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Dedicated to my mother
Lakshmi R. Dutta

(v)
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 PREFACE

I have immense pleasure to bring out the present book which is basically designed to cover
complete syllabus of Economics for Higher Secondary second year examination (Class XII) as
introduced by the Nagaland Board of Secondary Education from the session 2004–2005. The
book will also be useful for the students appearing in class XII examination under CBSE.
The introduction of new syllabus has created vacuum in respect of suitable books exactly
in conformity to NBSE syllabus. As such the present book has been written particularly
keeping in mind the problems faced by students studying economics as a paper under NBSE.
The book will equally serve the purpose of students opting either Arts or Commerce stream.
The book is written in a very simple language understanding that it is meant for beginners.
The book contains two Parts-A and B. Part-A analysis Microeconomics and Part-B deals with
Macroeconomics. The new syllabus containing microeconomics and macroeconomics with
eleven units in total have been suitably divided into twenty seven chapters. Unit-5 and
unit-11 in the contents are meant for CBSE students only. At the end of the book, selected
basic economic terms have been included under the heading ‘Elementary Economic Terms’.
These are the terms most commonly and frequently used in economics and also in real life.
The underlying idea is to provide a student general understanding of economics as a subject
more clearly and analytically. Past years examination question papers of the NBSE from 1995
onwards have also been incorporated.
I am thankful to my wife Mili Dutta for constant inspiration and my lovely daughter
Sneha who has given me much time to work on it smoothly. I am also thankful to my
colleagues who have directly or indirectly lent their helping hands. I am very much grateful
to Mr. Saumya Gupta (Managing Director), Mr. V.R. Damodaran (Production Editor) and Saba
Khan (Development Editor) of M/s New Age International (P) Limited, New Delhi for taking
prompt and sincere initiative for publishing the book in a right time.
I would always invite critical views and suggestions for improvement of the book from
both students and fellow teachers.

SUBHENDU DUTTA
Department of Economics,
Public College of Commerce,
Dimapur: Nagaland
Email:[email protected]
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 CONTENTS

PART A
INTRODUCTORY MICROECONOMICS

UNIT-1

1. INTRODUCTION TO MICROECONOMICS 3
What economics is all about? Wealth definition; Welfare definition, Scarcity
definition, Subject matter of economics, Positive and normative economics;
Questions for review.
2. PROBLEMS OF AN ECONOMY 11
Central problems of an economy, Production possibility curve, Uses of
production possibility curve, Opportunity cost; Questions for review.

UNIT-2

3. CONSUMER BEHAVIOUR 16
Consumer’s equilibrium—utility maximization, Utility, Total utility, Marginal
utility, Law of diminishing marginal utility; Questions for review.
4. DEMAND AND LAW OF DEMAND 21
Meaning of demand, Market demand, Determinants of demand, Demand
schedule and demand curve, Law of demand, Assumptions of the law, Why
does the law of demand operate? Exceptions to the law of demand, Movement
along and shifts in demand curve; Questions for review.
5. ELASTICITY OF DEMAND 32
Meaning of price elasticity of demand, Kinds of price elasticity of demand,
Measurement of price elasticity of demand—percentage, total expenditure/
outlay, arc method, geometrical method and revenue method. Income elasticity
of demand, Cross elasticity of demand, Determinants of price elasticity of
demand; Questions for review.
UNIT-3
6. THEORY OF PRODUCTION 41
Meaning of production, Meaning of production function, Returns to a factor
and returns to scale, Law of variable proportions, Law of diminishing returns,
Assumptions of law, Returns to scale; Questions for review.
7. SUPPLY AND ITS DETERMINANTS 47
Meaning of supply, Supply schedule, Supply curve, Market supply, Law of
supply, Determinants of supply, Supply function, Movement along and shifts
in supply curve; Questions for review.
8. CONCEPTS OF COST 54
Cost of production, Real cost and nominal cost, Explicit and Implicit costs,
Opportunity Alternative Transfer cost, Private, External and Social costs,
Economic costs, Short run costs and long run costs; Fixed and variable costs;
Total fixed cost, Total variable cost, Average cost, Average fixed cost, Average
variable cost, and Marginal costs; Relationship between average cost and
marginal cost; Questions for review.
9. CONCEPTS OF REVENUE 63
Meaning of revenue, Total, Average and Marginal revenue, Relationship
between average and marginal revenue; Questions for review.

