B-COM Part 1 Economics

PRINCIPLES OF ECONOMICS: MICRO ECONOMICS COMPILED BY SIR KHALID AZIZ
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Micro and Macro Analysis:
In recent years, the subject matter of economics is divided into two broad areas. One of them is
called Microeconomics and the other is called Macroeconomics. These two terms
microeconomics and macroeconomics were first coined and used by Ranger Frisco in 1933. In
recent years, division of economic theory into two separate parts has gained much importance.
Distinction/Difference between Micro and Macro Economics:
The distinction/difference between Micro and Macro economics is made clear below:
(1) Microeconomics:
Definition:
Microeconomics is a Greek word which means small.
"Microeconomics is the study of specific individual units; particular firms, particular households,
individual prices, wages, individual industries particular commodities. The microeconomic
theory or price theory thus is the study of individual parts of the economy".
It is economic theory in a microscope. For instance, in microeconomic analysis we study the
demand of an individual consumer for a good and from there we go to derive the market demand
for a good (that is demand of a group of individuals for a good). Similarly, in microeconomic
theory we study the behavior of individual firms the fixation of prices output. In the words
of Samuelson:
“Microeconomics we examine among other things how individual prices are set, consider what
determines the price of land and capital and enquire into the strength and weaknesses of market
mechanics”.
In the words of Left witch:
“Microeconomic theory or price theory deals with the economic behavior of individual decision
making units such as consumers, resources owners, business firms as well as individuals who are
too small to have an impact on the national economy".
Explanation:
(i) Microeconomics and allocation of resources. The microeconomic theory takes the total
quantity of resources as given. It seeks to explain how they are allocated to the production of
goods. The allocation of resources to the production of goods depends upon the price of various
goods and the prices of factors of production. Microeconomics analyses how the relative prices
of goods and factors are determined. Thus the theory of product pricing and the theory of factor
pricing (rent wages, interest and profit) fall within the domain of micro economics.
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(ii) Micro economics and economic efficiency. The microeconomic theory seeks to explain
whether the problems of scarcity and allocation of resources so determined are efficient.
Economic efficiency involves (a) efficiency in consumption (b) efficiency in production and
distribution and (c) over all economic efficiency. The price theory shows under hat conditions
these efficiencies are achieved.
Importance:
Before Keynesian revolution, the body of economics mainly consisted of micro economics. The
classical economics as well as the neo-classical
economics belonged to the domain of micro economics.
The importance and uses of micro economics in brief are as under.
(i) Helpful in understanding the working of private enterprise economy. The micro
economics helps us to understand the working of free market economy. It tells us as to how the
prices of the products and the factors of production are determined.
(ii) Helps in knowing the conditions of efficiency. Micro economics help in explaining the
conditions of efficiency in consumption, production and in distribution of the rewards of factors
of production.
(iii) Working economy without central control. The micro economics reveals how a free
enterprise economy functions without any central control.
(iv) Study of welfare economy. Micro economic involves the study of welfare economics.
Limitations:
Microeconomics despite its many advantages is not free from limitations. They in brief are:
(i) Assumption of full employment in the economy which is unrealistic.
(ii) Assumption of liaises fair policy which is no longer in practice in any country of the world.
(iii) It studies part of the economy and not the whole.
Summing up, microeconomics is the study of the decisions people and businesses and the
interaction of those decisions in the market. It analyses the ‘trees’ of the economy as distinct
from the ‘forest’.
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(2) Macroeconomics:
Definition:
The term macro is derived from the Greek word ‘uakpo’ which means large. Macroeconomics,
the other half of economics, is the study of the behavior of the economy as a whole. In other
words:
"Macroeconomics deals with total or big aggregates such as national income, output and
employment, total consumption, aggregate saving and aggregate investment and the general level
of prices". In the words of Boulding:
“Macroeconomics deals not with individual quantities as such but with aggregates of these
quantities, not with individual i.e., but with the national Income, not with individual prices but
with the price level, not with Individual outputs but with the national output. It studies
determination of national output and its growth overtime. It also studies the problems of
recession, unemployment inflation, the balance of international payments and the policies
adopted by the governments to deal with these problems".
Explanation:
The main issues which are addressed in macro economics are in brief as under:
(i) It helps understanding determination of income and employment. Late J.M. Keynes laid
great stress on macro-economic analysis. In his revolutionary book, “General Theory,
Employment interest and Money" brought drastic changes in economic thinking. He explained
the forces or factors which determine the level of aggregate employment and output in the
economy.
(ii) Determination of general level of prices. Macro economic analysis answers questions as to
how the general price level is determined and what is the importance of various factors which
influence general price level.
(iii) Economic growth. The macro-economic models help us to formulate economic policies for
achieving long run economic growth with stability. The new developed growth theories explain
the causes of poverty in under developed countries and suggest remedies to overcome them.
(iv) Macro economics and business cycles. It is in terms of macroeconomics that causes of
fluctuations in the national income are analyzed. It has also been possible now to formulate
policies for controlling business cycles i.e. inflation and deflation.
(v) International trade. Another important subject of macro-economics is to analyze the various
aspects of international trade in goods, services and balance of payment problems, the effect of
exchange rate on balance of payment etc.
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(vi) Income shares from the national income. Mr. M. Kalecki and Nicholas Kelder, by making
departure from Ricarde theory, have presented a macro theory of distribution of income.
According to these economists, the relative shares of wages and profits depend upon the ratio of
investment to national income.
(vii) Unemployment. Another macro economic issue is to explain the causes of unemployment
in the economy. Stagflation is another important issue of modern, economics. The Keynesian and
post Keynesian economists are putting lot of efforts in explaining the causes of cyclical
unemployment and high unemployment coupled with inflation and suggesting remedies to
counteract them.
(viii) Macro Economic Policies. Fiscal and monetary policies affect the performance of the
economy. These two major types’ policies are central in macro economic analysis of the
economy.
(ix) Global Economic System. In macro economic analysis, it is emphasized that a nation’s
economy is a part of a global economic system. A good or weak performance of a nation’s
economy can affect the performance of the world economy as a whole.
Limitations:
The main limitations of macro economics are as follows:
(i) The macro economies ignore the welfare of the individual. For instance, if national saving is
increased at the cost of individual welfare, it is not considered a wise policy.
(ii) The macro economics analysis regards aggregates as homogeneous but does not look into its
internal composition. For instance, if the wages of the clerks fall and the wages of the teachers
rise, the average wage may remain the same.
(iii) It is not necessary that all aggregate variables are important. For instance, national income is
the total of individual incomes. If national income in the country goes up, it is not necessary that
the income of all the individuals in the country will also rise. There is a possibility that the rise in
national income may be due to the increase in the incomes of a few rich families of the country.
Interdependence of Micro and Macro Economics:
The classical approach to macro economics is that individuals and firms act in their own best
interest. The wages and prices adjust quickly to achieve equilibrium in the free market economy.
The Keynesian approach to macro economics is that wages and prices do not adjust rapidly and
unemployment may remain high for a long time. The Keynesians are of the view that
government intervention in the economy can help in improving economic performance.
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Conclusion:
The micro and macro economics are interdependent. They are complementary and not
conflicting. We cannot put them in water tight compartments. Both these approaches help us in
analyzing the working of the economy. If we study one approach and neglect the other, we are
considered to be only half educated.
We should integrate the two approaches for the successful analysis of the working of economic
system. The macro approach should be applied where aggregate entities are involved and micro
approach when individual cases are to be examined. If we ignore one and lay emphasis on the
other, it will lead to wrong or inadequate conclusions.
Cardinal Utility Approach:
According to this approach, the utility is measurable and can be expressed in quantitative terms.
Cardinal utility approach is also known as classical approach because it was presented by
classical economists.
Concepts of Utility:
Following are important concepts of utility:
Utility:
The characteristics of a commodity or service is to satisfy a human want. The amount of
satisfaction a person derives from some commodity or service, is called utility.
Total Utility:
The amount of satisfaction a person derives from some commodity or service over a period of
time, is called utility. In other words, it is the sum of marginal utilities obtained from
consumption of each successive unit of a commodity or service. If continuous units of a
commodity 'X' are consumed, then TUx = ∑ MUx
Marginal Utility:
The extra amount of satisfaction to be obtained from having an additional increment of a
commodity or service. In brief, the change in total utility resulting from one unit change in the
consumption of a commodity or service per unit of time is called marginal utility. The following
formula may be used to measure it.
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Marginal utility = Change in total utility / Change in quantity consumed
or
MU = ∆TU / ∆Q
or
MU = d TU / d Q
Initial Utility:
The amount of satisfaction to be obtained from the consumption of very first unit of a
commodity or service is called the initial utility e.g. the amount of satisfaction to be obtained
from consumption of the first apple is units. It is called initial utility of the consumer.
Positive Utility:
When a consumer consumes successive units of a commodity or service, its marginal utility
decreases. The utility obtained from the consumption of all the units of a commodity or service
before reaching the marginal utility equal to zero, is called positive utility.
Saturation Point:
By the consumption of that unit of a commodity where the marginal utility drops down to zero, is
called the saturation point.
Negative Utility:
By using the next unit of a commodity after saturation point, that unit gives negative satisfaction
to the consumer and marginal utility becomes negative, it is known as negative utility.
Util:
Although utility cannot be measured but in cardinal approach of consumer behavior, the term
which is used as a unit of utility is known as util and arithmetic numbers (1, 2, 3, .......) are used.
