Principles of Microeconomics I, Semester-I/II, University of Delhi, PDF

B.A.(Programme) / B.Com (P) Semester-I/II Economics DISCIPLINE SPECIFIC CORE COURSE / In Lieu of MODERN INDIAN LANGUAGE Principles of Microeconomics I Study Material : 1 (1-8) SCHOOL OF OPEN LEARNING University of Delhi...

B.A.(Programme) / B.Com (P) Semester-I/II Economics DISCIPLINE SPECIFIC CORE COURSE / In Lieu of MODERN INDIAN LANGUAGE Principles of Microeconomics I Study Material : 1 (1-8) SCHOOL OF OPEN LEARNING University of Delhi Department of Economics Editor : Dr. Janmejoy Khuntia  Graduate Course DISCIPLINE SPECIFIC CORE COURSE / In Lieu of MODERN INDIAN LANGUAGE Principles of Microeconomics I CONTENTS Lesson 1 : Problem of Scarcity and Choice Lesson 2 : Demand Lesson 3 : Elasticity of Demand Lesson 4 : Supply and Elasticity of Supply Lesson 5 : Determination of Equilibrium Price and Quantity Lesson 6 : Some Applications of Demand & Supply Lesson 7 : Theory of Consumer's Demand Lesson 8 : Indifference Curve analysis Editor : Dr. Janmejoy Khuntia SCHOOL OF OPEN LEARNING University of Delhi 5, Cavalry Lane, Delhi-110007  LESSON: 1 PROBLEM OF SCARCITY AND CHOICE INTRODUCTION Institutionalized behaviour pattern of man with regard to production, distribution and consumption of wealth or the material means of satisfying human desires, is the distinguishing mark of a particular economic system. But at the foundation of any such system, there will always be found a few universal economic conditions. Although each economic system has its own peculiarities, yet certain basic economic problems are common to all. Learning Objectives After going through the lesson, you will be able to 1. Know and analyse the central problems facing the economies of the world 2. Explain the concept of opportunity cost and its different types 3. Draw the various shapes of Production Possibility Curves (PPC) 4. Understand the role and limitations of price mechanism 5. Realise the importance and role of government 1.1 THE THREE CENTRAL PROBLEMS OF AN ECONOMY There would not be existence of any problem if resources were unlimited, and an infinite amount of every good could be produced. The question of choice arises directly out of the scarcity of resources. The human wants that can be satisfied by consuming goods and services may be regarded, for all practical purposes, in today’s world as limitless. In relation to the known desires of individuals (for better food, clothes, housing, schooling entertainment and the like), the existing supply of resources is highly inadequate. Suppose a society possesses unlimited resources in the form of land, labour and capital equipment. There will then be no economic problem because the economy can produce enough goods and services to meet all the wants of persons, individually as well as collectively. There would then be no economic goods, i.e., no goods that are relatively scarce. And there would hardly be any need for a study of economics or economizing. All goods would be free goods, like air, sun- shine and rain water. But in reality, it is possible to produce only a small fraction of the goods and services that people desire. Any society, whether simple or complex, advanced or backward, free or controlled must somehow confront three fundamental, interdependent and central economic problems given below: (1) What goods and services shall be produced and in what quantities? This is called the problem of what to produce? (2) How will these goods and services be produced, i.e., by what method or technology and with what resources? This is called the problem of how to produce? (3) How will the goods produced be allocated among the members who make up the society, i.e., whom are the goods produced for? This is called the problem of for whom to produce? Let us discuss these problems and their solutions. 1 The Problem of What to Produce We know that resources can be used to produce more than one type of commodity. But the point to note is that the same unit of the factor/resource cannot be available simultaneously to all the activities for which it is useful. For example, a unit of labour can be employed either on a piece of land for agriculture, or for a factory building or housing. Therefore, the community must choose which activity to pursue from amongst the different activities. Choosing an activity further implies that other alternate activities have to be sacrificed. If a factor unit such as labour or combination of factors of production is used to produce one commodity, say steel, then you will have less of some other commodity, say, food grains. Similarly, if the community decides to consume more now, it will have less for the future, i.e., for the production of capital goods and machinery-which can produce more consumers goods in future. The question what goods, to produce and what not to produce, therefore, concerns the allocation of scarce resources among alternative uses. For resource allocation, one needs two sets of information. One, the wants of the people should be known with their preference intensifies. In other words, for a rational allocation of resources a society must set priorities among their needs. Second, information regarding production possibilities of different commodities with the given resources ought to be available. Such information is summarized in the production possibility curve. The Problem of How to Produce The second problem concerns the organisation of resources, i.e., choice of technique. This question arises whenever there is more than one technically possible way to produce goods. Agricultural commodities, for example, can be produced by farming a large area of land while using small quantities of inputs like fertilizers and machinery or by farming a small area of land intensively, using large quantities of inputs such as fertilizers, labour and machinery. Both methods can be used to produce the same quantity of some commodity. One method economizes on land and uses large quantities of other resources, the other makes use of a large area of land and economizes on capital. Similar possibilities are available in the industrial sector also. It is usually possible to have the same output by several different techniques, ranging from highly labour intensive techniques using large quantity of labour and a few tools, to those using a large quantity of highly sophisticated machinery and only a very small number of workers commonly referred to as capital intensive technology. Several considerations are made before choosing whether to use labour intensive or capital- intensive technology. One, a choice is open only to the extent one factor is substitutable for another. Two, factor costs are another important consideration. Firms or producers normally look for least- cost combinations of factors to produce certain level of output. The Problem of For Whom to Produce The third problem concerns the distribution of the national product among the members of the community. Since an economy can produce only a limited amount of goods and services (because of the resource constraint), it is not possible to meet all the demands of all the people. This poses before the community the problem of choosing criteria for allocating this limited amount of goods and services amongst various individuals and groups. In other words, the economy must decide as to who will share the limited output and to what extent, and who will go without it. As we know that the value of national product is called national income, the problem of for whom to produce concerns distribution of national income in various forms such as wage, rent, interest and profit. It is well-known that in the process of generation of income through production of goods and services, the factors of production are compensated for factor services rendered. Accordingly, wage is given for labour service, rent is paid for services of land and building, interest is earned for lending capital and profit accrues to the entrepreneurial efforts made during production 2 process. Wage, rent, interest and profit are used to acquire goods and services produced by rendering factor services. Hence, the problem of for whom to produce relates to distribution of income. The problems which we have just stated are common to all economies, but different economic systems try to solve them differently. In a primitive society, custom may rule every facet of behaviour. You can also imagine a dictator who by arbitrary decrees decides what, how and for whom to produce. On the other extreme there is the capitalist free enterprise economy where all the three questions are decided automatically by the price mechanism. Intext Questions Say True or False 1. Choice arises due to scarcity of resources. 2. The problem of how to produce concerns allocation of resources. 3. Choosing an appropriate technique of production is required to solve the problem of whom to produce. 4. Choice of technique of production depends on the ease of factor substitution. Solutions to the Central Problems in Different Economic Systems: The capatialistic economic system and socialistic economic system have different approaches to solve the central problems. These two distinct approaches are, (i) role of price mechanism and (ii) role of the government. Let us discuss these two approaches. 1.2 THE ROLE OF PRICE MECHANISM In a system of free enterprise economy, no individual or organisation is consciously concerned with any of the three central problems stated above. In such an economy, production and distribution are the outcome of millions of independent decisions made by consumer and producers, all acting through the market mechanism. Hundreds of thousands of commodities are produced by millions of people more or less of their own volition and without control, direction or any master plan. And yet it is not a system of chaos and anarchy. There is a certain order in it. Immediately the question arises, “how does the automatic price mechanism operate?” The bare outlines of a competitive market system are simple to describe. Everything has a price. Every commodity and service and every factor of production base its own price, freely determined by demand and supply in the market. There are millions of prices in fact as many prices as there are goods and factors of production. It is these prices which collectively are called the price mechanism. Everybody receives money for what he sells and uses this money to buy what he wants. In a free enterprise economy, the consumers have the final say because everything is done to satisfy them. What goods and services will be produced in an economy depend on consumer’s demand and the resources are allocated accordingly. If they prefer more or A and less of B, then factors of production will be diverted from the manufacture of B to the manufacture or A. And this wish of the consumer is communicated to the producers through the price mechanism. If consumers prefer more of coffee and less of tea, the price of coffee will go up while that of tea will come down. This will induce the producers to divert resources from tea to coffee as coffee is now comparatively dealer than tea. Production of coffee will rise and that of tea will fall. Similarly, if more or a commodity becomes available, then people want to buy at a given market price, its price will fall as a result of competition amongst the sellers. At a lower price, producers will no longer produce so much. Equilibrium will thus be restored by the forces of supply and demand. Resources will be diverted to some other branch or economic activity. This happens because the foundation of a free enterprise economy is the profit motive. All activities are carried on with a view of earning profits. 