E-LESSON-6 MICRO ECONOMICS-5 ENG

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B.A.English 2 All right are reserved with CU-IDOL Microeconomics-I Course Code: BAQ108 Semester: First e-Lesson: SLM Unit: 6 6 www.cuidol.in Unit-6(BAQ108)

MICRO ECONOMICS 33 OBJECTIVES INTRODUCTION Student will be able to define law of demand and In this unit we are going to elasticity of demand. learn about Demand Analysis. Students will be able to Identify the factors Under this you will be able to affecting demand elasticity understand the law of demand and elasticity of Demand. Discuss the concept of cross elasticity of demand . Students will be able to explain the law of Students will be able to supply. understand the law of supply . www.cuidol.in Unit-6(BAQ108) INSTITUTE OF DISTANACEll ArNigDhtOaNrLeINreEsLeErAvRedNIwNiGth CU-IDOL

TOPICS TO BE COVERED 4 Law of Demand. Elasticity of Demand Methods of Measuring Elasticity. Importance of Elasticity Law of Supply. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

WHAT IS DEMAND??? 5 Demand refers to the quantity of the commodity which the consumer is willing to buy at a particular price during a particular time period. • Desire to have a Rolex, but do not have enough money – wishful thinking • In spite of having the money you do not want to spend on Rolex – Want • Your desire to have a Rolex with the ability and willingness to pay for it combined together will be - Demand www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

WHAT IS DEMAND??? 6 Demand for a commodity refers to the quantity of the commodity which an individual household is willing and able to purchase per unit of time at a particular price. Demand for a commodity implies: 1. Desire to acquire it, 2. Willingness to pay for it, 3. Ability to pay for it. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

FACTORS DETERMINING 7 DEMAND & DEMAND FUNCTION • Dx = f (Px, PR,Y, T, E) Dx = Demand for commodity X Px = Price of commodity X PR= Price of related goods (Substitute and Complementary) Y = Income of the consumers T = Taste and preference E = Expectations of the buyers www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

The impact of these determinants 8 on demand is:  Price effect on demand: Demand for x is inversely related to its own price.  Substitution effect on demand: If y is a substitute of x, then as price of y increases, demand for x also increases. For example, tea and coffee, cold drinks and juice etc. are substitutes.  Complementary effect on demand: If z is a complement of x, then as the price of z falls, the demand for z goes up and thus the demand for x also tends to rise. For example, ink and pen, bread and butter etc. are complements  Price expectation effect on demand: Here the relation may not be defi nite as the psychology of the consumer comes into play. Your expectations of a price increase might be different from your friends’.  Income effect on demand: As income rises, consumers buy more of normal goods (positive effect) and less of inferior goods (negative effect). Examples of normal goods are t-shirts, tea, sugar, noodles, watches etc. and examples of inferior goods are low quality rice, jowar, second hand goods etc.  Promotional effect on demand: Advertisement increases the sale of a fi rm up to a point www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

DEMAND AND PRICES OF 9 OTHER GOODS Substitute Goods: These are those goods Complementary Goods: They are those goods which are an alternative to one another in which are jointly used or consumed together to consumption eg. Tea or coffee, Pepsi or Coca satisfy a want eg. Tea and sugar, bread and cola butter, A fall in the price of substitute good say Y, leads A fall in the price of complementary good say Y, to a fall in the quantity demanded of good X leads to a rise in the quantity demanded of good and vice versa X and vice versa Demand and Income of the consumer If X is a Normal Good, then with the increase in the income, consumer buys more of the good. It has positive income effect. If X is an Inferior Good, then with the increase n the income, consumer buys less of the good. Eg. Coarse Grains. It has negative income effect. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

The Law of Demand 10  The law of demand expresses a relationship between the quantity demanded and its price. It may be defined in Marshall’s words as “the amount demanded increases with a fall in price, and diminishes with a rise in price.” Thus it expresses an inverse relation between price and demand.  The law refers to the direction in which quantity demanded changes with a change in price. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