For example X ate an apple and got 10 util of utility.
Law of Diminishing Marginal Utility:
Definition of the Law:
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"Other things remaining the same when a person takes successive units of a commodity, the
marginal utility diminishes constantly".
The marginal utility of a commodity diminishes at the consumer gets larger quantities of it.
Marginal utility is the change in the total utility resulting from one unit change in the
consumption of a commodity per unit of time.
Assumptions:
Following are the assumptions of the law of diminishing marginal utility.
1. The utility is measurable and a person can express the utility derived from a commodity
in qualitative terms such as 2 units, 4 units and 7 units etc.
2. A rational consumer aims at the maximization of his utility.
3. It is necessary that a standard unit of measurement is constant
4. A commodity is being taken continuously. Any gap between the consumption of a
commodity should be suitable.
5. There should be proper units of a good consumed by the consumer.
6. It is assumed that various units of commodity homogeneous in characteristics.
7. The taste of the consumer remains same during the consumption o the successive units of
commodity.
8. Income of the consumer remains constant during the operation of the law of diminishing
marginal utility.
9. It is assumed that the commodity is divisible.
10. There should be not change in fashion. For example, if there is a fashion of lifted shirts,
then the consumer may have no utility in open shirts.
11. It is assumed that the prices of the substitutes do not change. For example, the demand
for CNG increases due to rise in the prices of petroleum and these price changes effect
the utility of CNG.
Explanation With Schedule and Diagram:
We assume that a man is very thirsty. He takes the glasses of water successively. The marginal
utility of the successive glasses of water decreases, ultimately, he reaches the point of satiety.
After this point the marginal utility becomes negative, if he is forced further to take a glass of
water. The behavior of the consumer is indicated in the following schedule:
Units of commodity Marginal utility Total utility
1st glass 10 10
2nd glass 8 18
3rd glass 6 24
4th glass 4 28
5th glass 2 30
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6th glass 0 30
7th glass -2 28
On taking the 1st glass of water, the consumer gets 10 units of utility, because he is very thirsty.
When he takes 2nd glass of water, his marginal utility goes down to 8 units because his thirst has
been partly satisfied. This process continues until the marginal utility drops down to zero which
is the saturation point. By taking the seventh glass of water, the marginal utility becomes
negative because the thirst of the consumer has already been fully satisfied.
The law of diminishing marginal utility can be explained by the following diagram drawn with
the help of above schedule:
In the above figure, the marginal utility of different glasses of water is measured on the y-axis
and the units (glasses of water) on X-axis. With the help of the schedule, the points A, B, C, D,
E, F and G are derived by the different combinations of units of the commodity (glasses of
water) and the marginal utility gained by different units of commodity. By joining these points,
we get the marginal utility curve. The marginal utility curve has the downward negative slope. It
intersects the X-axis at the point of 6th unit of the commodity. At this point "F" the marginal
utility becomes zero. When the MU curve goes beyond this point, the MU becomes negative. So
there is an inverse functional relationship between the units of a commodity and the marginal
utility of that commodity.
Exceptions or Limitations:
The limitations or exceptions of the law of diminishing marginal utility are as follows:
1. The law does not hold well in the rare collections. For example, collection of ancient
coins, stamps etc.
2. The law is not fully applicable to money. The marginal utility of money declines with
richness but never falls to zero.
3. It does not apply to the knowledge, art and innovations.
4. The law is not applicable for precious goods.
5. Historical things are also included in exceptions to the law.
6. Law does not operate if consumer behaves in irrational manner. For example, drunkard is
said to enjoy each successive peg more than the previous one.
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7. Man is fond of beauty and decoration. He gets more satisfaction by getting the above
merits of the commodities.
8. If a dress comes in fashion, its utility goes up. On the other hand its utility goes down if it
goes out of fashion.
9. The utility increases due to demonstration. It is a natural element.
Importance of the Law of Diminishing Marginal Utility:
The importance or the role of the law of diminishing marginal utility is as follows:
1. By purchasing more of a commodity the marginal utility decreases. Due to this
behaviour, the consumer cuts his expenditures to that commodity.
2. In the field of public finance, this law has a practical application, imposing a heavier
burden on the rich people.
3. This law is the base of some other economic laws such as law of demand, elasticity of
demand, consumer surplus and the law of substitution etc.
4. The value of commodity falls by increasing the supply of a commodity. It forms a basis
of the theory of value. In this way prices are determined
Ordinal Utility Approach:
The basic idea behind ordinal utility approach is that a consumer keeps number of pairs of two
commodities in his mind which give him equal level of satisfaction. This means that the utility
can be ranked qualitatively.
The ordinal utility approach differs from the cardinal utility approach (also called classical
theory) in the sense that the satisfaction derived from various commodities cannot be measured
objectively.
Ordinal theory is also known as neo-classical theory of consumer equilibrium, Hicksian theory of
consumer behavior, indifference curve theory, optimal choice theory. This approach also
explains the consumer's equilibrium who is confronted with the multiplicity of objectives and
scarcity of money income.
The important tools of ordinal utility are:
1. The concept of indifference curves.
2. The slop of I.C. i.e. marginal rate of substitution.
3. The budget line.
Assumptions:
The ordinal utility approach is based on the following assumptions:
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4. A consumer substitutes commodities rationally in order to maximize his level of
satisfaction.
5. A consumer can rank his preferences according to the satisfaction of each basket of
goods.
6. The consumer is consistent in his choices.
7. It is assumed that each of the good is divisible.
8. It is assumed that the consumer has full knowledge of prices in the market.
9. The consumer's scale of preferences is so complete that consumer is indifferent between
them.
10. Two commodities are used by the consumer. It is also known as two commodities model.
11. Two commodities X and Y are substitutes of each other. These commodities can be
easily substituted in various pairs.
Theory of Ordinal Utility/Indifference Curve Analysis:
Definition and Explanation:
The indifference curve indicates the various combinations of two goods which yield equal
satisfaction to the consumer. By definition:
"An indifference curve shows all the various combinations of two goods that give an equal
amount of satisfaction to a consumer".
The indifference curve analysis approach was first introduced by Slustsky, a Russian
Economist in 1915. Later it was developed by J.R. Hicks and R.G.D. Allen in the year 1928.
These economist are the of view that it is wrong to base the theory of consumption on two
assumptions:
(i) That there is only one commodity which a person will buy at one time.
(ii) The utility can be measured.
Their point of view is that utility is purely subjective and is immeasurable. Moreover an
individual is interested in a combination of related goods and in the purchase of one
commodity at one time. So they base the theory of consumption on the scale of preference
and the ordinal ranks or orders his preferences.
Assumptions:
The ordinal utility theory or the indifference curve analysis is based on four main
assumptions.
(i) Rational behavior of the consumer: It is assumed that individuals are rational in making
decisions from their expenditures on consumer goods.
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(ii) Utility is ordinal: Utility cannot be measured cardinally. It can be, however, expressed
ordinally. In other words, the consumer can rank the basket of goods according to the
satisfaction or utility of each basket.
(iii) Diminishing marginal rate of substitution: In the indifference curve analysis, the
principle of diminishing marginal rate of substitution is assumed.
(iv) Consistency in choice: The consumer, it is assumed, is consistent in his behavior during
a period of time. For insistence, if the consumer prefers combinations of A of good to the
combinations B of goods, he then remains consistent in his choice. His preference, during
another period of time does not change.
Marginal Rate of Substitution (MRS):
The concept of marginal rate substitution (MRS) was introduced by Dr. J.R. Hicks and Prof.
R.G.D. Allen to take the place of the concept of diminishing marginal utility. Allen and Hicks are
of the opinion that it is unnecessary to measure the utility of a commodity. The necessity is to
study the behavior of the consumer as to how he prefers one commodity to another and maintains
the same level of satisfaction.
For example, there are two goods X and Y which are not perfect substitute of each other. The
consumer is prepared to exchange goods X for Y. How many units of Y should be given for one
unit of X to the consumer so that his level of satisfaction remains the same?
The rate or ratio at which goods X and Y are to be exchanged is known as the marginal rate of
substitution (MRS). In the words of Hicks:
“The marginal rate of substitution of X for Y measures the number of units of Y that must be
scarified for unit of X gained so as to maintain a constant level of satisfaction”.
Marginal rate of substitution (MRS) can also be defined as:
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“The ratio of exchange between small units of two commodities, which are equally valued or
preferred by a consumer”.
Formula:
MRSxy = ∆Y
∆X
It may here be noted that the marginal rate of substitution (MRS) is the personal exchange rate of
the consumer in contrast to the market exchange rate.
Schedule:
The concept of MRS can be easily explained with the help of schedule given below:
Marginal Rate of Substitution
Combination Good X Good Y MRS of X for Y
1 1 13 --
2 2 9 4 : 1
3 3 6 3 : 1
4 4 4 2 : 1
5 5 3 1 : 1
In the table given above, all the five combinations of good X and good Y give the same
satisfaction to the consumer. If he chooses first combination, he gets 1 unit of good X and 13
units of good Y.
In the second combination, he gets one more unit of good X and is prepared to give 4 units of
good Y for it to maintain the same level of satisfaction. The MRS is therefore, 4:1.
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In the third combination, the consumer is willing to sacrifice only 3 units of good Y for getting
another unit of good X. The MRS is 3:1.