3 In such a society resources will be allocated to those activities which promise more profits to the entrepreneurs. In this way, ‘what goods will be produced’ is determined by the votes of consumers or their everyday decisions to purchase various commodities. What is true of the markets for consumers goods is also true of markets for factors of production such as labour, land and capital. Under competitive condition, only that producer who can adopt the most efficient method of production and keep the cost at the lowest, can hope to secure high profits. Thus every producer tries to produce in the cheapest possible mariner. The method that is cheapest at any time, will displace a more costly method. For example, motive power will be generated by atomic process rather than by steam, if the price of coal is high. But the most obvious choice is with regard to the use or capital and labour. If labour is cheaper than capital, as is the case in most of the underdeveloped countries, emphasis will placed on labour intensive techniques. On the contrary, highly sophisticated machines will be used with a minimum need for labour in developed countries where there is shortage of labour, but capital is in abundant supply. In agricultural sector, tractor-operated large farm will displace the family size farm if this leads to lower cost of production. The price system, therefore, indicates to the producer which combination of factors of production should be chosen to make production cheapest, given the state of technology. The choice of technique will thus depend upon the relative availability of resources reflected through their respective prices. The third problem, namely, the distribution of national product, is connected with the first. Goods and services will be produced for those who can afford to pay for them. This capacity to pay is reflected in the effective demand of the people for various goods and services. In other words, effective demand is dependent on people’s income. The first problem and third, therefore, are like two sides of the same coin. If people demand more of luxury goods, more of them will be produced and given to those who can pay for them. In a capitalist economy, therefore, the distribution of goods and services will depend upon the effective demand of people which in turn will depend on their incomes. Income of a person is determined by the quantities or various factors of production he owns and their prices. Thus the distribution of national product depends on the prices of factors of production, given the pattern of ownership. To sum up, we may say that in a capitalistic economy, there is no visible authority which controls and directs the economic system. However, the price mechanism solves and the economic problems-What goods will produced? How much will be produced? How will they be produced? Who will consume them? Intext Questions Say True or False 1. Choice arises due to scarcity of resources. 2. The problem of how to produce concerns allocation of resources. 3. Choosing an appropriate technique of production is required to solve the problem of whom to produce. 4. Choice of technique of production depends on the ease of factor substitution. Limitations of Price Mechanism We have tried to show above how in a modern capitalist economy, every economic activity is controlled, directed and guided by the price mechanism. A writer called the price mechanism as the “Invisible conductor of the economic orchestra”. There are millions of prices and all of them are determined simultaneously in such a way that there is perfect co-ordination in the production, distribution and consumption of all these goods and services. Overproduction and underproduction 4 of any commodity at a given time, will be set right by the price mechanism in course of time. Overproduction, for instance, will lead to a fall in price and curtailment of production by the producer, and underproduction will lead to a rise in the price and increase in production. The question now is, whether the price system is really so effective, as it is made out to be. Does the price mechanism really represent the wishes of the people? In a capitalist economy, demand is made effective by those who have an income and are prepared to spend and not by those who need various goods, but do not have the necessary purchasing power. The fortunate few with large, incomes are able to influence producers to manufacture those goods which they like. The poor, on the other hand, have sometimes to go without even the bare necessaries of life. The capilialist system, thus, does not bring about an equal and fair distribution of goods and services among the people according to their needs. Prices, wages and profits are supposed to be determined by demand and supply in a free market. But actually, markets are not free and competition is not perfect. Prices are determined and influenced by a few powerful producers who are called monopolistic. A monopolist can fix a high price. As a result of imperfect competition, there can be divergence between demand and supply. Besides, the tastes and fashions may change suddenly and consequently, there may be overproduction in some industries and underproduction in others. It is possible that by the time the necessary adjustment in supply takes place, demand may have changed again. The consumers, themselves may sometimes, be at fault. They may demand goods and services which do not yield real utility but which may be meant for show of power or prestige. Sometimes, they may even demand goods which are harmful. Many a time, a man will prefer a cheap detective novel to a good book. People may demand cheap films and drinks which tend to spoil their tastes and morals. In this connection, we can mention the possible adverse effects of advertisement on the consumers. It has been found that with the help of advertisement any commodity, however bad or inferior, can be sold. It is through the media of advertisement that many had and positively harmful drugs and medicines and other such goods are sold in a ‘free’ enterprise economy. Thus, though the capitalistic economy, may help in maximising national income, it is not necessary that this will automatically maximise national welfare. 1.3 ROLE OF GOVERNMENT The modern capitalist economy is not solely a price economy, but is a mixed system. The government attempts to control and direct production, distribution and consumption. The Government Controls through Social and Labour Laws: In the first place, the, governments enact laws to protect the women and children in mines, factories and workshops against exploitation. Women and children are weak and are not able to survive in a competitive economy without help. The workers are generally weaker than the employers in the matters of bargaining. Factory laws are passed to protect the labourers, to assure them minimum wages and to protect them from exploitation, by the factory owners. Through various laws, the government also tries to control the quality of products, to prevent adulteration of goods, to enforce standard weight and measures, to see that trade is fair and so on. Further the government passes laws to control the activities of monopolies and monopolistic organisations which tend to act against the interest of the consumers. Thus, modern governments| take all types of measures to restrict free enterprise and free play of self-interest and ensure perfect competition. To keep competition perfect means to create a situation in which all have equal opportunities to participate in the competition or the competition is amongst equals. Re-distribution of National Income by Taxes: Again, government attempts to control economic activity through its tax and expenditure measures. For instance, progressive taxes on income and property reduce the incomes of the rich and thus their effective demand for goods and 5 services. At the same time, through free education, free medical services, subsidised housing, recreational facilities, etc., the government can raise the real income of the masses. In these ways the government can influence and direct the volume of economic activity so as to promote the welfare of the community. Welfare and Social Measures: Further, in all modern economies, the government undertakes to provide certain essential services which the community requires but which cannot be provided by the private businessmen. These services involve large investments which are beyond the capacity of private individuals and groups. For instance, the government provides water supply, education and other social services; it protects the people from foreign aggression and it maintains law and order within the country. Government in certain countries have assumed responsibility of providing furl employment: In recent years the government has also taken the responsibility of maintaining full employment. The government helps people to secure jobs. During economic depression, the economy functions at a low level; there is a lot of unemployment. In certain countries, governments have gone far beyond all these. They undertake economic enterprises such as power projects, basic and heavy industries transport and communication, etc. Thus in a modern capitalist economy the government has started playing a very important role in the field of economic activity. In the 20th century, some of the feature of capitalism such as private property, self-interest and free enterprise have been considerably modified by government regulations. Many economists have, therefore, started calling the modem capitalist economy as mixed system in which private enterprise has a free hand but within the overall control and direction of the state. Intext Questions 1. Name three measures of the government which are helpful for raising real income of people? 2. Which type of tax can be used by government to redistribute income. 