LAW OF DEMAND 11 There is an inverse relationship between the price of a commodity and the quantity demanded of that commodity. Dx = f (Px) where, Dx = quantity demanded of good X Px = price of the good X As the price of a good rises, the quantity demanded of the good falls, and as the price of a good falls, the quantity demanded of the good rises. Price Quantity www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

ASSUMPTIONS OF 12 THE LAW OF DEMAND  Price of related goods is constant  The income of the consumers remain unchanged.  Consumers tastes and preferences remains same.  Expectations of the customers is constant  Number of population remains same.  All the units of the goods are homogenous.  Commodity should be normal good. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

DEMAND CURVE 13 Downward Slopping Demand Curve It’s a graphical representation of the demand schedule showing the different quantities of a good that the consumers are willing to pay at different levels of prices during a given period of time. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

Law of Diminishing Marginal 14 Utility According to this law, when a consumer buys more units of a commodity, the marginal utility of that commodity continues to decline. Therefore, the consumer will buy more units of that commodity only when its price falls. When less units are available, utility will be high and the consumer will be prepared to pay more for the commodity. This proves that the demand will be more at a lower price and it will be less at a higher price. That is why the demand curve is downward sloping. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

WHY DEMAND CURVE ALWAYS 15 SLOPES DOWNWARDS? New Consumers Creating Demand As price of a commodity falls, a new consumer class appears who can now afford the good. Thus, the demand increases. Different Uses With the fall in the price of a good, it is put to various uses and demand for that commodity increases and vice versa. Eg. Milk can be used for making butter, cheese, curd and drinking purposes etc. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

EXCEPTIONS TO 16 THE LAW OF DEMAND  Expectation of price rise in future If the price of a commodity rises and the consumer expects further rise in price, it leads to an increase in the demand for that commodity and vice versa. Eg. Shares.  Demonstration Effect: If people are buying the goods by imitating the consumption pattern of the higher income group – the demand will be higher even at higher price.  Emergency In case of emergency like war, drought or famine, the law of demand does not hold. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

ELASTICITY OF DEMAND 17  “Elasticity” is a standard measure of the degree of responsiveness (or sensitivity) of one variable to changes in another variable.  Elasticity of Demand measures the degree of responsiveness of demand for a commodity to a given change in any of the independent variables that influence demand for that commodity, such as price of the commodity, price of the other commodities, income, taste, preferences of the consumer and other factors.  Responsiveness implies the proportion by which the quantity demanded of a commodity changes, in response to a given change in any of its determinants . www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

ELASTICITY OF DEMAND 18  Mathematically, it is the percentage change in quantity demanded of a commodity to a percentage change in any of the (independent) variables that determine demand for the commodity.  Four major types of elasticity:  Price elasticity,  Income elasticity,  Cross elasticity  Advertising (or promotional) elasticity.  In order to assess the impact of one variable on demand, we assume other variables as constant (ceteris paribus) www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

PRICE ELASTICITY OF 19 DEMAND  Price is most important among all the independent variables that affect the demand for any commodity.  Hence Price elasticity of demand ( “ep” or “e”) is considered to be the most important of all types of elasticity of demand.  Price elasticity of demand means the sensitivity of quantity demanded of a commodity to a given change in its own price. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

DEGREES OF PRICE ELASTICITY 20 Perfectly elastic demand Price Q1 Q1 D Quantity • ep=∞ (in absolute terms). P • Unlimited quantities of the commodity can be sold at the O prevailing price • A negligible increase in price would result in zero quantity demanded • Horizontal demand curve Perfectly inelastic demand D • The other extreme of the elasticity range Price • ep=0 (in absolute terms) P1 • Quantity demanded of a commodity remains the same, P2 irrespective of any change in the price O Quantity • Such goods are termed neutral Q1 • Vertical demand curve www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

