, adults, males, females, rich, poor affects the demand for a particular
commodity. The demand for a commodity from the society would be affected if there is a
significant change in any of these factors, for example an increase in child population will
lead to an increase in demand for goods and services required by children like toys,
elementary education etc.
8) Advertisements –
Advertisements create demand by making consumers aware that a certain commodity exists
and persuade consumers to buy that certain product by informing and highlighting its
qualities.
9) Income distribution –
If distribution of Y is more equitable then the propensity to consume of the society will be
relatively higher i.e. there will be greater demand for goods. On the contrary, when
distribution is unequal the propensity to consume is low.
10) Savings –
Large saving means less money available for purchase of goods, therefore demand will
decrease and vice versa.
11) State of business –
If the business in a country is passing through a boom, there will be a marked increase in
demand. On the other hand, the level of demand goes down during a depression.
12) Technical progress –
Invention and discovery bring new commodities into the market with a result that old goods
are not demanded for, e.g. colour TVs have replaced black & white TVs.
13) Government policy (taxation and subsidy) –
Taxing a commodity increases its price and demand falls. Conversely, a subsidy for a good
from the government lowers the price and increases its demand.
Law of demand
The law of demand describes the general tendency of consumers behavious in demanding a
commodity in relation to change in its prices. Statement of the law “other things being equal
or higher the price of a commodity, smaller is the quantity demanded & lower the price,
larger the quantity demanded”. According to Marshall “the amount demanded increases with
a fall in price & diminishes with a rise in price”. Thus, the law expresses an inverse relation
between price & demand.
Demand extends as prices fall and demand contracts as prices rise.
The law assumes that the other determinants of demand are constant or ceteris peribus and
only price is the variable & influencing factor.
Assumptions:

 No change in tastes, preferences of consumers

 Consumer’s income remains the same
 The prices of related goods do not change
 Wealth of the consumers or their tastes remain constant

1. LDMU –
According to this law, when a consumer buys more units of a commodity the MU of that
commodity continues to fall. A rational consumer always equates the price with MU (gain) for
the unit of the commodity. Since MU falls as consumption rises, the consumer is ready to
pay less for every additional unit of the commodity.
2. Income effect –
When the price of a commodity falls, the real income (purchasing power) of the consumer
increases because he has to spend less in order to buy the same quantity. Thus, increase in
real income induces him to buy more.
3. Price effect –
Every commodity has certain consumers but when its price falls, new consumers start
consuming it, as a result the demand rises. On the contrary with an increase in the price of a
product, many consumers will either reduce or stop its consumption & demand falls.
Demand curve slopes downwards.
4. Substitution effect –
When the price of a commodity falls it becomes relatively cheaper than other commodities.
This causes a substitution effect, as a result of which the quantity demanded of a
commodity, whose price has fallen, rises.
There are different uses of certain commodities that are responsible for the negative slope of
the demand curve. With an increase in price of such products, they will be used only for the
most important uses & their demand will fall. Whereas, with a fall in price they will be put to
various uses & their demand will rise.
 2.3
Elasticity of demand: types and usefulness
How much or to what extent the quantity demanded of a good will change as a result of a
change in its price is provided by the concept of elasticity of demand. This is because if price
rises by 5%, it may lead to a fall in demand which would be greater than, less than or equal
to 5%.
The elasticity of demand is a measure of the extent to which the quantity demanded of a
good respond to changes in one of the determinants.
There are 3 kinds of demand elasticity:
1. Price elasticity of demand (Ped) –
Degree of responsiveness of quantity demanded of a commodity to changes in its price.
Marshall formula:
𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑄𝑑𝑥
Ped = 𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑥

Ped is the ratio of percentage change in quantity demanded of a commodity to a given

percentage change in its price.
For example if Px rises by 2% and Qdx falls by 4%
−4
Ped = ( 2 ) = -2