1.4 OPPORTUNITY COST AND PRODUCTION POSSIBILITY CURVE (PPC) How much of goods and services can the economy produce? This will depend upon (a) the extent of resources the economy has in terms of land, labour and capital which it can devote to the production of these goods, (b) the quality or efficiency of these factors and (c) the nature of technology available to the community. It is possible over a period of time to bring in additional land under cultivation, to have more labour through an increase in population and to increase machines and other capital equipment by means of capital accumulation. The quality of these factors of production can also be improved and the state of technology can always be raised through innovation and invention. The total volume of goods will depend upon these conditions. Every economy can produce a certain amount or goods with the help of its resources. Given the fact that resources have alternative uses and since the same factors of production can be used to produce more than one type of commodity, it is possible to have various combinations of different commodities, by transferring resources from the production of one commodity to another with each combination representing a distinct production possibility. Definition of Production Possibility Curve (PPC) Production Possibility Curve (PPC) or Production Possibility Frontier (PPF) is a graphical representation of maximum possible combinations of two goods that an economy can produce by efficiently utilizing its given resources and technology during a given time period. 6 Definition of Opportunity Cost Opportunity cost of producing a good is defined as the amount of the other good which has been reduced / given up by transforming resources from it. Given two goods X and Y, the opportunity cost of production of extra unit of X is the amount of good Y that is reduced by transforming resources from it. We can write Opportunity Cost as ratio of change in Y to that of X, i.e ∆Y/∆X where ∆ represents change in. On a PPC this ratio represents the slope which is also called Marginal Rate of Transformation (MRTxy). MRTxy = ∆Y/∆X = Slope of PPC = Measure of Opportunity Cost Depending on the rate at which a good is sacrificed to produce extra unit of other good, opportunity cost can be classified into three types – (i) Constant Opportunity Cost, (ii) Increasing Opportunity Cost, (iii) Decreasing Opportunity Cost. Accordingly, the shape of PPC will also change. Shape of PPC under Constant Opportunity Cost Let us take a simple example, say, production of wheat and cotton in India to explain the concept of opportunity cost. Let us assume that India is efficiently using all its resources to produce cotton and wheat. Let us further assume that all these resources are such that they are equally efficient in the production of both these goods. The table below gives the alternative possibilities of producing wheat and cotton by allocating different areas to the two crops out of the total available land. TABLE 1 Change in Change in Wheat (W) Cotton (C) Wheat Cotton (Million tons) ōp∆C / ∆W (Million bales) ∆W ∆C 0 100 - - - 20 80 20 20 1 40 60 20 20 1 60 40 20 20 1 80 20 20 20 1 100 0 20 20 1 You may note the two extreme possibilities. The first possibility shows that India is able to produce 100 million bales of cotton and no wheat if whole of the area is devoted to cultivation of cotton. The sixth possibility shows that India can produce 100 million tons of wheat and no cotton if whole of the area is devoted to cultivation of wheat. Between these two extreme possibilities the economy can produce different combinations of cotton and wheat. For instance, the second possibility shows that the country can produce 80 million bales of cotton and 20 million tons of wheat; the third possibility shows the combination of 60 million bales of cotton and 40 million tons of Wheat and so on. Here, the above table can be illustrated with the help of a straight line PPC given in diagram 1.1. 7  In the diagram, Wheat (W) is represented on the horizontal axis and cotton on the vertical- axis. Starting from origin 0, the X-axis is divided, into equal parts, each part presenting 20 million tons of wheat. Similarly, the Y-axis is divided, each division representing 20 million bales of Cotton (C). It is not necessary that the scales on both the axes should be the same which we have assumed for purpose of convenience. The first production possibility in this case is 100 million bales or cotton and no wheat. This is marked as A in the above figure. The second combination is 80 million bales of cotton and 20 million tons of wheat. Take a point against 80 on the Y-axis and 20 on the X-axis. This is point B For the other combinations, plot points C, D, E arid F. Connect all the points and you will have a downward sloping line AF. This line shows the production possibilities or two goods and is known as the production-possibility curve. It is also called the transformation curve, since the factors which can be used for the production of one commodity can be transformed to produce the other commodity. As we moved from A to B, resources employed in cotton production are being transferred to the production of wheat. Diagram 1.1 Straight Line Production-Possibility Curve (Constant Opportunity Cost) The downward shape of the AF curve shows that if the community wants more or wheat, it can have it only by reducing the quantity of cotton. Again, in the diagram, AF is a straight line. This implies that addition of a certain amount or wheat will replace the same amount or cotton throughout due to the assumption that the factors of production are equally efficient in the production of cotton and wheat. In the given example, for every increase of 20 million tons in the production of wheat, the production of cotton has to be decreased by 20 million bales. Here, change in Wheat is 20, change in Cotton is 20. Hence, opportunity cost or slope of PPC is given as Change in Cotton / Change in Wheat = ∆C/∆W = MRT = 20/20 = 1 = Slope of PPC = Constant. So PPC or AF curve is a straight line. Shape of PPC under Increasing Opportunity Cost Normally, the production-possibility curve in real life is not a straight line but concave towards the point of origin. The slope of such a curve increases, i.e for each extra unit of one good to be produced, more and more units of other good need to be reduced. In other words, MRT increases for such type of PPC. In case of increasing opportunity cost, the rate at which the other good must be reduced keeps increasing in order to produce extra unit of the good in demand thus giving rise to concave shape of PPC. To show this, continue with the above example by modifying the rate of change of cotton to produce a certain amount of wheat as given in the Table 2 below. 8  TABLE: 2 Alternative Possibilities in the Production of Wheat and Cotton Wheat (Million Cotton (Million Change in Change in Cotton ∆C / ∆W tons) bales) Wheat ∆C ∆W 0 100 - - - 20 90 20 10 0.5 40 75 20 15 0.75 60 55 20 20 1 80 30 20 25 1.25 100 0 20 30 1.5 For the above illustration, we do not assume that factors of production are equally efficient. Let us assume that some plots or agricultural land are more suitable for the production of cotton and some others are better suited for production or wheat. By using all the plots of land only for cotton, the community can produce 100 million bales of cotton. Now if the community wants to have 20 million tons of wheat, some plots or land which are less suitable for cotton will be put under wheat. But as the community wants to have more and more wheat, then the land allotted for cotton cultivation will also be used to produce wheat. As a result, the cost of producing wheat in terms of cotton will increase. For instance, to produce the first 90 million tons of wheat, the community has to sacrifice only 10 million bales of cotton but to produce the next 20 million tons of wheat, the community has to sacrifice 15 million bales of cotton and so on. Finally, in the case of the last 20 million tons or wheat, the community has to sacrifice 30 minion bales of cotton. This implies that land suitable for the production of cotton, which could produce as much as 30 million bales of cotton, when put under wheat can produce only 20 minion tons of wheat. It is clear from the above illustration that the cost or producing additional wheat in terms of cotton goes on increasing. The increasing cost of wheat in terms of loss of cotton is represented in last column of Table 3 under the head ∆C / ∆W. See that ∆C / ∆W increases from 0.5 to 0.75 for producing 20 units of W initially but after that it keeps on increasing to reach 1.5 as wheat production increases further in same units. Since ∆C / ∆W is the MRT or slope of PPC which is increasing here, the shape of PPC is concave in case of increasing opportunity cost as given in diagram 1.2. Diagram 1.2 Concave Production Possibility Curve (Increasing Opportunity Cost) 9 Note that increasing opportunity cost confirms to the law of diminishing returns in production. Refer to short run production function and law of variable proportion as well as diminishing returns to scale under long run production given in lesson 6. Shape of PPC under Decreasing Opportunity Cost Decreasing opportunity cost refers to a situation where in order to produce each extra unit of a good the rate of reducing the quantity of other good keeps decreasing. This means that the slope or MRT of PPC is negative or decreasing, thus giving rise to a convex shaped PPC. To illustrate this, we can modify our wheat and cotton example as given in Table 3. Here it is shown that for each 20 unit of wheat to be produced the economy sacrifices 30 units cotton initially but latter on the reduction in cotton falls to 25, 20, 15 and 10 for subsequent 20 units of wheat production respectively. The opportunity cost ∆C / ∆W falls from 1.5 to 1.25 and so on as can be seen in the last column in Table 3. TABLE: 3 Production Possibilities under Decreasing Opportunity Cost Cotton Change in Wheat Change in Cotton Wheat (Million ∆C / ∆W (Million tons) ∆W ∆C bales) 0 100 - - - 20 70 20 30 1.5 40 45 20 25 1.25 60 25 20 20 1 80 10 20 15 0.75 100 0 20 10 0.5 If we draw a diagram of PPC according to Table 3 depicting decreasing opportunity cost, we get a convex shaped curve as shown in diagram 1.3. Diagram 1.3: Convex Production Possibility Curve (Decreasing Opportunity Cost) One may question the existence of decreasing opportunity cost because of the fact that resources are scarce. Some economists believe that in a world of continuous advancement of technology there could be possibility of prevalence of decreasing opportunity cost in certain cases 10 while many other economists believe this to be a hypothetical situation or theoretical possibility only. Intext Questions 1. Shape of PPC is downward sloping ______ line, when opportunity cost is constant. 