DEGREES OF PRICE ELASTICITY 21 Highly elastic demand Price D D • Proportionate change in quantity demanded is more than P1 Q1 Q2 Quantity a given change in price P2 D D • ep >1 (in absolute terms) O Q1 Q2 Quantity • Such goods are called luxuries Price D Quantity Unitary elastic demand P1 D P2 Q1 Q2 • Proportionate change in price brings about an equal proportionate change in quantity demanded O Price • ep =1 (in absolute terms). • Demand curves are shaped like a rectangular hyperbola, P1 P2 asymptotic to the axes O Relatively inelastic demand • Proportionate change in quantity demanded is less than a proportionate change in price • ep <1 (in absolute terms) • Such goods are called necessities www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

METHODS OF MEASURING 22 ELASTICITY • Ratio (or Percentage) Method  The most popular method used to measure elasticity  Elasticity of demand is expressed as the ratio of proportionate change in quantity demanded and proportionate change in the price of the commodity  It allows comparison of changes in two qualitatively different variables  It helps in deciding how big a change in price or quantity is ep = Proportionate change in quantity demanded of commodityX Proportionate change in price of commodityX ep= Q2  Q1 / Q1 P2  P1 / P1 • where Q1= original quantity demanded, Q2= new quantity demanded, P1= original price level, P2= new price level www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

POINT ELASTICITY METHOD 23  Elasticity measured at a point of demand curve is referred as point elasticity of demand.  For nonlinear demand curve we need to apply calculus to calculate point elasticity.  Point elasticity can be expressed as:  ep = dQ / Q = dQ . P dP/ P dP Q www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

ARC ELASTICITY METHOD 24  Used when the available figures on price and quantity are discrete, and it is possible to isolate and calculate the incremental changes.  It is used to find the elasticity at the midpoint of an arc between any two points on a demand curve, by taking the average of the prices and quantities.  This method finds wider applications, as it reflects a movement along a portion (arc) of a demand curve ep = Q2  Q1 / P2  P1 = (Q1  Q2 ) / 2 (P1  P2 ) / 2 Q2  Q1 . P1  P2 Q1  Q2 P2  P1 www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

TOTAL OUTLAY METHOD (MARSHALL) 25  Elasticity is measured by comparing expenditure levels before and after any change in price, i.e. whether the new expenditure is more than, or less than, or equal to the initial expenditure level.  Helps a seller in taking a decision to raise price only if:  Reduction in quantity demanded does not reduce total revenue or  Reduction in price increases the quantity demanded to the extent that total revenue also increases.  Degrees  When demand is elastic, a decrease in price will result in an increase in the revenue (sales).  When demand is inelastic, a decrease in price will result in a decrease in the revenue (sales).  When demand is unit-elastic, an increase (or a decrease) in price will not change the revenue (sales) www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

DETERMINANTS OF PRICE 26 ELASTICITY OF DEMAND  Nature of commodity -Necessities are relatively price inelastic, while luxuries are relatively price elastic  Availability and proximity of substitutes -Price elasticity of demand of a brand of a product would be quite high, given availability of other substitute brands  Alternative uses of the commodity-If a commodity can be put to more than one use, it would be relatively price elastic.  Proportion of income spent on the commodity- The greater the proportion of income spent on a commodity, the more sensitive would the commodity be to price  Time- Demand for any commodity is more price elastic in the long run  Durability of the commodity- Perishable commodities like eatables are relatively price inelastic in comparison to durable items  Items of addiction- Items of intoxication and addiction are relatively price inelastic. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

REVENUE AND PRICE 27 ELASTICITY OF DEMAND  For relatively inelastic demand, a change in price would have a greater effect on revenue than a change in quantity demanded  AR is same as the price of the product  Demand curve is also the AR curve of the firm.  Marginal Revenue is the revenue a firm gains in producing one additional unit of a commodity www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