UNIT-4

10. FORMS OF MARKET AND PRICE DETERMINATION 67

Meaning of market, Forms of market, Perfect competition, Price and output
determination under perfect competition, Monopoly, Monopolistic competition,
Oligopoly, Duopoly; Questions for review.

UNIT-5

11. FACTOR PRICE DETERMINATION 74

Demand for a factor, Supply of a factor, Determination of price of a factor
under perfect competition, Marginal productivity theory; Questions for review.
12. FACTOR PRICES, COMPARATIVE ADVANTAGE AND
INTERNATIONAL TRADE 81
Internal and International trade, Absolute factor price difference, Relative
factor price difference, The classical theory of international trade—Theory of
absolute advantage–Adam Smith, Theory of comparative advantage–David
Ricardo, Theory of opportunity cost, Modern theory of international trade–
Heckscher and Ohlin, Terms of trade; Questions for review.
 PART B
INTRODUCTORY MACROECONOMICS

UNIT-6
13. INTRODUCTION TO MACROECONOMICS 91
Macroeconomics—meaning, Distinction between micro and macroeconomics;
Questions for review.
UNIT-7
14. NATIONAL INCOME AND RELATED AGGREGATES 94
Meaning of national income, National income at current and constant prices,
Circular flow of income, Concepts of GDP, GNP, NDP, NNP (at market price
and factor cost), Private income, Personal income and Personal disposal
income, National disposal income (gross and net). Income from Domestic
product accruing to Private Sector, Transfer payments—Current transfer
payments and Capital transfer payments, Relationship among important
national income aggregates; Questions for review. Appendix.
15. MEASUREMENT OF NATIONAL INCOME—VALUE ADDED METHOD 107
Measurement of national income—value added method, Steps to estimate
national income by value added/product method, Precautions in the estimation
of national income by product method, Difficulties of the product method;
Questions for review.
16. MEASUREMENT OF NATIONAL INCOME—INCOME METHOD 110
Precautions in the estimation of national income by income method, Difficulties
of the income method; Questions for review.
17. MEASUREMENT OF NATIONAL INCOME—EXPENDITURE METHOD 113
Components of final expenditure, Precautions in the estimation of national
income by expenditure method; Questions for review.

UNIT-8

18. AGGREGATE DEMAND AND AGGREGATE SUPPLY 115

Meaning of aggregate demand, Meaning of aggregate supply; Questions for
review.
19. DETERMINATION OF INCOME AND EMPLOYMENT 118
Classical theory of employment, Say’s Law of Markets, Assumptions of Say’s
Law, Full employment and involuntary unemployment, Determination of
income and employment; Questions for review.
20. CONSUMPTION FUNCTION 129
Propensity to consume or psychological law of consumption, Average and
marginal propensity to consume and save; Propensity to save/saving function,
Relationship between APC and MPC, Implication and Importance of
Psychological Law of Consumptions, Factors influencing consumption function,
Questions for review.
21. CONCEPT OF MULTIPLIER 135
Meaning of investment multiplier and its working; Assumptions of multiplier;
Importance of Multiplier; Leakages in the Working of Multiplier; Questions
for review.
22. EXCESS AND DEFICIENT DEMAND 140
Meaning of excess demand, Impact of excess demand in the economy, Meaning
of deficient demand, Impact of deficient demand in the economy, Causes of
excess and deficient demand, Measures to correct excess and deficient demand,
Availability of credit, Foreign trade policy; Questions for review.

UNIT-9

23. MONEY—MEANING AND FUNCTIONS 146

Barter system, Meaning of money, Functions of money, Supply of money,
Components of money; Questions for review.
24. BANKING 154
Commercial banks—meaning and functions. Central bank—meaning and
functions; Questions for review.

UNIT-10

25. GOVERNMENT BUDGET—MEANING AND COMPONENTS 160

Meaning of budget, Components of budget, Revenue budget, Capital budget,
Objectives of budget; Balanced budget, Surplus budget and deficit budget,
Types of deficit; Questions for review.