2. _______ cost is next best alternative cost. Answer 1. straight, 2. Opportunity 1.5 UNDERSTANDING ECONOMIC CONDITION THROUGH PPC It may be observed that the curves have been constructed on the assumption that all the resources available for the production of wheat and cotton are being fully utilised. For any reason, if some of the resources remain idle, the production-possibility will not be indicated by the curve but will be anywhere below the curve. Secondly, if there is a quantitative and qualitative improvement in the factors of production available to the community to produce these goods and if there is an improvement in the technology of production, the production-possibility curve will be pushed outwards. This will indicate that both the goods can be produced in larger quantities, with the resources fully employed. See diagram 1.4 below. Efficient Use of Resources takes place on PPC Outward shift of PPC indicates Economic such as at points B, D and C Growth Which happens due to improvement in technology and increase in productive Unemployment situation is shown inside PPC resources. such as at point A Point outside PPC such as point X is unachievable Diagram 1.4 Unemployment (left side) and Economic Growth (Right Side) Learning Outcomes: In this lesson you have learned the following: 1. The three central problems of any economy are – what to produce? How to produce? and For whom to produce? 2. The two major approaches to solve the central problems are price mechanism prevalent under free market system and government control and regulations seen in mixed economies. 11 3. Production Possibility Curve (PPC) shows the maximum production capabilities of an economy given its resources. 4. Slope of PPC known as Marginal Rate of Transformation (MRT) is called Opportunity Cost of producing a good in terms of another. 5. Opportunity cost is the cost of next best alternative. Given two goods, opportunity cost of producing an extra unit of one good is the amount of other good given up for that purpose by transforming resources from the latter. 6. Shape of PPC is – (i) a straight under constant opportunity cost, (ii) concave under increasing opportunity cost and (iii) convex under decreasing opportunity cost conditions respectively. 7. Any point inside PPC indicates underutilization/unemployment of resources while points on PPC indicate efficient use of resources. Points out side PPC are unachievable. 8. Outward shift of PPC indicates economic growth due to improvement in technology and increase in resources. TERMINAL QUESTIONS Short Questions 1. What are the three central problems of Economics? 2. How can government improve market outcomes? 3. Explain PPC. 4. By using PPC describe the idea of “efficiency”. 5. What do you mean by opportunity sets? Give one example. Long Questions 1. Explain the role of government in controlling price, production, distribution and consumption. 2. What is PPC? Explain its different shapes.   12  LESSON: 2 DEMAND INTRODUCTION Human wants are unlimited, but the resources which are required to satisfy these wants are limited. The scarcity of resources gives rise to economic problems which are termed as central problems. In a capitalist or free market economy these problems are solved with the help of what we call the price mechanism. Each commodity or service has a price. Earlier, goods were used to be exchanged for goods which was called the barter system of exchange. With the invention of money, the prices of goods and services are expressed in terms of money. Prices of all the goods and services collectively is known as price mechanism. The price of a commodity is determined by its demand and supply. However, it is not the demand of a single buyer or the supply of a single seller which determines the price of a commodity in the market. It is the demand of all the buyers of a commodity taken together and the supply made by all the sellers selling that commodity taken together, which determine the price of that commodity in the market. The price of a commodity is determined when its demand is equal to its supply. This is called the equilibrium price. We shall now discuss in detail the demand and supply analysis and explain how these together determine the price of a commodity in the market. Learning Objectives After going through this lesson, you will be able to: 1. Define individual demand for a good as well as market demand for that good. 2. Explain the determinants of individual demand and market demand for a good. 3. State the law of demand. 4. Make individual as well as market demand schedule for a good. 5. Draw the individual as well as market demand curves for a good respectively. 6. Find out the exceptions to law of demand. 7. Distinguish between change in quantity demanded and change in demand. 2.1 MEANING OF DEMAND Demand, in economics, refers to the amount of a commodity which the consumers are prepared to purchase at a particular price per unit of time. Demand in economics, is therefore, is not the same thing as desire. You may have a desire to have a car but if you do not have sufficient money with you to purchase it and even if you have sufficient money with you but are not prepared to spend it on the purchase of the car, it will merely remain a desire and will not be called demand. Your desire to have a car will become demand when you have sufficient money with you and are willing to spend the money on the purchase of the car at the particular price per unit of time. The time may be one hour, one day, one week, one month and so on. It is meaningless to say that the demand of car in our country is 10,000 because this statement does not specify the price of car and the unit of time. Even it is not correct when you say that the demand of. car in India is 10,000 when price per car is Rs. 80,000, because it does not refer to the unit of time. The correct statement would be that the demand for car in India per year is 10,000 at the price of Rs. 80,000 per car. Thus desire becomes demand when the consumer has sufficient resources with him and is willing to spend those resources on the purchase of the commodity at a particular price and per unit of time. Even if you have, say, one lakh rupees with you but are not willing to spend the money on the purchase of a car at the price of Rs. 80,000 per car today, then you cannot say that you have a demand for a car. 13 Factors Determining Demand The demand for a commodity does not remain constant. It keeps on varying with changing conditions. We shall, therefore, now discuss the various factors which determine the demand for a commodity by a consumer or the family of the consumer i.e. household demand and the total demand of the whole market i.e., market demand of a commodity. (i) Factors Determining Household Demand The demand for a commodity by a consumer or a household depends upon the following factors: (a) Income: The income of family is a very important factor determining its demand for a commodity. Other things remaining constant, if the income increases, normally the demand for goods will increase and vice-versa. With increase in income the demand for superior goods and goods of comforts and luxuries will increase and the demand for inferior goods will decline. But if the income declines the demand for superior goods and those of comforts and luxuries will decline. (b) Price of the commodity: Normally there is an inverse relationship between the price of a commodity and its demand. Other things remaining constant, if the price of a commodity declines normally more of it will be purchased and if the price increases, lesser amount of the commodity will be purchased. (c) Taste and Preferences of consumers: Taste, fashion and preferences of the consumers also affect the demand for a commodity. If people have developed a taste or preference for a commodity-its demand will increase but if a commodity has gone out of fashion, its demand will decline. (d) Price of related goods: The changes in the price of related goods i.e., complementary and substitute goods also affect the demand for a commodity. Complementary goods are those goods where one commodity has utility and is demanded only when the second related commodity is also available. For instance scooter and petrol are complementary goods. If the price of petrol increases, it will reduce the demand for scooter. Similarly, change in the price of refills will affect the demand for ball-pens. Substitutes goods are those where one goods can be used in place of another. For instance, tea and coffee are close substitutes. One can use tea in place of coffee and vice-versa. If the price of coffee increases, people will start substituting tea for coffee and therefore the demand for tea will increase even though there is no change in the price of tea. (ii) Factors Determining Market Demand The above factors determine the households demand for a commodity. When we take market demand i.e. the total demand for a commodity in the market, in addition to the above four factors, there are two other factors which also determine the market demand. These two factors are: the size and composition of the population and distribution of income: (e) Size and composition of Population: Large and increasing population increases the demand for various types of goods and vive-versa. Similarly the composition of population i.e., ratios of male-female, children-adult-old-age people etc., also affect the demand for different types of goods. For instance, if there are more children, the demand for goods such as toys, baby foods, biscuits etc., will be more. (f) Distribution of Income: If there is an unequal distribution of national income and few people have large income while other have to do with small income, the demand for goods of comforts and luxuries will be more and that of the goods needed by the majority 14  of people, who are poor, will be small. If there is an even distribution of income in a country, the demand for luxuries will be less and that of goods of mass consumption will be more. Intext questions Fill in the blanks. 1. __________ and __________ affects market demand. 