Foundation Paper 1: Fundamentals of Economics and Management (PDF)

 FOUNDATION : PAPER - 1 FUNDAMENTALS OF ECONOMICS AND MANAGEMENT FOUNDATION STUDY NOTES The Institute of Cost Accountants of India CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 First Edition : January 2013 Second Ed...

 FOUNDATION : PAPER - 1 FUNDAMENTALS OF ECONOMICS AND MANAGEMENT FOUNDATION STUDY NOTES The Institute of Cost Accountants of India CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 First Edition : January 2013 Second Edition : September 2014 Published by : Directorate of Studies The Institute of Cost Accountants of India (ICAI) CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 www.icmai.in Printed at : Repro India Limited Plot No. 50/02, T.T.C. MIDC Industrial Area, Mahape, Navi Mumbai 400 709, India. Website : www.reproindialtd.com Copyright of these Study Notes is reserved by the Insitute of Cost Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof.  Syllabus PAPER1: FUNDAMENTALS OF ECONOMICS AND MANAGEMENT (FEM) Syllabus Structure A Fundamentals of Economics 50% B Fundamentals of Management 50% B A 50% 50% ASSESSMENT STRATEGY There will be written examination paper of three hours OBJECTIVES To gain basic knowledge in Economics and understand the concept of management at the macro and micro level Learning Aims The syllabus aims to test the student’s ability to:  Understand the basic concepts of economics at the macro and micro level   Conceptualize the basic principles of management  Skill sets required Level A: Requiring the skill levels of knowledge and comprehension CONTENTS Weightage Section A : Fundamentals of Economics 50% 1. Basic concepts of Economics 2. Forms of Market 3. National Income 4. Money 5. Banking 6. (a) Indian Economy – an Overview (b) Infrastructure of the Indian Economy Section B: Fundamentals of Management 50% 7. (a) Management Process (b) Evolution of Management thought 8. (a) Concept of Power (b) Leadership & Motivation 9. (a) Group Dynamics (b) Management of Organizational Conflicts 10. Decision-making – types and process SECTION A: FUNDAMENTALS OF ECONOMICS [50 MARKS] 1. Basic Concepts of Economics (a) The Fundamentals of Economics & Economic Organizations (b) Utility, Wealth, Production, Capital (c) Central Problems of an Economy (d) Production Possibility Curve ( or Transformation Curve) (e) Theory of Demand ( meaning, determinants of demand, law of demand, elasticity of demand- price, income and cross elasticity) and Supply ( meaning , determinants, law of supply and elasticity of supply) Indian Contract Act, 1872 (f) Equilibrium (g) Theory of Production ( meaning , factors, laws of production- law of variable proportion, laws of returns to scale) (h) Cost of Production ( concept of costs, short-run and long-run costs, average and marginal costs, total, fixed and variable costs) 2. Forms of Market (a) Various forms of market- monopoly, perfect competition, monopolistic competition, oligopoly, duopoly (b) Pricing strategies in various markets 3. National Income (a) Gross National Product (b) Net National Product (c) Measurement of National Income (d) Economic growth and fluctuations (e) Consumptions, Savings and Investment 4. Money (a) Definition and functions of money (b) Quantity theory of money (c) Inflation and effect of inflation on production and distribution of wealth (d) Control of Inflation (e) Money Supply (f) Liquidity preference and marginal efficiency (g) Rate of Interest and Investment 5. Banking (a) Definition (b) Functions and utility of Banking (c) Principles of Commercial Banking (d) Essentials of sound Banking system (e) Multiple credit creation (f) Functions of Central Bank (g) Measures of credit control and Money Market (h) National & International Financial Institutions 6.(a) Indian Economy – An overview Nature, key sectors and their contribution to the economy (a) Meaning of an Underdeveloped Economy (b) Basic Characteristics of the Indian Economy (c) Major Issues of Development (d) Natural resources in the process of Economic Development (e) Resources - land; forest; water, fisheries, minerals (f) Economic development and Environmental Degradation (g) Global Climate Change and India (h) The role of Industrialization, pattern of Ownership of Industries Role and Contribution of Industries in Economic development (with special reference to the following industries): Iron and Steel, Cotton and Synthetic Textile, Jute, Sugar, Cement, Paper, Petrochemical, Automobile, IT & ITES, Banking and Insurance (b) Infrastructure of the Indian Economy (i) Infrastructure and Economic Development, Private Investment in Infrastructure, Public Private Partnership (PPP) Model in Infrastructure Energy (ii) Power Sector (iii) Transport System in India’s Economic Development – Railways, Roads, Water, Civil Aviation (iv) Information Technology (IT) and ITES (Information Technology Enabled Services) including the Communication System in India (v) Urban Infrastructure (vi) Science and Technology SECTION B – FUNDAMENTALS OF MANAGEMENT [50 MARKS] 7. (a) Management Process – introduction, planning, organizing, staffing, leading, control, communication, co-ordination. (b) Evolution of Management thought – Classical, Neo-classical, Modern 8. (a) Concept of Power, Authority, Responsibility, Accountability, Delegation of Authority, Centralization & Decentralization (b) Leadership & Motivation – Concept & Theories 9. (a) Group Dynamics- concept of group and team, group formation, group cohesiveness (b) Management of organizational conflicts- reasons, strategies 10. Decision-making- types of decisions, decision-making process. 4 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT  Contents SECTION A : ECONOMICS Study Note 1 : Basic Concepts of Economics 1.1 Definition & Scope of Economics 1.3 1.2 Few Fundamental Concepts 1.6 1.3 Demand 1.13 1.4 Supply 1.34 1.5 Equilibrium 1.42 1.6 Theory of Production 1.46 1.7 Theory of Cost 1.54 Study Note 2 : Market 2.1 Various Forms of Market 2.1 2.2 Concepts of Total Revenue, Average Revenue & Marginal Revenue 2.4 2.3 Pricing in Perfect Competition 2.4 2.4 Pricing in Imperfect Competition 2.9 Applications on Basic Concepts of Economics and Market 2.17 Study Note 3 : National Income 3.1 Concept of National Income 3.1 3.2 Measurement of National Income 3.2 3.3 National Income & Economic Welfare 3.3 3.4 Concept of Consumption, Saving & Investment 3.3 3.5 Economic Growth & Fluctuation 3.6 Study Note 4 : Money 4.1 Money 4.1 4.2 Gresham’s Law 4.2 4.3 Quantity Theory of Money 4.3 4.4 Inflation 4.4 4.5 Investment & Rate of Interest 4.11 4.6 Money Supply 4.11 4.7 Liquidity Preference & Marginal Efficiency 4.12 Exercise 4.12  Study Note 5 : Banking 5.1 Bank 5.1 5.2 Central Bank 5.6 5.3 Financial Institutions 5.10 Applications on National Income, Money and Banking 5.18 Study Note 6 : Indian Economy – An Overview Section A : An Overview 6.1 Meaning of an Underdeveloped Economy 6.1 6.2 Basic Characteristics of the Indian Economy as developing country 6.2 6.3 Major Issues of Development 6.3 6.4 Natural Resources in the process of Economic Development 6.4 6.5 Economic Development & Environmental Degradation 6.4 6.6 The role of Industrialisation 6.5 6.7 Pattern of Ownership of Industries 6.5 6.8 Role & Contribution of some Major Industries in Economic Development 6.6 Section B : Infrastructure 6.9 Infrastructure & Economic Development 6.11 6.10 Energy 6.12 6.11 Transport System in India’s Economic Development 6.12 6.12 Communication System of India 6.13 6.13 Public Private Partnership (PPP) model 6.14 SECTION B : MANAGEMENT Study Note 7 : Evolution of Management Thought 7.1 Evolution of Management Thought - Introduction 7.1 7.2 Principles of Scientific Management : Fredrick Taylor 7.3 7.3 Principles and Techniques of Management : Henri Fayol 7.4 7.4 Bureaucratic Management : Max Weber 7.5 7.5 Organisation Theory 7.6  Study Note 8 : Management Process 8.1 Management- Introduction 8.1 8.2 Planning - Introduction 8.2 8.3 Forecasting 8.9 8.4 Decision-Making 8.10 8.5 Organising 8.15 8.6 Staffing 8.28 8.7 Directing 8.34 8.8 Supervision 8.35 8.9 Communication 8.37 8.10 Controlling 8.40 8.11 Co-ordination 8.49 Study Note 9 : Leadership and Motivation 9.1 Leadership - Introduction 9.1 9.2 Motivation 9.8 Study Note 10 : Group Dynamics 10 Group Dynamics 10.1 Study Note 11 : Organizational Conflicts 11.1 Meaning of Conflict 11.1 11.2 Causes of Organizational Conflict 11.2 11.3 Ways of Managing Conflict in Organizations 11.2 11.4 Conflict Control & Organizational Strategy 11.3 11.5 Causes of Interpersonal Conflict 11.4 11.6 Types of Conflict 11.5 11.7 Strategies of Dealing with Conflict in Organizatons 11.5 11.8 Strategies to Manage Workplace Conflict 11.5 Multiple Choice Questions 11.7  Section - A ECONOMICS Study Note - 1 BASIC CONCEPTS OF ECONOMICS This Study Note includes 1.1 Definition & Scope of Economics 1.2 Few Fundamental Concepts. 