Likewise, when the consumer moves from 4th to 5th combination, the MRS of good X for good
Y falls to one (1:1). This illustrates the diminishing marginal rate of substitution.
Diminishing Marginal Rate of Substitution:
In the above schedule, we have seen that as the consumer moves from combination first to fifth,
the rate of substitution of good X for good Y goes, down. In other words, as the consumer has
more and more units of good X, he is prepared to forego less and less of good Y.
For instance, in the 2nd combination, the consumer is willing to give 4 units of good Y in
exchange for one unit of good X, in the fifth combination only one unit of Y is offered for
obtaining one unit of X.
This behavior showing falling MRS of good X for good Y and yet to remain at the same level of
satisfaction is known as diminishing marginal rate of substitution.
Diagram/Figure:
The concept of marginal rate of substitution (MRS) can also be illustrated with the help of the
diagram.
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In the fig. 3.3 above as the consumer moves down from combination 1 to combination 2, the
consumer is willing to give up 4 units of good Y (∆Y) to get an additional unit of good X (∆X).
When the consumer slides down from combinations 2, 3 and 4, the length of ∆Y becomes
smaller and smaller, while the length of ∆X is remain the same. This shows that as the stock of
the consumer for good X increases, his stock of good Y decreases.
He, therefore, is willing to give less units of Y to obtain an additional unit of good X. In other
words, the MRS of good X for good Y falls as the consumer has more of good X and less of
good Y. The indifference curve IC slopes downward from left to the right. This means a negative
and diminishing rate of substitution of one commodity for the other.
Importance of Marginal Rate of Substitution (MRS):
(i) Measures utility ordinally: The concept of MRS is superior to that of utility concept because
it is more realistic and scientific than the theory of utility. It does not measure the utility of a
commodity in isolation without reference to other commodities but takes into consideration the
combination of related goods to which a consumer is interested to purchase.
(ii) A relative concept: The concept of marginal rate of substitution has the advantage that it is
relative and not absolute like the utility concept given by Marshall. It is free from any
assumptions concerning the possibility of a quantitative measurement of utility.
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Price Line or Budget Line:
The understanding of the concept of budget line is essential for knowing the theory of
consumer’s equilibrium.
"A budget line or price line represents the various combinations of two goods which can be
purchased with a given money income and assumed prices of goods".
For example, a consumer has weekly income of $60. He purchases only two goods, packets of
biscuits and packets of coffee. The price of each packet of biscuits is $6 and the price of each
packet of coffee is $12. Given the assumed income and the price, of the two goods, the consumer
can purchase various combination of goods or market combination of goods weekly.
Schedule:
The various alternative market baskets (combinations of goods) are shown in the table below:
Market Basket Packets of Biscuits Per Week Packets of Coffee Per Week
A 10 0
B 8 1
C 6 2
D 4 3
E 2 4
F 0 5
Income $60 Per Week = Packets of Biscuits Costs $6 = Packets of Coffee is Priced $12 Each
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(i) Market basket A in the table above shows that if the whole amounts of $60 is spent on the
purchase of biscuits, then the consumer buys 10 packets of biscuits at a price of $6 each and
nothing is left to purchase coffee.
(ii) Market basket F shows the other extreme. If the consumer spends the entire amount of $60
on the purchase of coffee, a maximum of 5 packets of coffee can be purchased with it at a price
of $12 each with nothing left over for the purchase of biscuits.
(iii) The intermediate market baskets B to E shows the mixes of packets of biscuits and packets
of coffee that the cost a total of $60. For example, in combination of market basket C, the
consumer can purchase 6 packets of biscuits and 2 packets of coffee with a total cost of $60.
Budget Line:
The budget line is an important element analysis of consumer behavior. The indifference map
shows people’s preferences for the combination of two goods. The actual choices they will make,
however, depends on their income. The budget line is drawn as a continuous line. It identifies
the options from which the consumer can choose the combination of goods.
Diagram/Figure:
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In the fig. 3.9 the line AF shows the various combinations of goods the consumer can purchase.
This line is called the budget line.
It shows 6 possible combinations of packets of biscuits and packets if coffee which a consumer
can purchase weekly. These combinations are indicated by points A, B, C, D, E and. Point A
indicates that 10 packet of biscuits can be purchased if the entire income of $60 is devoted to the
purchase of biscuits. Similarly, point F shows the purchase of 5 packets of coffee for the entire
income of $60 per week.
The budget line AF indicates all the combinations of packets of biscuits and packets of coffee
which a consumer can buy given the assumed prices and income. In case, a consumer decides to
purchase combination of goods inside the budget line such as G, then it involves a total outlay
that is smaller then the amount of $60 per week. Any point outside the budget line such as H
requires an outlay larger than the consumer’s weekly income of $60.
The slope of the budget line indicates how many packets of biscuits a purchaser must give up to
buy one more packet of coffee. For example, the slope at point B on the budget line is ∆Y / ∆X
or two packets of biscuits 1 = packet of coffee. This indicates that a move from B to C involves
sacrificing two packets of biscuits to gain an additional one packet of coffee. Since AF budget
line is straight, the slope is constant at -2 packets of biscuits per one packet of coffee at all points
along the line.
Shifts in Budget Line:
The price line is determined by the income of the consumer and the prices of goods in the
market. If there is a change in the income of the consumer or in the prices of goods, the price line
shifts in response to a exchange in these two factors.
(i) Income changes: When there is change in the income of the consumer, the prices of goods
remaining the same, the price line shifts from the original position. It shifts upward or to the right
hand side in a parallel position with the rise in income.
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A fall in the level of income, product prices remaining unchanged, the price line shifts left side
from the original position. With a higher income, the consumer can purchase more of both goods
than before but the cost of one good in terms of the other remains the same.
In the fig. 3.10 (a), a change in income is shown when product prices remain unchanged. The
rise in income results in a parallel upward shifts in the budget line from L/ M/ to L2M2. The
consumer is able to purchase more of both the goods A and B.
(ii) Price changes. Now let us consider that there is a change in the price of one good. The
income of the consumer and price of other good is held constant. When there is a fall in the price
of one good say commodity A, the consumer purchases more of that good than before. A price
change causes the budget line to rotate about point L fig. 3.10 (b).
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It becomes flatter and give the new budget line from LM/ to LM2. A flatter budget line means
that the relative price of the good A on the horizontal axis is lower. If the greater amount is spent
on the purchase of good A, the consumer can buy increased OM2 amount of good A.
Consumer's Equilibrium Through Indifference Curve Analysis:
Definition:
"The term consumer’s equilibrium refers to the amount of goods and services which the
consumer may buy in the market given his income and given prices of goods in the market".
The aim of the consumer is to get maximum satisfaction from his money income. Given the price
line or budget line and the indifference map:
"A consumer is said to be in equilibrium at a point where the price line is touching the highest
attainable indifference curve from below".
Conditions:
Thus the consumer’s equilibrium under the indifference curve theory must meet the following
two conditions:
First: A given price line should be tangent to an indifference curve or marginal rate of
satisfaction of good X for good Y (MRSxy) must be equal to the price ratio of the two goods. i.e.
MRSxy = Px / Py
Second: The second order condition is that indifference curve must be convex to the origin at the
point of tangency.
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Assumptions:
The following assumptions are made to determine the consumer’s equilibrium position.
(i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his
income and prices.
(ii) Utility is ordinal: It is assumed that the consumer can rank his preference according to the
satisfaction of each combination of goods.
(iii) Consistency of choice: It is also assumed that the consumer is consistent in the choice of
goods.
(iv) Perfect competition: There is perfect competition in the market from where the consumer is
purchasing the goods.
(v) Total utility: The total utility of the consumer depends on the quantities of the good
consumed.
Explanation:
The consumer’s consumption decision is explained by combining the budget line and the
indifference map. The consumer’s equilibrium position is only at a point where the price line is
tangent to the highest attainable indifference curve from below.
(1) Budget Line Should be Tangent to the Indifference Curve:
The consumer’s equilibrium in explained by combining the budget line and the indifference map.
Diagram/Figure:
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In the diagram 3.11, there are three indifference curves IC1
, IC2
and IC3
. The price line PT is
tangent to the indifference curve IC2
at point C. The consumer gets the maximum satisfaction or
is in equilibrium at point C by purchasing OE units of good Y and OH units of good X with the
given money income.
The consumer cannot be in equilibrium at any other point on indifference curves. For instance,
point R and S lie on lower indifference curve IC1
but yield less satisfaction. As regards point U
on indifference curve IC3
, the consumer no doubt gets higher satisfaction but that is outside the
budget line and hence not achievable to the consumer. The consumer’s equilibrium position is
only at point C where the price line is tangent to the highest attainable indifference curve
IC2
from below.
(2) Slope of the Price Line to be Equal to the Slope of Indifference Curve:
The second condition for the consumer to be in equilibrium and get the maximum possible
satisfaction is only at a point where the price line is a tangent to the highest possible indifference
curve from below. In fig. 3.11, the price line PT is touching the highest possible indifferent curve
IC2
at point C. The point C shows the combination of the two commodities which the consumer
is maximized when he buys OH units of good X and OE units of good Y.
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Geometrically, at tangency point C, the consumer’s substitution ratio is equal to price ratio Px /
Py. It implies that at point C, what the consumer is willing to pay i.e., his personal exchange rate
between X and Y (MRSxy) is equal to what he actually pays i.e., the market exchange rate. So
the equilibrium condition being Px / Py being satisfied at the point C is:
Price of X / Price of Y = MRS of X for Y
The equilibrium conditions given above states that the rate at which the individual is willing to
substitute commodity X for commodity Y must equal the ratio at which he can substitute X for Y
in the market at a given price.