UNIT-11

26. FOREIGN EXCHANGE RATE—MEANING AND DETERMINATION 167

Demand for foreign exchange, Supply of foreign exchange, Spot and forward
foreign exchange transaction, Exchange rate systems—Floating exchange
rates, Pegged or rigidly fixed exchange rates, Managed flexibility—adjustable
peg system, Crawling or trotting or gliding parity, System of clean float and
dirty float, Band system; Questions for review.
27. BALANCE OF PAYMENTS ACCOUNT—MEANING
AND COMPONENTS 173
Goods account, Services account, Unilateral transfers account, Long-term
capital account, Short-term capital account, International liquidity account,
Balance of trade, Balance of payments on current account, Balance of payments
on capital account, Basic balance, Overall balance of payments, Accounting
balance of payments, Autonomous and accommodating transactions, Deficit
and surplus balance of payments. Questions for review.
APPENDICES 179
I. Solved Questions From NBSE Exam. Papers 179
II. Solved Numerical Problems 200
III. NBSE Question Papers (1995–2005) 215
IV. How to Pass Exam in better way! 228
V. Elementary Economic Terms 233

APPENDICES 234
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 PART A

INTRODUCTORY
MICROECONOMICS
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INTRODUCTION TO MICROECONOMICS 3

UNIT-1
INTRODUCTION TO
1 MICROECONOMICS

WHAT ECONOMICS IS ALL ABOUT?

Economics is about economizing; that is, about choice among alternative uses of scarce resources.
Choices are made by millions of individuals, businesses, and government units. Economics examines
how these choices add up to an economic system, and how this system operates. (L.G. Reynolds)
Scarcity is central to economic theory. Economic analysis is fundamentally about the
maximization of something (leisure time, wealth, health, happiness—all commonly reduced to the
concept of utility) subject to constraints. These constraints—or scarcity—inevitably define a trade-
off. For example, one can have more money by working harder, but less time (there are only so
many hours in a day, so time is scarce). One can have more apples only at the expense of, say,
fewer grapes (you only have so much land on which to grow food—land is scarce). Adam Smith
considered, for example, the trade-off between time, or convenience, and money. He discussed
how a person could live near town, and pay more for rent of his home, or live farther away and
pay less, “paying the difference out of his convenience”.
Economics as a subject came into being with the publication of very popular book in 1776,
“An Enquiry into the Nature and Causes of Wealth of Nations”, written by Prof. Adam Smith.
At that time it was called Political economy, which remained operational at least up to the middle
part of the 19th century. It is since then that the economists developed tools and principles using
inductive and deductive reasoning. In fact, the ‘Wealth of Nations’ is a landmark in the history
of economic thought that separated economics from other social sciences.
The word ‘Economics’ was derived from the Greek words ‘Oikos’ (a house) and ‘Nemein’
(to manage), which meant managing a household, using the limited money or resources a household
has.
Let us explain a few important definitions frequently referred to in the economic theory.

3
4 INTRODUCTORY ECONOMICS

Adam Smith (June 5, 1723-July 17, 1790) was a Scottish political economist and moral
philosopher. His ‘Inquiry into the Nature and Causes of Wealth of Nations’ was one of the
earliest attempts to study the historical development of industry and commerce in Europe. That
work helped to create the modern academic discipline of Economics and provided one of the
best-known intellectual rationales for free trade and capitalism.
At the age of about fifteen, Smith proceeded to the University of Glasgow, studying moral
philosophy under “the never-to-be-forgotten” (as Smith called him) Francis Hutcheson. In 1740
he entered the Balliol College of the University of Oxford, but as William Robert Scott has said,
“the Oxford of his time gave little if any help towards what was to be his lifework,” and he left
the university in 1746. In 1748 he began delivering public lectures in Edinburgh under the
patronage of Lord Kames. Some of these dealt with rhetoric and belles-lettres, but later he took
up the subject of “the progress of opulence,” and it was then, in his middle or late 20s, that
he first expounded the economic philosophy of “the obvious and simple system of natural
liberty” which he was later to proclaim to the world in his Inquiry into the Nature and Causes
of the Wealth of Nations.

