Economy Class 1 To 5 Notes PDF

Economy © Sarrthi IAS 9569093856 Economy Foundation Module 1  Economy The study of Economics 4 Microeconomics:...

Economy © Sarrthi IAS 9569093856 Economy Foundation Module 1  Economy The study of Economics 4 Microeconomics: 4 Macroeconomics: 4 Logic of Economics 5 Positive and Normative Economics 5 Terms related to Economics 6 Nine Central Concepts 6 Scarcity 7 Choice 8 Opportunity Cost 8 Utility 9 The basic economic problem 10 Alternative ways to answer the economic questions 10 Market and Command Approaches to Economic Systems 11 Rationing and Economic Systems 12 Modern Economies and Mixed Systems 13 Resource Allocation and Output/Income Distribution 14 Factors of Production (FoP) 15 Production Possibilities Curve 16 Introducing the Production Possibilities Curve Model 16 Conditions for Maximum Output 17 The Production Possibilities Curve and Scarcity, Choice, and Opportunity Cost 18 Shape of the Production Possibilities Curve (PPC) 18 Potential GDP and the Production Possibilities Curve (PPC) 19 Economic Growth and the PPC 20 Factors Leading to an Outward Shift of the PPC 20 Maintaining Growth with Low Unemployment and Efficiency 21 Efficiency, Sustainability and the Production Possibility Curve (PPC) 21 Concept of Economic Growth v/s Economic Development 22 Questions 22 The Law of Demand 24 Law of Demand 24 Cross Elasticity of Demand (CED) 24 Non-Price Determinants 25 Types of Goods 28 How do economists explain the law of Demand? 33 Key Assumptions Behind the Theory of Demand 33 Reevaluating Assumptions in the Rational Consumer Model 34 Movement along the Demand Curve v/s Shift of the Demand Curve 34 Elasticity of demand 34 Price Elasticity of Demand (PED) 35 Price Elasticity of Demand (PED) and Its Range of Values 35 Practical Ranges of PED: 35 Determinants of Price Elasticity of Demand (PED) 37 © Sarrthi IAS 9569093856 Economy Foundation Module 2  Economy Applications of Price Elasticity of Demand 38 Income Elasticity of Demand (YED) 39 Range of YED Values 39 Engel Curve 39 Importance of Income Elasticity of Demand (YED) 40 Questions 41 The Law of Supply 44 Supply and Supply Curve 44 Law of Supply 44 Non-price determinants of Supply 44 How Economists Explain the Law of Supply? 47 Determinants of Price Elasticity of Supply (PES) 48 What is Price Elasticity of Supply (PES)? 50 Normal PES Values 50 Determinants of Price Elasticity of Supply (PES) 51 Application of Price Elasticity of Supply 52 Market Equilibrium 53 Questions 53 © Sarrthi IAS 9569093856 Economy Foundation Module 3  Economy The study of Economics Economics is the study of how people, businesses, governments, and nations use limited resources to produce, distribute, and consume goods and services. A key concept is that people think and make choices, unlike robots, so individual behavior can be unpredictable. However, the behavior of large groups often follows patterns, making it possible to study and analyze. Thus, Economists study group behavior in economics. Social sciences are academic disciplines focused on studying human society and social relationships. They aim to uncover general principles that explain how societies function and are structured. Fields within the social sciences include anthropology, economics, political science, psychology, sociology, and more. Economics is classified as a social science because it examines human behavior and society, particularly in terms of how people organize their activities and make choices to fulfill their needs and wants. It is considered a social science because it applies the scientific method to study societal interactions. Microeconomics: The Greek origin of “micro” is “micró,” meaning small, reflecting its focus on smaller units within the economy. Microeconomics deals with smaller, discrete economic agents and their reactions to changing events.It focuses on the behavior of individual entities such as firms, consumers, and workers. The study of microeconomics looks at how these individual decision-makers make choices, interact in markets, and determine prices.It analyzes the consequences of their decisions and the allocation of resources within specific markets. It is concerned with individual consumers (or households) and firms (or businesses) and examines factors such as demand and supply, pricing, and market structures. Macroeconomics: The Greek origin of “macro” is “makros,” meaning large, indicating its comprehensive view of the economic system. Macroeconomics takes a broader perspective, analyzing the economy as a whole. It considers large-scale economic factors such as total economic activity, inflation, unemployment, and the distribution of income. Macroeconomics looks at aggregates, which include the collective behaviors of all consumers and firms, total income, and total output of the economy. It uses aggregated data to study economic-wide phenomena like national productivity, economic growth, and general price levels. It Involves analyzing sectors such as the consumer sector (total consumer behavior) and the business sector (total firm behavior). © Sarrthi IAS 9569093856 Economy Foundation Module 4  Economy Microeconomics is like viewing the economic world through a microscope, examining the detailed and specific behaviors of individual units. Macroeconomics is like using a telescope, providing a broad overview of the entire economy and observing overall trends and patterns. Logic of Economics Positive and Normative Economics Economists approach the economic world in two different ways: positive economics and normative economics. These approaches help differentiate between statements that describe what is and those that express opinions on what ought to be. Positive economics is concerned with objective analysis and is based on factual statements. It seeks to describe, explain, and predict economic events through the use of © Sarrthi IAS 9569093856 Economy Foundation Module 5  Economy hypotheses, theories, models, and the scientific method. Positive statements are factual and can be tested for validity by examining evidence. For instance, a statement such as "the unemployment rate is 4% in China" can be checked against data to determine if it is accurate. Similarly, statements that predict future events, such as "unemployment will increase next year," fall under positive economics because they can be verified or disproven when the time comes. In contrast, normative economics deals with value-based judgments and opinions on how the economy should function. It is rooted in beliefs about what is good or bad, right or wrong, and is used to make policy recommendations. Normative statements cannot be proven true or false as they are based on subjective views and value judgments. An example would be "India ought to curb unemployment." This statement reflects an opinion that managing unemployment is essential, but its truthfulness depends on individual beliefs or societal values. Terms related to Economics Goods: Physical objects that can be touched (tangible), such as vegetables, meat, or motor vehicles. Services: Intangible items that cannot be touched, like motorcycle repairs, haircuts, or online courses. Wants: Items we would like to have but are not essential for immediate survival, such as iPhones or televisions. Needs: Essential items required for survival, including food, shelter, and clothing. Resources: Goods used to produce other goods, including land, labor, capital, and entrepreneurship—collectively known as factors of production. Nine Central Concepts There are nine central concepts that overarch economic issues. Key Concept Description Scarcity Scarcity is a central concept in economics. It refers to the limited availability of economic resources relative to society’s unlimited demand for goods and services. Economics studies human behavior as a relationship between ends and scarce resources with alternative uses. Choice Since resources are scarce, economics is the study of choices. This requires decision-making between competing alternatives and analyzing the consequences of these choices. Economics examines both present and future implications. © Sarrthi IAS 9569093856 Economy Foundation Module 6  Economy Efficiency Efficiency is a measurable concept, determined by the ratio of useful output to total input. Allocative efficiency involves making the best use of scarce resources to produce optimal combinations of goods and services, minimizing resource waste. Equity Equity refers to fairness and is distinct from equality. It is a normative concept that can refer to the fair distribution of income, wealth, or economic opportunity. Inequity (or inequality) is a significant issue within and between societies. Economic Economic well-being refers to the level of prosperity and quality of life Well-being experienced by members of an economy. It includes: present and future financial security, the ability to meet basic needs, make choices, and maintain adequate income levels. Disparities in well-being exist both within and across nations. Sustainability Sustainability involves meeting present needs without compromising future generations’ ability to meet their own. This includes limiting resource depletion and avoiding environmental degradation, which can impact future resources and well-being. Change Understanding change is crucial in economics as the economy is in a continual state of flux. Economists study both the causes and effects of change, considering institutional, structural, technological, economic, and social levels. Interdependence Economic actors such as consumers, firms, and governments interact, creating interdependence. The greater this interaction, the higher the level of interdependence, which can result in significant economic consequences for various actors. Intervention Intervention typically refers to government involvement in markets to achieve specific goals like equity, economic well-being, or sustainability. While markets are efficient, they may not always meet these goals, necessitating intervention to address market failures. Scarcity Scarcity is the situation in which available resources, or factors of production, are finite, whereas wants are infinite. Scarcity refers to the idea that resources are limited and cannot fully satisfy the endless needs and wants of humans. Scarcity means there is not enough of something to fulfill everyone’s desires, which is why it has a price. If a resource or item costs something, it is considered scarce and is therefore rationed. When you pay a price for an item, it becomes an economic good—defined as any good or service with a price, indicating that it is limited and rationed. Conversely, if something were not scarce, it would be a "free good" and available in unlimited quantities without any cost. It is one of the central concepts in economics. In fact, without scarcity, there would be no need for the study of economics. Economics exists to understand how limited resources can be best utilized to meet the unlimited needs and desires of people.’ © Sarrthi IAS 9569093856 Economy Foundation Module 7  Economy Choice In a fundamental sense, economics is the study of choice. Because resources are scarce, it is impossible to satisfy all human needs and wants, making choices essential. This means decisions must be made about which goods and services will be produced and which will be foregone (not produced and therefore sacrificed). Economics examines how different decision-makers choose between competing options and assesses the present and future consequences of these choices. Since people do not have infinite incomes, they must decide how to allocate their limited financial resources, choosing between various alternatives whenever they purchase goods and services. Opportunity Cost Opportunity cost refers to what you give up in order to have something else. For example, if you buy an empanada instead of a chicken wrap, the opportunity cost of your empanada is the chicken wrap you chose not to buy. In broader terms, if a good or service has an opportunity cost, it must be relatively scarce, which means it has a price and is considered an “economic good.” On the other hand, "free goods" do not have an opportunity cost because they are not scarce, have no price, and are available without any trade-offs. Free and Economic Goods Using the concept of opportunity cost, we can distinguish between free goods and economic goods (where "goods" broadly refers to items, services, or resources). 1. Free Goods: These are goods that are not scarce and, therefore, have zero opportunity cost. Free goods can be obtained without needing to give up anything else. Examples include clean air in rural areas or sunlight in most open spaces. Since they are naturally abundant, they do not require the sacrifice of other resources. 2. Economic Goods: These are goods that are scarce by nature or due to their production process, and they always have an opportunity cost. Economic goods might include natural resources like oil, coal, or gold, or manufactured items, as all these require scarce resources to produce. Free goods are relatively rare. Sometimes, a good can be a free good in one context and an economic good in another. For instance, land in early America was so plentiful that it was a free good; however, as the population grew, land became scarce and thus an economic good. Similarly, clean air is usually a free good in open rural areas, but in a crowded, enclosed space, it becomes limited and is considered an economic good. Free Goods vs. Free-of-Charge Economic Goods It's essential to distinguish free goods from economic goods provided free of charge to users. Goods that are freely accessible but have an opportunity cost include: © Sarrthi IAS 9569093856 Economy Foundation Module 8  Economy Government-Provided Goods: Public goods and services, such as roads, parks, education, and healthcare, may be free for users but are economic goods funded through tax revenue and produced with limited resources. Common Resources: Natural resources like clean air, forests, and rivers are common pool resources, meaning they are available to everyone but are limited and subject to depletion. These are economic goods as their scarcity requires careful management. Free goods, therefore, are distinct from those goods or resources available at no charge, as these latter resources still require scarce inputs for their provision and upkeep. Utility Utility measures the usefulness and satisfaction a consumer receives from consuming a product. There are two basic types of utility: Total Utility: The overall satisfaction gained from consuming a certain quantity of a product. Marginal Utility: The additional satisfaction obtained from consuming one more unit of a product. In most cases, it is believed that as consumption increases, the marginal utility (satisfaction from each additional unit) decreases. Law of Diminishing Marginal Utility The law of diminishing marginal utility is an economic principle that states that the satisfaction derived from each additional unit of a good or service decreases as the quantity consumed increases. Carl Menger is credited with developing the law of diminishing marginal utility and presenting it in his 1871 work “Principles of Economics”. For example, if someone is thirsty and drinks a glass of water, the first glass will provide great satisfaction. However, the second glass will provide less satisfaction because the person's thirst has been partially quenched. The third glass will provide even less satisfaction, and so on. Eventually, the utility will drop to zero, which is the point of consumer equilibrium or maximum satisfaction. The law of diminishing marginal utility explains why consumers are often willing to pay the most for the first unit of something they buy, but are less likely to buy additional units without a price decrease. © Sarrthi IAS 9569093856 Economy Foundation Module 9  Economy The basic economic problem Resources are relatively scarce and wants are infinite, which leads to choices to be made. These choices are often expressed in terms of three questions and represent the basic economic problem: What should be produced, and in what quantities? Every economy must decide on the specific goods and services to produce and in what quantities. This decision involves considering the allocation of scarce resources. How should things be produced? There are multiple ways to produce goods, using different combinations of resources. Economies must choose the most efficient methods to utilize their resources effectively. The choice involves selecting between combinations of factors of production (e.g., more labour with fewer machines or more machines with less labour), skill levels of labour, technologies, or raw materials (e.g., plastic versus wood). For whom should things be produced? This question addresses the distribution of goods and services among the population. Decisions need to be made on whether goods and services should be distributed equally among all or if some groups should receive more than others. Essential services like education and healthcare may also be prioritized for more equal distribution. Alternative ways to answer the economic questions Countries around the world use different methods to make allocation and distribution decisions, which revolve around answering fundamental economic questions: The two main © Sarrthi IAS 9569093856 Economy Foundation Module 10  Economy approaches to answering these questions are the market method and the command method. In the market method, resources are privately owned, and economic decisions are influenced by prices determined through market interactions. This system, typical of a free-market economy (capitalism), relies on how consumers and firms respond to price signals, promoting efficient resource allocation. In contrast, the command method involves government ownership of resources and centralized economic decision-making. In such planned economies, the government regulates and commands how resources are used and distributed. Free and Planned Economic Systems The ideal-type free market and planned economies are distinguished from each other on the basis of three criteria. Market and Command Approaches to Economic Systems The market-based and command-based approaches to answering key economic questions represent two ideal types of economies: the free market economy and the planned economy. An ideal type is an abstract concept that highlights certain characteristics, offering a standard to compare with real-world economies. (Here, “ideal” does not mean perfect or superior.) As discussed, actual economies mix elements of market and command approaches, resulting in mixed economies. The ideal types of free market and planned economies can be distinguished based on three main criteria: Resource Ownership: Public vs. Private Sector Ownership of resources may fall under either the public or private sector. Public Sector: Refers to parts of the economy owned and managed by the government at the national, regional, or local level, often referred to as "the state." Private Sector: Refers to areas owned by private individuals or groups, such as consumers, businesses, and resource owners. This also includes NGOs and interest groups, such as consumer protection organizations. In a free market economy, resources are primarily owned by the private sector, whereas in a planned economy, resources are largely owned by the public sector. Economic