(3) Indifference Curve Should be Convex to the Origin:
The third condition for the stable consumer equilibrium is that the indifference curve must be
convex to the origin at the point of equilibrium. In other words, we can say that the MRS of X
for Y must be diminishing at the point of equilibrium. It may be noticed that in fig. 3.11, the
indifference curve IC2
is convex to the origin at point C. So at point C, all three conditions for the
stable-consumer’s equilibrium are satisfied.
Summing up, the consumer is in equilibrium at point C where the budget line PT is tangent to
the indifference IC2
. The market basket OH of good X and OE of good Y yields the greatest
satisfaction because it is on the highest attainable indifference curve. At point C:
MRSxy = Px / Py
Properties/Characteristics of Indifference Curve:
Definition, Explanation and Diagram:
An indifference curve shows combination of goods between which a person is indifferent. The
mainattributes or properties or characteristics of indifference curves are as follows:
(1) Indifference Curves are Negatively Sloped:
The indifference curves must slope down from left to right. This means that an indifference
curve is negatively sloped. It slopes downward because as the consumer increases the
consumption of X commodity, he has to give up certain units of Y commodity in order to
maintain the same level of satisfaction.
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In fig. 3.4 the two combinations of commodity cooking oil and commodity wheat is shown by
the points a and b on the same indifference curve. The consumer is indifferent towards points a
and b as they represent equal level of satisfaction.
At point (a) on the indifference curve, the consumer is satisfied with OE units of ghee and OD
units of wheat. He is equally satisfied with OF units of ghee and OK units of wheat shown by
point b on the indifference curve. It is only on the negatively sloped curve that different points
representing different combinations of goods X and Y give the same level of satisfaction to make
the consumer indifferent.
(2) Higher Indifference Curve Represents Higher Level:
A higher indifference curve that lies above and to the right of another indifference curve
represents a higher level of satisfaction and combination on a lower indifference curve yields a
lower satisfaction.
In other words, we can say that the combination of goods which lies on a higher indifference
curve will be preferred by a consumer to the combination which lies on a lower indifference
curve.
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In this diagram (3.5) there are three indifference curves, IC1
, IC2
and IC3
which represents
different levels of satisfaction. The indifference curve IC3
shows greater amount of satisfaction
and it contains more of both goods than IC2
and IC1
(IC3
> IC2
> IC1
).
(3) Indifference Curve are Convex to the Origin:
This is an important property of indifference curves. They are convex to the origin (bowed
inward). This is equivalent to saying that as the consumer substitutes commodity X for
commodity Y, the marginal rate of substitution diminishes of X for Y along an indifference
curve.
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In this figure (3.6) as the consumer moves from A to B to C to D, the willingness to substitute
good X for good Y diminishes. This means that as the amount of good X is increased by equal
amounts, that of good Y diminishes by smaller amounts. The marginal rate of substitution of X
for Y is the quantity of Y good that the consumer is willing to give up to gain a marginal unit of
good X. The slope of IC is negative. It is convex to the origin.
(4) Indifference Curve Cannot Intersect Each Other:
Given the definition of indifference curve and the assumptions behind it, the indifference curves
cannot intersect each other. It is because at the point of tangency, the higher curve will give as
much as of the two commodities as is given by the lower indifference curve. This is absurd and
impossible.
In fig 3.7, two indifference curves are showing cutting each other at point B. The combinations
represented by points B and F given equal satisfaction to the consumer because both lie on the
same indifference curve IC2. Similarly the combinations shows by points B and E on
indifference curve IC1 give equal satisfaction top the consumer.
If combination F is equal to combination B in terms of satisfaction and combination E is equal to
combination B in satisfaction. It follows that the combination F will be equivalent to E in terms
of satisfaction. This conclusion looks quite funny because combination F on IC2 contains more
of good Y (wheat) than combination which gives more satisfaction to the consumer. We,
therefore, conclude that indifference curves cannot cut each other.
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(5) Indifference Curves do not Touch the Horizontal or Vertical Axis:
One of the basic assumptions of indifference curves is that the consumer purchases combinations
of different commodities. He is not supposed to purchase only one commodity. In that case
indifference curve will touch one axis. This violates the basic assumption of indifference curves.
In fig. 3.8, it is shown that the in difference IC touches Y axis at point C and X axis at point E.
At point C, the consumer purchase only OC commodity of rice and no commodity of wheat,
similarly at point E, he buys OE quantity of wheat and no amount of rice. Such indifference
curves are against our basic assumption. Our basic assumption is that the consumer buys two
goods in combination.
Application of Indifference Curve Analysis:
We now describe in brief as to how indifference curves and budget lines can be used to analysis
the effects on consumption due to (a) changes in the income of a consumer (b) changes in the
price of a commodity.
(1) Changes in Consumer's Equilibrium (Income Effect):
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In the consumer’s equilibrium analysis, it is primarily assumed that the price of the goods X and
Y and the income of the consumer remains constant. We now examine as to how the consumer
reacts as regards to his purchases of good when his income changes within the indifference curve
frameworks. Income is one of the most important factors affecting the purchase of commodities.
If the prices of goods, tastes and preferences of the consumer remains constant and there a
change in his income, it will directly affect consumer’s demand. This effect on the purchase due
to change in income is called the income effect.
A rise in consumer’s income will shift the price line or budget line upward to the right and he
goes on to higher point of equilibrium. A fall in the income, will shift the price line downward to
the left and the consumer attains lower (tangency) points of equilibrium. The shift of the price
line is parallel as the prices of the goods are assumed to remain the same. The income effect is
explained with the help of following diagram.
Diagram/Figure:
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In the diagram (3.12) wheat is measured along OX and rise along OY. When the price line or
budget line is BB/
, the consumer gets maximum satisfaction or is in equilibrium position at point
K where it touches the indifference curve IC1
. The consumer buys OS quantity of wheat and ON
quantity of rice. We suppose now that the income of the consumer has increased and the price
line is now CC1
. Which shifts in a parallel fashion to the right.
The consumer is in equilibrium at a level at point L which is its equilibrium point. If there is
further increase in income: shift of the price line now will be DD1
, and the consumer is in
equilibrium at point T and will be purchasing OZ quantity of wheat and OE quantity of rice. If
these, equilibrium points K, L, T are joined together by a dotted line passing through the origin,
we get income consumption curve ICC.
This shows that with the rise in income, the consumer generally buys more quantities of the two
commodities rice and wheat. The income consumer is now better off at T on indifference curve
IC3
as compared to L at a lower indifference curve IC2
. The income effect is positive in case of
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both the goods rice and wheat as these are normal goods. The income consumption curve ICC
which is derived by joining the successive equilibrium positions has a positive slope.
Example:
Income Effect When Wheat is an Inferior Good:
Sometimes it also happens that with the rise in income, the consumer buys more of one
commodity and less of another. For instance, he may buy less of wheat and more of rice as is,
illustrated in figures 3.13.
In diagram 3.13, the income consumption curve bends back on itself. With the rise in income, the
consumer buys more of rice and less of wheat. The price effect for rice is positive and for wheat
is negative. The good which is purchased less with the increase in income is called inferior good.
Income Effect When Rice is an Inferior Good:
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In the figure 3.14, it is shown that with the rise in money income, the purchase of wheat has
increased from M1 to M4 indicating positive income effect on the purchase of normal good
wheat. The income effect on inferior good is negative. The income consumption curve ICC is
starts bending towards the horizontal axis which shows that wheat is a normal good and rice is
inferior good.
(2) Changes in Consumer’s Equilibrium (Price Effect):
Price Effect on the Consumption of a Normal Good:
We now discuss the reaction of the consumer to the changes in the price of a good while his
money income, tastes, preferences and prices of other goods remain unchanged. When there is
change in the price of a good shown on the two axes of an indifference map, there takes place a
change in demand in response to a change in price of a commodity, other things remaining the
same, is called price effect.
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For example in fig. 3.15, AB is the initial budget line. It is assumed that the price of wheat has
fallen and the price of rice and the income of the consumer remains unchanged. The price line
takes a new position AC and the equilibrium point shifts from P to U.
The consumer buys now OT quantity of wheat (the amount demanded rises from OE to OT and
OZ quantity of rice. With further fall in the price of wheat, the consumer is in equilibrium at
point S, where the budget line AD is tangent to a higher indifference curve AC3. He buys now
OF quantity of wheat and OR quantity of rice.
The rise in amount purchased of wheat (OE to OF) as a result of a fall in its price is called price
effect. The price effect on the consumption of a normal good is negative. If we join the
equilibrium points PUS, we get price consumption curve (PCC) of the consumer for the
commodity wheat.
Price Effect When Commodity X is a Giffen Good:
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Giffen good is a particular type of inferior good. When there is a decrease in the quantity
demanded of a good with a fall in its price, the good is called Giffen good after the name of
Robert Giffen.
A British Economist Robert Giffen (1837-1910), observed that sometimes it so happens that a
decrease in the price of a particular good causes its quantity demanded to fall. The consumer
spends the money he saves (by curtailing the demand) on the purchase of increased quantity of
the other good. The decease in the price of Giffen good has an effect similar to an an increase in
the income of a buyer. This particular type of behavior of the consumer to decrease demanded of
good when its price falls is called Giffen Paradox.