1.3 Demand 1.4 Supply 1.5 Equilibrium 1.6 Theory of Production 1.7 Theory of Cost 1.1 DEFINITION & SCOPE OF ECONOMICS 1.1.1 Definition of Economics The analysis of economic environment requires the knowledge of economic decision making and hence the study of “Economics” is significant. There are 4 definitions of Economics. (i) Wealth Definition: Adam Smith defined “Economics as a science which inquired into the nature and cause of wealth of Nations”. According to this definition — Economics is a science of study of wealth only; It deals with production, distribution and consumption; This wealth centered definition deals with the causes behind the creation of wealth, and It only considers material wealth. Criticisms of this definition: (a) Wealth is of no use unless it satisfies human wants. (b) This definition is not of much importance to man and welfare. (ii) Welfare definition: According to Alfred Marshall “Economics is the study of man in the ordinary business of life”. It examines how a person gets his income and how he invests it. Thus on one side it is a study of wealth and on the other most important side, it is a study of well being. Features: (a) Economics is a study of those activities that are concerned with material welfare of man. (b) Economics deals with the study of man in ordinary business of life. The study enquires how an individual gets his income and how he uses it. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.1 Basic Concepts of Economics (c) Economics is the study of personal and social activities concerned with material aspects of well being. (d) Marshall emphasized on definition of material welfare. Herein lies the distinction with Adam Smith’s definition, which is wealth centric. (iii) Scarcity definition This definition was put forward by Robbins. According to him “Economics is a science which studies human behavior as a relationship between ends and scarce means which have alternative uses. Features: (a) human wants are unlimited (b) alternative use of scarce resources (c) efficient use of scarce resources (d) need for optimisation (iv) Growth Oriented definition This definition was introduced by Paul. A. Samuelson. According to the definition “Economics is the study of how man and society choose with or without the use of money to employ the scarce productive resources, which have alternative uses, to produce various commodities over time and distributing them for consumption, how or in the future among various person or groups in society.” It analyses costs and benefits of improving patters of resource allocation. 1.1.2 Scope of Economics Economics is a social science. It studies man’s behaviour as a rational social being. Traditional It considered as a science of wealth in relation to human welfare. Approach Earning and spending of income was considered to be end of all economic activities. Wealth was considered as a means to an end – the end being human welfare. An individual, either as a consumer or as a producer, can optimize his goal is an economic decision. The scope of Economics lies in analyzing economic problems and suggesting policy measures. Social problems can thus be explained by abstract theoretical tools or by empirical methods. Modern In classical discussion, Economics is a positive science. Approach It seeks to explain what the problem is and how it tends to be solved. In modern time it is both a positive and a normative science. Economists of today deal economic issues not merely as they are but also as they should be. Welfare economics and growth economics are more normative than positive. 1.1.3 Subject Matter of Economics The subject matter of economics is presently divided into two major branches. Micro Economic and Macro Economics. These two terms have now become of general use in economics. 1.2 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT Micro Economics Micro economics studies the economic behaviour of individual economic units. The study of economic behaviour of the households, firms and industries form the subject-matter of micro economics. It examines whether resources are efficiently allocated and spells out the conditions for the optimal allocation of resources so as to maximize the output and social welfare. For example, micro economics is concerned with how the individual consumer distributes his income among various products and services so as to maximize utility. Thus, micro-economics is concerned with the theories of product pricing, factor pricing and economic welfare. Macro Economics Macro economics deals with the functioning of the economy as a whole. For example, macro economics seeks to explain how the economy’s total output of goods and services and total employment of resources are determined and what explains the fluctuation in the level of output and employment. It deals with the broad economic issues, such as full employment or unemployment, capacity or under capacity production, a low or high rate of growth, inflation or deflation. It is the theory of national income, employment, aggregate consumption, savings and investment, general price level and economic growth. Interdependence between Micro Economics and Macro Economics Micro Economic analysis and Macro Economic analysis are complementary to each other; They do not complement but supplement each other. The basic goal of both the theories is same: the maximization of the material welfare of the nation. From the micro economic point of view, the nation’s material welfare will be maximized by achieving optimal allocation of resources. From the macro economic point of view, the nation’s material welfare will be maximized by achieving full utilisation of productive resources of the economy. The study of both is equally vital so as to have full knowledge of the subject-matter of economics. The contemporary economists are concerned with both micro economics and macro economics. 1.1.4 Nature of Economics Nature of economics refers to whether economics is a science or art or both, and if it is a science, whether it is positive science or normative science or both. Economics as a Science — We have often stated that economics is a social science. Economics as a social science studies economic activities of the people. Economics is a systematic body of knowledge as it explains cause and effect relationship between various variables such as price, demand, supply, money supply, production, national income, employment, etc. Economic laws, like other scientific laws, state what takes place when certain conditions (assumptions) are fulfilled. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.3 Basic Concepts of Economics This is the traditional Deduction Method where economic theories are deduced by logical reasoning. The law of demand in economics states that a fall in the price of commodity leads to a large quantity being demanded ‘given other things’, such as income of the consumer, prices of other commodities, etc., remaining the same. In economics we collect data, classify and analyse these facts and formulate theories or economic laws. The truth and applicability of economic theories can be supported or challenged by confronting them to the observations of the real world. If the predictions of the theory are refuted by the real-world observations, the theory stands rejected. If the predictions of the theory are supported by the real-world events, then the theory is formulated. The laws of economics or economic theories are conditional subject to the condition that other things are equal. Economic theories are seldom precise and are never final; they are not as exact and definite as laws of physical and natural sciences. The laws of physical and natural sciences have universal applicability, but economic laws are not of universally applicable. The laws of physical and natural sciences are exact, but economic laws are not that exact and definite. Economics as an Art — Various branches of economics, like consumption, production, distribution, money and banking, public finance, etc., provide us basic rules and guidelines which can be used to solve various economic problems of the society. The theory of demand guides the consumer to obtain maximum satisfaction with given income. Theory of production guides the producer to equate marginal cost with marginal revenue while using resources for production. The knowledge of economic laws helps us in solving practical economic problems in everyday life. Economics as a Positive Science — A positive science is that science in which analysis is confined to cause and effect relationship. Positive economics is concerned with the facts about the economy. It studies the economic phenomena as they exist. It finds out the common characteristics of economic events. It specifies cause and effect relationship between them. It generalizes their relationship by formulating economic theories and makes predictions about future course of these economic events. Economics as a Normative Science — The objective of Economics is to examine real economic events from moral and ethical angles and to judge whether certain economic events are desirable or undesirable. Normative economics involves value judgment. It deals primarily with economic goals of a society and policies to achieve these goals. It also prescribes the methods to correct undesirable economic happenings. 