ECO 101 Economic Theories and Principles I 2024 PDF

STUDY PACK ECO 101 ECONOMIC THEORIES AND PRINCIPLES I Lecturer in Charge: Dr. M. I. Azeez Course Guides 1. Introduction to Economics 2. History of Economic Thought 3. Demand and Supply 4. Elasticity of Demand and Supply 5. Consumer Behaviour (cardinal and Ordinal) 6....

STUDY PACK ECO 101 ECONOMIC THEORIES AND PRINCIPLES I Lecturer in Charge: Dr. M. I. Azeez Course Guides 1. Introduction to Economics 2. History of Economic Thought 3. Demand and Supply 4. Elasticity of Demand and Supply 5. Consumer Behaviour (cardinal and Ordinal) 6. Theory of Production 7. Cost Theory 8. Revenue and Profit Maximization 1. Introduction to Economics i. What Economics is all about? Economics is about economizing; that is, about choice among alternative uses of scarce resources. Choices are made by millions of individuals, businesses, and government units. Economics examines how these choices add up to an economic system, and how this system operates. (L. G. Reynolds) Economics is a branch of social science that focuses on the production, consumption and transfer of wealth. Broken into two classes, macroeconomics and microeconomics, economics directly affect everyday life. Scarcity is central to economic theory. Economic analysis is fundamentally about the maximization of something (leisure time, wealth, health, happiness, all commonly reduced to the concept of utility) subject to constraints. These constraints or scarcity inevitably define a trade-off. For example, one can have more money by working harder, but less time (there are only so many hours in a day, so time is scarce). ii. Wealth Definition of Economics The early economists like J. E. Cairnes, J. B. Say, and F. A.Walker have defined economics as a science of wealth. Adam Smith, who is also regarded as father of economics, stated that economics is a science concerned with the nature and causes of wealth of nations. That is, economics deal with the question as to how to acquire more and more wealth by a nation. J.S.Mill opined that it is the practical science dealing with the production and distribution of wealth. However, the above definitions have been criticized on various grounds. As a result, economists like Marshall, Robbins and Samuelson have put forward more comprehensive and scientific definitions. iii. Welfare Definition of Economics According to Marshall, economics not only analyses the aspect of how to acquire wealth but also how to utilize this wealth for obtaining material gains of human life. In fact, wealth has no meaning in itself unless it is used to purchase all those things which are required for our sustenance as well as for the comforts necessary for life. Marshall, thus, opined that wealth is a means to achieve certain ends. On examining the Marshall’s definition, we find that he has put emphasis on the following four points: (a) Economics is not only the study of wealth but also the study of human beings. Wealth is required for promoting human welfare. (b) Economics deals with ordinary men who are influenced by all natural instincts such as love, affection and fellow feelings and not merely motivated by the desire of acquiring maximum wealth for its own sake. Wealth in itself is meaningless unless it is utilized for obtaining material things of life. (c) Economics is a social science. It does not study isolated individuals but all individuals living in a society. Its aim is to contribute solutions to many social problems. (d) Economics only studies ‘material requisites of wellbeing’. That is, it studies the causes of material gain or welfare. It ignores non-material aspects of human life. This definition has also been criticized on the ground that it only confines its study to the material welfare. Non-material aspects of human life are not taken into consideration. Further, as Robbins said the science of economics studies several activities, that hardly promotes welfare. The activities of producing intoxicants, for instance, do not promote welfare; but it is an economic activity. iv. Scarcity Definition of Economics Lionel Robbins challenged the traditional view of the nature of economic science. His book, “Nature and Significance of Economic Science”, published in 1932 gave a new idea of thinking about what economics is. He called all the earlier definitions as classificatory and unscientific. According to him, “Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.” This definition focused its attention on a particular aspect of human behaviour, that is, behaviour associated with the utilization of scarce resources to achieve unlimited ends (wants). Robbins definition, thus, laid emphasis on the following points: (a) ‘Ends’ are the wants, which every human being desires to satisfy. Want is an effective desire for a thing, which can be satisfied by making an effort for obtaining it. We have unlimited wants and as one want gets satisfied another arises. For instance, one may have the desire to buy a car or a flat. Once the car or the flat is purchased, the person wishes to buy a more spacious and designable car and the list of his wants does not stop here but goes on one after another. As human wants are unlimited, we have to make a choice between the most urgent want and less urgent wants. Thus the problem of choice arises. That is why economics is also called as a science of choice. If wants had been limited, they would have been satisfied and there would have been no economic problem. (b) ‘Means ’or resources are limited. Means are required to be used for the satisfaction of various wants. For instance, money is an important means to satisfy many of our wants. As stated, means are scarce (short in supply in relation to demand) and as such these are to be used optimally. In other words,  scarce or limited