2. The demand for a commodity __________ with changing conditions. Answer 1. Population, size of income 2.2 LAW OF DEMAND We have earlier explained that the demand for a commodity is always expressed with reference to a price. There will be different quantities of goods demanded at different prices. If the price of a commodity rises, normally less of its quantity will be demanded and vice-versa. This inverse relationship between the price of a commodity and the quantity of its demand is known as the Law of Demand. We have explained that the price a commodity is only one of the various factors which determine the demand for a commodity. The other factors are the income of the consumer, their tastes, preference etc., prices of related goods, expectations about the future changes in the price of the commodity etc. the price of a commodity as well as these other factors keep on changing. We therefore, cannot find out the effect of the changes in the price of a commodity on its demand unless we assume that all other factors which also affect the demand for a commodity remain constant. For instance, suppose the price of a commodity has increased and therefore, normally its demand should decline. But if the same time, the income of the consumers has also increased, the consumers will demand more of the commodity even at a higher price because the increase in income may offset the impact of the price rise on his demand. Therefore, in order to find out the effect of the change in the price of commodity on its quantity demanded, we have to assume that there is no change in factors other than the price. We may say that ‘other things being equal’ normally more of a commodity will be demanded at lower price and less will be demanded at higher price. This is known as the Law of Demand. The Law of Demand is only a qualitative statement. It tells only the direction in which the quantity of a commodity will normally change in response to any change in its price. The Law of Demand does not say anything about the quantum or the amount of change in resporise to change in the price of a commodity. We should like to emphasis, that the law of demand is always qualified by such phrases as ‘in given conditions of demand’ or’ other things remaining equal or constant’. This relates to the assumption on which the law of demand is based. It means that law may not hold true if any of the factors, mentioned above, other than the price of a commodity in question is also changing. Law of Demand can be explained with the help of what is called a demand schedule and a demand curve. Demand Schedule If we put the different amounts of a commodity demanded at different prices in a tabular form, as given below in tables 2.1 and 2.2, it is called demanded schedule. Thus the demand schedule is a tabular statement which states different quantities of a commodity demanded at different prices. Demand schedule is of two types: (i) Individual or Household demand schedule and (ii) Market demand schedule. 15  Individual or Household Demand Schedule: Individual Household demand schedule shows the different amounts of a commodity demanded by a consumer or a household at its different prices. Let us take an example. Suppose a consumer (or a household) demands 1, 2, 3 and 4 dozens of oranges at prices of Rs.3.00, Rs.2.50, Rs.2.00 and Rs. 1.50 per dozen of oranges respectively. When we put the different quantities of oranges demanded at different prices in a tabular form, as given in Table 2.1, we call it an individual (or household) demand schedule. TABLE 2.1 Household Demand Schedule Price of Oranges (Per dozen) Rs. Quantity Demanded (Oranges) (dozens) 3.00 1 2.50 2 2.00 3 1.50 4 This demand schedule clearly shows that more of oranges are demanded at a lower price and vice-versa. Individual or Household Demand Curve: If we represent the above demand schedule (Table 2.1) graphically we can get a demand curve as given in figure a 2.1 below: Diagram 2.1 Individual or Household Demand Curve: In the diagram 2.1, the horizontal axis represents the quantity of oranges demanded and vertical axis represents the price of oranges per dozen. A, B, C and D, show the different quantities of oranges demanded at different prices as given in the demand schedule, Table 2.1. By joining these points, we get a curve which is called the demand curve. This demand curve shows the different quantities of a commodity demanded at different prices. It shows that at a higher price, less is demanded and at a lower price, more is demanded, other things remaining equal. The demand curve may be a straight line or a curve depending upon the changes in quantities demanded in response to changes in price. 2.3 MARKET DEMAND SCHEDULE AND CURVE Different consumers or household demand different amounts of a commodity at different prices. Therefore, if we add the demand schedule of all individuals or household, we can get the market demand schedule. Let us take an example. Suppose, for the sake of simplicity, say, there are only two consumers or household, say, A and B , that demand orange. Their demand for oranges 16 at different prices are given in table 2.2. If we add the demand schedule of these two consumers, we can get the market demand schedule, as given below: TABLE 2.2 Prices of Oranges Individual Demand Schedule Market Demand Schedule (per dozen) Quantity Demanded Total Market Demand for (dozens) Oranges (A+B) Rs. A B (dozens) 3.00 1 2 3 2.50 2 3 5 2.00 3 4 7 1.50 4 5 9 Thus, the market demand schedules is the aggregate of the individual demand schedules. This also shows, as the individual demand schedule, that more of a commodity is demanded at a lower price and vice-versa. If we represent the above table 2.2 on a diagram, we can get the market demand curve, as shown in diagram 2.2. The market demand curve DD as shown in figure (c) has been obtained by adding the individual demand curve D1D2 of consumer A as given in figure (a) and the individual demand curve D2D2 of consumer B as given in figure (b). For instance, consumer A buys 4 dozen (A) and (B) buys 5 dozen (B) of oranges when the price is Rs. 1.50 per dozen. Therefore, the market demand for orange will be 9 dozen its (A + B = C). Market demand curve also shows the inverse relationship between price of a commodity and its quantity demanded i.e. more of a commodity will be demanded at a lower price and less will be demanded at higher price. Diagram 2.2 From Individual Demand Curve to Market Demand Curve In the examples of a market demand schedule and the market demand curve given above, for the sake of convenience we have assumed that there are only two consumers A and B of the commodity i.e. oranges. The market demand schedule and the market demand curve have been obtained by the addition of the individual schedules and the individual demand curves of the two consumers A and B. However, in practice we find that there are many consumers of a commodity. In such a case it becomes very difficult and cumbersome to determine the individual demand schedule or individual demand curves of all the consumers of that commodity and then add them all together to find out the market demand schedule and market demand curve of the commodity. There is an alternative method of finding market demand schedule or market demand curve of a 17 commodity. Of all the consumer of a commodity, one consumer of that commodity is taken as an average or representative consumer and find out the average consumer’s demand schedule. Then we multiply the quantities being demanded by this average consumer at different prices by the estimated number of total consumers of this commodity. This will give us the market demand schedule of the commodity and on its basis, we can draw the market demand curve of the commodity. For example, suppose at the price of Rs. 2.50 per dozen, an average consumer demands 2 dozen of oranges. Suppose there are 1000 consumers of oranges. In that case the market demand for oranges at the price of 2.50 per dozen will be 2000 dozens of oranges. Similarly, we can find out the market demand for oranges at different price by multiplying with the total number of consumers of oranges i.e. 1000. Both demand schedule and demand curve show the different quantities of a commodity which the consumers are prepared to but at different prices given in the market. It does not mean that at a particular time there are different prices of a commodity prevalent in the market. The demand schedule or demand curve is prepared on the basis of the past experience of a consumer (s). A consumer, on the basis of his past experience, can say that if other things remain constant, what will be the different quantities of a commodity which he would be prepared to buy at different prices in the market. Therefore, a demand schedule or demand curve is imaginary. Intext Questions 2 1. Law of demand states that there is a positive relationship between price and demand. 2. Market demand is the aggregate of the individual demand schedule. Answer 1. False 2. True 2.4 REASON FOR DOWNWARD SLOPING DEMAND CURVE Why does a demand curve generally slope downwards from left to right: A demand curve generally slopes downwards from left to right or in other words it shows that more of a commodity is demanded at a lower price and less is demanded at a higher price. Why do people purchase more of a commodity at a lower price and purchase less at a higher price? In other words why does law of demand operate or demand curves slope downward? The law of demand operates or demand curves slope downwards due to the following reasons: (i) Operation of Law of Diminishing Marginal Utility: The Law of Demand is based on the law of diminishing marginal utility. According to law of diminishing marginal utility, which we shall discuss in detail later on in section 4.1. As the consumer consumes more and more units of a commodity the marginal utility which he derives from the successive units will keep on diminishing. In the example of the individual demand schedule given in the table 1.1 the consumer demands one dozen of oranges when the price is Rs 3.00 per dozen. He is prepared to pay Rs 3 because as per the utility analysis, the marginal utility which he gets from the consumption of first dozen of oranges is worth Rs. 3.00 (As per the Marshallian utility analysis, the utility which a consumer gets from the consumption of a commodity can be measured in terms of money i.e., the maximum price which he gets from the second dozen will be less than what he had got from the first dozen of oranges and therefore he is prepared to pay to obtain that commodity). But when he consumes the second dozen, the utility which he will be prepared to buy second dozen of oranges only if price is less than Rs. 3.00. Suppose he gets marginal utility from the second dozen of oranges worth Rs 2.50 and therefore, he would be prepared to buy the second dozen of oranges, if price per dozen of oranges declines to Rs. 2.50. In other words, consumer will buy more of a commodity only at a lower price. A diminishing marginal utility curve can be converted into a demand curve. We shall discuss it 18  in detail later on when we discuss the Marshallian utility analysis of demand. Similarly consumer will be prepared to buy 3rd and 4th dozens of oranges only at lower and lower prices. (ii) New Consumers: The market demand for any commodity is made up of individual demands of numerous consumers. When the price of any commodity is sky high, only the rich few can afford to purchase such a costly commodity and the poor sections of the society have to go without it or do with the inferior substitutes. When the price falls, the commodity becomes accessible to some more consumers who are not very poor. And when the price falls, still further the commodity becomes accessible to still more persons. Thus, one reason why market demand for any good increases in response to a fall in its price, is that each fall in its price brings in new consumers for the commodity. (iii) Income effect: The change in the price of a commodity also affects the real income or the purchasing power of the consumer. A fall in the price of a commodity in fact amounts to a rise in the real income or the purchasing power of the consumer. Therefore, he can afford to buy more of the commodity. On the other, a rise in price will reduce his purchasing power or real income and therefore he will be able to buy only less amount of the commodity. In other words fall or rise in the price of a commodity induces consumers to buy more or less of a commodity. The change in the demand for a commodity as a result of the change in real income (due to fall or rise in the price of the commodity) is called income effect of a price change. (iv) Substitution effect: When the price of a commodity falls, besides, increasing purchasing power or a real income, it becomes relatively attractive to the consumers to substitute this commodity in the place of other commodity and therefore they buy more of it. For instance a fall in the price of tea will induce consumers to substitute tea for coffee and therefore the demand for tea will increase but conversely, a rise in the price of tea will induce consumers to substitute coffee for tea and will reduce the demand for tea. Because of these factors, normally a demand curve slopes downwards from left to right i.e. more of a commodity is demanded at lower price and vice-versa. 