1.4 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT Economics as a Science and an Art — Being a systematized body of knowledge and establishing the cause and effect relationship of a phenomenon, Economics is a scientific study. The laws of economics are conditional. Economics cannot predict with so much certainty and accuracy as the subject deals with the behaviour of human beings as such controlled experiment is not possible. Some economists prefer to treat economics as an art. Every science has an art or a practical side. Every art has a scientific side which is theoretical. Economics deals with both theoretical aspects as well as practical side of many economic problems we face in our daily life. Thus, Economics is both science as well as an art. 1.1.5 Central Problem of all Economies In case of any economy, whatever the economy required cannot be satisfied fully. Economic resources or means of production are limited and they can be put to alternative uses. Every economy faces some common problems. A country cannot produce all goods because it has limited resources. What to It has to make a choice between different goods and services. produce? Every economy has to decide what goods and services should be produced. As an economy decides to produce certain goods, it faces the problem to decide how these goods will be produced. How to The problem arises because of unavailability of some resources. produce? It also involves the choice of technique of production. A country may produce by labour intensive methods or by capital intensive methods of production, depending upon its stock or man power. Goods and services are produced for people who have the means to pay for them. For whom to A country may produce mass consumption goods at a large scale or goods for produce? upper classes. All it depends upon the policies of the government as well as private producing units. 1.1.6 Economic Organizations It refers to the arrangements of a country’s economy in terms of production, distribution and consumption of goods and services. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.5 Basic Concepts of Economics 1.2 FEW FUNDAMENTAL CONCEPTS 1.2.1 Wealth By wealth we mean the stock of goods under the ownership of a person or a nation. It means the stock of all goods like houses and buildings, furniture, land, money in cash, money kept in banks, clothes, company shares, stocks of other commodities, etc. owned by a person. (i) Personal Health, goodwill, etc., can also be considered to be parts of an individual’s wealth. wealth In Economics, they are transferable goods (whose ownership can be transferred to another person). These are considered to be components of wealth. It includes the wealth of all the citizens of the country. There are public properties whose benefits are enjoyed by the citizens of the country but no citizen personally owns these goods. Natural resources (mineral resources, forest resources, etc), roads, bridges, parks, (ii) National hospitals, public educational institutions and public sector projects of various types wealth (public sector industries, public irrigation projects, etc.) are example of public properties. There is some personal wealth which is to be deducted from national wealth. Example, if a citizen of the country holds a Government bond, it is personal wealth. But from the point of view of the Government, it is a liability and, hence, it should not be considered as a part of the nation’s wealth. 1.2.2 Wealth and Welfare Welfare means the satisfaction or the well-being enjoyed by society. Social welfare depends on the wealth of the nation. In general, wealth gives rise to welfare, although they are not same. If wealth of society increases, but the distribution among the citizens of the country is very unequal, this inequality may create social jealousy and tension. Economists, however, assume that when wealth increases, welfare increases too. Similarly, when wealth decreases, welfare is assumed to decrease. 1.2.3 Money Anything which is widely accepted in exchange for goods, or in settling debts. In Barter System, goods were used as medium of exchange. When general acceptability of any medium of exchange is enforced by law, that medium of exchange in called the legal tender, (example, the rupee notes and coins). When some commodity is used as a medium of exchange by custom, it is called customary money, (example, the rupee notes and coins). Constituents of money supply In any economy, the constituents of money supply are as follows: (a) Rupee notes and coins with the public, 1.6 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT (b) Credit cards, (c) Traveller’s cheques, etc. 1.2.4 Markets A system by which the buyers and sellers of a commodity can come into touch with each other (directly or indirectly). In Economics, a market for a commodity is a system. Here, the buyers and the sellers establish contact with each other directly or indirectly. They have a view to purchasing and selling the commodity. Functions of a market The major functions of a market for a commodity are : (i) to determine the price for the commodity, and (ii) to determine the quantity of the commodity that will be bought and sold. Both the price and the quantity are determined by the interactions between the buyers and the sellers of the commodity. The market mechanism When economists talk of the market mechanism, they mean the totality of all markets (i.e., the markets for all the goods and services in the economy). The market mechanism determines the prices and the quantities bought and sold of all the goods and services. 1.2.5 Investment Investment means an increase in the capital stock. For a country, as a whole, investment is the increase in the total capital stock of the country. For an individual, investment is the increase in the capital stock owned by him. Real investment and portfolio investment Economists talk of two types of investment : real investment and portfolio investment. (a) Real investment : Real investment means an increase in the real capital stock, i.e., an addition to the stock of machines, buildings, materials or other types of capital goods. (b) Portfolio investment : Portfolio investment essentially means the purchase of shares of companies. However, it is only the purchase of new shares issued by accompany that can properly be termed as investment (because the company will use the money for expanding its productive capacity, i.e., the company’s real capital stock will increase). Purchase of an existing share from another shareholder is not an investment because in this case the company’s real capital stock does not increase. Gross investment and net investment In any economy, the aggregate investment made during any year is called gross investment. The gross investment includes (a) inventory investment and (b) fixed investment. Investment in raw materials, semi- finished goods and finished goods is referred to as inventory investment. On the other hand, investment made in fixed assets like machineries, factory sheds etc. is called fixed investment. By deducting depreciation cost, of capital from the gross investment, we get new investment. So, Net investment = Gross investment – depreciation cost. 1.2.6 Production Production means “creation of utility”. It also refers to creation of goods (or performance of services) for the purpose of selling them in the market. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.7 Basic Concepts of Economics There was a time when production meant the fabrication of material goods only. A tailor’s activity was considered to be production but the activity of the trader who sold clothes to the purchasers was not considered as production. At present, both material goods and services are considered as production. Production must be for the purpose of selling the produced goods (or, services) in the market. Factors of production The goods and services with the help of which the process of production is carried out, are called factors of production. Economists talk about four main factors of production : land, labour, capital and entrepreneurship (or organization). They are also called as the inputs of production. On the other hand, the goods produced with the help of these inputs, are called as the output. 1.2.7 Consumption By consumption, we mean satisfaction of wants. It is because we have wants that we consume various goods and services. Moreover, it is assumed that, if we have wants, these can be satisfied only through the consumption of goods and services. Thus, consumption is defined as the satisfaction of human wants through the use of goods and services. Other determinants of consumption Present income It is the main determinant of consumption Expected future Most people try to save for the future. income People display a low average propensity to consume when they are young. A low propensity to save when they are old. Wealth A person may have a low income, but he may be wealthy He may have a great amount of accumulated wealth, In this case, he may have high consumption expenditure. 1.2.8 Saving Saving is defined as income minus consumption. Whatever is left in the hands of an individual after meeting consumption expenditure is the individual’s saving. The sum-total of funds in the hands of an individual is obtained by accumulating the saving of the past years. Saving is generated out of current income of an individual. Savings are created out of past income of an individual. 