means/resources are to be economized. We should not make waste of the limited resources but utilize them very judiciously to get the maximum satisfaction. (c) Robbins also said that, the scarce means have alternative uses. It means that a commodity or resource can be put to different uses. Hence, the demand in the aggregate for that commodity or resource is almost insatiable. For instance, if we have a hundred thousand naira note, we can use it either to purchase a book or a fashionable clothe. We may use it in other unlimited ways as we like. REASONS WHY WE STUDY ECONOMICS Why do we study economics? The simple answer is it affects our everyday lives through important areas such as tax, interest rates, wealth, and inflation. Economists provide the tools by which analysts can study the costs, benefits and effects of government policies in a range of areas that affect society. These can include healthcare and education. They help guide these decisions to work towards stable economic growth and a thriving society. Reasons to Study Economics i. High earning potential Economics graduates have some of the highest starting salaries with plenty of opportunities for promotions (the Complete University Guide 2021). The average starter salary for an economist in the UK is £25,000 a year, which can increase to £75,000+ over time as you gain more experience (National Careers Service 2023). ii. Great career prospects Obtaining an economics degree will give you great job prospects and a variety of potential career paths. As economics are present in all sectors of business, job opportunities are not in short supply. This is one of the biggest reasons why we study economics. Some of the roles you could work in as an economics graduate are: a. Chartered accountant b. Compliance officer c. Data analyst d. Economist e. Financial risk analyst f. Investment analyst g. Risk manager h. Stockbroker. Economics graduates have high employability due to the varied subjects they have studied such as mathematics and research skills. The skills and knowledge developed during your study will make you a well-rounded and attractive candidate to future employers. One of the biggest advantages of studying economics is the academic knowledge and skills you gain that can be applied to work in many different sectors. These include: a. Business b. Banking c. Finance d. Government e. Consultancy. Within economics, there are plenty of opportunities for promotion and career progression. Gaining a masters degree in the subject will help you be a more favourable option for high-level positions as it shows your ability to commit and succeed in completing challenging work. iii. Develop transferable skills One of the best reasons of studying economics is the valuable transferable skills you will develop during your degree. These transferable skills are very attractive to employers and can be applied to work in any field of economics. Analytical thinking and complex problem solving, skills you will develop during an economics degree, are the most important skills to have when looking for job opportunities in 2025 (World Economic Forum 2020). Developing these skills will be invaluable when looking for a job once you have successfully graduated with an economics degree. Some of the transferable skills you will gain during your economics study are: a. Problem solving b. Communication c. Research d. Time management e. Analytical thinking. iv. Have a direct impact on society The importance of studying economics is the impact it has on society. If you want to do work that will have real meaning in the world, then economics is the perfect choice for you. As an economist you will research economic issues, interpret and forecast market trends, and recommend solutions to economic threats. The goal of economic science is to improve the everyday living conditions of society through increasing gross domestic product. This means higher wages, good housing, and hot water – the things a society needs to thrive. v. Gain international perspective Economies across the globe interact with each other and this will give you a better knowledge of how the world works from a financial standpoint. Understanding the world economy is the key for driving success for many national and international corporations. Having a greater understanding of international economies will also make you a standout candidate when applying for graduate jobs. 1.2 Economics as a subject-matter The subject matter of economics is divided into two categories: a. Microeconomics b. Macroeconomics. a. Microeconomics deals with individual agents, such as households and businesses. b. Macroeconomics considers the economy as a whole, in which case, it considers aggregate supply and demand for money, capital and commodities. It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports. Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on the overall subject of the economy. Aspects receiving particular attention in economics are resource allocation, production, distribution, trade, and competition. Economics may in principle be (and increasingly is) applied to any problem that involves choice under scarcity or determining economic value. The term ‘Micro’ and ‘Macro’ economics have been coined by Prof. Ragnar Frisch of University of Oslo, Norway, during 1920’s. In short, microeconomics is the study of the economic behaviour of individual consumers, firms, and industries and the distribution of production and income among them. It considers individuals both as suppliers of labour and capital and as the ultimate consumers of the final product. On the other hand, it analyses firms both as suppliers of products and as consumers of labour and capital. Microeconomics seeks to analyse the market form or other types of mechanisms that establish