2.5 EXCEPTIONS TO THE LAW OF DEMAND Normally, the demand curve slopes downwards from left to right, showing that more is demanded at lower price and vice-versa. However, there are some exceptions to the law of demand in which case the fall in the price of a commodity will contract the demand and vice-versa i.e., the demand curve may slope upward to the right. These are as follows: (i) Goods which are expected to become scarce or whose prices are expected to rise in future: In case of goods which are expected to become scarce in future the consumers may buy more of those goods even at a higher price. Similarly when the price of a good has increased but consumers expect that it will rise further in future, then they will prefer to buy more of the commodity even at a higher price at present. Conversely, though the price has fallen but the people expect that it will fall further in future, they prefer not to buy more of it even at lower price at present and will prefer to wait for the further fall. (ii) Goods carrying social status (veblen goods): There are some goods e.g., diamonds, the possession of which carry social status and are bought by rich people because their prices are very high. If the prices of these goods become low, the consumers will buy less of them because the fall in their prices will reduce their prestige value. If their prices go up, their demand may also go up because of increase in their social prestige. 19  Diagram 2.3 Upward sloping Demand Curve for Giffen Good (iii) Giffen goods: The real exception of the law of demands is in case of giffen goods. If the price of inferior good falls, its demand may also fall. This is because the fall in the price of an inferior good increases the real income of the consumers and therefore they can afford to buy superior goods. They will start substituting superior good in place of an inferior good and therefore the demand for the inferior good will decline. Conversely, if the price of an inferior good reduces the real income of the consumers and they will also increase. The increase in the price of an inferior good reduces the real income of the consumers and they will be forced to spend more on the inferior good. This phenomenon was first of all observed by Sir Robert Giffen. In Great Britain, in early 19th century when the price of bread (considered to be an inferior good) increased, low paid British workers purchased more bread and not less of it. This was contrary to the law of demand. Giffen explained this paradox by stating that the bread was a necessity of life. Low-paid British workers consumed a diet of mainly bread. When the price of bread increased, they had to spend more on the given quantity of bread. They were left with little income to be spent on meat and therefore could not afford to buy as much meat as before. They substituted even bread for meat in order to maintain their total food intake. Therefore, increased price of bread resulted into the increased demand for bread. In other words there was a direct price-demand relationship. After the name of Robert Giffen, all such goods whose demands increase with increase in prices and whose demands fall with fall in their prices, are called ‘Giffen Goods’. However, it should be noted that a ‘Giffen Good’ is an inferior good but every inferior good can not be called a ‘Giffen Good’. There is a difference between an inferior good and a Giffen good. Only those inferior goods are called Giffen Goods, in whose case there is a direct price-demand relationship i.e., both price and demand of the commodity move in the same direction as shown in diagram 2.3 In the figure, when the price per bread (loaf) is 20 paise each, a consumer buys 30 loaves of bread. But when the price of bread increases to 30 paise each, he buys 40 loaves of bread. It means that when the price of bread increases, a consumer buys more of it and vice-a-versa. In this case, there is a positive or direct relationship between the price of a commodity and its quantity demanded. Therefore, the demand curve will slope upward from left to right, as is shown by the demand curve DD in diagram 1.3 Here bread will be considered as ‘Giffen’ good. We shall discuss the case of Giffen Good in detail in the section on the Indifference Curve Analysis of the Demand. However, it is extremely difficult, if not impossible to find an example of a Giffen good in real life. 20 Intext Questions 3 1. Define giffen goods. 2. Why demand Curve slopes downward? 3. Name a good that violates law of demand? 2.6 DIFFERENCE BETWEEN EXPANSION AND CONTRACTION OF DEMAND OF A COMMODITY AND INCREASE AND DECREASE IN DEMAND OF A COMMODITY Expansion and Contraction of Demand: We have told you that the demand is affected by various factors. In explaining the law of demand we consider only the effect of the changes in the price of a commodity on its demand, assuming that there is no change in other factors e.g., income, taste and fashion of the consumers, prices of other goods etc. Change in the demand of a commodity due to changes in its price alone, are called extension and contraction in demand. It is also called ‘change in the quantity demanded’ or ‘movement along the same demand curve’. When the quantity demanded of a commodity rise due to fall in its price alone, it is called extension of demand. On the other hand, if the quantity demanded falls due to rise in prices, it is called contraction of demand. Suppose, as a result of the fall in the price of oranges from Rs. 3.00 per dozen to Rs. 2.50 per dozen, the demand for oranges rises from 1 dozen to 2 dozens, it is called extension of demand. Conversely, if as a result of rise in price of oranges from Rs. 1.50 per dozen to Rs. 2.00 per dozen the demand for oranges falls from 4 dozens, it is called the contraction of demand. Here we have assumed that the rise or fall in the demand for a commodity has taken place only due to fall or rise in the price of oranges, assuming that there is no change in other factors which also affect the demand. We can explain them with the help of the diagram 2.4. Diagram 2.4 We have drawn the demand curve DD which shows the different quantities of commodity X demanded at different prices, assuming that other factors which also effect the demand e.g. income, tastes and fashion of the consumers, prices of related goods etc. are constant. In the figure, when the price is OP, the quantity demanded is OS. If the price falls from OP to OQ the quantity demanded rises from OS to OT. This rise in demand ST is called extension of demand. Conversely, it the price of the commodity X rises from OP to OM, the quantity demanded falls from OS to OR. This RS fall in the quantity demanded is called contraction of demand. Thus the extension and contraction of demand takes place only due to changes in the price of the commodity and are represented by the movement on the same downward sloping demand curve. 21 Increase and Decrease in Demand: The changes in the demand for a commodity due to the factors other than the price of the commodity e.g., changes in consumer’s income, tastes, fashion, prices or related goods etc., are called increase and decrease in demand. Suppose the income of the consumer has increased (assuming the price of commodity has remained constant) and therefore he will demand more of the goods. The rise in his demand for goods is called increase in demand. On the other hand if the income of the consumer declines he demands less of goods. This fall in his demand is called decrease in demand. Though the extension and contraction of demand can be represented on the same demand curve, but the increase or decrease in demand are represented by the upward or downward shifts in demand curve. This is explained in diagram 2.5. Diagram 2.5 Initially, DD is the demand curve. At price OP the quantity demanded of commodity X is OM. Suppose the price of the commodity has remained constant but the consumer’s income increases or the fashion of a good has increased, the consumer is able to buy greater quantities of the good than before and therefore the demand curve DD will shift upward to right and the new demand curve is D1D1. The consumer will now buy ON quantity instead of OM quantity at the old price OP. This is called increase in demand. On the other hand, when the consumer’s income declines or the fashion of a good has declined, the demand curve DD will shift downwards to the left and the new demand curve will be D2D2. The consumer will now be able to buy only OR quantity of the good at the old price OP instead of OM quantity and this decline in demand is called decrease in demand. To sum up, extension and contraction of demand take place due to changes in the price of the commodity alone assuming other things being equal and are represented by the movements on the same demand curve. Increase and decrease in demand take place due to changes in other factors e.g., consumer’s income, tastes, preferences, fashion, prices of related goods etc., and are represented by upward or downward shifts in the demand curve. Intext Questions True / False 1. Extension and contraction of demand occurs because of changes in the income of the consumer. 22 2. There can be increase or decrease in demand because of other factors affecting demand except the price of the commodity. Answer 1. false 2. True 2.7 LEARNING OUTCOMES In the preceding sections of this lesson you have learned the following: 1. The individual demand for a commodity is defined as the quantity of the commodity purchased by the individual at a given price at a given time period. 2. The individual demand schedule provides the information about different quantities of the goods purchases by the individual at different prices. 3. The determinants or the factors affecting individual demand of a commodity are: own price of the commodity (P), income of the consumer (Y), prices of related goods (Pr) and taste and preferences of the consumer 4. The law of demand gives relationship between price of the commodity and quantity purchased of the commodity keeping other determinants of demand constant. The law of demand states that other things remaining same, price of the commodity and its quantity are inversely related. 