Decision-Making: Public vs. Private Sector Decisions about what, how much, how, and for whom to produce can be made by either the public sector (government) or the private sector. The main private decision-makers include consumers (households), businesses, and resource owners. In a free market economy, these economic decisions are mainly made by the private sector In a planned economy, they are made by the public sector. © Sarrthi IAS 9569093856 Economy Foundation Module 11  Economy Rationing and Economic Systems Rationing is a method used to allocate resources or distribute something among those who want it. In economics, rationing methods help decide how resources are allocated and how output and income are distributed. There are two main types of rationing: price rationing and non-price rationing. Price Rationing: In a free market economy, price rationing determines how resources are allocated and who receives the goods, services, and income. Here, decisions about what to produce, how to produce it, and who gets the output are made based on prices. Prices are set by market interactions, where supply and demand meet to determine the value of goods, services, and resources. The private sector, which includes households and firms, owns most resources and makes economic decisions through buying and selling in markets. Non-Price Rationing: In a planned or command economy, non-price rationing is used instead. This approach involves resource allocation and distribution based on government decisions rather than prices. The government, as the primary resource owner, directs what and how much will be produced, how it will be produced, and who will receive the output. These decisions are based on government commands and planning, without the influence of market prices. In such economies, the government creates detailed plans that guide and coordinate all economic activities. While full command economies are rare today, North Korea and, to a lesser extent, Cuba, still retain high levels of centralized planning. Disadvantages of Pure Free Markets Disadvantages of Pure Planned Economy Demerit goods (e.g., drugs, harmful Complicated planning makes it difficult services) will be over-provided due to efficiently allocate resources, leading to high prices and profit motives. to shortages and surpluses. Merit goods (e.g., education, No price system results in inefficient healthcare) will be underprovided, use of resources and arbitrary only serving those who can afford decision-making. them. Resource depletion and Distorted incentives make it difficult to environmental damage as firms motivate workers and managers with prioritize profits and minimize costs. guaranteed employment. Vulnerable groups (e.g., orphans, Government dominance may lead to the sick) may lack support and loss of personal liberty and freedom of struggle to survive. choice. Industry domination by large firms Misaligned government aims may not can lead to high prices, inefficiency, reflect the population's needs, leading and excessive power. to unpopular or corrupt policies. © Sarrthi IAS 9569093856 Economy Foundation Module 12  Economy Modern Economies and Mixed Systems In practice, most economies today blend both market mechanisms and government planning, making them mixed economies. The extent to which markets or government commands dominate varies by country, but nearly all economies incorporate a balance of both systems to make resource allocation decisions. Increasingly, mixed economies are evolving into mixed market economies, where most economic activities are market-based rather than centrally planned, and price rationing is more common than non-price rationing. In these economies, both public and private sectors play a role in ownership and decision-making, each contributing to the allocation of resources and the provision of goods and services. In a mixed market economy: Private sector firms typically decide what and how to produce and sell. The government makes decisions about activities under its ownership, such as public health services, transportation infrastructure, parks, and defense facilities. The government’s role extends beyond managing public sector activities; it also influences the private sector. For example, in the United States, a highly market-oriented economy, government policies impact the private sector in various areas, including minimum wage laws, agricultural subsidies, import tariffs, regulation, anti-monopoly policies, tax collection, and income redistribution. In fact, all mixed market economies have government intervention, whether to address market failures or respond to political demands from influential groups. Examples of Government Involvement by Country: In the United Kingdom and the United States, the market plays a central role, with limited government intervention. In the Nordic countries (like Denmark and Sweden), government intervention focuses on income redistribution. In Japan, government involvement includes planning and coordinating private sector activities. © Sarrthi IAS 9569093856 Economy Foundation Module 13  Economy In mixed market economies, both price and non-price rationing are present, with price rationing more common. Price rationing occurs in open markets, where prices allocate resources. However, in areas without markets or where markets are regulated, non-price rationing is used. For instance, governments often provide national defense, public health care, and flood control without charging a price, relying on non-price rationing methods like waiting lines or service queues to allocate resources among users. National health systems funded by taxes are a common example, where services are available to all at minimal or no direct cost to users, necessitating a non-price mechanism like wait times. Over time, the balance between public and private sector involvement in mixed market economies continues to evolve based on social needs, political influences, and economic challenges. Difference between Free Market Economy, Planned Economy and Mixed Economy Criteria Free Market Planned Economy Mixed Economy Economy (based on (based on prices) commands) Resource Private sector Public sector Private sector and Ownership Public sector Economic Private sector Public sector Private and Public Decision-Making sector Rationing Price rationing Non-price rationing Price rationing and System Non-price rationing Resource Allocation and Output/Income Distribution In economics, the first two fundamental questions—what/how much to produce and how to produce—concern resource allocation, while the third question—for whom to produce—addresses the distribution of output and income. Resource Allocation is the process of assigning available resources, or factors of production, to specific uses among many possible alternatives, answering the questions of what/how much to produce and how to produce. For instance, if a decision is made to produce certain amounts of food and weapons, this means resources are allocated to each type of production. At the same time, choices are made about how to produce, such as which types and quantities of resources (e.g., labor, machinery) are assigned to food production versus weapons production. If the quantity of goods produced is adjusted (for example, more food and fewer weapons), this represents a reallocation of resources. Sometimes, resources may be allocated inefficiently—producing too much or too little of certain goods relative to what is socially desirable. For example, an overallocation occurs if too many resources are dedicated to weapons production, while an underallocation happens if there are insufficient resources for socially beneficial goods, such as education or healthcare. © Sarrthi IAS 9569093856 Economy Foundation Module 14  Economy The third question, for whom to produce, pertains to output and income distribution. This involves determining how much output different individuals or groups in a population will receive. It is also closely tied to income distribution, as the amount of goods people can buy depends on their income levels. Changes in how income or output is distributed among social groups are known as redistribution of income, which occurs when income or output shifts, leading certain groups to receive more or less than before. Factors of Production (FoP) The factors of production are the essential resources required for the creation of goods and services. These resources are the building blocks of the economy and are grouped into four main categories: land, labor, capital, and entrepreneurship. Each of these inputs is vital for the generation of economic profit. FoP Definition Characteristics Income Land All natural resources Includes raw (e.g., gold, coal) and Rent used in production, cultivated (e.g., wheat, rice) natural not limited to resources. physical land. Resources found on or under the land (e.g., forests, minerals). Resources found in or under the sea (e.g., oil reserves). Labor The physical and Ranges from manual labor (e.g., Wages intellectual effort waiters) to intellectual work (e.g., individuals engineers, artists). contribute to The human factor in production, production. involving both physical and mental contributions. Capital Tools, machinery, Includes machinery, tools, Interest and buildings used equipment, and buildings used in to produce goods the production process. and services (not Helps increase the productivity of money). land and labor. Entrepre The ability to Involves taking risks, Profit neurship innovate and decision-making, and resource manage land, labor, management. and capital to create Drives economic growth and goods and services. combines other factors of production. Capital In its broadest sense, "capital" refers to resources