1.2.9 Income The income of a person means the net inflow of money (or purchasing power) of this person over a certain period. For instance, an industrial worker’s annual income is his salary income over the year. A businessman’s annual income is his profit over the year. Wealth and income The difference between wealth and income must be clearly understood. A person (or a nation) consumes a part of the income and saves the rest. These savings are accumulated in the form of wealth. Wealth is a stock. It is stock of goods owned at a point of time. Income is a flow; it is the inflow of money (or purchasing power) over a period of time. 1.8 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT 1.2.10 Consumer Surplus The concept was introduced by Prof. Marshall in Economics. The excess satisfaction or utility that a consumer can enjoy from the purchase of a thing when the price that he actually pays is less than the price he was willing to pay for it. It is the difference between individual demand price and market price. The price that a man is willing to pay is determined by the marginal utility of the thing to him. The concept is derived from the Law of Diminishing Marginal Utility. As a man consumes successive units of a commodity, the Marginal Utility from each unit goes on falling. It is often argued that the surplus satisfaction cannot be measured precisely. It is difficult to measure the marginal utilities of different units of a commodity consumed by person. 1.2.11 Capital In a fundamental sense, capital consists of any produced thing that can enhance a person’s power to perform economically useful work. Example, a stone or an arrow is capital for a caveman who can use it as a hunting instrument. Capital is an input in the production process. It refers to financial resources available for use. Capital is different from money. Money is used simply to purchase goods and services for consumption. Capital is more durable and is used to generate wealth through investment. Capital is something owned which provides ongoing services. Economic capital is used for measuring and reporting market and operational risks across a financial organization. 1.2.12 Utility Utility, or usefulness, is the ability of something to satisfy needs or wants. Utility is an important concept in economics because it represents satisfaction experienced by the consumer of a good. Utility is a representation of preferences over some set of goods and services. One cannot directly measure benefit, satisfaction or happiness from a good or service, so instead economists have devised ways of representing and measuring utility in terms of economic choices that can be counted. Economists consider utility to be revealed in people’s willingness to pay different amounts for different goods. Total utility is the aggregate sum of satisfaction or benefit that an individual gains from consuming a given amount of goods or services in an economy. The amount of a person’s total utility corresponds to the person’s level of consumption. Usually, the more the person consumes, the larger his or her total utility will be. Marginal utility is the additional satisfaction, or amount of utility, gained from each extra unit of consumption. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.9 Basic Concepts of Economics Total utility usually increases as more of a good is consumed. Marginal utility usually decreases with each additional increase in the consumption of a good. This decrease demonstrates the law of diminishing marginal utility. 1.2.13 Law of Diminishing Marginal Utility This Law is a fundamental law of Economics. It relates to a man’s behaviour as a consumer. The Law states that as a man gets more and more units of a commodity, marginal utility from each successive unit will go on falling till it becomes zero or negative. Marginal utility means the additional utility obtained from one particular unit of a commodity. It is expressed in terms of the price that a man is willing to pay for a commodity. The basis of the Law is satiability of a particular want. Although human wants are unlimited in number yet a particular one can be fulfilled. The Law can be explained in the following illustration: Units of goods Total utility (TU) Marginal utility (MU) 1 4 – 2 5 1 3 6 1 4 6 0 5 5 -1 The above table can be shown by the following graph — Y TU X O Q MU Fig 1.1 : Marginal Utility and Total Utility Curve In this graph the curve MU is Marginal Utility curve. It has a negative slope denoting the fact that as the quantity of a commodity increases, marginal utility goes on following. At Q it is zero and after it, it becomes negative. 1.10 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT The Law is based upon certain assumptions — It is assumed that the different unit consumed should be identical in all respects. Further it is assumed that consumer’s habit taste, preference remain unchanged. Thirdly, there should be no time gap or interval between the consumption of one unit and another unit. Lastly, the different units consumed should consist of standard units which are not too small or large in size. Notion of the Law The Law of Diminishing utility is not applicable in some cases. The Law may not apply to articles like gold, money where more quantity may increase the lust for them. Further the Law does not apply to music, hobbies. Thirdly, Marginal utility of a commodity may be affected by the presence or absence of articles which are substitutes or complements. 1.2.14 Demand Forecasting In modern business, production is carried out in anticipation of future demand. There is thus a time-gap between production and marketing. So production is done on the basis of demand forecasting. The success of a business firm depends to a large extent upon its successful forecasting. The following methods are commonly used in forecasting demand. (a) Expert opinion method – experts or specialists in the fields are consulted for their opinion regarding future demand for a particular commodity. (b) Survey of buyers’ intentions – generally a limited number of buyers’ choice and preference are surveyed and on the basis of that the business man forms an idea about future demand for the product it is going to produce. (c) Collective opinion method – the firm seeks opinion of retailers and wholesalers in their respective territories with a view to estimate expected sales. (d) Controlled experiments – the firm takes into account certain factors that effect demand like price, advertisement, packaging. On the basis of these determinants of demand the firm makes an estimate about future demand. (e) Statistical methods – More often firms make statistical calculations about the trend of future demand. Statistical methods comprising trend projection method, least squares method progression analysis etc. are used depending upon the availability of statistical data. 1.2.15 Production Posibility Curve (PPC) In economics, a production–possibility curve (PPC), is also called a production–possibility frontier (PPF), production-possibility boundary or product transformation curve, is a graph that compares the production rates of two commodities that use the same fixed total of the factors of production. Graphically bounding the production set, the PPF curve shows the maximum specified production level of one commodity that results given the production level of the other. By doing so, it defines productive efficiency in the context of that production set. Let us consider the shape and use of the production possibility curve. In our discussion we make the following assumptions: (1) Only two goods, X and Y, are being produced. (2) Only one factor of production is used in the production. That factor of production is labour. Supply of labour in the economy is fixed and total amount of labour is fully employed. (3) The two goods can be produced in various ratios. This means that the country can produce more of X and less of Y or less X and more of Y. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.11 Basic Concepts of Economics (4) In the production of both goods, law of increasing cost operates. This means that if the production of one good rises, its marginal cost will rise. (5) There is no change in production process or production technology. With the help of these assumptions we can explain how the production possibility curve can be obtained. Suppose the country can produce different alternative combinations of X and Y with its given amount of labour. Those combinations are shown with the help of the following hypothetical schedule: Production Possibility Schedule Good X Good Y 0 10 1 9 2 7 3 4 4 0 From this schedule we see that if the country produces only Y and no amount of good X, then it can produce a maximum of 10 units of Y. So, we get a combination (0, 10) on the production possibility curve. Again, if the country does not produce good Y and devote its entire resources in the production of X, then it can produce a maximum of 4 units of X. Hence, point (4, 0) will be a combination of two goods on the production possibility curve. In this way, employing the entire resource (labour), the country can produce 1 unit of good X and 9 units of good Y, or 2 units of good X and 7 units of good Y, etc. y A´ 10 A B 9 Good Y 7 C F D 4 E E´ x O 1 2 3 4 Good X Fig. 1.2 In our figure, we plot the amount of good X (say, x) on the horizontal axis and the amount of good Y (say, y) on the vertical axis. In this figure, AE is the production possibility curve. 