Wealth Definition
The early economists like J.E. Cairnes, J.B.Say, and F.A.Walker have defined economics as a
science of wealth. Adam Smith, who is also regarded as father of economics, stated that economics
is a science concerned with the nature and causes of wealth of nations. That is, economics deal
with the question as to how to acquire more and more wealth by a nation. J.S.Mill opined that
it is the practical science dealing with the production and distribution of wealth. The American
economist F.A.Walker says that economics is that body of knowledge, which relates to wealth.
Thus, all these definitions relate to wealth.
However, the above definitions have been criticized on various grounds. As a result, economists
like Marshall, Robbins and Samuelson have put forward more comprehensive and scientific
definitions. Emphasis has been gradually shifted from wealth to man. As Marshall puts, it is “on
the one side a study of wealth; and on the other, and more important side, a part of the
study of man.”
INTRODUCTION TO MICROECONOMICS 5

UNIT-1
Alfred Marshall (July 26, 1842- July 13, 1924), born in Bermondsey, London, England, became
one of the most influential economists of his time. His book, Principles of Political Economy
(1890) brought together the theories of supply and demand, of marginal utility and of the costs
of production into a coherent whole. It became the dominant economic textbook in England for
a long period.
Marshall grew up in the London suburb and was educated at the Merchant Taylor’s School and
St. John’s College, Cambridge, where he demonstrated an aptitude in mathematics. Although
he wanted early on, at the behest of his father, to become a clergyman, his success at
Cambridge University led him to take an academic career. He became a professor in 1868
specializing in political economy. He desired to improve the mathematical rigor of economics
and transform it into a more scientific profession. In the 1870s he wrote a small number of
tracts on international trade and the problems of protectionism. In 1879, many of these works
were compiled together into a work entitled The Pure Theory of Foreign Trade: The Pure Theory
of Domestic Values. Marshall began work on his seminal work, the Principles of Economics,
in 1881, and he spent much of the next decade at work on the treatise. His most important
legacy was creating a respected, academic, scientifically-founded profession for economists
in the future that set the tone of the field for the remainder of the twentieth century. Marshall’s
influence on codifying economic thought is difficult to deny. He was the first to rigorously attach
price determination to supply and demand functions; modern economists owe the linkage
between price shifts and curve shifts to Marshall. Marshall was an important part of the
“marginalist revolution;” the idea that consumers attempt to equal prices to their marginal utility
was another contribution of his. The price elasticity of demand was presented by Marshall as
an extension of these ideas. Economic welfare, divided into producer surplus and consumer
surplus, was contributed by Marshall, and indeed, the two are sometimes described eponymously
as ‘Marshallian surplus.’ He used this idea of surplus to rigorously analyze the effect of taxes
and price shifts on market welfare. Marshall also identified quasi-rents.

Welfare Definition
Thus according to Marshall, economics not only analysis the aspect of how to acquire wealth but
also how to utilize this wealth for obtaining material gains of human life. In fact, wealth has no
meaning in itself unless it is used to purchase all those things which are required for our sustenance
as well as for the comforts necessary for life. Marshall, thus, opined that wealth is a means to
achieve certain ends.
6 INTRODUCTORY ECONOMICS

In other words, economics is not a science of wealth but a science of man primarily. It may
be called as the science which studies human welfare. Economics is concerned with those
activities, which relates to wealth not for its own sake, but for the sake of human welfare that
it promotes. According to Cannan, “The aim of political economy is the explanation of the
general causes on which the material welfare of human beings depends.” Marshall in his
book, “Principles of Economics”, published in 1890, describes economics as, “the study of mankind
in the ordinary business of life; it examines that part of the individual and social action
which is most closely connected with the attainment and with the use of the material requisites
of well being”.
On examining the Marshall’s definition, we find that he has put emphasis on the following
four points:
(a) Economics is not only the study of wealth but also the study of human beings. Wealth
is required for promoting human welfare.
(b) Economics deals with ordinary men who are influenced by all natural instincts such as
love, affection and fellow feelings and not merely motivated by the desire of acquiring
maximum wealth for its own sake. Wealth in itself is meaningless unless it is utilized
for obtaining material things of life.
(c) Economics is a social science. It does not study isolated individuals but all individuals
living in a society. Its aim is to contribute solutions to many social problems.
(d) Economics only studies ‘material requisites of well being’. That is, it studies the causes
of material gain or welfare. It ignores non-material aspects of human life.
This definition has also been criticized on the ground that it only confines its study to the
material welfare. Non-material aspects of human life are not taken into consideration. Further, as
Robbins said the science of economics studies several activities, that hardly promotes welfare.
The activities of producing intoxicants, for instance, do not promote welfare; but it is an economic
activity.