that generate a future stream of benefits. © Sarrthi IAS 9569093856 Economy Foundation Module 15  Economy Types of Capital Basis: The nature of the resources they provide Physical Capital Man-made resources like machinery, buildings, and equipment that contribute to production. Physical capital generates future benefits by enabling greater production of goods and services. Human Capital Skills, knowledge, abilities, and health acquired by individuals that enhance productivity. It provides a stream of future benefits because it increases the amount of output that can be produced in the future by people who embody skills, education and good health. Natural Capital Natural resources and ecosystems essential for human life and economic activity, such as air, biodiversity, soil quality, ozone layer, and climate. Natural capital provides a stream of future benefits because it is necessary to humankind's ability to live, survive and produce in the future. Financial Capital Monetary assets or investments, such as stocks, bonds, or funds, used to generate financial returns for their holders. Financial capital also provides a stream of future benefits, which take the form of an income for the holders, or owners, of the financial instruments. Social Capital Social capital is the sum of the resources, actual or virtual, that accrue to an individual or a group by virtue of possessing a durable network of more or less institutionalized relationships of mutual acquaintance and recognition. Social capital can also be thought of as the potential ability to obtain resources, favors, or information from one's personal connections. Production Possibilities Curve A Production Possibilities Curve (PPC) illustrates the maximum combinations of goods and services that an economy can produce within a given time period, assuming all resources are fully and efficiently utilized and the technology remains constant. Introducing the Production Possibilities Curve Model Consider a simple hypothetical economy that produces only two goods: microwave ovens and computers. In this economy, the quantity and quality of resources (factors of production) are fixed, and the technology used for production remains unchanged. © Sarrthi IAS 9569093856 Economy Foundation Module 16  Economy Table presents the various combinations of microwave ovens and computers that the economy can produce. Figure visualizes this data, with the quantity of microwave ovens plotted on the vertical axis and the quantity of computers on the horizontal axis. If all resources are allocated to producing microwave ovens, the economy will produce 40 microwave ovens and 0 computers, represented by point A. If all resources are dedicated to producing computers, the economy will produce 33 computers and 0 microwave ovens, represented by point E. All points along the curve connecting A and E represent alternative production possibilities, where resources are divided between producing microwave ovens and computers. For example, at point B, the economy would produce 35 microwave ovens and 17 computers, and at point C, it would produce 26 microwave ovens and 25 computers. The collection of all possible combinations of the goods and services that can be produced from a given amount of resources and a given stock of technological knowledge is called the production possibility set of the economy. The line joining points A and E is known as the production possibilities curve (PPC) or production possibilities frontier (PPF). Conditions for Maximum Output In order for the economy to achieve the greatest possible output—i.e., to be somewhere on the PPC—two conditions must be met: 1. Full Employment of Resources: All resources must be fully employed, meaning no resources are left unused. If any resources are unemployed, the economy would not be producing at its maximum capacity. 2. Efficient Use of Resources: Resources must be used efficiently, meaning they are allocated in the best possible way to avoid waste. Efficiency in production means that output is produced with the fewest possible resources, or at the lowest possible cost. If resources are not being used efficiently, this results in inefficiency. If either of these conditions is not met, the economy will not produce at a point on the PPC but somewhere inside it. For example, at point F, the economy might be producing 15 microwave ovens and 12 computers, indicating either unemployment of resources or inefficiency in production. If the economy could utilize its resources fully and efficiently, it could move to a more efficient point, like point C, where it would produce 26 microwave ovens and 25 computers. © Sarrthi IAS 9569093856 Economy Foundation Module 17  Economy Thus, The production possibilities curve (or frontier) represents all combinations of the maximum amounts of two goods that can be produced by an economy, given its resources and technology, when there is full employment of resources and efficiency in production. All points on the curve are known as production possibilities. The Production Possibilities Curve and Scarcity, Choice, and Opportunity Cost The production possibilities model is an effective tool for demonstrating key economic concepts, such as scarcity, choice, and opportunity cost: Scarcity: Due to scarcity, an economy cannot produce beyond its PPC. With a fixed quantity and quality of resources and technology, it is not possible to move to any point outside the curve (e.g., point G in Figure) because the economy lacks the necessary resources. This illustrates resource scarcity. Choice: Scarcity forces an economy to make choices about what combination of goods and services to produce. If the economy achieves full employment and efficiency, it must decide the best point on the PPC for production. In reality, the economy might operate inside the PPC, meaning some resources are underutilized. Opportunity Cost: The concept of opportunity cost arises from scarcity and the need for choice. When an economy is operating at any point on the PPC, it is impossible to increase the quantity of one good without reducing the quantity of the other. This sacrifice is the opportunity cost. Opportunity Cost and the PPC: Opportunity cost only arises when the economy is operating on the PPC (or close to it). When the economy operates inside the curve (point F), it has unused resources and can increase the production of both goods without sacrificing one for the other. In such a case, there is no opportunity cost. The economy simply needs to better utilize its resources, reduce unemployment, or improve production efficiency. Shape of the Production Possibilities Curve (PPC) The shape of the Production Possibilities Curve (PPC) reflects the opportunity cost associated with the production of different goods. The two primary shapes of the PPC—bowed outward and straight—represent different economic conditions. Outward-Bowed PPC When the PPC is bowed outward, indicating increasing opportunity costs as the economy moves from one point on the curve to another. When production shifts from one good to © Sarrthi IAS 9569093856 Economy Foundation Module 18  Economy another, the opportunity cost increases. This happens because the factors of production (such as labor and capital) are not equally efficient at producing both goods. For instance, resources that are well-suited for making microwave ovens are less effective at producing computers. As a result, for each additional unit of computers produced, a larger sacrifice in microwave ovens is required. Straight lined PPC In contrast, when the PPC is a straight line, the opportunity cost remains constant. This occurs when the factors of production are equally suited for producing both goods. For example, basketballs and volleyballs may require similar resources, leading to constant opportunity costs. In this scenario, the sacrifice of basketballs for each additional unit of volleyballs produced does not change, as the resources used for one are as effective as those used for the other. Potential GDP and the Production Possibilities Curve (PPC) Potential GDP refers to the level of output that an economy can produce when all its resources (labor, capital, land, and entrepreneurship) are fully employed and used efficiently. It represents the maximum sustainable output an economy can achieve without generating inflationary pressures, assuming optimal use of available resources and technology. Relationship Between Potential GDP and the PPC 1. Points on the PPC and Potential GDP: When the economy operates on the PPC, it is producing at its potential GDP. This means that all resources are fully employed, and there is no underutilization of factors of production. The economy is maximizing its output, and the production is considered efficient. 2. Inside the PPC and Below Potential GDP: If the economy is operating inside the PPC, it means that resources are not being fully utilized, resulting in lower output than potential GDP. This could be due to unemployment, inefficiency, or underutilized resources. For example, during a recession, an economy might produce less than its potential GDP because of reduced demand and idle resources. 