1.12 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT  At A on this curve, x = 0 and y = 10 i.e., point A expresses the combination (0, 10). Similarly, point B represents the combination (1, 9), point C represents the combination (2, 7), point D represents the combination (3, 4) and point E expresses the combination (4, 0). With the given amount of labour, the country can produce any product combination on the production possibility curve AE. This curve is downward sloping. It implies that, given the amount of labour, if the country increases the production of one good, it must reduce the production of the other. The country can produce any combination below AE but it cannot produce any combination lying to the right of AE. Let F be a point to the left of AE. At this point, some amount of labour will remain unutilised. By full employment of labour, the country can move from F to any point on AE where the production of at least one commodity will increase. Again, if it is found that there is full employment of labour but output is obtained as represented by F, then it should be understood that production has not been done efficiently. In that case, it is possible to increase the production of both goods by efficient utilisation of labour. If the given amount of labour is fully utilised, the country can produce any combination of X and Y on AE. Hence, to determine the production levels of two goods means to determine the point on the production possibility curve at which the country will stay. 1.3 DEMAND In the ordinary sense, demand means desires. Demand in Economics means both the willingness as well as the ability to purchase a commodity by paying a price and also its actual purchase. A man may be willing to get a thing but he is not able to pay the price. It is not demand in the economic sense. Demand is related to price. Generally demand for a commodity depends upon the price of the commodity. Generally the relation between price and demand is inverse. When price of a particular commodity goes up, its demand falls and vice-versa. But in exceptional cases the two variables may move in the same direction. There are other factors that may influence the quantity demanded for a quantity. One such factor is the income of the consumer. If a man’s income increases, obviously he will be able to demand more of the goods at a given price. Except that, demand for a commodity depends upon the taste and preference of the consumers, the price of substitute goods etc. 1.3.1 Law of Demand The law of demand expresses the functional relationship between the price of commodity and its quantity demanded. It states that the demand for a commodity tends to vary inversely with its price this implies that the law of demand states- Other things remaining constant, a fall in price of a commodity will lead to a rise in demand of that commodity and a rise in price will lead to fall in demand. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.13 Basic Concepts of Economics Assumption: (i) Income of the people remaining unchanged. (ii) Taste, preference and habits of consumers unchanged. (iii) Prices of related goods i.e., substitute and complementary goods remaining unchanged (iv) There is no expectation of future change in price of the commodity. (v) The commodity in question is not consumed for its prestige value. Importance of Law of Demand 1. Basis of the Law of Demand : The law of Demand is based on the consumers that they are prepared to buy a large quantity of a certain commodity only at a lower price. This results from the fact that consumption of additional units of a commodity reduces the marginal utility to him. 2. Basis of consumption Expenditure : The law of Demand and the law of equi-marginal utility both provide the basis for how the consumer should spend his income on the purchase of various commodites. 3. Basis of Progressive Taxation : Progressive Taxation is the system of Taxation under which the rate of tax increase with the increase in income. This implies that the burden of tax is more on the rich than on the poor. The basis of this is the law of Demand. Since it implies that the marginal utility of Money to a rich man is lower than that to a poor man. 4. Diamond-water paradox : This means that through water is more useful than diamond. Still the price of diamond is more than that of water. The explanation lies in law of diminishing marginal utility. The price of commodity is determined by its marginal utility. Since the supply of water is abundant the marginal utility of water is very low and so its price. On the contrary, supply of diamond is limited so the marginal utility of diamond is very high, therefore the price of diamond is very high. 1.3.2 Demand Schedule It is a numerical tabulation, showing the quantity that is demanded at selected prices. A demand schedule can be of 2 types; Individual Demand Schedule, Market Demand Schedule 1.3.2.1 Individual Demand Schedule : It shows the quantity of a commodity that one consumer or a particular household will buy at selected prices, at a given time period. Price of x (`) Quantity demanded of x (units) 100 4 50 2 20 10 10 15 5 20 1.3.3.2 Market Demand Schedule : When we add the individual demand schedule of various household, we get the market demand schedule. For example, there are four households in the market and their demand schedule at different prices are given below : Price Quantity Demanded Market Demand A B C D 100 1 2 1 2 6 50 2 5 2 4 13 20 10 10 5 10 35 10 15 15 10 15 55 5 20 20 15 20 75 1.14 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT 1.3.3 Demand Curve : Demand curve is a diagrametic representation of the demand schedule when we plot individual demand schedule on a graph, we get individual demand curve and when we plot market schedule, we get market curve. Both individual and market demand curves slope downward from left to right indicating an inverse relationship between price and quantity demanded of goods. Y D P P1 Price D´ X O Q Q1 Quantity Demanded Fig.1.3 : Demand Curve The demand curve is downward sloping because of the following reasons. 1) Some buyer may simply not be able to afford the high price. 2) As we consume more units of a product, the utility of that product becomes less and less. This is called the principle of diminishing Marginal Utility. The quantity demanded rises with a fall in price because of the substitution effect. A low price of x encourages buyer to substitute x for other product. 1.3.4 Substitution effect - As the relative price of the commodity decreses, the consumer purchases more of the cheaper commodity and less of the dearer ones. Hence, with the fall in relative prices, the demand for the commodity rises. Due to inverse relation, the substution effect is negative. 1.3.5 Determinants of demand - There are many factors other than price that can affect the level of quantity demanded. This defines demand function. (i) Price of the Commodity : There is an inverse relationship between the price of the commodity and the quantity demanded. It implies that lower the price of commodity, larger is the quantity demanded and vice-versa. (ii) Income of the consumers : Usually there is a direct relationship between the income of the consumer and his demand. i.e. as income rises his demand rises and vice-a-versa. The income demand relationship varies with the following three types of commodities : (a) Normal Goods : In such goods, demand increases with increase in income of the consumer. For eg. demands for television sets, refrigerators etc. Thus income effect is positive. (b) Inferior Goods : Inferior Goods are those goods whose demand decrease with an increase in consumes income. For e.g. food grains like Malze , etc. If the income rises demand for such goods to the consumers will fall. Thus income effect is negative. (c) Giffen goods : In case of Giffen goods the demand increases with an increase in price but it decreases with the rise in income. Thus income effect is negative. (iii) Consumer’s Taste and Preference : Taste and Preferences which depend on social customs, habit of the people, fashion, etc. largely influence the demand of a commodity. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.15 Basic Concepts of Economics (iv) Price of Related Goods : Related Goods can be classified as substitute and complementary goods. (v) Substitute Goods : In case of such goods, if the price of any substitute of commodity rises, then the commodity concern will become relatively cheaper and its demand will rise. The demand for the commodity will fall if the price of the substitute falls. eg. If the price of coffee rises, the demand for tea will rise. (vi) Complementary Goods : In case of such goods like pen and ink with a fall in the price of one there will be a rise in demand for another and therefore the price of one commodity and demand for its complementary are inversely related. (vii) Consumer’s Expectation : If a consumer expect a rise in the price of a commodity in a near future, they will demand it more at present in anticipation of a further rise in price. (viii) Size and Composition of Population : Larger the population, larger is likely to be the no. of consumers. Besides the composition of population which refers to the children, adults, males, females, etc. in the population. The demographic profile will also influence the consumer demand. 