5. The market demand for the commodity is derived by horizontal summation of the individual demand curves i.e., by adding the quantity purchased by different consumers in the market at the given price. 6. Besides the determinants of the individual demand, the market demand curve is also affected by distributions of income in the market/economy and number of buyers of the commodity in the market. 7. Change in quantity demanded refers to increase or decrease in the quantity of the good due to decrease or increase of the price of the goods on the same demand curve. Hence change in quantity demanded implies movement along the same demand curve, keeping other factors except price constant. 8. Change in demand refers to increase or decrease in the quantity of the good at the given price due to change in other factors such as income price related goods taste and preference for the good. In other words, change in demand implies shift in the demand curve at the given price. Increase in demand implies rightward shift of the demand curve, whereas decrease in demand implies leftward shift of the demand curve. Terminal Questions 1. What is the difference between change in demand and change in the quantity demanded? 2. Explain the law of demand. Why does a demand curve slope downward? What are its determinants?   23  LESSON: 3 ELASTICITY OF DEMAND INTRODUCTION The demand for a commodity depends, as we have already discussed in detail, on a number of factors such as price of the commodity itself, prices of other commodities, incomes of consumers., their tastes and preferences, advertisement, taxes or subsidies, and a host of other factors including weather and expectations about movement of prices in future. For example, the law of demand tells us that, other things remaining constant, normally the quantity demanded of a commodity increases when its price falls and vice versa. Similarly, we known how quantities demanded of different goods vary in response to changes in the incomes of the consumers or prices of related goods. Or, to take another example the demand for ice varies with changes in temperature. However, these laws or tendencies only point to the direction in which quantities demanded of various goods tend to vary in response to changes in certain factors but do no tell us the extent of changes in the quantities demanded. Learning Objectives After going through this lesson, you will be able to: 1. Define price elasticity of demand 2. Draw different demand curves as per the different types of elasticity 3. Measure elasticity of demand at a point on a straight-line demand curve 4. Measure arc elasticity of demand 5. Measure price elasticity of demand by using total outline on the commodity 6. Explain the determinants of price elasticity of demand 7. Compare price elasticity of demand on various demand curves 3.1 THE CONCEPT For analytical purposes and practical decision-making it is often necessary to know the degree of responsiveness of demand to each of the factors that may be influencing it as well as relative responsiveness of demand to one factor compared to another factor or a comparison of the relative responsiveness of demand for different goods to the same factor. The concept of elasticity of demand is a device to measure the responsiveness of the quantity demanded to change in any factor that may influence the demand for a commodity. In principle, it be possible to use the concept of elasticity of demand to measure the responsiveness of quantity demanded to changes in any factor that may influence the demand for various goods are quantifiable and it is, therefore, possible to measure responsiveness of demand to changes in them, some other factors cannot be quantified and responsiveness of demand to changes in them cannot possibly be measured. The concept of elasticity of demand is generally used to measure the responsiveness of demand to changes in (a) prices of the goods themselves, (b) changes in the prices of related goods and (c) changes in the incomes of the consumers. The measure of the degree of responsiveness of the quantity demanded of a good change in its price is described as ‘price elasticity of demand’. A measure of the degree of responsiveness of demand for a good to changes in the incomes of the consumers is described as the ‘income elasticity of demand’. And, finally, a measure of the degree of responsiveness of demand for a good X to changes in the price of another related good Y is called the ‘cross elasticity of demand’. 24 3.1.1 Price Elasticity of Demand (e) Price elasticity of demand in defined as the degree of responsiveness of quantity demanded to change in the price of the commodity. % change in quantity demanded Price elasticity of demand = % change in price % change in quantity demanded  100 original in quantity = change in price  100 original price For example, suppose when the price of a good falls from Rs. 20 to Rs.19, the quantity demanded increases from 1000 units to 1100 units. In this example the percentage change in price 100 is 5% (1/20 × 100 = 5) and percentage change in quantity demanded is 10% ( × 100 = 10). 100 Thus, value of elasticity in the case would be 10% 5% = 2. Symbolically, if we write ‘e’ for elasticity of demand, ‘Q’ and ‘P’ for the original quantity demanded and the original price respectively and AQ and AP for absolute changes in quantity and price respectively, we can write the above formula in the form of the following expression. ( Q/Q )100 e = ( P/P )100 Q/Q = P/P Q P =  Q P Q P =  Q P Normally e is negative because of negative relationship between price and quantity given other things. The value of e ranges from 0 to ∞. The shape of the demand curve will vary depending on value of e. 1. In the extreme case when there is no change in the quantity demanded in response to a price change, elasticity of demand is said to be equal to zero or demand is described as ‘perfectly inelastic’. The demand curve is vertical as shown in diagram 3.1 (A). 2. On the other hand, when there is an infinite change in quantity demanded due to a change in price, elasticity of demand is said to be equal to infinity or demand for the good is described as ‘perfectly elastic’. The demand curve is horizontal as shown in dig. 3.1 (B). 3. If the percentage change in quantity demanded is equal to the percentage change in price, elasticity of demand is said to be equal to be equal to one or demand for the good in question is described as of ‘unit elasticity’. The demand curve is rectangular hyperbola as shown in diagram 2.1 (C), 25 4. It the percentage change in quantity demanded is greater than the percentage change in price, elasticity of demand is said to be greater than one or demand for the good in question is described as ‘elastic’. The curve is flatter as shown in diagram 3.1 (D). 5. If the percentage change in quantity demanded is less than the percentage change in price, elasticity of demand is said to be less one or demand for the good in question is described as ‘inelastic’. The curve is steeper as shown in diagram 3.1 (E). Diagram 3.1 (A) Perfectly Inelastic Demand, (B) Perfectly Elastic Demand, (C) Unitary Elastic Demand, (D) Elastic Demand and € Inelastic Demand Intext Questions MCQ 1. The Price elasticity of demand depends on a) The units used to measure price but not the units used to measure quantity. b) The units used to measure price and the units used to measure quantity. c) The units used to measure quantity but not the units used to measure price. d) Neither the units used to measure price nor the units used to measure quantity. 26 2. If there is no change in quantity demand in response to price, then price elasticity of demand is a) inelastic b) elastic c) less than unit elastic d) None of the above Ans. 1. (d) 2. (a) 3.2 MEASUREMENT OF ELASTICITY OF DEMAND When we think of measuring elasticity of demand one method which at once suggests itself is to measure responsiveness of quantity demanded in terms of absolute changes in price and quantity demanded. However, from the nature of the problem it is evident that we cannot measure responsiveness of demand in terms of absolute changes in price and quantity demanded. For example, due to a one rupee fall in price the quantity demanded of rice may increase by 1000 quintals. But the units of measurement being different (e.g., price is measured in rupees and rice in quintals), there is no basis for comparing a rupee change in price with a 1000 quintal change in demand. On the basis of these figures we cannot say whether the change in quantity demanded is more than equal to or less than the change in the price. And, when it is a question of comparing the relative responsiveness of the quantities demanded of two or more than two goods, even equal absolute changes in their prices or quantities demanded as a measure of relative responsiveness may actually conceal more than what it reveals. For example, suppose that as a result of a Rs.5/- reduction in the prices of wheat and radios, the demand for the former expends by 10,000 quintal and the demand for the latter. expands by 500 units. Ignoring the question of incomparability of a quintal of wheat with a unit of radio, on the basis of the absolute changes in prices and quantities we are tempted to conclude that demand for wheat is more price-elastic than the demand for radios. But the given change in the prices of the two goods may not have the same significance for the consumers. Suppose the original price of wheat was Rs. 100 per quintal and that of radios was Rs.500 per set. A Rs.5 reduction out of Rs.100 is certainly a more significant price cut than the same reduction out of Rs.500. This simply means that the prices cut is 5% in case of wheat and only 1% in case of radios. Similarly, a given change in demand may be an insignificant change if the original quantity demanded was high and it would be a significant change if the original demand was small. Suppose, according to the above example, the demand for wheat expanded from 1,000,000 tons to 1,0010,000 tons and the demand for radios expanded from 10,000 to 10,500 units. This means that the demand for wheat expanded only by 1 % while the demand for radios expended by 5%. By comparing the percentage change in prices and quantities it turns out that due to a 5% fall in the price of wheat its demand expanded only by 1% whereas due to a 1% fall in the price of radios demand expanded by 5%. It is thus evident that the demand for radios is much more price- elastic than the its demand for wheat. A comparison of the absolute changes in prices and quantities had given us an entirely distorted impression. Therefore, elasticity of demand (and for that matter all elasticities) is always measured in terms of (i.e., percentage or proportionate) changes in prices and quantities demanded. These percentage changes are independent of the units of measurement. Merely by comparing the percentage changes in price and quantity demanded we can immediately say whether percentage change in demand is more than, equal to or less than the percentage change in price. Because of the difficulties mentioned above elasticity is never measured in terms of absolute changes. It is always measured in term of relative (i.e., the proportionate or percentage) changes in price and quantity demanded. The purpose of all elasticity measures is to determine whether the percentage change in demand is more than equal to or less than the percentage change in price causing the change in the former. 