3. Outside the PPC and Beyond Potential GDP: Points outside the PPC are unattainable with the current resources and technology. If the economy is © Sarrthi IAS 9569093856 Economy Foundation Module 19  Economy producing beyond the PPC, it means it is exceeding its potential GDP, which is not possible unless there is an increase in resources or technological advancement. It would indicate an unsustainable situation, such as overworking resources or causing inflationary pressure. Economic Growth and the PPC In the PPC model, an economy is often located at some point inside the curve, as it is challenging for an economy to be fully efficient with maximum employment of all resources. The further an economy is from its PPC, the higher the levels of unemployment and inefficiency. By reducing unemployment and improving efficiency, an economy can move closer to its PPC, thereby increasing its output. This shift toward the curve represents actual growth. However, reducing inefficiencies and lowering unemployment can only lead to a limited increase in output. As the economy approaches the PPC, it becomes harder to achieve further growth. To continue growing, the economy needs an outward shift of the PPC itself. This outward shift indicates that the economy can now produce more of both goods (X and Y), where the PPC shifts from PPC1 to PPC3. The economy’s points of actual production also move outward, from A to B to C, reflecting this expansion in production capacity. Factors Leading to an Outward Shift of the PPC The growth of production possibilities, represented by an outward shift of the PPC, is driven by several factors: 1. Increase in the Quantity of Resources: An increase in the factors of production, such as labor, capital, or natural resources, can expand an economy’s capacity to produce goods and services. 2. Improvement in the Quality of Resources: Enhancements in the quality of resources, such as a more educated workforce or better-trained labor, lead to higher productivity and, in turn, greater output. 3. Technological Advancements: Technological innovations allow for more efficient production, enabling the economy to produce more output with the same amount of resources. © Sarrthi IAS 9569093856 Economy Foundation Module 20  Economy Inward Shift of PPC: The PPC can shift inward, indicating a reduction in production possibilities, meaning that the economy is capable of producing less of both goods. This shift occurs due to a decrease in the quantity of resources or a deterioration in the quality of resources. Non-Uniform shift in PPC: An outward or inward shift of the PPC does not always occur uniformly. For instance, a technological advancement that benefits the production of one good (X) will increase the output of that good more significantly than the other. Similarly, an influx of unskilled workers into a country might lead to a larger increase in the production of goods that require relatively more unskilled labor, resulting in a disproportionate shift in the PPC. Maintaining Growth with Low Unemployment and Efficiency As the PPC shifts outward, it is crucial to keep unemployment low and minimize inefficiencies to ensure that actual output continues to grow alongside production possibilities. For instance, if an increase in the labor force is accompanied by high unemployment, the economy could remain stuck at a lower point (e.g., point A) even as the PPC shifts outward (from PPC1 to PPC2). Similarly, the discovery of major natural resources, such as oil, may not immediately increase actual output if much of the economy remains underutilized. Therefore, both the growth in production possibilities and the effective use of resources are essential for sustained economic growth. Efficiency, Sustainability and the Production Possibility Curve (PPC) When an economy uses all available resources to their fullest extent, operating on the Production Possibility Curve (PPC), it achieves productive efficiency. This means the economy is maximizing output with its current resources. However, if the economy operates at a point inside the PPC, it signifies inefficiency. At this point, not all resources are being fully utilized; there may be unemployed workers or idle factories, meaning labor and capital are underutilized. Inefficiency could also stem from poor allocation, like land better suited for agriculture being used for factories. Operating inside the PPC indicates an underuse of resources or inefficient allocation, with some potential output wasted. Moving from a point within the PPC toward the curve increases total output, known as actual economic growth. The PPC illustrates an economy's production potential but does not suggest which point is ideal for societal needs. Although productive efficiency implies no waste, it may involve high resource consumption that harms the environment and threatens sustainability. Excessive resource extraction might reduce future production possibilities and impact long-term economic well-being. © Sarrthi IAS 9569093856 Economy Foundation Module 21  Economy Concept of Economic Growth v/s Economic Development Economic Growth Economic growth measures changes in a country's total output, often referred to as Gross Domestic Product (GDP) or Gross National Income (GNI). It provides information about the overall size of the economy but does not necessarily reflect the actual welfare or quality of life of its citizens. Economic Development Economic development, unlike economic growth, focuses on the welfare and well-being of a country's population. It is commonly assessed using indicators beyond just GDP, including metrics related to education, health, and social welfare. The Human Development Index (HDI) is a widely used measure for assessing development, combining economic and social factors to give a broader view of societal progress. Questions Which one of the following statements about production possibility frontier is not correct? [UPSC CAPF 2021] (a) The production possibility frontier slopes downwards to the right as the resources are limited. (b) The different combinations of various goods and services given the available resources and technology are denoted by the production possibility frontier. (c) Any point on or inside the production possibility frontier is attainable under the existing technology and resources. (d) On the production possibility frontier, the output of one commodity can be increased without changing the output of another commodity. Answer: D Q. Which one of the following statements is not correct? ( UPSC-CDS-2019-i) (a) When total utility is maximum, marginal utility is zero (b) When total utility is decreasing, marginal utility is negative (c) When total utility is increasing, marginal utility is positive (d) When total utility is maximum , marginal and average utility are equal to each other Answer: D Q. In the context of any country, which one of the following would be considered as part of its social capital? [UPSC CSE Prelims 2019] © Sarrthi IAS 9569093856 Economy Foundation Module 22  Economy (a) The proportion of literates in the population (b) The stock of its buildings, other infrastructure and machines (c) The size of population in the working age group (d) The level of mutual trust and harmony in the society Answer: D Q. Which one of the following statements is true with regard to an economy which is on its production possibility frontier? [UPSC CAPF 2019] (a) The economy has to sacrifice some production of one commodity in order to increase the production of another commodity (b) There is no limit or constraint for the economy in the production of goods and services (c) The economy can produce more of one commodity up to a point without reducing the production of any other commodity (d) Its production possibility frontier is an upward sloping curve. Answer: A Which one of the following is the opportunity cost of a chosen activity? [CDS 2021 II] (a) Out of pocket cost (b) Out of pocket cost plus cost incurred by the Government (c) Value of all opportunities forgone (d) Value of next best alternative that is given up Answer: D Q. Distinguish between gender equality, gender equity and women’s empowerment. Why is it important to take gender concerns into account in programme design and implementation? (150 words, 10 Marks) [UPSC CSE Mains 2023] Q. Define Potential GDP and explain its determinants. What are the factors that have been inhibiting India from realizing its potential GDP? (150 Words, 10 Marks) [UPSC CSE Mains 2020] © Sarrthi IAS 9569093856 Economy Foundation Module 23  Economy The Law of Demand Demand and Demand Curve Demand is the quantity of a good or service that consumers are willing and able to purchase at a given price in a given time period. The important phrase here is "willingness and ability". It is not enough for consumers to be willing to purchase a good or service. They must also have the financial means to buy the product; that is, the ability to buy. This is known as "effective demand". Demand is expressed as a function of various factors and is represented graphically by a curve known as the demand curve. Law of Demand The Law of Demand simply states that "as the price of a product falls, the quantity demanded of the product will usually increase, ceteris paribus". all else equal, there is an inverse relationship between a good’s price and the quantity demanded by consumers 1 𝑃𝑟𝑖𝑐𝑒 ∝ 𝐷𝑒𝑚𝑎𝑛𝑑 It is sometimes expressed even more simply as "the demand curve normally slopes downwards". Cross Elasticity of Demand (CED) Cross Elasticity of Demand (CED) measures how the quantity demanded of one good changes in response to a price change in a related good. It highlights the relationships between two products and can indicate whether they are substitutes or complements. Types of Relationships: 1. Substitute Goods: When two goods are substitutes, a price increase in one will typically increase demand for the other, giving a positive CED. ○ Close Substitutes: Products that are very similar in use or preference, such as Coke and Pepsi. Consumers can switch between them easily when the price of one changes, leading to a high positive CED. ○ Remote Substitutes: Products that can replace each other but are not perfect substitutes, like tea and energy drinks. They are less interchangeable, so a price increase in one may only slightly increase demand for the other, resulting in a lower positive CED. 2. Complementary Goods: For complementary goods (e.g., cars and gasoline), an increase in the price of one good will likely reduce demand for the other. CED is negative for complements. © Sarrthi IAS 9569093856 Economy Foundation Module 24  Economy ○Example: If the price of cars rises, the demand for gasoline may decrease as fewer cars are purchased. 