The price effect on the consumption of the Giffen good X is now explained with the help of
diagram below:
In fig. 3.16, the consumer is in equilibrium at point E where the budget line AB is tangent to the
indifference curve IC1. The consumer purchases OX1 quantity of Giffen good X and
OY1 quantity of good Y.
When there is a reduction in the price of good X but no change in the price of good Y, the budget
line AB/
will showing upward. The consumer is in equilibrium at point E/
where the budget line
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AB/
is a tangent to the indifference curve IC2. In the new equilibrium position, the consumer
purchases only OX2 units of Giffen good X and OY2 units of good Y.
We find that the decrease in the price of Giffen good X, its quantity purchased has fallen from
OX1 to OX2and the quantity demanded of Y commodity goes up from OY1 to OY2. The price
effect on the consumption of Giffen good is positive. If is indicated by the backward bending
PCC in the case of X as a Giffen good.
The Substitution Effect:
The substitution effect relates to the change in the quantity demanded resulting from a change in
the price of good due to the substitution of relatively cheaper good for a dearer one, while
keeping the price of the other good and real income and tastes of the consumer as constant. Prof.
Hicks has explained the substitution effect independent of the income effect through
compensating variation in income. “The substitution effect is the increase in the quantity bought
as the price of the commodity falls, after adjusting income so as to keep the real purchasing
power of the consumer the same as before. This adjustment in income is called compensating
variations and is shown graphically by a parallel shift of the new budget line until it become
tangent to the initial indifference curve.”
Thus on the basis of the methods of compensating variation, the substitution effect measure the
effect of change in the relative price of a good with real income constant. The increase in the real
income of the consumer as a result of fall in the price of, say good X, is so withdrawn that he is
neither better off nor worse off than before.
The substitution effect is explained in Figure 12.17 where the original budget line is PQ with
equilibrium at point R on the indifference curve I1. At R, the consumer is buying OB of X and
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BR of Y. Suppose the price of X falls so that his new budget line is PQ1. With the fall in the
price of X, the real income of the consumer increases. To make the compensating variation in
income or to keep the consumer’s real income constant, take away the increase in his income
equal to PM of good Y or Q1N of good X so that his budget line PQ1 shifts to the left as MN and
is parallel to it.
At the same time, MN is tangent to the original indifference curve l1 but at point H where the
consumer buys OD of X and DH of Y. Thus PM of Y or Q1N of X represents the compensating
variation in income, as shown by the line MN being tangent to the curve I1 at point H. Now the
consumer substitutes X for Y and moves from point R to H or the horizontal distance from В to
D. This movement is called the substitution effect. The substitution affect is always negative
because when the price of a good falls (or rises), more (or less) of it would be purchased, the real
income of the consumer and price of the other good remaining constant. In other words, the
relation between price and quantity demanded being inverse, the substitution effect is negative.
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The Price Effect:
The price effect indicates the way the consumer’s purchases of good X change, when its price
changes, A given his income, tastes and preferences and the price of good Y. This is shown in
Figure 12.18. Suppose the price of X falls. The budget line PQ will extend further out to the right
as PQ1, showing that the consumer will buy more X than before as X has become cheaper. The
budget line PQ2 shows a further fall in the price of X. Any rise in the price of X will be
represented by the budget line being drawn inward to the left of the original budget line towards
the origin.
If we regard PQ2, as the original budget line, a two time rise in the price of X will lead to the
shifting of the budget line to PQ1, and PQ2. Each of the budget lines fanning out from P is a
tangent to an indifference curve I1, I2, and I3 at R, S and T respectively. The curve PCC
connecting the locus of these equilibrium points is called the price- consumption curve. The
price-consumption curve indicates the price effect of a change in the price of X on the
consumer’s purchases of the two goods X and Y, given his income, tastes, preferences and the
price of good Y.
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Law of Variable Proportions/Law of Non Proportional Returns/Law of Diminishing
Returns:
(Short Run Analysis of Production):
Definition:
There were three laws of returns mentioned in the history of economic thought up till Alfred
Marshall's time. These laws were the laws of increasing returns, diminishing returns and constant
returns. Dr. Marshall was of the view that the law of diminishing returns applies to agriculture
and the law of increasing returns to industry. Much time was wasted in discussion of this issue.
However, it was later on recognized that there are not three laws of production. It is only one law
of production which has three phases, increasing, diminishing and negative production. This
general law of production was named as the Law of Variable Proportions or the Law of Non-
Proportional Returns.
The Law of Variable Proportions which is the new name of the famous law of Diminishing
Returns has been defined by Stigler in the following words:
"As equal increments of one input are added, the inputs of other productive services being held
constant, beyond a certain point, the resulting increments of produce will decrease i.e., the
marginal product will diminish".
According to Samuelson:
"An increase in some inputs relative to other fixed inputs will in a given state of technology
cause output to increase, but after a point, the extra output resulting from the same addition of
extra inputs will become less".
Assumptions:
The law of variable proportions also called the law of diminishing returns holds good under the
following assumptions:
(i) Short run. The law assumes short run situation. The time is too short for a firm to change the
quantity of fixed factors. All the, resources apart from this one variable, are held unchanged in
quantity and quality.
(ii) Constant technology. The law assumes that the technique of production remains unchanged
during production.
(iii) Homogeneous factors. Each factor unit in assumed to he identical in amount and quality.
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Explanation and Example:
The law of variable proportions is, now explained with the help of table and graph.
Schedule:
Fixed Inputs
(Land
Capital)
Variable
Resource
(labor)
Total
Produce (TP
Quintals)
Marginal Product (MP
Quintals)
Average
Product (AP
Quintals)
30
30
1
2
10
25
10
15
Increasing marginal
return
10
12.5
30
30
30
30
30
3
4
5
6
7
37
47
55
60
63
12
10
8
5
3
Diminishing marginal
returns
12.3
11.8
11.0
10.0
9.0
30
30
8
9
63
62
0
-1
Negative marginal
returns
7.9
6.8
In the table above, it is assumed that a farmer has only 30 acres of land for cultivation. The
investment on it in the form of tubewells, machinery etc., (capital) is also fixed. Thus land and
capital with the farmer is fixed and labor is the variable resource.
As the farmer increases units of labor from one to two to the amount of other fixed resources
(land and capital), the marginal as well as average product increases. The total product also
increase at an increasing rate from 10 to 25 quintals. It is the stage of increasing returns.
The stage of increasing returns with the employment of more labor does not last long. It is shown
in the table that with the employment of 3rd labor at the farm, the marginal product and the
average product (AP) both fall but marginal product (MP) falls more speedily than the average
product AP). The fall in MP and AP continues as more men are put on the farm.
The decrease, however, remains positive up to the 7th labor employed. On the employment of
7th worker, the total production remains constant at 63 quintals. The marginal product is zero. if
more men are employed the marginal product becomes negative. It is the stage of negative
returns. We here find the behavior of marginal product (MP). it shows three stages. In the first
stage, it increases, in the 2nd it continues to fall and in the 3rd stage it becomes
negative.
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Three Stages of the Law:
There are three phases or stages of production, as determined by the law of variable proportions:
(i) Increasing returns.
(ii) Diminishing returns.
(iii) Negative returns.
Diagram/Graph:
These stages can be explained with the help of graph below:
(i) Stage of Increasing Returns. The first stage of the law of variable proportions is generally
called the stage of increasing returns. In this stage as a variable resource (labor) is added to fixed
inputs of other resources, the total product increases up to a point at an increasing rate as is
shown in figure 11.1.
The total product from the origin to the point K on the slope of the total product curve increases
at an increasing rate. From point K onward, during the stage II, the total product no doubt goes
on rising but its slope is declining. This means that from point K onward, the total product
increases at a diminishing rate. In the first stage, marginal product curve of a variable factor rises
in a part and then falls. The average product curve rises throughout .and remains below the MP
curve.
Causes of Initial Increasing Returns:
The phase of increasing returns starts when the quantity of a fixed factor is abundant relative to
the quantity of the variable factor. As more and more units of the variable factor are added to the
constant quantity of the fixed factor, it is more intensively and effectively used. This causes the
production to increase at a rapid rate. Another reason of increasing returns is that the fixed factor
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initially taken is indivisible. As more units of the variable factor are employed to work on it,
output increases greatly due to fuller and effective utilization of the variable factor.
(ii) Stage of Diminishing Returns. This is the most important stage in the production function.
In stage 2, the total production continues to increase at a diminishing rate until it reaches its
maximum point (H) where the 2nd stage ends. In this stage both the
marginal product (MP) and average product of the variable factor are diminishing but are
positive.
Causes of Diminishing Returns:
The 2nd phase of the law occurs when the fixed factor becomes inadequate relative to the
quantity of the variable factor. As more and more units of a variable factor are employed, the
marginal and average product decline. Another reason of diminishing returns in the production
function is that the fixed indivisible factor is being worked too hard. It is being used in non-
optima! proportion with the variable factor, Mrs. J. Robinson still goes deeper and says that the
diminishing returns occur because the factors of production are imperfect substitutes of one
another.
(iii) Stage of Negative Returns. In the 3rd stage, the total production declines. The TP, curve
slopes downward (From point H onward). The MP curve falls to zero at point L2
and then is
negative. It goes below the X axis with the increase in the use of variable factor (labor).