Lionel Charles Robbins (1898-1984) was a British economist of the 20th century who proposed
one of the early contemporary definitions of economics, “Economics is a science which studies
human behavior as a relationship between ends and scarce means which have alternative
uses.”
Robbins’s early essays were very combative in spirit, stressing the subjectivist theory of value
beyond what Anglo-Saxon economics had been used to. His famous work on costs (1930,
1934) helped bring Wieser’s “alternative cost” theorem of supply to England (which was
opposed to Marshall’s “real cost” theory of supply). It was his 1932 Essay on the Nature and
Significance of Economic Science where Robbins made his Continental credentials clear.
Redefining the scope of economics to be “the science which studies human behavior as a
relationship between scarce means which have alternative uses”.

Scarcity Definition
Lionel Robbins challenged the traditional view of the nature of economic science. His book,
“Nature and Significance of Economic Science”, published in 1932 gave a new idea of thinking
INTRODUCTION TO MICROECONOMICS 7

about what economics is. He called all the earlier definitions as classificatory and unscientific.

UNIT-1
According to him, “Economics is the science which studies human behaviour as a relationship
between ends and scarce means which have alternative uses.” This definition focused its
attention on a particular aspect of human behaviour, that is, behaviour associated with the utilization
of scarce resources to achieve unlimited ends (wants). Robbins definition, thus, laid emphasis on
the following points:
(a) ‘Ends’ are the wants, which every human being desires to satisfy. Want is an effective
desire for a thing, which can be satisfied by making an effort for obtaining it. We have
unlimited wants and as one want gets satisfied another arises. For instance, one may
have the desire to buy a car or a flat. Once the car or the flat is purchased, the person
wishes to buy a more spacious and designable car and the list of his wants does not
stop here but goes on one after another. As human wants are unlimited, we have to
make a choice between the most urgent want and less urgent wants. Thus the problem
of choice arises. That is why economics is also called as a science of choice. If wants
had been limited, they would have been satisfied and there would have been no economic
problem.
(b) ‘Means ’or resources are limited. Means are required to be used for the satisfaction
of various wants. For instance, money is an important means to satisfy many of our
wants. As stated, means are scarce (short in supply in relation to demand) and as such
these are to be used optimally. In other words, scarce or limited means/resources are
to be economized. We should not make waste of the limited resources but utilize them
very judiciously to get the maximum satisfaction.
(c) Robbins also said that, the scarce means have alternative uses. It means that a
commodity or resource can be put to different uses. Hence, the demand in the aggregate
for that commodity or resource is almost insatiable. For instance, if we have a hundred
rupee note, we can use it either to purchase a book or a fashionable clothe. We may
use it in other unlimited ways as we like.
Let us now turn our attention to the definitions put forward by modern economists. J.M.Keynes
defined economics as the study of the management of scarce resources and of the determination
of income and employment in the economy. Thus his study centered on the causes of economic
fluctuations to see how economic stability could be established. According to F. Benham, economics
is, “a study of the factors affecting the size, distribution and stability of a country’s national
income.” Recently, economic growth and development has taken an important place in the study
of economics. Prof. Samuelson has given a growth oriented definition of economics. According
to him, economics is the study and use of scarce productive resources overtime and distribute
these for present and future consumption.
In short, economics is a social science concerned with the use of scarce resources in an
optimum manner and in attainment of desired level of income, output, employment and economic
growth.

SUBJECT MATTER OF ECONOMICS

The subject matter of economics is divided into two categories–microeconomics and
8 INTRODUCTORY ECONOMICS