3. Unrelated Goods: If two goods are unrelated (e.g., bread and shampoo), a price change in one will not affect demand for the other. CED is close to zero. Non-Price Determinants Income: Income levels significantly impact demand, but their effect varies depending on the type of goods: Normal Goods For most goods, an increase in income leads to an increase in demand. Higher incomes enable consumers to purchase more, resulting in a rightward shift in the demand curve for these goods. Such goods are called normal goods. The size of the demand shift varies depending on the nature of the good. For instance, a rise in income increases demand for air travel, shifting the demand curve to the right, indicating more air travel is demanded at every price level. © Sarrthi IAS 9569093856 Economy Foundation Module 25  Economy Inferior Goods Inferior goods are products for which demand decreases as income rises. As consumers’ incomes increase, they often switch from these lower-priced goods to more expensive substitutes. Examples of inferior goods might include generic brands of detergent. When income rises, the demand curve for an inferior good shifts to the left, reflecting decreased demand. At a certain income level, consumers may stop buying the inferior good entirely, causing its demand curve to disappear. Price of Related Goods: Demand is influenced by the prices of related goods, which can be substitutes, complements, or unrelated to each other. Substitute Substitute goods can replace each Goods other. A change in the price of one affects the demand for the other. E.g., a drop in the price of coffee may increase its quantity demanded while reducing the demand for tea. This results in a leftward shift of the demand curve for tea. Similarly, if the price of a substitute rises, the demand for the alternative will increase, shifting its demand curve to the right. © Sarrthi IAS 9569093856 Economy Foundation Module 26  Economy Complementar Complementary goods are typically y Goods used together. A change in the price of one affects the demand for its complement. E.g, A decrease in the price of shoes may lead to a higher quantity demanded for shoes and an increase in demand for socks. This would shift the demand curve for socks to the right. Conversely, if the price of shoes rises, the demand for socks may decrease, shifting its demand curve to the left. Unrelated If goods are unrelated, a change in Goods the price of one has no effect on the demand for the other. E.g., a price increase in toilet paper will not impact the demand for pencils. Future Price Expectations Expectations about future prices can also shift demand. If consumers anticipate a price increase, they may buy more now, shifting the demand curve to the right. E.g. Rumors of a fuel price increase can lead to a temporary surge in fuel purchases. Conversely, if prices are expected to drop, consumers might delay buying, shifting the demand curve to the left. An example is people waiting for holiday season discounts before purchasing electronics. Tastes and Preferences © Sarrthi IAS 9569093856 Economy Foundation Module 27  Economy Consumer tastes and preferences significantly impact demand. If preferences shift favorably toward a product, demand at all price levels increases, moving the demand curve to the right. E.g., Avacado Conversely, if a product becomes less popular, demand decreases, shifting the curve left. Factors such as marketing, advertising, peer influence, and media can drive these changes. E.g., Telephone E.g., a popular skateboarding event might increase demand for skateboards. Number of Consumers An increase in the number of consumers raises demand, shifting the curve to the right. This is influenced by population growth or demographic changes. For instance, as the population ages in some countries, demand rises for products tailored to older adults, such as mobility aids and senior-targeted vacations. Special Circumstances Changes in factors like seasons, weather conditions, natural disasters, and scientific research findings can lead to a shift in the demand curve. Also, A change in the number of consumers or population shifts the demand curve. Types of Goods A. Based on the Slope of the Demand Curve © Sarrthi IAS 9569093856 Economy Foundation Module 28  Economy Necessary These goods have Goods demand that does not change significantly even when there is a large change in price. Example: Life-saving drugs, essential medicines for addicts, basic water supply, etc. Price Sensitivity: The demand is inelastic, meaning it is relatively unresponsive to price changes. Luxury Goods These goods have demand that is highly sensitive to price changes. A small decrease in price can lead to a significant increase in quantity demanded. Example: High-end accessories (e.g., jewelry, designer watches), luxury cars (e.g., sports cars), expensive wine, high-value estates, etc. Price Sensitivity: The demand is elastic, meaning it responds significantly to price changes. B. Based on the Behavior of Demand with Income Normal Goods Goods that see an increase in quantity demanded when income rises. Example: Food items, clothing, electronics. Inferior Goods Goods that see a decrease in quantity demanded when income increases. As consumers’ incomes rise, they tend to buy less inferior goods, opting for more expensive alternatives instead. Example: Cheap processed foods, public transport (if one can afford a car), discount store items, etc. C. Based on the Relationship of Demand with Other Goods Substitute/Altern Goods that can be used in place of each other. While they may ative Goods not be perfect substitutes, they can replace each other when one is unavailable or becomes too expensive. Example: Tea and coffee, butter and margarine, sugar and jaggery. Price Impact: If the price of one good increases, the demand for the substitute generally increases as well. © Sarrthi IAS 9569093856 Economy Foundation Module 29  Economy Complementary Goods that are consumed together. The demand for one good is Goods directly related to the demand for another. Example: iPad and pencil, tea and biscuits, left and right shoes, mobile phone and charger. Price Impact: If the price of one good increases, the demand for its complementary good usually decreases. For example, an increase in the price of tea may reduce the demand for biscuits that are commonly consumed with it. D. Goods that Deviate from the Law of Demand In certain exceptional circumstances, some goods exhibit demand behaviors that appear to defy the usual economic principle: the Law of Demand, which suggests that demand decreases as price increases. However, certain goods actually see an increase in demand as their prices rise. The curve of these goods will be the Exceptional Demand Curve. Veblen Goods Veblen goods are luxury items that serve as a status symbol. As their price increases, demand for them also increases because they are associated with exclusivity and prestige. Price and Demand Relationship: These goods are often considered desirable because of their high price, rather than despite it. The higher the price, the more they are coveted. Examples: High-end designer jewelry, rare art pieces, luxury cars, and exclusive watches. Behavior: The demand curve for Veblen goods is upward sloping, contrary to the standard downward sloping demand curve. Essentially, when the price of a Veblen good rises, its demand increases, and when the price falls, demand also decreases. Giffen Goods Giffen goods are inferior goods that, under certain circumstances, see an increase in demand as their prices increase. Example: Consider two goods: Potatoes (A) and Eggs (B). If the price of Eggs increases, they become unaffordable for lower-income consumers, who then substitute their consumption with Potatoes, a Giffen good. As the price of Potatoes increases due to © Sarrthi IAS 9569093856 Economy Foundation Module 30  Economy increased demand, the overall quantity demanded also rises because of the substitution effect. Behavior: In contrast to the Law of Demand, the demand for Giffen goods rises when the price increases, primarily due to income effects and consumption substitution. E. Goods Based on Their Position in the Production Process Intermediate These are goods that are used in the production of other goods. Goods They are not ready for final consumption by consumers and will undergo further processing or transformation in the production process. Examples: Raw materials like steel or wheat, components used in manufacturing such as car parts. Final Goods These are goods that are ready for final consumption and have reached their end-use. They are no longer processed or modified in any way, and consumers directly purchase them. Examples: Household products like salt, food items, and finished cars that are sold to customers. Goods Based on Their Role in the Production Process Capital Goods Capital goods are final goods used to produce other goods or services. They are used in the production process rather than consumed by themselves. Examples: Machinery, factory equipment, and tools used in production. Lifecycle: Capital goods have a usable lifetime, and their value depreciates over time through usage. They are essential for sustaining and enhancing production capabilities. Consumer Consumer goods are