Causes of Negative Returns:
The 3rd phases of the law starts when the number of a variable, factor becomes, too excessive
relative, to the fixed factors, A producer cannot operate in this stage because total production
declines with the employment of additional labor.
A rational producer will always seek to produce in stage 2 where MP and AP of the variable
factor are diminishing. At which particular point, the producer will decide to produce depends
upon the price of the factor he has to pay. The producer will employ the variable factor (say
labor) up to the point where the marginal product of the labor equals the given wage rate in the
labor market.
Importance:
The law of variable proportions has vast general applicability. Briefly:
(i) It is helpful in understanding clearly the process of production. It explains the input output
relations. We can find out by-how much the total product will increase as a result of an increase
in the inputs.
(ii) The law tells us that the tendency of diminishing returns is found in all sectors of the
economy which may be agriculture or industry.
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(iii) The law tells us that any increase in the units of variable factor will lead to increase in the
total product at a diminishing rate. The elasticity of the substitution of the variable factor for the
fixed factor is not infinite.
From the law of variable proportions, it may not be understood that there is no hope for raising
the standard of living of mankind. The fact, however, is that we can suspend the operation of
diminishing returns by continually improving the technique of production through the progress in
science and technology.
Law of Increasing Returns/Law of Diminishing Cost:
(Version of Classical and Neo Classical Economists):
The law of increasing returns is also called the law of diminishing costs. The law of increasing
return states that:
"When more and more units of a variable factor is employed, while other factor remain fixed,
there is an increase of production at a higher rate. The tendency of the marginal return to rise per
unit of variable factors employed in fixed amounts of other factors by a firm is called the law of
increasing return".
An increase of variable factor, holding constant the quantity of other factors, leads generally to
improved organization. The output increases at a rate higher than the rate of increase in the
employment of variable factor.
The increase in output faster than inputs continues so long as there is not deficiency of an
essential factor in the process of production. As soon as there occurs shortage or a wrong or
defective combination in productive process, the marginal product begins to decline. The law of
diminishing return begins to operate. We can, therefore, say that there are no separate laws
applicable to agriculture and to industries. It is only the law of variable proportions which applies
to a!! the different industries. However, the duration of stages in each productive undertaking
will vary. They will depend upon the availability of resources, their combination in right
proportions, etc., etc.
Application of the Law of Increasing Returns in Industries:
There are certain manufacturing industries where the factors of production can be combined and
substituted up to a certain limit, it is the law of increasing returns which operates. In the words
of Prof. Chapman:
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"The expansion of an industry in which there is no dearth of necessary agents of production
tends to be accompanied, other things being equal, by increasing returns".
The increasing returns mainly arises from the fact that large scale production is able to secure
certain economies of production, both internal and external. When an industry is expanded, it
reaps advantages of division of labor, specialized machinery, commercial advantages, buying
and selling wholesale, economies in overhead expenses, utilization of by products, use of
extensive publicity and advertisement, availability of cheap credit, etc.. etc.
The law of increasing returns also operates so long as a factor consists of large indivisible units
and the plant is producing below its capacity. In that case, every additional investment will result
in the increase of marginal productivity and so in lowering the cost of production of the
commodity produced. The increase in the marginal productivity continues till the plant begins to
produce to its full capacity.
Assumptions:
The law rests upon the following assumptions:
(i) There is a scope in the improvement of technique of production.
(ii) At least one factor of production is assumed to be indivisible.
(iii) Some factors are supposed to be divisible.
Example:
The law of increasing returns can also be explained with the help of a schedule and a curve.
Schedule:
Inputs Total Returns (meters of cloth) Marginal Returns
(meters of cloth)
1 100 100
2 250 150
3 450 200
4 750 300
5 1200 450
6 1850 650
7 2455 605
8 3045 600
In the above table it is dear that as the manufacturer goes on expanding his business by investing
successive units of inputs, the marginal return goes on increasing up to the 6th unit and then it
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beings to decline steadily, Here, a question ca be asked as to why the law of diminishing returns
has operated in an industry?
The answer is very simple. The marginal returns has diminished after the sixth unit because of
the non-availability of a factor or factors of production or. the size of the business has become so
large that it has become unwieldy to manage it, or the plant is producing to its full capacity and it
is not possible further to reap the economies of large scale production, etc., etc.
Diagram/Graph:
In figure 11.3, along OX axis are measured the units of inputs applied and along OY axis the
marginal return is represented. PF is the curve representing the law of increasing returns.
Compatibility of Diminishing and Increasing Returns:
It is often pointed out by the classical economists that the law of diminishing returns is
exclusively confined to agriculture and other extractive industries, such as mining fisheries, etc.
while manufacturing industries obey the law of increasing returns. In the words of Marshall:
"While the part which Nature plays in production shows a tendency to diminishing returns and
the part which man plays shows a tendency to increasing returns".
The modern economists differ with this view and are of the opinion that the law of diminishing
returns applies both to agriculture and the industry. The only difference is that in agriculture the
law of diminishing returns begins to operate at an early stage and in an industry somewhere at a
later stage.
The law of increasing returns is also named as the Law of Diminishing Cost. When the addition
to output becomes larger, as the firm adds successive units of a variable input to some fixed
inputs, the per unit cost begins to decline. The tendency of the cost per unit to decline with
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increased application of a variable factor to fixed factors is called the Law of Diminishing
Cost.
Law of Constant Returns/Law of Constant Cost:
The law of constant returns also called law of constant cost. It is said to operate when with the
addition of successive units of one factor to fixed amount of other factors, there arises a
proportionate increase in total output. The yield of equal return on the successive doses of inputs
may occur for a very short period in the process of production. The law of constant return may
prevail in those industries which represent a combination of manufacturing as well as extractive
industries.
On the side of manufacturing industries, every increased investment of labor and capital may
result in a more than proportionate increase in the total output. While on the other extractive side,
an increase in investment may cause, in general, a less than proportionate increase in the amount
of produce raised. If the tendency of the marginal return to increase is just balanced by the
tendency of the marginal return to diminish yielding an equal return, we have the operation of
the law of constant returns. In the words of Marshall:
"If the actions of the law of increasing and diminishing returns are balanced, we have the law of
constant return".
In actual life, the law of constant returns can operate only if the following conditions are
fulfilled:
(i) There should not be any increase in the prices of raw materials in the industry. This can only
be possible if commodities are available in large supply.
(ii) The prices of various factors of production should remain the same. The .supply of various
factors of production needed for a particular industry should be perfectly elastic.
(iii) The productive services should not be fixed and indivisible.
If we study the above mentioned conditions carefully, we will easily conclude that in the actual
world, it is not possible to find an industry which obeys the law of constant returns. The law of
constant returns can operate for a very short period when the marginal return moves towards the
optimum point and begins to decline. If the marginal return, at the optimum level remains the
same with the increased application of inputs for a short while, then we have the operation of law
of constant returns. The law is represented now in the form of a table and a curve.
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Schedule:
Productive doses Total Return (meters of
cloth)
Marginal Return
(meters of cloth)
1 60 60
2 120 60
3 180 60
4 240 60
5 300 60
In the table given above, the marginal return remains the same, i.e. 60 meters of cloth with the
increased investment of inputs.
Diagram/Graph:
In figure (11.4) along OX are measured the productive resources and along OY is represented the
marginal return. CR is the fine representing the law of constant returns. It is parallel to the base
axis.
Law of Diminishing Returns/Law of Increasing Cost:
Definition:
The law of diminishing returns (also called the Law of Increasing Costs) is an important law of
micro economics. The law of diminishing returns states that:
"If an increasing amounts of a variable factor are applied to a fixed quantity of other factors per
unit of time, the increments in total output will first increase but beyond some point, it begins to
decline".
Richard A. Bilas describes the law of diminishing returns in the following words:
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"If the input of one resource to other resources are held constant, total product (output) will
increase but beyond some point, the resulting output increases will become smaller and smaller".
The law of diminishing return can be studied from two points of view, (i) as it applies to
agriculture and (ii) as it applies in the field of industry.
(1) Operation of Law of Diminishing Returns in Agriculture:
Traditional Point of View. The classical economists were of the opinion that the taw of
diminishing returns applies only to agriculture and to some extractive industries, such as mining,
fisheries urban land, etc. The law was first stated by a Scottish farmer as such. It is the practical
experience of every farmer that if he wishes to raise a large quantity of food or other raw
material requirements of the world from a particular piece of land, he cannot do so. He knows it
fully that the producing capacity of the soil is limited and is subject to exhaustation.
As he applies more and more units of labor to a given piece of land, the total produce no doubt
increases but it increases at a diminishing rate.
For example, if the number of labor is doubled, the total yield of his land will not be double. It
will be less than double. If it becomes possible to increase the. yield in the very same ratio in
which the units of labor are increased, then the raw material requirements of the whole world
can be met by intensive cultivation in a single flower-pot. As this is not possible, so a rational
farmer increases the application of the units of labor on a piece of land up to a point which is
most profitable to him. This is in brief, is the law of diminishing returns. Marshall has stated this
law as such:
"As Increase in capital and labor applied to the cultivation of land causes in general a less than
proportionate increase in the amount of the produce raised, unless it happens to coincide with the
improvement in the act of agriculture".
Explanation and Example:
This law can be made more clear if we explain it with the help, of a schedule and a curve.