1.3.6 Movement and Shift of Demand (a) Movement of Demand curve or Extension and Constriction of Demand or change in quantity. demanded. In the quantity demanded of a commodity increases or decreases due to a fall or rise in the price of a commodity alone, ceteris paribus. It is called movement along the demand curve which occurs only due to change in price of that commodity, ceteris paribus, Extension of Demand or movement along the demand curve to the right. When the quantity demanded rises due to fall in price of that commodity, and other parameters remaining constant it is called extension of demand which is shown in the following diagram. Y D a b Extension of Demand P1 a Price P2 b D´ X O Q1 Q2 Quantity Demanded Fig.1.4 : (a) Movement along Demand Curve (Decreasing) In the diagram, we find that the quantity demanded has increased from Q1 to Q2 due to a fall in price from P1 to P2, Ceteris Paribus. This is shown by a movement along a demand curve toward the right from point a to b. 1.16 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT Contraction or Movement towards left of demand curve : When the quantity demanded of a commodity falls due to rise in the price of that commodity it is called contraction of demand and is shown in the following diagram. Y D a b Contraction of Demand b P1 Price P2 a D´ X O Q1 Q2 Quantity Demanded Fig.1.4 : (b) Movement along Demand Curve (Increasing) In the diagram, when the price was P2, quantity demanded was Q2. As the price rises to P1 the quantity demanded falls to Q1. Such a fall in demand is shown by a movement along the same demand curve towards the left from point a to b. Both the situation of extension and contraction can be shown in a single diagram as below : Y D a b Contraction of Demand b P2 b a Extension of Demand a Price P1 c P D´ X O Q2 Q1 Q Quantity Demanded Fig.1.4 : (c) Movement along Demand Curve (b) Change in Demand or shift of demand or Increase and Decrease in demand : When the quantity demanded of a commodity rises or falls due to change in factors like income of the consumer, price of related goods, etc. and keeping the price of the commodity to be constant, it is called shift in Demand. (i) Increase in Demand or Shift of Demand Curve towards the Right : When the quantity demanded of a commodity rises due to change in factors like income of the consumable etc. price of the commodity remaining unchanged it is called increase in demand. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.17 Basic Concepts of Economics Y a b a b Increase of Demand Price P D´ D X O Q1 Q Quantity Demanded Fig.1.5 : Shift of Demand Curve (Rightward) In the above diagrams, we see that quantityty demanded has increased from Q1 to Q, the price remaining unchanged to OP. D1 Increase in Demand or Shift of Demand Curve towards right. (ii) Decrease in Demand or shift of Demand Curve towards the left : When the demand for a commodity falls due to other factors, the price remaining constant, it is termed as decrease in demand or shift of demand curve towards the left. Y b a a b Decrease of Demand Price P D1 D X O Q1 Q2 Quantity Demanded Fig.1.6 : Shift of Demand Curve (Leftward) 1.3.7 Causes of downward slope of demand curve : (i) Law of Diminishing Marginal Utility : This law states that when a consumer buys more units of same commodity, the marginal utility of that commodity continues to decline. This means that the consumer will buy more of that commodity when price falls and when less units are available, utility will be high and consumer will prefer to pay more for that commodity. This proves that the demand would be more at lower prices and less at a higher price and so the demand curve is downward sloping. 1.18 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT (ii) Income effect : As the price of the commodity falls, the consumer can increase his consumption since his real income is increased. Hence he will spend less to buy the same quantity of goods. On the other hand, with a rise in price of the commodities the real income of the consumer will fall and will induce them to buy less of that good. (iii) Substitution effect : When the price of a commodity falls, the price of its substitutes remaining the same, the consumer will buy more of that commodity and this is called the substitution effect. The consumer will like to substitute cheaper one for the relatively expensive one on the other hand, with a rise in price the demand fall due to unfavorable substitution effect. It is because the commodity has now become relatively expensive which forces the consumer’s to buy less. (iv) Goods having multipurpose use : Goods which can be put to a number of uses like coal, aluminum, electricity, etc. are eg. of such commodities. When the price of such commodity is higher, it will not used for a variety of purpose but for use purposes only. On the other hand, when price falls of the commodity will be used for a variety of purpose leading to a rise in demand. For eg : if the price of electricity is high, it will be mainly used for lighting purposes, and when its price falls, it will be needed for cooking. (v) Change in number of buyers : Lower the price, will attract new buyers and raising of price will reduce the number of buyers. These buyers are known as marginal buyers. Owing to such reason the demand falls when price rises and so the demand curve is downward sloping. 1.3.8 Exceptions to the law of demand: (i) Conspicuous goods : These are certain goods which are purchases to project the status and prestige of the consumer. For e.g. expensive cars, diamond jewellery, etc. such goods will be purchased more at a higher price and less at a lower price. (ii) Giffen goods : These are special category of inferior goods whose demand increases even if with a rise in price. For eg. coarse grain, clothes, etc. (iii) Share’s speculative market : It is found that people buy shares of those company whose price is rising on the anticipation that the price will rise further. On the other hand, they buy less shares in case the prices are falling as they expect a further fall in price of such shares. Here the law of demand fails to apply. (iv) Bandwagon effect : Here the consumer demand of a commodity is affected by the taste and preference of the social class to which he belongs to. If playing golf is fashionable among corporate executive, then as the price of golf accessories rises, the business man may increase the demand for such goods to project his position in the society. (v) Veblen effect : Sometimes the consumer judge the quality of a product by its price. People may have the expression that a higher price means better quality and lower price means poor quality. So the demand goes up with the rise in price for eg. : Branded consumer goods. 1.3.9 Elasticity of Demand Whenever a policy maker wishes to examine the sensitivity of change in quantity demanded due to the change in price, income or price of the related goods, he wishes to study the magnitude of this response with the help of “elasticity” concept. Thereby, the concept is crucial for business decision-making and also for forecasting future demand policies. Determinants of Elasticity of demand: (i) Nature, necessity of a commodity : The demand for necessary commmodity like rice, wheat, salt, etc is highly inelastic as their demand does not rise or fall much with a change in price. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.19 Basic Concepts of Economics On the other demand for luxuries changes considerably with a change in price and than demand is relatively elastic. (ii) Availability of substitutes : The Demand for commodities having a large number of close substitute is more elastic than the commodities having less or no substitutes. If a commodity has a large no. of substitutes its elasticity is high because when there is a rise in its prices, consumers easily switch over to other substitutes. (iii) Variety of uses : The Product which have a variety of uses like steel, rubber etc. have a elastic demand and if it has only limited uses, then it has inelastic demand. For eg. if the unit price of electricity falls then electricity consumption will increase,more than proportionately as it can be put to use like washing, cooking, as the price will go up, people will use it for important purposes only. (iv) Possibility of postponement of consumption : The commodities whose consumption can easily be postponed has more elastic demand and the commodities whose consumption cannot be easily postponed has less elastic demand for eg. for expensive jewellery, perfume it is possible to postpone consumption in case the price is high and so such goods are elastic on the other hand, the necessities of life cannot be postponed and so they are inelastic in demand. (v) Durable commodities : Durable goods like furniture’s, etc, which will last for a longer time have valuably inelastic demand. This is because in such case, a fall in price will not lead to a large increase in demand and a rise in price again will not load to a huge fall in demand. But in case of perishable goods, the demand is elastic is nature. 1.3.9.1 Price Elasticity of Demand It is defined as the degree of responsiveness of quantity demanded of a commodity due to change in its price when other factor remaining constant. Price elasticity of Demand is usually measured by the following formula : Price elasticity of demand = % Change in Quantity Demand / % Change in Price ed = (dq/q) x 100 / (dp/p) x 100 = dq/dp x p/q Where dq = change in quantity demanded dp = change in price, p = Original price, q = Original quantity If ed > 1, we call it relatively elastic demand. If ed = 1, we call it unitary elastic demand. If ed I) X O Q Q1 Quantity Demanded Fig.1.8 : Relative Elasticity of Demand Curve In the diagram we see that change in quantity demanded QQ1 is more than proportionate to the change in price PP1. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.21 Basic Concepts of Economics (c) Unit Elastic Demand (ed = 1) Here the rate of change in demand is exactly equal to the rate of change in price. Therefore the products or service with unit elasticity are neither elastic nor inelastic. Y 20 16 Price 12 8 4 d (ed = 1) O 1 2 3 4 5 6 X Fig. 1.9 : Unit Elasticity of Demand Curve A Unit elastic Demand curve is a rectangular - hyperbola as shown above (d) Relatively Inelastic Demand (ed < 1) In this type of goods and services the proportionate change in quantity demand is less than the change in price. These are mostly essential goods of daily use like rice, wheat etc. Y P P1 Price d (ed < I) X O Q Q1 Quantity Demanded Fig.1.10 : Relatively Inelastic Demand Curve In the diagram change in quantity QQ1 is less than proportionate to the change in price PP1. 1.22 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT (e) Perfectly Inelastic Demand : These are certain goods like salt, match box etc. whose demand neither increase nor decrease with a change in price. X d (ed = 0) Price X O Quantity Demanded Fig.1.11 : Perfectly Inelastic Demand Curve A perfectly inelastic demand curve is a vertical straight line parallel to Y –axis which shows that whatever may be the change in price the demand will remain constant at OQ. Importance of Price Elasticity of Demand : (i) Business decisions : The concept of price elasticity of demand helps the firm to decide whether or not to increase the price of their product. Only if the product is inelastic in nature, then raising of price will be beneficial. On other hand, if the product is elastic in nature, then a rise in price might lead to considerable fall in demand. Therefore the price of different commodities are determined on the basis of relative elasticity. (ii) To monopolist : A monopolist often practices price discrimination. Price discrimination is a process in which a single seller sells the same commodity in two different markets at two different prices at the same time. The knowledge of price elasticity of the product to the monopolist is important because he would charge higher price from those consumers who have inelastic demand and lower price from those consumers who have elastic demand. (iii) Determination of Factor Price : The concept of elasticity of demand also helps in determining the price of various factors of production. Factor having inelastic demand gets higher price and factors having elastic demand gets lower price. (iv) Route for International Trade : If demand for exports of a country is inelastic, that country will enjoy a favorable terms of trade while if the exports are more elastic than imports, then the country will lose in the terms of trade. (v) The Govt : Elasticity of demand is useful in formulation Govt. Policy particularly taxation policy and the policy of subsides if the Govt. wants to impose excise duty, or sales tax, the Govt. should have an idea about the elasticity of the product. If the product is elastic in nature, then the burden of the tax is shifted to the consumer and the demand might fall remarkably: on the other hand, if the demand is inelastic in nature, then any extra burden of indirect tax will not affect the demand to that extent. Application of Price Elasticity of Demand : An individual spends all his income to two goods X and Y. If with the rise in the price of good X, quantity demanded of good Y remain unchanged, what is price elasticity of demand for X? Hint: Quantity purchased of good Y will remain the same even when the price of good X rises. This implies that the expenditure on good X remain constant. This concludes that the price elasticity of demand for good X equals one. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.23 Basic Concepts of Economics The price elasticity of demand for colour TV is estimated to be -2.0. If the price of the colour TV is reduced by 20% then what the rise in quantity sold do you expect? Hint: The price elasticity of demand being equal to -2.0 means that one percent change in price causes 2.0% change in quantity demanded or sold. Thus 20% reduction in price will cause 2.0 × 20 = 40 percent rise in quantity demanded or sold. The initial price and quantity for a commodity X are ` 50 and 500 units respectively. If the price reduces to ` 40,The quantity demanded rises to 1,000 units Compute the price elasticity of demand. Solution: Given, Po = ` 50 Qo = 500 units P1 = ` 40/- Q1 = 1,000 units Hence, for price elasticity, (Q1 − Qo )/ Qo ep = (P1 − Po )/ Po (Q1 − Qo ) Po = × P1 − Po Qo (1000 − 500) 50 = × (40 − 50) 500 500 50 = × = 5 >1 10 500 Hence, the demand is highly price elastic. Measurement of Price Elasticity Elasticity of demand can be measured using three methods namely, arc elasticity, point elasticity and total outlay method. (i) Arc elasticity : This is the average measure of the elasticity on the arc of the demand cure. Here within the entire demand curve, two points A & B are considered. Joining them, we get an arc, and on average, the elasticity is measured. P P1 A B P2 Q O Q1 Q2 Fig.1.12 : Arc Elasticity Demand Curve 1.24 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT  P1 + P 2 i.e. initial price = 2 Q1 + Q 2 initial quantity = 2 dQ P... Price elasticity =. dP Q dQ (P1 + P2 )/ 2 =. dP (Q1 + Q2 )/ 2 (ii) Point Elasticity Method : This method is more acceptable and prime than the previous one. In case of arc elasticity, initial price and quantity are not appr calculated since, they do not have single points. But in case of point elasticity, a single price – quantity combination exist. Here the price elasticity varies along various points on the linear demand curve. It may be considered as the approximation of extreme case of an arc of the demand curve. Lower Segment It is measured by the formula = p Upper Segment Lower Segment Elasticity at E = D Upper Segment ED1 E´ = ED Cases: p1 E 1. If E is the midpoint, ep at E = 1 (... ED1 = ED) 2. At E’, eP > 1 (E´D1 > DE´) E˝ 3. At D, ep = α (DD1 / O  α) D1 E′′ q 4. At E˝, ep = 1 a1 Income D X O b b1 Quantity Demanded Fig.1.15(b) D´ Y a ey < 1 Income a1 D X O b b1 Quantity Demanded Fig.1.15(c) Y ey = 0 Income X O D Quantity Demanded Fig.1.15(d) FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.31 Basic Concepts of Economics Y Y Income ey < 0 Y1 X O q q1 Quantity Demanded Fig.1.15(e) In Fig (1.15a) we see that change in quantity demanded is exactly same in proportion to the change in income. Therefore, the income elasticity is unitary (ey = 1) In Fig (1.15b) the change in quantity demand is more than proportion to the change in income. This shows that the commodity in highly income elastic. (ey > 1) In fig (1.15c) the change in quantity demanded is less than proportionate to the change in income and it is called relatively income inelastic (ey < 1) In fig (1.15d), a rise in income does not lead to any change in demand such commodities are called perfectly income inelastic (ey = 0) In fig (1.15e), we see a negatively sloping income demand curve. In this case, the commodities concern are inferior goods here if the income increases, the demand falls which is indicated in the diagram. (b) Cross Price Elasticity : Cross price elasticity of demand is defined as the ratio of proportionate change in quantity of a commodity say x due to change in price of another relative commodity say y. exy = % change in quantity demanded for x % change in price of y = dqx /qx ÷ dpy /py = d qx /dpy x py/qx Where d = change qx = Original quantity demanded of x. py = Original Income of y. In case of substitute goods, the cross elasticity of demand is positive i.e. if the price of one good changes, the demand for the other changes in the same direction. For eg. if the price of tea rises, the demand for coffee will also rise, since coffee has now become relatively cheaper. The cross elasticity of demand is negative in case of complementary goods. 1.32 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT At a glance : Analysis Elasticity of Demand Price elasticity (ep) Income elasticity (ey) ep > 1 ep = 1 ep < 1 ey > 1 ey = 1 ey < 1 (luxury) (comfort) (necessities) (luxury) (comfort) (necessities) Application: The demand function for commodity x is stated as, Qx = 80 – 0.5Px + 0.2Py + 0.3M Where, Px ⇒ Price of Commodity x Py ⇒ Price of related good y M ⇒ Money income Qx ⇒ Quantity demanded for good x (i) Interpret the demand function (ii) Comment on the demand curve. (iii) If money income rises, what would be the impact demand curve? (iv) Comment on the relation between x and y (v) If income elasticity is 2.1, what can you comment about x ? Hint: Gain, Qx = 80 – 0.5 px + 0.2py + 0.3 M (i) Here 80 is autonomous quantity independent of prices and income which the consumer always enjoys. The relation between price and quantity demanded is increases (due to 0.5). The income rises, Qx also rises. (ii) The demand curve is downward sloping due to (-0.5 < 0). (iii) If money income rises, the demand curve shifts rightward at same price. This is because as income effect is positive, a rise in income increases the quantity demand. (iv) Here as py rises, the demand for Qx rises because x & y are substitutes. (v) The commodity x is a Luxury since income elasticity = 2.1 > 1. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.33 Basic Concepts of Economics Problem 16 : If the cross elasticity of demand between peanut butter and milk is -1.11, then are peanut butter and milk substitutes or complements? Be able to explain your answer. Solution: Peanut butter and milk are complements because a negative cross price elasticity of demand means that as the price of milk goes up, the demand for peanut butter goes down. This would indicate that when the price of milk goes up, we buy less milk and we are also buying less peanut butter (so we must buy these together — they are complements). 1.4 SUPPLY Supply is defined as a quantity of a commodity offered by the producers to be supplied at a particular price and at a certain time. 1.4.1 Individual Supply and Market Supply It refers to the quantity of a commodity which a firm is willing to produce and offer for sale. Individual supply An individual supply schedule shows the different qualities of a commodity that a producer of a firm would offer for sale at different prices. The quantity which all producers are willing to produce and sell is known as market supply. Market Supply A market supply schedule shows the various quantities of a commodity that all the firms are willing to supply at each market price during a specified time period. 1.4.2 Law of Supply If the price of commedity rises, the level of quantity supplied rises, after factors remaing constant. Y S0 B P2 A P1 Price S X O Q1 Q2 Quantity Fig.1.16 : Supply Curve Supply Curve: in the grophical representation of supply schedule when ither factors affecting supply remain constant. Movement from A to B: Extension in Supply Movement from B to A: Contraction in Supply 1.34 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT 1.4.3 Factor Determining Supply or Supply Function: (i) Price of the commodity: When the price of a commodity in the market rises, seller increases the price. The cost of production remaining constant the higher will be the profit margin. This will encourage the producers to supply more at higher prices. The reverse will happen when the price fall. (ii) Goals of the firm : Firms may try to work on various goals for eg. Profit maximization, sales maximization, employment maximization. If the objective is to maximize profit, then higher the profit from the sale of a commodity, the higher will be the quantity supplied by the firm and vice-versa. Thus, the supply of goods will also depend upon the priority of the firm regarding these goals and the extent to which it is prepared to sacrifice one goal to the other. (iii) Input Prices : The supply of a commodity can be influenced by the raw materials, labour and other inputs. If the price of such inputs rise leading to a lower profit margin becomes less. This will ultimately lead to a lower supply. On the other hand, if there is a fall in input cost firm, will be ready to supply more than before at a given price level. (iv) State of Technology : If improved and advanced technology is used for the production of a commodity, it reduces its cost of production and increases the supply. On the other hand, the supply of those goods will be less whose production depend on unfair and old technology. (v) Government policies : The impostion of sales tax reduces supply and grant of subsidy on the other hand increases the supply. (vi) Expectation about future prices : If the producers expect an increase in the price of a commodity, then they will supply less at the present price and hoard the stock in order to sell it at a higher price in the near future. This will be opposite in case if they anticipate fall in future price (eg. fruit seller) (vii) Prices of the other commodities : Usually an increase in the prices of other commodities makes the production of that commodity whose price has not risen relatively less attractive we thus, expect that other things remaining the same, the supply of one commodities falls as the price of other goods rises. For eg. suppose a farmer produces wheat and pulses in his firm. If the price of pulses increases he grows less wheat. Hence the supply of wheat decrease. (viii) Number of firms in the market : Since the market supply is the sum of the suppliers made by individual firms, hence the supply varies with changes in the number of firm in the market and increases the supply. An decreases in the number of firm reduces the supply. (ix) Natural factor : In case of natural disorders flood, drought, etc. the supply of a commodity specially agricultural products is adversely affected. 1.4.4 Movement & Shift of Supply Curve The quantity supplied of a commodity may change broadly due to two reasons : When the quantity supplied changes due to change in the price of that commodity it is called change in quantity supplied or movement along the supply curve or extension and contraction of supply. On the other hand when the supply changes due to change in other factors, price of the commodity remaining unchanged, such a change in supply curve, increase and decrease of supply or change in supply. (a) Movement along the supply curve or extension or contraction of supply or change in quantity supplied: (i) Extension of Supply : When the quantity supplied of a commodity rises with a rise in price of that commodity other determinants of supply remaining unchanged. It is known as extension of supply or movement along the same supply curve towards the right. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.35 Basic Concepts of Economics Y S Price P1 b P2 a X O Q Q1 Quantity Supplied Fig.1.17:(a) Movement along Supply Curve (rising price) In the diagram as the price rises from P2 to P1 the quantity supplied Q to Q1. This is shown by a movement along the supply curve from point a to point b (towards the right). It is called extension of supply. (ii) Contraction of supply : When the quantity supply of a commodity falls with a fall in its price, other factors remaining comtant, it is known as contraction of supply. Y S P1 a Price P b X O Q Q1 Quantity Supplied Fig. 1.17: (b) Movement along Supply Curve (falling price) Here, the quantity supplied as fallen from Q1 to q due to a fall in price of the commodity from P1 to P. This is shown by a movement along the supply curve S from point a to point b (towards the left). The extension and contraction of a supply can be shown together in a single diagram. 1.36 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT  Y S P1 b P Price a P2 c X O Q Q1 Q2 Quantity Supplied Fig.1.17: (c) Movement along Supply Curve (b) Shift of Supply Curve or Increase & Decrease of supply curve or change in supply : (i) Increase in Supply : When the quantity supplied increase due to other determinants of supply price remaining constant it is called increase in supply. Y a Price P b S S1 X O Q Q1 Quantity Supplied Fig.1.18 : Shift of Supply Curve (rightward) In the diagram we see that quantity supplied has increased from Q to Q1, the price of the commodity remaining constant at OP. This is shown by the shift of the original supply curve S to the right to from a new supply curve S1. (ii) Decrease in Supply : When quantity supplied of the commodity decrease due to change in factors determining supply but for price. It is termed as decrease in supply or shift of supply curve towards the left. FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.37 Basic Concepts of Economics Y b Price P a S1 S X O Q Q1 Quantity Supplied Fig.1.19: Shift of Supply Curve (leftward) In the diagram we see that supply has fallen from Q1 to Q, the price remaining constant at P. this is shown by a shift of the original supply curve S to the left to form a new supply curve S1. Both the Increase and Decrease in supply can be shown in a single diagram. a b = Increase a c = Decrease c a b Price P S1 S S2 O Q Q1 Quantity Supplied Fig.1.20: Shift of Supply Curve 1.4.5 Exceptions to the Law of Supply : (i) Agricultural Goods : In case of such goods the supply cannot be adjusted to market conditions. The production of agriculture goods is largely dependent on natural phenomenon and therefore its supply depends upon natural factors like rainfall, etc. Moreover the supply of such goods is mostly seasonal and therefore it cannot be increased with a rise in price. (ii) Rare objects : These are certain commodities like rare coins, classical paintings old manuscripts, etc. whose supply cannot be increased or decreased with the change in price. Therefore, such goods are said to have inelastic supply and the supply curve is a vertical straight line parallel to Y – axis. 1.38 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT  Y S Price X O Q1 Quantity Supplied Fig.1.21: Inelastic Supply Curve In the diagram, the supply remains constant at OQ with respect to any change in price. (iii) Labour Market : In the labour market, the behavior of the supply of labour goes against the law of supply. In case of such labourers, if the wages rise the workers will work for less hour, so as to enjoy more leisure. This is explained with the following diagram: Y S´ W1 Price W T Backward Bending Supply Curve of Labour S X O L L1