Or if Px falls by 2% and Qdx rises by 8%

8
Ped = (−2) = -4

Because of the inverse price demand relationship, ed is always <0, and it is a convention to
ignore the -ve sign before the value of Ped. Ped is also called the coefficient of elasticity of
demand.
a) Perfectly inelastic demand: Ped = 0
In this case any small change in price (rise or fall) will be followed by absolutely no
change in quantity demanded. Demand is non-responsive. E.g. %age change in price is
5% and %age change in quantity demanded is 0, then
Ped = 0/5
Ped = 0
b) Relatively inelastic demand: Ped < 1
In this case a big proportionate change in price will be followed by a less than
proportionate change in quantity demanded. E.g. %age change in price is 3% and the
%age change in quantity demanded is 2%, then
Ped = 2/3
Hence, Ped < 1
 c) Unit elastic demand: Ped = 1
In this case any change in price will be followed by an equal proportionate change in
quantity demanded. E.g. %age change in price is 2% and the %age change in quantity
demanded is also 2%, then
Ped = 2/2
Hence, Ped = 1
d) Relatively elastic demand: Ped > 1
In this case a small proportionate change in price will be followed by a more than
proportionate change in quantity demanded. E.g. %age change in price is 2% and the
%age change in quantity demanded is 3%, then
Ped = 3/2
Hence, Ped > 1
e) Perfectly elastic demand: Ped = ∞
In this case, even a very small change in price causes an infinitely large change in
quantity demanded. Demand is hyper-sensitive. E.g. %age change in price is 0 and
%age change in quantity demanded is 2%, then
Ped = 2/0
Hence, Ped = ∞

2. Income elasticity of demand (Yed) –

Yed shows the degree of responsiveness of quantity demanded of a good to a change in the
income of the consumers.
𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑎 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦
Yed = 𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

𝛥𝑄/𝑄 𝛥𝑄 𝑌
= 𝛥𝑌/𝑌
= 𝛥𝑌 × 𝑄

Q stands for quantity demanded

Y stands for income
𝞓Q stands for change in q
𝞓Y stands for change in y
For example a consumer’s income rise from ₹500 to ₹600, resulting in an increase in the
quantity demanded from 10 units and 15 units. Then, Yed for X is
Yed = 5/100 × 500/10
= 2.5
Yed can also be written as
𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑎 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦
Yed = 𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
e.g. if a 1% rise in income is accompanied by a 5% rise in demand, then
Yed = 5/1
=5
a) Yed = 0
e.g. salt
b) Yed < 0
e.g. jowar, bajra
c) Yed = 1
d) Yed < 1
e.g. soap, matches
e) Yed > 1
e.g. luxuries like gold, jewellery, motorcars
3. Cross elasticity of demand (exy)
exy refers to the degree of responsiveness of quantity demanded of X to a change in the
price of Y.
𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑋
exy = 𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑡𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌

𝛥𝑄𝑥 𝑃𝑦
= 𝛥𝑃𝑦 × 𝑄𝑥

a) X and Y are substitutes

A reduction in the price of Y, decreases the demand for X. Also, if a rise in the price of
one commodity (e.g. coffee) increases the demand for the other commodity (e.g. tea).
The cross elasticity of demand between substitutes is +ve.
For example,

Qx (tea) Py (coffee)
(in kg.) (in ₹ per kg.)
10 100
15 125
exy = 5/25 × 100/10 = 2 (cross elasticity for substitutes with a rise in price)
exy > 0
OR
exy = -5/-25 × 125/15 = 1.66 (cross elasticity for substitutes with a fall in price)
exy > 0
b) X and Y are complements
X and Y are complementary goods if a fall in the price of Y increases the demand for X
and conversely if a rise in the price of one commodity (e.g. ink) decreases the demand
for the other (e.g. pens). The cross elasticity of complementary goods is -ve.
For example,

Qx (pen) Py (ink)
3 7
2 10
exy = (-1/3) × 7/3 = -0.77 (cross elasticity for complements with a rise in price)
exy = 0
OR
exy 1/-3 × 10/2 = -1.6 (cross elasticity for complements with a fall in price)
exy < 0
c) X and Y are unrelated commodities
X and Y are unrelated goods if a change in the prices of Y causes no change in the
demand for X.
For example,
Qx (tea) Py (ink)
5 7
5 10
Here, 𝞓Qx = 0
Hence exy = 0
Therefore, if two goods have no relation between them, the cross elasticity of demand is
zero.