relative prices amongst goods and services and/or allocates society’s resources amongst their many alternative uses. In microeconomics, the following are studied: i. Theory of product pricing, which includes: (a) Theory of consumer behaviour. (b) Theory of production and costs. ii. Theory of factor pricing, which constitutes: (a) Theory of wages. (b) Theory of rent. (c) Theory of interest. (d) Theory of profits. iii. Theory of economic welfare. Significance of the study of Microeconomics i. Microeconomics is of great help in the efficient management of the limited resources available in a country. ii. Microeconomics is helpful in understanding the working of free enterprise economy where there is no central control. iii. Microeconomics is utilized to explain the gains from international trade, balance of payments disequilibrium and determination of foreign exchange rate. iv. It explains how through market mechanism goods and services produced in the community are distributed. v. It helps in the formulation of economic policies, which are meant for promoting efficiency in production, and welfare of the people. vi. Microeconomics is the basis of welfare economics. vii. Microeconomics is used for constructing economic models for better understanding of the actual economic phenomena. Limitation of Microeconomics Despite the fact that it has so many benefits, it also suffers from certain defects or limitations. These are: i. It is not capable of explaining the functioning of an economy as a whole. ii. It assumes full employment; which is rare in real life. iii. It cannot be used for solving the problem relating to public finance, monetary and fiscal policy etc. 2. History of Economic Thought – 2nd Topic - Assignment 3. DEMAND AND SUPPLY – 3rd Topic 3.1. Demand: In Economics, Demand means desire to have a commodity backed by enough money to pay for the good demanded. Demand for a good is always expressed in relation to a particular price and a particular time. Therefore, demand for a good may be defined as the amount of it, which will be purchased per unit of time at a given price. According to F. Benham, “The demand for anything at a given price is the amount of it which will be bought per unit of time at that price.” Another good definition of demand, given by Bober is “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.,” constitute demand. Demand, in economics, always refers to a schedule. It is not a single quantity. The quantity which is purchased at some particular price is called the quantity demanded. 3.2 MARKET DEMAND Market demand is a series of various quantities of a product or service that consumers in a given market are able and willing to purchase collectively at each of a series of potential prices per unit of the product or service, provided other things such as number of consumers, consumer incomes and consumer tastes etc. remain constant. Market demand is obtained from horizontal summation of the individual demand schedules or demand curves of all the consumers in a given market. When markets are large, we take a representative sample of consumers and multiply their average quantities demanded by the total number of consumers in the market to obtain market demand schedule. Example 1 Let us assume there are only three consumers in a hypothetical market of product. The following table shows their individual demand schedules as well as the market demand which is obtained by horizontally adding the quantities demanded by individuals at a given price. Unit Price Individual Demand Market Demand Aaron David Sarah 8 0 0 44 44 7 0 16 51 67 6 4 32 57 93 5 8 51 65 124 4 13 75 74 162 3 20 104 86 210 2 30 147 103 280 1 46 220 134 400 The following chart shows the individual demand curves as well as the market demand curve. The points on individual and market demand curves have same vertical coordinate i.e. price per unit of the product. But the horizontal coordinates of the points on market demand curve are the sums of the horizontal coordinates of the points on individual demand curves i.e. quantities demanded by individual customer. Figure 1: Market Demand Curve At any given price different quantities may be demanded by different consumers and the difference in slopes of the individual curves shows that their elasticity of demand may also be different. However a single consumer has insignificant effect on equilibrium in a large market. Therefore we use market demand and market supply curves to determine equilibrium price and quantity. Example 2 Market demand is the total sum of the demands of all individual consumers, who purchase the commodity in the market. A market demand schedule is shown as under: Price (per A’s Demand B’s Demand C’s Demand Market unit) Demand (A + (N) B + C) 1 8 9 10 27 2 7 6 9 22 4 6 4 8 18 6 5 3 7 15 8 4 2 6 12 10 3 1 5 9 Let us assume that there are three consumers: A, B and C. Their individual demand schedule is shown in 2nd, 3rd and 4th columns respectively. Market demand is the sum of A’s, B’s and C’s demand of, say, apples. It is found that the market demand schedule also behaves in the same way as an individual’s demand for a commodity. That is, at lower price, demand is more and vice versa. The market demand curve is the summation of all the individual demand curves in the market for a particular good. It shows the quantity demanded of the good at varying price points. Because quantity demanded decreases as price increases, the market demand curve has a negative, or downward, slope. A market demand curve is also the graphical representation of market demand and is derived by the lateral/horizontal summation of all individuals’ demand curve in the market as shown below. As the individual’s demand curve slope downward from left to right, the market demand curve also slopes downward to the right. 