products that are bought and used by individuals or Goods households for personal use and consumption, rather than for further production. These goods are classified based on their durability, the frequency of use, and how long they last. Consumer goods are typically divided into two main categories: Durable Goods: Durable goods, also known as hard goods, are goods that have a long lifespan and are used over an extended period of time. These goods are typically not purchased frequently, as they last for several years and are more expensive. Examples: Appliances (washing machines, refrigerators), Electronics (televisions, smartphones), Furniture (sofas, tables), Cars and other vehicles Non-Durable Goods: Non-durable goods, also called soft goods, are goods that are consumed or used up quickly and have a short lifespan. These are typically purchased regularly because they need to be replaced frequently. © Sarrthi IAS 9569093856 Economy Foundation Module 31  Economy Examples: Food and beverages, Clothing and shoes, Personal care items (soap, shampoo) and Paper products (toilet paper, tissues) Merit and Demerit Goods Merit Goods Merit goods are those that provide societal benefits and contribute positively to public welfare. Their consumption or production improves the overall well-being of individuals and society. Example: Vaccines, education, and healthcare services. Government Role: Governments often encourage the production and consumption of merit goods because of their positive externalities. Demerit Goods Demerit goods are those that cause harm to individuals or society. Their consumption has negative externalities, such as health problems or environmental degradation. Example: Tobacco products, sugary drinks, and high-end cars that contribute to environmental harm. Government Role: Governments may impose taxes or restrictions on the production and consumption of demerit goods to discourage their use. Goods Based on Market Behavior Private Goods Private goods are goods that are produced and exchanged in the market, where consumers can buy them at market prices. These goods exhibit both rivalry (consumption by one prevents consumption by another) and excludability (others can be excluded from using the good if they do not pay). Examples: Personal items like food, clothing, and cars. Public Goods Public goods are those that, in the event of market failure, are provided by the government because they benefit society as a whole. These goods are non-rivalrous (one person's use does not prevent others from using it) and non-excludable (no one can be excluded from using them). Free Rider Problem: Public goods often face the "free rider" problem, where individuals benefit from the good without paying for it. Because no one can be excluded from their use, there’s little incentive for individuals to pay for them, leading to market failure. Examples: National defense, clean air, public parks, and street lighting. Government Role: Governments step in to provide public goods through taxation, since private markets may fail to supply these goods adequately. © Sarrthi IAS 9569093856 Economy Foundation Module 32  Economy How do economists explain the law of Demand? Income Effect: When the price of a product decreases, consumers experience an increase in their "real income," which is the amount of goods and services their income can buy. This effectively boosts their purchasing power, allowing them to buy more of the product. E.g, If someone buys 14 coffees per week at Rs 200 each, their weekly expense is Rs 2800. If the price drops to Rs 150 per coffee, they save Rs 700, meaning they have more real income. This increase may lead them to buy more coffees, explaining the rise in quantity demanded as the price falls. Substitution Effect: When the price of a product decreases, its value or "utility" per dollar spent improves, making it more appealing compared to other products whose prices remain unchanged. This may lead consumers to substitute this cheaper product for others. E.g, if a coffee provides 10 units of satisfaction (utils) at Rs 200, the satisfaction-to-price ratio is 1 util per Rs 20. If the price drops to Rs 150, the ratio improves to 1 util per Rs 20, making the coffee a better deal. Consequently, consumers may buy more of it due to its improved cost-benefit ratio. Key Assumptions Behind the Theory of Demand Economic models aim to explain consumer behavior by making certain assumptions. In neoclassical theory, several key assumptions are made about how consumers make choices as economic "agents." The standard model assumes that consumers behave rationally, meaning they evaluate all options and choose the one providing maximum satisfaction, or utility. It is further assumed that consumers act solely in their own self-interest and have access to all relevant information, known as the assumption of perfect information. This rational, self-interested consumer with complete information is often referred to as homo economicus, or "rational economic man," who is expected to make logical, utility-maximizing decisions. Behavioral Economics and Realistic Assumptions Behavioral economics, pioneered by Richard Thaler, challenges the idea of homo economicus. Thaler argues that actual consumers, whom he calls "Humans," differ significantly from idealized "Econs" (homo economicus). He highlights these distinctions: Econs are fully rational, have perfect information, can perform complex calculations, and aim to maximize utility in self-interest. They also have consistent preferences over time, no issues with self-control, and make unbiased decisions. Humans, in contrast, have limited rationality (bounded rationality), access incomplete information, and may struggle with complex calculations. They are social beings who consider others in decision-making, change tastes over time, sometimes lack self-control, and may exhibit biases. © Sarrthi IAS 9569093856 Economy Foundation Module 33  Economy Reevaluating Assumptions in the Rational Consumer Model Perfect Information: The standard model assumes consumers have complete, equal access to information about all products. However, in reality, information asymmetries exist, where consumers, producers, and governments possess different levels of information. Additionally, even with abundant information, consumers may struggle with processing it due to cognitive limitations or information overload. This leads to bounded rationality, where decisions are made with limited knowledge and resources. Self-Interest: The assumption that consumers act solely in their own interest is not always valid. Many people make altruistic choices, such as donating to charity, supporting Fairtrade products, or volunteering. This behavior reflects bounded selfishness, indicating that people often act with others’ well-being in mind, challenging the traditional model’s self-interest assumption. Perfect Willpower: The standard model also assumes that consumers always exercise self-control. In reality, people sometimes yield to temptation, which illustrates bounded self-control. This natural tendency to indulge or prioritize immediate satisfaction sometimes overrides rational, long-term decision-making. Movement along the Demand Curve v/s Shift of the Demand Curve Concept Movement Along the Demand Curve Shift of the Demand Curve Cause Change in the price of the good itself Change in non-price determinants (e.g., income, tastes, government policies) Effect on A change in price results in a change in the A change in non-price factors leads to a shift Demand quantity demanded along the existing of the entire demand curve to the left or right curve Example Price of books decreases from p to p', A government subsidy for electric cars leading to an increase in quantity causes the demand curve for electric cars to demanded from q to q' shift right from D to D', increasing demand at every price level Direction Movement along the curve (either upward Shift of the curve (either leftward or of or downward) rightward) Change Price Affects the position on the demand curve, No change in price, but the demand curve Change not its shape itself moves Elasticity of demand Elasticity of demand is a measure of how much the demand for a product changes when there is a change in one of the factors that determine demand. © Sarrthi IAS 9569093856 Economy Foundation Module 34  Economy Price Elasticity of Demand (PED) Price elasticity of demand (PED) is a measure of how responsive the quantity demanded of a product is to a change in its price. In other words, it shows the percentage change in the quantity demanded when the price of the product changes. Formula: The price elasticity of demand can be calculated using the following equation: 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑃𝐸𝐷 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 This formula helps quantify the relationship between price changes and the corresponding changes in demand. A high PED indicates that the quantity demanded is highly sensitive to price changes, while a low PED suggests that demand is less responsive to price fluctuations. Price Elasticity of Demand (PED) and Its Range of Values Price elasticity of demand (PED) measures how much the quantity demanded of a product changes when its price changes. The range of values for PED can theoretically vary from zero to infinity, with practical PED values lying between these extremes. Extreme Values: 1. Perfectly Inelastic Demand (PED = 0): If PED equals zero, a change in the price of the product has no effect on the quantity demanded. Regardless of how much the price changes, the quantity demanded remains constant. A perfectly inelastic demand curve is vertical, indicating no response in demand to price changes. 