macroeconomics. Microeconomics, which deals with individual agents, such as households and
businesses, and macroeconomics, which considers the economy as a whole, in which case it
considers aggregate supply and demand for money, capital and commodities. Aspects receiving
particular attention in economics are resource allocation, production, distribution, trade, and
competition. Economics may in principle be (and increasingly is) applied to any problem that
involves choice under scarcity or determining economic value.
The term ‘Micro’ and ‘Macro’ economics have been coined by Prof. Ragnar Frisch of Oslo
University during 1920’s. The word micro means a millionth part. In Greek mickros means small.
Thus microeconomics deals with a small part of the whole economy. For example, if we study
the price of a particular commodity instead of studying the general price level in the economy, we
actually are studying microeconomics. Precisely, microeconomics studies the behaviour of individual
units of an economy such as consumers, firms, and industry etc. Therefore, it is the study of a
particular unit rather than all units combined together. Microeconomics is called Price theory,
which explains the composition, or allocation of total production.
In short, microeconomics is the study of the economic behaviour of individual consumers,
firms, and industries and the distribution of production and income among them. It considers
individuals both as suppliers of labour and capital and as the ultimate consumers of the final
product. On the other hand, it analyses firms both as suppliers of products and as consumers of
labour and capital.
Microeconomics seeks to analyze the market form or other types of mechanisms that establish
relative prices amongst goods and services and/or allocates society’s resources amongst their
many alternative uses. In microeconomics, we study the following:
1. Theory of product pricing, which includes-
(a) Theory of consumer behaviour.
(b) Theory of production and costs.
2. Theory of factor pricing, which constitutes-
(a) Theory of wages.
(b) Theory of rent.
(c) Theory of interest.
(d) Theory of profits.
3. Theory of economic welfare.
Microeconomics has occupied a very important place in the study of economic theory. In
fact, it is the stepping–stone to economic theory. It has both theoretical and practical implications.
Important points of its significance are mentioned as under:
1. Microeconomics is of great help in the efficient management of the limited resources
available in a country.
2. Microeconomics is helpful in understanding the working of free enterprise economy
where there is no central control.
INTRODUCTION TO MICROECONOMICS 9

3. Microeconomics is utilized to explain the gains from international trade, balance of

UNIT-1
payments disequilibrium and determination of foreign exchange rate.
4. It explains how through market mechanism goods and services produced in the community
are distributed.
5. It helps in the formulation of economic policies, which are meant for promoting efficiency
in production, and welfare of the people.
6. Microeconomics is the basis of welfare economics.
7. Microeconomics is used for constructing economic models for better understanding of
the actual economic phenomena.
Despite the fact that it has so many benefits, it also suffers from certain defects or limitations.
These are:
1. It is not capable of explaining the functioning of an economy as a whole.
2. It assumes full employment; which is rare in real life.
3. It cannot be used for solving the problem relating to public finance, monetary and fiscal
policy etc.
Positive and Normative Economics
While discussing the scope of economics, we also think of whether economics is a positive or
normative science. A positive science describes ‘what is’ and normative science explains ‘what
ought to be’. Thus a positive science describes a situation as it is, whereas normative science
analysis the situation and suggests/comments on wrongness or rightness of a thing/state. For
example, ‘population in India is rising’, is a positive statement and ‘Rising population is an obstacle
in the way of development’ is a normative statement.
Classical economists consider economics as a positive science. They declined any comment
about wrongness or rightness of an economic situation. Robbins also supported the classical view
and stated that economics is not concerned with the desirability or otherwise of ‘ends’. Therefore,
the task of an economist is not to condemn or advocate but to explore and explain. However,
economics should not be treated as only positive science. It should be allowed to pass moral
judgments of an economic situation. It is, therefore, considered both positive and normative
science. Thus, Economics is the social science that studies the allocation of scarce resources to
satisfy unlimited wants. This involves analyzing the production, distribution, trade and consumption
of goods and services. Economics is said to be positive when it attempts to explain the consequences
of different choices given a set of assumptions or a set of observations, and normative when it
prescribes that a certain action should be taken.

Questions for Review

1. Define economics as given by L. Robbins.
2. Who is regarded as the father of economics?
3. Who coined the terms—micro and macroeconomics?
4. Name the book written by Adam Smith.
10 INTRODUCTORY ECONOMICS

5. ‘Economics is a science of choice’—explain.

6. “Economics is a science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses.” Explain.
7. Give the meaning of the term opportunity cost.
8. How is the study of microeconomics significant?
9. What is the scope of microeconomics?
10. What do you mean by marginal rate of transformation?
11. What is the basic problem of an economy?
12. What do you mean by the terms ‘ends’ and ‘means’?
13. Define want.
14. What is the meaning of economizing of resources? Why is there a need for economizing
resources?
16. What do you understand by Micro Economics?
17. What specific problem of an economy is studied in welfare economics?
18. Give the definition of a scarce resource.
19. What is meant by scarcity in economics?
20. Define an economy.
21. State Marshall’s definition of Economics.
22. “Economics enquires into the nature and causes of wealth of nations”. Who gave this definition
of economics? What does it imply?
23. What is economics about? (NCERT)
24. Explain how scarcity and choice go together. (NCERT)
25. “Economics is about making choices in the presence of scarcity.” Explain. (NCERT)
26. What are the main features of Marshall’s Definition of economics?
27. “Scarce means have alternative uses.”—Explain.
28. Name the Economist who coined the terms micro and macro.
29. Write five importances of micro economics.
30. Mention three shortcomings of microeconomic theory.
31. What do you understand by positive and normative economics?
32. Is economics a positive science?
PROBLEMS OF AN ECONOMY 11