3.3 DETERMINANTS OF DEMAND Demand for a product depends upon a number of factors. The most important of these are the price of the product, income of the consumer, tastes and fashion and the prices of related goods. These can be put in the functional form as: Dx = f (Px, I, Py, T, F…) Where Dx = demand of good x; Px, = price of good x; I = income of the consumer; Py = prices of related goods; T = tastes and F = fashion. Thus, demand for a commodity depends upon the following factors: i. Price of the commodity: Price of a commodity is an important factor that determines demand for a commodity. When price of a commodity rises, consumers buy less and when prices fall, demand increases. Here, we assume other things (factors) to be remaining constant, i.e., ceteris paribus. ii. Income of the consumer: The demand for goods depends upon the incomes of the people. The greater the income, the greater will be the demand for a good. More income means greater purchasing power. People can afford to buy more  when their incomes rise. On the other hand, if income falls, demand for a commodity also decreases. iii. Prices of related goods: Related goods are of two types: substitute and complements. a. Substitute goods can be interchangeably used. For example, tea and coffee are substitute goods. If tea is dearer, one can use coffee and vice versa. When price of a substitute for a good falls, the demand for that good declines and when price of substitute rises, the demand for that good increases. Note that if the sign of the coefficient of the price of related good is positive, the goods are substitute. b. Complementary goods are demanded together as bread and butter or car and petrol. In case of complementary goods, the change in the price of any of the two goods also affects the demand of the other. For instance, if demand for two-wheelers fall, the demand for petrol also goes down. It is noteworthy that if the sign of the coefficient of the price of related good is negative, the goods are complementary. iv. Taste and preferences of the consumer: These are important factors, which affects the demand for a product. If tastes and preferences are favourable, the demand for a good will be large. On the other hand, when any good goes out of fashion or people’s tastes and preferences no longer remain favourable, the demand decreases. Demand Function Demand Function, provides a detailed explanation on the formula and showcases its real-world applicability. You will also be introduced to the concept of the Linear Demand Function and Elasticity of Demand, giving you insights into how they interact and can be visualised through graphs. By exploring case studies and tackling common challenges, you'll learn how to find and apply the Demand Function effectively in various managerial economic scenarios. The term "demand function" refers to the mathematical expression revealing the relationship between the quantity of a good or service that customers are willing and able to purchase and its determinants. These determinants may include the price of the good or service, income level, tastes, and the prices of related goods or services. Example 1 If business A is selling pencils, the demand function might show how the quantity of pencils demanded changes according to the price. The mathematical expression of the demand function can be represented as: Qd = f(P, Y, Prg, T) where: Qd = Quantity demanded; P = Price of the good or service; Y = Income level; Prg = Prices of related goods/services; and T = Taste or preference Example 2 If pencils are priced at N1 each, and customers have an income level of N1000, the demand function might show that customers would buy 100 pencils. However, if the price of pencils increases to N1.50 each, the demand might decrease to 50 pencils, assuming the income level remains the same. Practical Exercises: Utilising Demand Function Formula in Real-World Scenarios To best understand how to use the demand function formula, consider a company "B" that sells handmade soaps. The company can use the demand function formula to determine how various factors would influence the demand for their soaps and plan their production accordingly. Example 3 Suppose a single unit of soap sells for £5 and the average consumer income is £2000. Also, consider that the prices of related products (such as liquid soap and bath bombs) are £4 and £6 respectively. Let's assume that the taste for handmade soaps is consistent amongst consumers. By substituting these values into our demand function, you can predict the number of soaps demanded. Adapt the demand function accordingly and observe changes in demand. For instance: i. what happens when consumer income rises or falls? ii. What if a competitor reduces their pricing? Conduct various simulations to gain insights into how changes in these factors alter product demand. This real-time application of the demand function formula is a valuable business tool to anticipate market behaviour, thereby enabling a proactive response. It is clear to see that the demand function, predominantly the formula it encompasses, is a vital component of strategic decision-making processes in businesses. From pricing to production, to understanding consumer behaviour - mastering this mathematical representation might just provide you the edge in the cut-throat business market. Main elements of the demand function a. The main elements of the demand function include price stability, interest rates, inflation rates, and exchange rates. b. The main elements of the demand function include supply of the product, manufacturing cost, competitive pricing, and the economic climate. c. The main elements of the demand function include price of the good or service, income level, prices of related goods or services, and taste or