REVENUE AND PRICE 28 ELASTICITY OF DEMAND  Till ep>1 MR is positive and TR Price, is rising Revenue ep=∞  At the midpoint of the demand ep>1 curve, ep=1 and MR is equal to ep=1 0 and TR is at its peak ep<1  When ep<1, MR is negative  MR= AR[1- ep] O MR ep=0 Quantity Price, Revenue www.cuidol.in Unit-6(BAQ108) O TR Quantity All right are reserved with CU-IDOL

INCOME ELASTICITY OF 29 DEMAND (EY) • ey measures the degree of responsiveness of demand for a good to a given change in income, ceteris paribus. Proportionate change in quantity demanded of commodityX ey = Proportionate change in income of consumer • Degrees: • Positive income elasticity • Demand rises as income rises and vice versa • Normal good • Negative income elasticity • Demand falls as income rises and vice versa • Inferior good www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

CROSS ELASTICITY OF DEMAND 30  ec measures the responsiveness of demand of one good to changes in the price of a related good ec = Proportionate change in quantity demanded of commodityX Proportionate change in price of commodityY  Degrees  Negative Cross Elasticity  Complementary goods  Positive Cross Elasticity  Substitute goods www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

PROMOTIONAL ELASTICITY OF 31 DEMAND  iAndcvuerrritnisginagn(o“er xppreonmdoittuiornea” l)onelaasdtviceitrytisoinf gd,evmisa-nàd-v(iseaa) nmienacsreuaresse the effect of in demand, ceteris paribus.  Some goods (like consumer goods) are more responsive to advertising than others (like heavy capital equipments). ea = Proportionate change in quantity demanded (or sales)of commodityX Proportionate change in advertising expenditure  Degrees  ea>1  Firm should go for heavy expenditure on advertisement.  ea <1  Firm should not spend too much on advertisement www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

IMPORTANCE OF ELASTICITY 32  Determination of price  Elasticity is the basis of determining the price of a product keeping its possible effects on the demand of the product in perspective  Basis of price discrimination  Products having elastic demand may be sold at lower price, while those having inelastic demand may be sold at high prices  Determination of rewards of factors of production  Factors having inelastic demand are rewarded more than factors that have relatively elastic demand.  Government policies of taxation  Goods having relatively elastic demand are taxed less than those having relatively inelastic demand. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

Meaning of Supply 33  In economics, supply during a given period of time means the quantities of goods which are offered for sale at particular prices.  Thus, the supply of a commodity may be defined as the amount of that commodity which the sellers (or producers) are able and willing to offer for sale at a .particular price during a certain period of time www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

The Law of Supply 34 The law states that the supply of a commodity expands (i.e., rises) with a rise in its price, and contracts (i.e., falls) with a fall in its price. The law, thus, suggests that the supply varies directly with the changes in price. So, a larger amount is supplied at a higher price than at a lower price in the market. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

Assumptions Underlying the 35 Law of Supply The law of supply is conditional, since we have stated it under the assumption: “other things remaining unchanged.” It is based on the following ceteris paribus assumptions:  Cost of Production is Unchanged. It is assumed that the price of the product changes, but there is no change in the cost of production. If the cost of production increases along with the rise in the price of product, the sellers will not find it worthwhile to produce more and supply more. Therefore, the law of supply is valid only if the cost of production remains constant. It implies that the factor prices, such as wages, interest, rent, etc., are also unchanged.  No Change in Technique of Production. The technique of production is assumed to be unchanged. This is essential for the cost to remain unchanged. With the improvement in technique, if cost of production is reduced, the seller would supply more even at fallingprices.  Fixed Scale of Production. During a given period of time, it is assumed that the scale of production is held constant. If there is a change in scale of production, the level of supply will change, irrespective of the changes in the price of the product. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