Schedule:
Fixed Input Inputs of Variable
Resources
Total Produce TP (in
tons)
Marginal product MP (in
tons)
12 Acres
12 Acres
12 Acers
12 Acres
12 Acers
12 Acres
1 Labor
2 Labor
3 Labor
4 Labor
5 Labor
6 Labor
50
120
180
200
200
195
50
70
60
20
0
-5
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In the schedule given above, a firm first cultivates 12 acres of land (Fixed input) by applying one
unit of labor and produces 50 tons of wheat.. When it applies 2 units of labor, the total produce
increases to 120 tons of wheat, here, the total output increased to more than double by doubling
the units of labor. It is because the piece of land is under-cultivated. Had he applied two units of
labor in the very beginning, the marginal return would have diminished by the application of
second unit of labor.
In our schedules the rate of return is at its maximum when two units of labor are applied. When a
third unit of labor is employed, the marginal return comes down to 60 tons of wheat With the
application of 4th
unit. the marginal return goes down to 20 tons of wheat and when 5th
unit is
applied it makes no addition to the total output. The sixth unit decreased it. This tendency of
marginal returns to diminish as successive units of a variable resource (labor) are added to a
fixed resource (land), is called the law of diminishing returns. The above schedule can be
represented graphically as follows:
Diagram/Graph:
In Fig. (11.2) along OX are measured doses of labor applied to a piece of land and along OY, the
marginal return. In the beginning the land was not adequately cultivated, so the additional
product of the second unit increased more than of first. When 2 units of labor were applied, the
total yield was the highest and so was the marginal return. When the number of workers is
increased from 2 to 3 and more. the MP begins to decrease. As fifth unit of labor was applied, the
marginal return fell down to zero and then it decreased to 5 tons.
Assumptions:
The table and the diagram is based on the following assumptions:
(i) The time is too short for a firm to change the quantity of fixed factors.
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(ii) It is assumed that labor is the only variable factor. As output increases, there occurs no
change in the factor prices.
(iii) All the units of the variable factor are equally efficient.
(iv) There are no changes in the techniques of production.
Importance:
The law of diminishing returns occupies an important place in economic theory. The British
classical economists particularly Malthus, and Ricardo propounded various economic theories,
on its basis. Malthus, the pessimist economist, has based his famous theory of Population on this
law.
The Ricardian theory of rent is also based on the law of diminishing return. The classical
economists considered the law as the inexorable law of nature.
Price Elasticity of Demand:
The law of demand is straight forward. It tells us when the price of a good rises, its quantity
demanded will fall, all other things held constant. The law dose not indicate as to how much the
quantity demanded will fall with the rise in price or how much responsive demand is to a rise
price. The economists here use and measure the quantity demanded to a change in price by the
concept of elasticity of demand.
What is Price Elasticity of Demand?
Definition:
Price elasticity of demand measures the degree of responsiveness of the quantity demanded of a
good to a change in its price. It is also defined as:
"The ratio of proportionate change in quantity demanded caused by a given proportionate change
in price".
Formula For Calculation:
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Price elasticity of demand is computed by dividing the percentage change in quantity demanded
of a good by the percentage change in its price.
Symbolically price elasticity of demand is expressed as under:
Ed = Percentage Change in Quantity Demanded
Percentage Change in Price
Simple formula for calculating the price elasticity of demand:
Ed = %∆Q
%∆P
Here:
Ed stands for price elasticity of demand.
Q stands for original quantity.
P stands for original price.
∆ stands for a small change.
Example:
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The price elasticity of demand tells us the relative amount by which the quantity demanded will
change in response to a change in the price of a particular good. For example, if there is a 10%
rise in the price of a tea and it leads to reduction in its demanded by 20%, the price elasticity of
demand will be:
Ed = -20
+10
Ed = -2.0
Degrees of Elasticity of Demand:
We have stated demand for a product is sensitive or responsive to price change. The variation in
demand is, however, not uniform with a change in price. In case of some products, a small
change in price leads to a relatively larger change in quantity demanded.
Elastic and Inelastic Demand:
For example, a decline of 1% in price leads to 8% increase in the quantity demanded of a
commodity. In such a case, the demand is said to elastic. There are other products where the
quantity demanded is relatively unresponsive to price changes. A decline of 8% in price, for
example, gives rise to 1% increase in quantity demanded. Demand here is said to be inelastic.
The terms elastic and inelastic demand do not indicate the degree of responsiveness and
unresponsiveness of the quantity demanded to a change in price.
The economists therefore, group various degrees of elasticity of demand into five categories.
(1) Perfectly Elastic Demand:
A demand is perfectly elastic when a small increase in the price of a good its quantity to zero.
Perfect elasticity implies that individual producers can sell all they want at a ruling price but
cannot charge a higher price. If any producer tries to charge even one penny more, no one would
buy his product.
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People would prefer to buy from another producer who sells the good at the prevailing market
price of $4 per unit. A perfect elastic demand curve is illustrated in fig. 6.1.
Diagram:
It shows that the demand curve DD/
is a horizontal line which indicates that the quantity
demanded is extremely (infinitely) response to price. Even a slight rise in price (say $4.02),
drops the quantity demanded of a good to zero. The curve DD/
is infinitely elastic. This elasticity
of demand as such is equal to infinity.
(2) Perfectly Inelastic Demand:
When the quantity demanded of a good dose not change at all to whatever change in price, the
demand is said to be perfectly inelastic or the elasticity of demand is zero.
For example, a 30% rise or fall in price leads to no change in the quantity demanded of a good.
Ed = 0
30%
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Ed = 0
In figure 6.2 a rise in price from OA to OC or fall in price from OC to OA causes no change
(zero responsiveness) in the amount demanded.
Ed = 0
Δp
Ed = 0
(3) Unitary Elasticity of Demand:
When the quantity demanded of a good changes by exactly the same percentage as price, the
demand is said to has a unitary elasticity.
For example, a 30% change in price leads to 30% change quantity demand = 30% / 30% = 1.
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One or a one percent change in price causes a response of exactly a one percent change in the
quantity demand.
In this figure (6.3) DD/
demand curve with unitary elasticity shows that as the price falls from
OA to OC, the quantity demanded increases from OB to OD. On DD/
demand curve, the
percentage change in price brings about an exactly equal percentage in quantity at all points a, b.
The demand curve of elasticity is, therefore, a rectangular hyperbola.
Ed = %∆q
%∆p
Ed = 1
(4) Elastic Demand:
If a one percent change in price causes greater than a one percent change in quantity demanded
of a good, the demand is said to be elastic.
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Alternatively, we can say that the elasticity of demand is greater than. For example, if price of a
good change by 10% and it brings a 20% change in demand, the price elasticity is greater than
one.
Ed = 20%
10%
Ed = 2
In figure (6.4) DD/
curve is relatively elastic along its entire length. As the price falls from OA to
OC, the demand of the good extends from OB to ON i.e., the increase in quantity demanded is
more than proportionate to the fall in price.
Ed = %∆q
%∆p
Ed > 1
(5) Inelastic Demand:
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When a change in price causes a less than a proportionate change in quantity demand, demand is
said to be inelastic.
The elasticity of a good is here less than I or less than unity. For example, a 30% change in price
leads to 10% change in quantity demanded of a good, then:
Ed = 10%
30%
Ed = 1
3
Ed < 1
In figure (6.5) DD/
demand curve is relatively inelastic. As the price fall from OA to OC, the
quantity demanded of the good increases from OB to ON units. The increase in the quantity
demanded is here less than proportionate to the fall in price.
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Note: It may here note that the slope of a demand curve is not a reliable indicator of elasticity. A
flat slope of a demand curve must not mean elastic demand. Similarly, a steep slope on demand
curve must not necessarily mean inelastic demand.
The reason is that the slope is expressed in terms of units of the problem. If we change the units
of problem, we can get a different slope of the demand curve. The elasticity, on the other hand, is
the percentage change in quantity demanded to the corresponding percentage change in price.
Types of Elasticity of Demand:
The quantity of a commodity demanded per unit of time depends upon various factors such as
the price of a commodity, the money income of the prices of related goods, the tastes of the
people, etc., etc.
Whenever there is a change in any of the variables stated above, it brings about a change in the
quantity of the commodity purchased over a specified period of time. The elasticity of demand
measures the responsiveness of quantity demanded to a change in any one of the above factors
by keeping other factors constant. When the relative responsiveness or sensitiveness of the
quantity demanded is measured to changes, in its price, the elasticity is said be price elasticity of
demand.
When the change in demand is the result of the given change in income, it is named as income
elasticity of demand. Sometimes, a change in the price of one good causes a change in the
demand for the other. The elasticity here is called cross electricity of demand. The three main
types of elasticity of demandare now discussed in brief.
(1) Price Elasticity of Demand:
The concept of price elasticity of demand is commonly used in economic literature. Price
elasticity of demand is the degree of responsiveness of quantity demanded of a good to a change
in its price. Precisely, it is defined as:
"The ratio of proportionate change in the quantity demanded of a good caused by a given
proportionate change in price".
Formula:
The formula for measuring price elasticity of demand is:
Price Elasticity of Demand = Percentage in Quantity Demand
Percentage Change in Price
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Ed = Δq X P
Δp Q
Example:
Let us suppose that price of a good falls from $10 per unit to $9 per unit in a day. The decline in
price causes the quantity of the good demanded to increase from 125 units to 150 units per day.