preferences. d. The main elements of the demand function include production capacity, marketing efforts, taxation rates, and the economic environment. Understanding the Demand Function in Managerial Economics The term “demand function” is a crucial concept in managerial economics, particularly in business studies. It plays a vital role in making important decisions related to production or sales and achieving business objectives. Drilled down to its essence, the demand function helps a firm assess the market's desire to acquire a product or service. Linear Demand Function Moving further into the realm of mathematical economics, you will encounter a more specific form of the demand function, namely, the Linear Demand Function. A linear demand function, unlike the more versatile demand function, assumes a linear relationship between the quantity demanded of a product/service and its price. By mapping out this relationship, you can visualise and interpret the probable demand trends for products or services based on varying price points. A linear demand function, as the name suggests, represents a straight-line relationship between two variables - typically the price and quantity demanded. It is one of the most straightforward forms of the demand function because it assumes that changes in the price of a commodity will result in proportional changes in the quantities demanded, with no other influencing factors. In the mathematically defined universe, the linear demand function can be represented as: Qd = a – bP Where: a = a constant that indicates the quantity demanded when the price is zero. It is often referred to as the "intercept". b = the slope, showing how much the quantity demanded changes for each unit of change in price. The constant primarily measures consumer demand when the price is zero. The coefficient, on the other hand, shows the rate of change in demand for each unit change in price. It measures the sensitivity of the quantity demanded to changes in price, also termed as "price elasticity of demand". A higher value of would imply a steeper slope, indicating greater sensitivity of demand relative to price. Understanding the linear demand function gets easier with examples. To explain this, let us lay out two product scenarios. Consider a product, say, ‘Milkshake’ with a linear demand function represented as Qd = 20 – 2P i This implies that if the price is zero, or the quantity demanded would be 20 units. However, for each unit increase in price, the demand would fall by 2 units. In another instance, let us say a ‘Novel’ has a linear demand function represented as: Qd = 15 – P ii In the case of equation ii, a price of zero would lead to a demand of 15 units, and each unit increase in the price would result in a one unit fall in demand. In both equations i. and ii, it is clear that the intercepts are 20 and 15 units for the milkshake and novel, respectively. These intercepts represent the highest demand possible, at zero pricing. A lower slope for the novels indicates less price sensitivity or inelastic demand as compared to the milkshake. This means that consumers are less likely to reduce their quantity demanded of novels despite a rise in its price. You must note that real-world scenarios may not often showcase a perfect linear demand function. Nonetheless, this simplified model equips you with the fundamentals needed in grasping more complex forms and assists in making more informed managerial decisions. 3.4 DEMAND SCHEDULE AND DEMAND CURVE A demand schedule is a tabular statement that shows the different quantities of a commodity that would be demanded at different prices. It expresses what quantities of a good will be purchased at different possible prices. A demand schedule is shown as below: Demand Schedule Price of apple per unit (N) No. of Quantity Demand 8 5 6 7 4 8 2 10 It is clear from the table, that when price of an apple is N8, the consumer demands 5 apples and when price falls to N2 each, demand of apples goes up to 10 units. Thus, price and quantity demanded shows inverse relationship. On the basis of the above demand schedule, an individual’s demand curve is derived. A Demand curve is the graphical representation of the demand schedule. This is shown below. Hypothetical Graph of Demand Schedule and Curve Figure 1 From figure 1, prices of apples are measured along Y-axis and quantities demanded along X-axis. The points along the curve are the different combinations of price and quantity demanded. Joining these points, the demand curve (DD) sloping downwards to the right is derived, indicating inverse relationship between price and quantity demanded. 3.5 LAW OF DEMAND The law of demand expresses the functional relationship between price and quantity demanded of a good. It is one of the most important laws of economic theory. According to this law, other things remaining constant (ceteris paribus), if the price of a commodity falls, the quantity demanded of it will rise and if price of the good rises, quantity demanded will fall. Thus, there is inverse relationship between price and quantity demanded. Law of demand only applies when certain conditions are met and these are referred to as assumptions of the law of demand. That is, the law of demand assumes the following: i. Incomes of consumers do not change. If consumer’s income increases or decreases, the law will not hold good. ii. People’s tastes and preferences remain unchanged; iii. Prices of substitutes and complements do not change. The law of demand can be explained with the help of a demand schedule and through a demand curve. WHY DOES THE LAW OF DEMAND OPERATE? (or Reasons for downward sloping Demand Curve) i. Law of Diminishing Marginal Utility Demand curve by and large slopes downward to the right. This is because of operation of the law of