Assumptions Underlying the 36 Law of Supply  Government Policies are Unchanged. Government policies like taxation policy, trade policy, etc., are assumed to be constant. For instance, an increase in or totally fresh levy of excise duties would imply an increase in the cost or in case there is fixation of quotas for the raw materials or imported components for a product, then such a situation will not permit the expansion of supply with a rise in prices.  No Change in Transport Costs. It is assumed that the transport facilities and transport costs are unchanged. Otherwise, a reduction in transport cost implies lowering of cost of production, so that more would be supplied even at a lower price.  No Speculation. The law also assumes that the sellers do not speculate about the future changes in the price of the product. If, however, sellers expect prices to rise further in future, they may not expand supply with the present price rise.  The Prices of Other Goods are Held Constant. The law assumes that there are no changes in the prices of other products. If the price of some other product rises faster than that of the given product in consideration, producers might transfer their resources to the other product – which is more profit yielding due to rising prices. Under this situation, more of the product in consideration may not be supplied, despite the rising prices www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

Multiple Choice Questions 37 1. The law of demand states that an increase in the price of a good: A)Increases the supply of that good. B)Decreases the quantity demanded for that good. C) Increases the quantity supplied of that good. D) None of these answers. 2. Demand for a product should have the following pre-requisite A) Ability to buy B) Willingness C) Need D). All of these 3. A single point on the demand curve shows A) Demand and supply relationship B) Price and supply relationship C). Price and demand relationship D) None of these 4. The price elasticity of demand measures how much the quantity demanded responds to or change in: A)Income B) Price C)Taste D) Place Answers: 1.B) 2.A) 3.C) 4.B) www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

SUMMARY 38  Demand for any commodity implies: desire to acquire it, willingness to pay for it, ability to pay for it and at a particular time.  Law of Demand:- there is an inverse relationship between the price of a commodity and the quantity demanded (other things remaining equal)  Changing demand curve-A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve.  Elasticity of Demand measures the degree of responsiveness of demand for a commodity to a given change in any of the independent variables that influence demand for that commodity, such as price of the commodity, price of the other commodities, income, taste, preferences of the consumer and other factors.  Law of Supply -The law states that the supply of a commodity expands (i.e., rises) with a rise in its price, and contracts (i.e., falls) with a fall in its price www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

Frequently Asked Questions 39 Q.1 Define law of demand? Ans:-The law states that other things being equal the quantity demanded varies inversely with price. Lower the price, greater is the effective demand; higher the price; lesser is the effective demand. Q2. Why does Demand Curve Slope Downward? Ans:- Price has an inverse relationship with demand leads the demand curve to slope downwards. Q.3 What is meant by cross elasticity of Demand ? Ans :The cross elasticity of demand is a numerical measure of the degree to which quantity demanded of a good responds to changes in the prices of other commodities, the other determinants of demand being kept constant. Q4. Define Law of supply? Ans: The law states that the supply of a commodity expands (i.e., rises) with a rise in its price, and contracts (i.e., falls) with a fall in its price www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

REFERENCES 40 1. Ahuja, H.L.(1999). Advanced Economic Theory. New Delhi: S.Chand&Co. 2. Chopra,P.N.(1998). Micro Economic Theory and Welfare Economics. New Delhi: Kalyani Publishers. 3. Chopra,P.N.(2006). Advanced Economic Theory. New Delhi: Kalyani Publishers. 4. Lekhi, R.K., Walia, H.S. & Talwar,S.J.(2003).Micro Economics. New Delhi: Kalyani Publishers. 5. Lipsey,R.G. & Chrystal, K.A.(2004). Economics. New Delhi: Oxford University Press. 6. Mandal,R.K.(2007). Micro Economics Theory. New Delhi: Atlantic Publishers. 7. Ray, N.C.(1980). An introduction to Micro Economics. New Delhi: The Macmillan Company of India. 8. Salvatore,D. (2003). Micro Economics: Theory & Applications. New York: Oxford University Press. 9. Singh,M. (1971). MangSidhant Ate Mishrat Arth-VivsthaVich Arthik Ganana. Patiala: Punjabi University. 10. Vohra, P.& Mehta,R. (2007). Micro Economics. New Delhi: Commonwealth Publishers. www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL

41 THANK YOU For queries Email: [email protected] www.cuidol.in Unit-6(BAQ108) All right are reserved with CU-IDOL