2. Perfectly Elastic Demand (PED = ∞): If PED equals infinity, a small change in price causes an infinite change in demand. This means that at a specific price, the quantity demanded is infinite, but any increase in price above that level will reduce demand to zero. A perfectly elastic demand curve is horizontal, showing infinite demand at one price but zero demand at any other price. Practical Ranges of PED: © Sarrthi IAS 9569093856 Economy Foundation Module 35  Economy 1. Inelastic Demand (0 < PED < 1): In this case, the quantity demanded responds less than proportionately to a change in price. A price increase will lead to a less than proportional decrease in quantity demanded, resulting in an increase in total revenue for the firm. E.g., If the unit price of curd increases from ₹80 to ₹96, and the quantity demanded falls from 12 tonnes to 10.8 tonnes, the PED is 0.5. In this scenario, total revenue increases from ₹9,60,000 to ₹10,36,800. 2. Elastic Demand (PED > 1): Here, the quantity demanded responds more than proportionately to a price change. If the price increases, the quantity demanded falls by a larger percentage, leading to a decrease in total revenue. E.g., If the price of a burger rises from ₹160 to ₹168, and quantity demanded falls from 200 to 180, the PED is 2. In this case, total revenue decreases from ₹32,000 to ₹30,240. 3. Unit Elastic Demand (PED = 1): For unit elastic demand, a change in price leads to a proportionate change in quantity demanded. When the price increases by a certain percentage, the quantity demanded decreases by the same percentage, leaving total revenue unchanged. The demand curve in this case is a rectangular hyperbola, where the total revenue remains constant regardless of price changes. E.g., If the price increases by 10%, and the quantity demanded decreases by 10%, the PED is 1, and total revenue remains unchanged. What does the value of PED mean? Value (ignoring Meaning Change in Price the negative sign) Inelastic 0 < PED < 1 % Δ in price < % Δ Price ↑ TR ↑ in Qd Inelastic 0 < PED < 1 % Δ in price < % Δ Price ↓ TR ↓ in Qd Elastic 1 < PED < ∞ % Δ in price > % Δ Price ↑ TR ↓ in Qd Elastic 1 < PED < ∞ % Δ in price > % Δ Price ↓ TR ↑ in Qd Unity PED = 1 % Δ in price = % Δ Price ↑ No change in TR in Qd © Sarrthi IAS 9569093856 Economy Foundation Module 36  Economy Unity PED = 1 % Δ in price = % Δ Price ↓ No change in TR in Qd Determinants of Price Elasticity of Demand (PED) The price elasticity of demand (PED) varies for different products, influenced by several factors: The Number and Closeness of Substitutes: The more substitutes available, the more elastic the demand. Closer substitutes make demand more elastic. ○ Elastic Example: Ghee brands—If the price of one brand increases, consumers can easily switch to other brands of ghee or butter. ○ Inelastic Example: Petrol—Few substitutes for petrol for vehicles, making demand relatively inelastic even with price increases. Necessity of the Product and How Widely It Is Defined: Necessities tend to have inelastic demand, while more specific products may have elastic demand. ○ Inelastic Example: Rice is a staple food in India, so its demand is inelastic. ○ Elastic Example: Specific types of meat (like chicken or mutton)—Demand for meat varies based on price and regional preferences, so consumers may switch from one type to another more easily. Proportion of Income Spent on the Good: If a good constitutes a small portion of income, demand tends to be inelastic. ○ Example: Tea or coffee—For an average household, a small price increase (e.g., from ₹10 to ₹12 per cup) would likely have little effect on demand, as it forms a small part of the budget. Time Period Considered: Demand is more inelastic in the short term and more elastic in the long term as consumers adjust. ○ Example: Cooking Gas (LPG)—Short-term demand for LPG remains inelastic since it is essential for daily cooking, but over time, if prices rise, people may look for alternatives like biogas or switch to electric cooking. Difference in elasticities of Primary Commodities and Manufactured Products Aspect Primary Commodities Manufactured Products Nature of Inelastic Elastic Demand Main Manufacturing industries Everyday households Consumers Reason for Few or no substitutes; necessity for Many substitutes available; product Inelasticity/ production differentiation Elasticity © Sarrthi IAS 9569093856 Economy Foundation Module 37  Economy Example Raw coffee beans: coffee processing Branded vacuum cleaners: consumers can companies must continue buying switch brands if prices rise for one brand despite price changes Effect of Price Small proportional decrease in Significant decrease in quantity demanded Increase quantity demanded as consumers switch to substitutes Effect of Price Minimal increase in quantity Potential significant increase in quantity Decrease demanded; limited by production demanded due to consumer options targets Applications of Price Elasticity of Demand Firms: Understanding the elasticity of demand is valuable for maximizing revenue (and potentially profit). Consumer Responsiveness: Firms benefit by knowing how responsive their consumers are to price changes. This helps in setting prices strategically. ○ Elastic Demand: If a firm knows demand for its product is highly elastic, it may choose to lower prices to attract new customers, increasing sales volume and, potentially, revenue. ○ Inelastic Demand: Conversely, if demand is highly inelastic, a firm may raise prices, as this won’t result in a significant loss of customers. This approach can lead to higher revenues without much reduction in sales. For governments aiming to maximize tax revenue, understanding consumer responses to taxes on specific goods is essential. Consumer Response: The government needs to anticipate how consumers will react to price changes caused by taxes on different goods. ○ Elastic Demand: If a good has elastic demand (like restaurant meals), a tax increase may not generate much revenue since demand will drop sharply as the price rises. ○ Inelastic Demand: Conversely, a tax on a good with inelastic demand (such as cigarettes) is likely to raise significant revenue, as most consumers will continue purchasing it despite the higher price, thus paying the tax. © Sarrthi IAS 9569093856 Economy Foundation Module 38  Economy Income Elasticity of Demand (YED) Income Elasticity of Demand (YED) measures how much the demand for a product changes when a consumer's income changes. It is calculated using the following formula: 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 YED = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒​ Range of YED Values Positive YED (Normal Goods): For normal goods, the demand rises as income rises, resulting in a positive YED value. ○ If YED > 1, demand is income-elastic (demand changes more than income). ○ If YED between 0 and 1, demand is income-inelastic (demand changes less than income). ○ Necessity goods (e.g., bread) tend to have low income elasticity; their demand doesn’t increase much as income rises. Negative YED (Inferior Goods): For inferior goods, the demand decreases as income rises, so the YED is negative. Example: As income rises, people may switch from purchasing inexpensive jeans to branded jeans, causing the demand for cheaper jeans to fall. Examples: Income-elastic Goods: ○ International holidays—As income rises, demand for vacations abroad increases significantly. ○ Luxury cars—As consumer income grows, more people may opt for premium cars, increasing their demand. Income-inelastic Goods: ○ Rice or wheat—Demand for basic food items changes little even as income increases. ○ Public transportation—Demand remains relatively stable, even if income increases, as it is a necessity for many. Inferior Goods: ○ Cheap clothing brands—As income rises, people may switch to buying higher-end brands, reducing demand for inexpensive alternatives. Engel Curve © Sarrthi IAS 9569093856 Economy Foundation Module 39  Economy The Engel Curve illustrates the relationship between income and the demand for a good over time. For example, as income rises in a country, the demand for staples like potatoes may initially increase, stabilize, and eventually decline as consumers opt for superior goods, like pasta, as their standard of living improves. Importance of Income Elasticity of Demand (YED) 1. Strategic Decision Making by Firms Market Entry and Product Strategy: Firms utilize knowledge of YED to decide which markets to enter and which products to offer. Products with high YED experience substantial demand increases as consumer incomes rise, signaling potential rapid market growth. Example: In the smartphone industry, rising income levels in a country often lead to a disproportionately larger increase in demand for smartphones. Companies capitalize on this by expanding sales in economies experiencing significant income growth. Product Diversification: Firms often produce different versions of a product to target consumers across various income levels. This flexibility allows them to adjust their production strategies based on anticipated changes in consumer income. Adapting to Economic Conditions: If a country is projected to enter a recession, firms may shift their focus to producing more inferior goods, which have higher demand when incomes decrease. 2. Explaining Sectoral Shifts in the Economy Economic Sectors Overview: ○ Primary Sector: Encompasses industries such as agriculture, fishing, forestry, and mining, producing raw materials. ○ Secondary Sector (Manufacturing): Includes industries that convert raw materials into consumer and producer goods, along with the construction industry. ○ Tertiary Sector (Services): Provides intangible goods and serv