diminishing marginal utility. When the price of a commodity decreases, new demand is created. Also, that existing buyers buy more. As the particular commodity has become cheaper, some people will purchase it in preference to other commodities. If the law of diminishing marginal utility is true, the demand curve must slope downwards. This is because only a downward sloping demand curve represents increase in demand due to fall in the prices of a commodity. ii. Income Effect When price of a commodity falls, real income of the people increases. In other words, they are able to buy more goods and services now with the same amount of money they have. This is called income effect. Technically, it is said that the fall in price leads to an increase in the consumer’s purchasing power (defined as the quantity of goods and services a consumer has command over giver her income and market prices). It should be noted that income effect does not imply a change in income but follows from a change in the price of the commodity; income remain constant, but purchasing power changes when price changes. Income effect is negative for a normal good. A fall in price raises the purchasing power so that the consumer increases the quantity purchased at the new price, and vice versa. However, it is not the same for inferior goods, giffen goods and may not hold in the case of ostentatious goods. For instance, in the case of inferior or giffen goods, the income effect of a price change is positive. iii. Substitution Effect When the commodity is cheaper, it tends to be substituted for other commodities, which are dearer. This is called substitution effect. The substitution effect is negative for all goods (except probably for ostentatious goods which by their nature are articles of affluence). If the price of the commodity rises, quantity demanded will fall via the substitution effect, and vice versa. Note that both income effect and substitution effect together increase the capacity of consumers to buy more of a commodity, when its price comes to low level. Another reason for downward sloping demand curve is that when a commodity becomes cheaper, it can be put to more uses or not so urgent uses. This also makes demand to be greater when price falls. 3.6 EXCEPTIONS TO THE LAW OF DEMAND There are a few exceptions to the law of demand. It means those conditions when the law does not hold good. These are: i. Giffen Goods or Paradox There are certain goods called Giffen goods. In case of such goods, the law of demand does not hold good. Sir Francis Giffen observed that when Irish potato prices increased in bad years, people curtailed spending on other commodities and increased their spending on potatoes. With high potato prices and no increase in their money incomes, they were too poor to afford meat and other foodstuffs. So they had to sustain themselves by eating more potatoes. That is people demanded more potatoes when their prices increased and vice versa. This is called Giffen Paradox. ii. Demonstration Effect (Veblen Goods) An economist Thorstein Veblen invented the concepts of conspicuous consumption and status-seeking on the observation that ‘in case of conspicuous consumption, the demand curve does not slope downwards’. Sometimes people buy some products to show their status in the society. The possession of such commodities, they feel, may confer a higher level of social status on their holder. These goods are diamonds and other precious stones etc. Rich class buys such goods at very high price to show that they belong to a prestigious class. In fact, the Veblen effect is one of a family of theoretically possible anomalies in the general theory of demand in microeconomics. The other related effects are: a. the snob effect: preference for good decreases as the number of people buying it increases; b. the bandwagon effect: preference for good increases as the number of people buying it increases; c. the counter-Veblen effect, in which preference for good increases as its price falls. The concept of the counter-Veblen effect is less well known, which was introduced by Lea. [(Lea, S. E. G., Tarpy, R. M., & Webley, P. (1987). The individual in the economy. Cambridge: Cambridge University Press.]  None of these effects in itself predicts what will happen to actual demand for the good (the number of units purchased) as price changes - they refer only to preferences or propensities to purchase. The actual effect on demand will depend on the range of other goods available, their prices, and their substitutability for the goods concerned. The effects are anomalies within demand theory because the theory normally assumes that preferences are independent of price or the number of units being sold. They are therefore collectively referred to as interaction effects. iii. Commodities whose qualities are judged by their high prices The law of demand does not apply to a commodity whose quality is judged by its high price. At high prices, some people buy more of such commodity than at lower price thinking that high priced are better than those priced lower. This is out of sheer ignorance that people act in such a way. iv. Speculation of Future High Price of a Commodity Speculation (a guesswork or prediction of a future event and act accordingly) is another exception to the law of demand. If the price of commodity is increasing and people expect a further rise in the price, they will tend to buy more of the commodity at higher price than they did at the lower price. It is observed that when there is a hike in edible oil prices recently, some people purchased more of it in the expectation that future prices will be even more. 3.7 CHANGES IN QUANTITY DEMANDED AND CHANGES IN DEMAND i. Movement along Demand Curve (Change in Quantity Demanded) A distinction between movement