27 3.3 METHODS OF MEASUREMENT We will discuss three different methods of measuring elasticity of demand, namely-total outlay method, point method and arc elasticity. (i) The Total Outlay Method A variant of the above method is to compare the consumer’s total outlay (i.e., expenditure = quantity bought * price) on the commodity after the price change with their original outlay and make qualitative statements about the value of elasticity as was done above. The logic behind this variant is very simple. When due to a price change the quantity demanded of a good change, this tends to change the total outlay of the consumers on the commodity. We know that if the percentage in the quantity demanded is greater than the percentage change in price, the total outlay of consumers will be larger than before in case of a fall in price and less than before in case of a rise in price. On the other hand if the percentage change in quantity demanded is less than the percentage change in price, the total outlay of consumers will be smaller than before in case of a fall in price and larger than before in case of a rise in price. And if the percentage change in quantity demanded is equal to the percentage change in price, the total outlay will remain constant. Making use of this simple arithmetical property economists have devised a variant of the percentage change method which is known as the ‘total outlay method’. According to the total outlay method, instead of comparing the percentage change in quantity demanded with the percentage change in price, we simply compare the total outlay of consumers on the commodity after the price change with their original outlay and make following qualitative statements about the value of elasticity: 1. If the total outlay of consumers on the commodity after the price change (i.e.Q1 × P1) is greater than the original outlay (Q0 × P0) in case of a fall in price (and less than the original outlay in case of rise in price), elasticity of demand is said to be greater than one or demand is described as’elastic’. 2. If the total outlay of consumers remains the same even after a rise or fall in price (i.e.Q1 × P1 = Q0 × P0) then elasticity of demand is said to equal one or demand is described as of ‘unit elasticity’. 3. If the total outlay of consumers after the price change is less than the original outlay in case of a fall in price (Q1 × P1 < Q0 × P0) and greater than the original outlay in case of a rise in price (Q1 × P1 > Q0 × P0) or the changes in the price and total outlay move in the same direction, elasticity of demand is said to be less than one or demand is described as ‘inelastic’. Let us explain the above method with a simple arithmetical example. Suppose, as the price of a commodity falls, the total outlay of consumers changes as shown in the table 3.1: TABLE 3.1 Price Quantity demanded (Units) Total Outlay Value of elasticity Rs. 9 13 Rs. 117 Rs. 8 15 Rs. 120 >1 Rs. 6 20 Rs. 120 =1 Rs. 5 23 Rs. 115 1) because BD1 > BD. On the other hand, the elasticity on any point say C, which lies below the mid-point A on the demand curve DD1, the elasticity of demand will be less than one (e < 1) because CD1 < CD. In other words, as we move towards D1, the elasticity of demand goes on decreasing because the lower segment of the demand curve becomes smaller and smaller and the upper segment will be increasing. At point D1 the elasticity will become zero because at D1, the lower segment will be equal to zero and the upper segment will be the whole DD1. Diagram 3.7 Price Elasticity varies from 0 to ∞ on a straight-line demand curve 2. Elasticity at different points along two (or more) parallel (i.e., having the same slope) demand curves. A. Of the two (or more) parallel demand curves, the one farther from the origin is less elastic at each price than the one closer to the origin. 38  dq P Proof: e =  dp Q See diagram 3.8. Being parallel the value of dq/dp is the same at all points along D1D2 and D2D2 but the ratio P/Q is smaller at each price on D2D2 than D1D1. Therefore, D2D2 is less elastic at each price than D1D1. From this also follows the conclusion that parallel rightward shift of a downward sloping demand curve makes it less elastic at each price and a parallel leftward shift makes it more elastic at each price. B. The one farther form origin is more elastic at each level of demand than the one closer to the origin given same quantity. Proof: e = dq/dp. P/Q In the diagram 3.9, being parallel the ratio dq/ dp is the same at all point along D1D1 and D2D2. But the ratio P/Q is greater at each level of demand along D2D2 than D1D1 (e.g., P2Q/OQ > P1Q/OQ). Therefore, D2D2 is more elastic at each level of demand than D1D1. Diagram 3.8: Comparison of price elasticity on two parallel straight-line demand curves at given price Diagram 3.9 Comparison of price elasticity on two parallel demand curves at given quantity 39  Diagram 3.10 C. Have the same elasticity at points lying along a straight line drawn from the origin (0) dq P Proof: e =  dp q In the diagram 3.10, being parallel the ratio dq./dp is the same at all points along D1D1 and D2D2. The ratio P/Q is also the same at all points along OZ because the two triangle OQ1P1 and OQ2P2 are similar and therefore, Pq Q1 P2 Q2 the ratio = = OQ1 OQ 2 Therefore, elasticity of two (or more) parallel demand curves at points lying along a straight line drawn from the origin (0) is the same. 3. Value of elasticity of downward sloping straight-line demand curves originating from the same point on the price axis. (i) Are iso elastic at each price Proof: In the diagram 3.11, PP2 has been drawn parallel to OD2. P2 D2 P1D1 OP Therefore, = = P2 D P1D PD P2 D 2 Elasticity of DD2 at P2 = and P2 D P1D1 Elasticity of DD1 at P1 = P1D Therefore, elasticity at P2 and P1 is the same. 40  Diagram 3.11 (ii) The flatter is more elastic at each level of demand than the steeper one. P D QD1 P2 D2 QD2 Proof: In the diagram 3.12 P2Q being paralleled to OD, 1 1 = and =. P1D OQ P2 D OQ QD2 QD1 QD2 QD1 P2 D2 P1D1 Comparing the two ratios and we find that . Therefore, . OQ OQ OQ OQ P2 D P1D  PD   P1D1  Hence value of elasticity at P2  = 2 2  is greater than value of elasticity at P1 = .  P2 D   P1D  Diagram 3.12 Therefore, of two (or more) demand curves originating from the same point on the price axis, the flatter is more elastic at each levels of demand than the steeper one. 4. Downward sloping straight-line demand curves meeting the quantity axis at the same point have the same elasticity at each level of demand. P2 D P D QD Proof: In the diagram 3.13 since P2Q is parallel to OD2 therefore, = 1 =. P2 D2 P1D1 OQ 41  P2 D PD Elasticity at P2 = and elasticity at P1 = 1. Hence elasticity at P2 = elasticity at P2 D 2 P1D1 P1. Therefore, D1D and D2D have the same elasticity at each level of demand. Diagram 3.13 5. Of the two (or more) intersecting straight-line demand curves the flatter one is more elastic at the point of intersection, than the steeper one. In the diagram 3.14, at P the ratio P/Q is the same for D1D1 as well as D2D2. Therefore, value of elasticity will vary only with the value of dq/dp along the two curves. Value of dq/dp is larger at each point along D2D2. (i.e the flatter curve) than along D1D1 (i.e., the steeper of two). Therefore elasticity of D2D2 at P is greater than elasticity of D1D1 at the same point p. Diagram 3.14 Intext Questions Fill in the blanks 1. Value of price elasticity of demand varies from ________. 2. At the mid point of downward sloping demand curve, elasticity of demand is ________. Ans. 1. 0 to infinity 2. One 42 Learning outcomes 1. Price elasticity of demand is defined as the ratio of percentage change in quantity demanded to percentage change in price 2. For given price and quantity of the good, its price elasticity of demand is inversely related to the slope of the demand curve 3. Demand curve is vertical when price elasticity is Zero, steeper for price elasticity less than One, rectangular hyperbola for price elasticity equals One, flatter for elasticity greater than One and horizontal for elasticity Infinity. 4. On a straight-line demand curve the elasticity at any point equals the ratio between lower portion of the demand curve at that point and upper portion of the demand curve. Accordingly the price elasticity of demand varies from zero on the quantity axis to infinity on the price axis along the straight-line demand curve with unity at the mid-point. 5. The arc elasticity of demand takes into consideration the average of prices and quantities respectively before and after change along with their differences. This is done in order to measure price elasticity in case of large changes in prices. 6. The price elasticity of demand is related to the Total Expenditure (TE) in the following way:- a) e=1 if, TE does not change with change in price b) e1 if, TE is negatively related to price 7. The factor affecting elasticity of demand are: - Number of substitutes of the commodity, number of various uses of the commodity, time period of consumption, level of income of the consumer, level of the price of the good, etc. 8. At the point of intersection of two straight-line demand curves the elasticity is higher on the flatter demand curve than that on the steeper one. 9. At a given price on various parallel straight-line demand curves the price elasticity of demand decreases as the demand curve moves away from the origin. 10. At a given quantity on a various straight-line parallel demand curves the price elasticity of demand increases as the demand curves moves away from the origin. 11. Elasticity of demand remains same at a given price on two or more straight-line demand curves originating from the same point on the price axis. 12. Elasticity of demand remains same at a given quantity on two or more straight-line demand curves originating from the same point on the quantity axis. 13. Price elasticity remains same along the straight-line from the origin which intersects two or more parallel demand curves. TERMINAL QUESTIONS Short Questions 1. Explain the total expenditure method of measuring price elasticity of demand. 2. Discuss the factors affecting price elasticity of demand. 3. Explain the various degree of price elasticity of demand. 4. The demand for a commodity at Rs. 4 per unit is 100 units. The price of the commo