The price elasticity using the simplified formula will be:
Ed = Δq X P
Δp Q
Δq = 150 - 125 = 25
Δp = 10 - 9 = 1
Original Quantity = 125
Original Price = 10
Ed = 25 / 1 x 10 / 125 = 2
The elasticity coefficient is greater than one. Therefore the demand for the good is elastic.
Types:
The concept of price elasticity of demand can be used to divide the goods in to three groups.
(i) Elastic. When the percent change in quantity of a good is greater than the percent change in
its price, the demand is said to be elastic. When elasticity of demand is greater than one, a fall in
price increases the total revenue (expenditure) and a rise in price lowers the total revenue
(expenditure).
(ii) Unitary Elasticity. When the percentage change in the quantity of a good demanded equals
percentage in its price, the price elasticity of demand is said to have unitary elasticity. When
elasticity of demand is equal to one or unitary, a rise or fall in price leaves total revenue
unchanged.
(iii) Inelastic. When the percent change in quantity of a good demanded is less than the
percentage change in its price, the demand is called inelastic. When elasticity of demand is
inelastic or less than one, a fall in price decreases total revenue and a rise in its price increases
total revenue.
(2) Income Elasticity of Demand:
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Income is an important variable affecting the demand for a good. When there is a change in the
level of income of a consumer, there is a change in the quantity demanded of a good, other
factors remaining the same. The degree of change or responsiveness of quantity demanded of a
good to a change in the income of a consumer is called income elasticity of demand. Income
elasticity of demand can be defined as:
"The ratio of percentage change in the quantity of a good purchased, per unit of time to
a percentage change in the income of a consumer".
Formula:
The formula for measuring the income elasticity of demand is the percentage change in demand
for a good divided by the percentage change in income. Putting this in symbol gives.
Ey = Percentage Change in Demand
Percentage Change in Income
Simplified formula:
Ey = Δq X P
Δp Q
Example:
A simple example will show how income elasticity of demand can be calculated. Let us assume
that the income of a person is $4000 per month and he purchases six CD's per month. Let us
assume that the monthly income of the consumer increase to $6000 and the quantity demanded
of CD's per month rises to eight. The elasticity of demand for CD's will be calculated as under:
Δq = 8 - 6 = 2
Δp = $6000 - $4000 = $2000
Original quantity demanded = 6
Original income = $4000
Ey = Δq / Δp x P / Q = 2 / 200 x 4000 / 6 = 0.66
The income elasticity is 0.66 which is less than one.
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Types:
When the income of a person increases, his demand for goods also changes depending upon
whether the good is a normal good or an inferior good. For normal goods, the value of elasticity
is greater than zero but less than one. Goods with an income elasticity of less than 1 are called
inferior goods. For example, people buy more food as their income rises but the % increase in its
demand is less than the % increase in income.
(3) Cross Elasticity of Demand:
The concept of cross elasticity of demand is used for measuring the responsiveness of quantity
demanded of a good to changes in the price of related goods. Cross elasticity of demand is
defined as:
"The percentage change in the demand of one good as a result of the percentage change in the
price of another good".
Formula:
The formula for measuring, cross, elasticity of demand is:
Exy = % Change in Quantity Demanded of Good X
% Change in Price of Good Y
The numerical value of cross elasticity depends on whether the two goods in question are
substitutes, complements or unrelated.
Types and Example:
(i) Substitute Goods. When two goods are substitute of each other, such as coke and Pepsi, an
increase in the price of one good will lead to an increase in demand for the other good. The
numerical value of goods is positive.
For example there are two goods. Coke and Pepsi which are close substitutes. If there is increase
in the price of Pepsi called good y by 10% and it increases the demand for Coke called good X
by 5%, the cross elasticity of demand would be:
Exy = %Δqx / %Δpy = 0.2
Since Exy is positive (E > 0), therefore, Coke and Pepsi are close substitutes.
(ii) Complementary Goods. However, in case of complementary goods such as car and petrol,
cricket bat and ball, a rise in the price of one good say cricket bat by 7% will bring a fall in the
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demand for the balls (say by 6%). The cross elasticity of demand which are complementary to
each other is, therefore, 6% / 7% = 0.85 (negative).
(iii) Unrelated Goods. The two goods which a re unrelated to each other, say apples and pens, if
the price of apple rises in the market, it is unlikely to result in a change in quantity demanded of
pens. The elasticity is zero of unrelated goods.
Factors Determining Price Elasticity of Demand:
The price elasticity of demand is not the same for all commodities. It may be or low depending
upon number of factor. These factors which influence price elasticity of demand, in brief, are as
under:
(i) Nature of Commodities. In developing countries of the world, the per capital income of the
people is generally low. They spend a greater amount of their income on the purchase of
necessaries of life such as wheat, milk, course cloth etc. They have to purchase these
commodities whatever be their price. The demand for goods of necessities is, therefore, less
elastic or inelastic. The demand for luxury goods, on the other hand is greatly elastic.
For example, if the price of burger falls, its demand in the cities will go up.
(ii) Availability of Substitutes. If a good has greater number of close substitutes available in the
market, the demand for the good will be greatly elastic.
For examples, if the price of Coca Cola rises in the market, people will switch over to the
consumption of Pepsi Cola, which is its close substitute. So the demand for Coca Cola is elastic.
(iii) Proportion of the Income Spent on the Good. If the proportion of income spent on the
purchase of a good is very small, the demand for such a good will be inelastic.
For example, if the price of a box of matches or salt rises by 50%, it will not affect the
consumers demand for these goods. The demand for salt, maker box therefore will be inelastic.
On the other hand, if the price of a car rises from $6 lakh to $9 lakh and it takes a greater portion
of the income of the consumers, its demand would fall. The demand for car is, therefore, elastic.
(iv) Time. The period of time plays an important role in shaping the demand curve. In the short
run, when the consumption of a good cannot be postponed, its demand will be less elastic. In the
long run if the rise price persists, people will find out methods to reduce the consumption of
goods. So the demand for a good in the, long run is elastic, other things remaining constant.
For example if the price of electricity goes up, it is very difficult to cut back its consumption in
the short run. However, if the rise in price persists, people will plan substitution gas heater,
fluorescent bulbs etc. so that they use less^electricity. So the electricity of demand will be greater
(Ed = > 1) in the long run than in the short run.
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(5) Number of Uses of a Good. If a good can be put to a number of uses, its demand is greater
elastic (Ed > 1).
For example, if the price of coal falls, its quantity demanded will rise considerably because
demand will be coming from households, industries railways etc.
(6) Addition. If a product is habit forming say for example, cigarette, the rise in its price would
not induce much change in demand. The demand for habit forming good is, therefore, less
elastic.
(7) Joint Demand. If two goods are Jointly demand, then the elasticity of demand depends upon
the elasticity of demand of the other Jointly demanded good.
For example, with the rise in price of cars, its demand is slightly affected, then the demand for
petrol will also be less elastic.
(2) Geometric Method/Point Elasticity Method:
"The measurement of elasticity at a point of the demand curve is called point elasticity".
The point elasticity of demand method is used as a measure of the change in the quantity
demanded in response to a very small changes in price. The point elasticity of demand is defined
as:
"The proportionate change in the quantity demanded resulting from a very small proportionate
change in price".
Measurement of Geometric/Point Elasticity Method:
(i) Measurement of Elasticity on a Linear Demand Curve:
The price elasticity of demand can also be measured at any point on the demand curve. If the
demand curve is linear (straight line), it has a unitary elasticity at the mid point. The total
revenue is maximum at this point.
Any point above the midpoint has an elasticity greater than 1, (Ed > 1). Here, price reduction
leads to an increase in the total revenue (expenditure). Below the midpoint elasticity is less than
1. (Ed < 1). Price reduction leads to reduction in the total revenue of the firm.
Graph/Diagram:
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B-COM PART 1
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The formula applied for measuring the elasticity at any point on the straight line demand curve
is:
Ed = %∆q X p
%∆p q
The elasticity at each point on the demand curve can be traced with the help of point method as:
Ed = Lower Segment
Upper Segment
In the figure (6.9) AG is the linear demand curve (1). Elasticity of demand at its mid point D is
equal to unity. At any point to the right of D, the elasticity is less than unity (Ed < 1) and to the
left of D, the elasticity is greater than unity (Ed > 1).
(1) Elasticity of demand at point D = DG = 400 = 1 (Unity).
DA 400
(2) Elasticity of demand at point E = GE = 200 = 0.33 (<1).
EA 600
(3) Elasticity of Demand at point C = GC = 600 = 3 (>1).
CA 200
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(4) Elasticity of Demand at point C is infinity.
(5) At point G, the elasticity of demand is zero.
Summing up, the elasticity of demand is different at each point along a linear demand curve. At
high prices, demand is elastic. At low prices, it is inelastic. At the midpoint, it is unit elastic.
(3) Arc Elasticity:
Normally the elasticity varies along the length of the demand curve. If we are to measure
elasticity between any two points on the demand curve, then the Arc Elasticity Method, is used.
Arc elasticity is a measure of average elasticity between any two points on the demand curve. It
is defined as:
"The average elasticity of a range of points on a demand curve".
Formula:
Arc elasticity is calculated by using the following formula:
-
Ed = ∆q X P1 + P2
∆p q1 + q2
Here:
∆q denotes change in quantity.
∆p denotes change in price.
q1
signifies initial quantity.
q2
denotes new quantity.
P1
stands for initial price.
P2
denotes new price.
Graphic Presentation of Measuring Elasticity Using the Arc Method:
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B-COM Part 1 Economics

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