along the demand curve and shifts in the demand curve is very important while studying demand theory. Movement along the demand curve takes place when there is a change in price of a good, other things remaining same. This is also termed as a change in Quantity demanded. That is changes in demand due to a change in the price of a commodity, other things being equal. In other words, when either due to increase or decrease in the price of a good, the demand increases, then it is seen that the demand curve remain the same; only the equilibrium position on the demand curve is changed. This is called extension and contraction in demand. Thus when quantity demanded of a good rises due to the decrease in price alone, it is said that extension of demand have taken place. And quantity demanded falls due to rise in price; it is called contraction in demand. The extension and contraction in demand is illustrated in the figure below. Graph showing a movement along Demand curve Quantity Demanded in Units Figure 2 From figure 2 above, assuming other factors such as tastes, income and price of related goods are held constant, demand curve ‘DD’ is drawn. At price of N10, 55 unit of the commodity is demanded so that the equilibrium point is at the middle of the curve as shown above. If price falls to N7, the quantity demanded increases to 75. This is called an extension along the demand curve but the consumer remains on the same curve DD; only equilibrium position moves from middle point to the right to C. In case of rise in price to N12, demand shrinks to 40 and the equilibrium position also moves to the left from middle point to left. This is called contraction in demand. The extension and contraction in demand take place only due to changes in the price of a commodity, other factors remaining same.  ii. Shifts in Demand Curve Let us explain shifts in the demand curve. A demand curve either shifts to the right or left, due to changes taking place in other factors and not price of the commodity. The change in the position of the demand curve due to these changes can be termed as the increase and decrease in demand. As seen in figure 3 below, when due to changes in the factors such as tastes, fashion, price of related commodities, income etc, the demand curve (D0D0) shifts upwards or to the right, increase in demand is said to have taken place which is (D1D1) even when price remains P1, but the quantity demanded increases to Q1 from Q0. Similarly, when less is demanded at the same price of P1 due to changes in other factors, it is called decrease in demand. Here, the demand curve gets shifted leftward. In figure 3, the decrease in demand is (D2D2) at the same price of P1 with a decrease of quantity demanded from Q0 to Q2. Shift in Demand P D1 D0 Price (N) D2 P1 D1 D0 D2 0 Q Q2 Q0 Q1 Quantity Demanded in Units Figure 3 Factors responsible for increase in demand are: i. Taste and fashion/preferences are more favourable for the commodity. ii. Income of the consumer increases. iii. Price of substitutes has risen. iv. Price of complementary goods has declined. v. Propensity to consume of the people has increased. vi. Numbers of consumers have increased. Likewise, decrease in demand may take place due to the following reasons: i. Taste and fashion/preferences are not favourable for the good. ii. Income of the consumers has fallen. iii. Price of substitutes has fallen. iv. Price of complementary goods has risen. v. Propensity to save of the people has increased. Example 1 a. Graph the demand function of: Qd = -4P + 0.01Y – 5Pr + 10T When Y = 8000, Pr = 8, and T = 4 b. What type of good is the related good? c. What happens if T increases to 8, indicating greater preference for the good? 4. ELASTICITY OF DEMAND Elasticity, roughly, means responsiveness. What response demand of a commodity shows when there is either increase or decrease in its price, is explained with the help of elasticity. Managers have great advantages by knowing elasticity of the products he is selling. Greater response means greater elasticity and small response indicates less elasticity. A manager is very interested in knowing whether sales will increase by 4 percent, 10 percent or more by cutting down price by 8 percent. Elasticity of demand, thus, measures the degree of responsiveness of demand to a change in price of the commodity. Prof. Alfred Marshall introduced the concept of elasticity of demand in the economic theory. In his words, “The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price and diminishes much or little for a given rise in price.” From the foregoing, we may define elasticity of demand as the ratio of the percentage change in quantity demanded to the percentage change in price. Demand may be elastic or inelastic. When there is a great change in demand as a result of a small change in price, it is said that demand is elastic. If a 5 percent cut in prices of car results in an increase of 30 percent in sales, demand is said to be highly elastic. In other words, demand has responded greatly. However, if a great change in price is followed by a small change in demand, it is inelastic demand. For example, the demand for salt is said to be inelastic because same quantity of it will be purchased even if price rises or declines. Whereas, demand for a car is elastic because a small rise/fall in price may greatly reduce/increase its demand. Price elasticity of demand is expressed as under: Percentage change in demand Ep = Percentage change in price 4.1 TYPES OF PRICE ELASTICITY OF DEMAND There are five cases/kinds of price elasticity of demand. These are as follows: i. Perfectly Inelastic Demand: Demand for a commodity will be said to be perfectly inelastic, if the quantity demanded does not change at all in response to a given change in price. If 10 percent change in price results in zero percent change in demand, it is exactly inelastic demand. The demand curve, in this case, is vertical straight line perpendicular to Y-axis as shown in Fig. 5.1. ii. Inelastic or less than Unit Elastic Demand: Demand for commodity will be said to be inelastic (or less than unit elastic) if the percentage change in quantity demanded is less than the percentage change in price. If 10 percent change in price results in 6 percent change in demand, it is inelastic demand. This is shown in Fig. 5.2. iii. Unitary Elastic Demand: Demand for a commodity will be said to be unit elastic if the percentage change in quantity demanded equals the percentage change in price. If 10 percent change in price results in 10 percent change in demand, it is unit elastic demand. The demand curve in such case is called rectangular hyperbola shown in the adjacent Fig. 5.3. iv. More than Unit Elastic: Demand for a commodity will be said to be more than unit elastic if a change in price results in a significant change in demand for this commodity. If 10 percent change in price results in 14 percent change in demand, it is elastic demand. Figure 5.4 below shows elastic demand. v. Perfectly Elastic Demand: Demand for a commodity is said to be perfectly elastic, when a small change in its price results in an infinite change in its quantity demanded. If 10 percent change in price results in (α) percent change in demand, it is exactly elastic demand. In this case, demand curve is horizontal straight line parallel to X-axis as shown in Fig. 5.5. The first and the last cases are rare in real life. In short, the types of elasticity can be summarized in tabular form as follows: Percentage Percentage Change Types Coefficient of Change in Price in Demand Elasticity (e) 10 0 Perfectly Inelastic e = 0 10 6 Inelastic e1 10 ∞ Perfectly Elastic e=∞ The table shows how a 10% change in price of a good influences quantity demanded. If there is no change or zero change in quantity demanded, elasticity is perfectly inelastic. Likewise, if the change is relatively less, demand is inelastic. In case of same change and more changes in demand, elasticity is unitary and elastic demand respectively. When there is very great change, demand is perfectly elastic. 4.2 MEASUREMENT OF PRICE ELASTICITY OF DEMAND It is very important to know to what extent demand is responsive, that is elastic or inelastic. For this purpose measurement of elasticity is necessary. The important methods to measure elasticity are the following: i. Total outlay/expenditure method ii. Percentage method ii. Arc method iv. Point/Geometrical method v. Revenue method i. TOTAL OUTLAY/EXPENDITURE METHOD Elasticity of demand for a commodity can be measured with the help of the Total Outlay/expenditure incurred by a household on the purchase of a commodity. The formulae for total outlay is Total expenditure (TE) after change in price e= Total expenditure (TE) before change in price And TE formulae = p × q Where: e represents price elasticity, TE stands for total outlay, p and q for price and quantity respectively. This method provides us with three different measurements of the elasticity of demand, which are as follows: a. Unit Elastic (e = 1) b. More than Unit Elastic (e > 1) c. Less than Unit Elastic (e < 1) Total outlay method to measure elasticity of demand was primarily used by Prof. Marshall. According to this method, elasticity is measured by comparing the total money spent by the consumer on the goods before and after the changes in price. Elasticity can be measured for the following three situations: a. Unit elasticity (e = 1): When the total money, outlay, or expenditure (TE) remains unchanged even after a change in the price of the commodity, elasticity is said to be unitary. Take for instance the following example, where TE remains the same. It is seen that when price falls to N2 per unit from N5 per unit, total expenditure does not change. The formulae using total outlay/expenditure method is: Price per unit (N) Quantity (Q) Total Expenditure (N) 5 10 50 2 25 50 b. More than unit elastic (e > 1): When the total money expenditure rises with a fall in price and falls with a rise in price, it is the case of elasticity greater than one or elastic demand. In the case of elastic demand, there are two (2) categories (a) when price falls and quantity rises; (b) when price rises and quantity falls. This will be clear from the table below. When price falls from N5 to N2 per unit, total expenditure rises from N50 to N60. Thus there is inverse relationship between price and total expenditure. a. when price falls and quantity rises Price per unit (N) Quantity (Q) Total Expenditure (N) 5 (Old) 10 50 2 (New) 30 60 b. when price rises and quantity falls Price per unit (N) Quantity (Q) Total Expenditure (N) 5 (New) 15 75 2 (Old) 30 60 c. Inelastic demand (e < 1): When the total money expenditure rises with an increase in price and falls with a fall in price, it is the case of inelasticity of demand or elasticity less than one. The adjacent table shows this case. In this case, when price decreases, total expenditure also declines. Thus price and total expenditure have direct relationship. Price per unit (N) Quantity (Q) Total Expenditure (N) 5 (Old) 10 50 2 (New) 15 30 The Figure below also depicts how price elasticity can be measured with the help of total outlay method. Demand is unit elastic over the price range R and Q; inelastic over the price range S and R, and elastic over the price range P and Q.  Y A P e>1 Q B e=1 Price R C e1 Price R e=1 T e>1 e=0 D Demand For instance, let us find elasticity at point R using the above figure. RD e= =1 RD'' The above is true because RD = RD'' Similarly, elasticity at different points is shown as under: D''D At D'': e= =∞ 0 SD At S: e= >1 SD'' TD At T: e=