UNIT-1
2 PROBLEMS OF AN ECONOMY

CENTRAL PROBLEMS OF AN ECONOMY

Scarcity is the root cause of all economic problems. We know that resources are scarce or short
in supply in relation to demand; but wants or ends are unlimited. As a consequence, we face the
problem of choice among so many of our wants. This is because scarce means have alternative
uses. Thus, we have to choose among the most urgent and less urgent wants. In fact, the basic
problem of an economy is the problem of choice. More precisely, problem before us is to take
right decisions in regard to the goals or ends to be attained and the way, the scarce means to be
utilized for this purpose. Every economy faces some fundamental problems called as central
problems of an economy. These are the following:
(1) What goods and services are to be produced? The first major problem faced by
an economy is what types of goods and services to be produced. As resources are
limited, we must choose between different alternative collection of goods and services
that may be produced. It may also imply whether to produce capital/producer goods or
consumer goods. Moreover, we have to decide about the quantity of the goods to be
produced in the economy.
(2) How to produce these goods and services? The next problem we have to tackle
is the problem of how to produce the desired goods in the economy. Thus the question
of techniques to be used in the production comes in the mind. Whether we should use
labour-intensive technique or capital – intensive technique. Labour-intensive method of
production implies more use of labour per unit than capital whereas; capital-intensive
technique indicates more use of capital per unit than labour. The choice depends on the
availability of resources. A labour surplus economy can well use the labour–intensive
technology.
(3) For whom these goods and services are to be produced? Once we have decided
what goods to be produced and what techniques to be used in the production of goods,
we are encountered with another problem, i.e., the problem of distribution of goods in
the economy. This is the problem of sharing of national income.
(4) Are the resources efficiently used? We have also to see that scarce resources are
efficiently utilized. This is the problem of economic efficiency or welfare maximization.
11
12 INTRODUCTORY ECONOMICS

(5) Are the resources fully employed? An economy must also try to achieve full
employment of all its resources.
(6) How to attain growth in the economy? An economy is to ensure that it is attaining
sufficient growth rate so that it is able to grow larger and larger and develop at faster
rate. It should be able not only to make a structural change from agrarian to industrial
sector but also to increase per capita and national income of the country. An economy
must not remain static. Its productive capacity must increase continuously.
It is clear that the basic problem of an economy is the economizing of resources. The
economizing problem arises in every type of economic society owing to the fact that resources
are scarce in relation to multiple wants/ends.

PRODUCTION POSSIBILITY CURVE

The production possibility Curve is a graph that depicts the trade-off between any two items
produced. It is also known as Transformation Curve or Production Frontier, which shows the
maximum feasible quantities of two or more goods that, can be produced with the resources
available. In other words, it indicates the opportunity cost of increasing one item’s production in
terms of the units of the other forgone. Prof. Samuelson analyzed the economizing problem by
the use of production possibility curve.
Thus, a PPC shows the maximum obtainable amount of one commodity for any given amount
of another commodity, given the availability of factors of production and the society’s technology
and management skills. The concept is used in macroeconomics to show the production possibilities
available to a nation or economy, and also in microeconomics to show the options open to an
individual firm. All points on a production possibilities curve are points of maximum productive
efficiency or minimum productive inefficiency: resources are allocated such that it is impossible
to increase the output of one commodity without reducing the output of the other. That is, there
must be a sacrifice—an opportunity cost—for increasing the production of any good. All resources
are used as completely as possible (without the situation becoming unsustainable) and appropriately.
The production possibility curve does not remain stationary. It moves outward overtime with
growth of resources and improvement in technology. This is because we get more output from
the same quantities of resources. The table below illustrates production possibilities of a simple
economy producing two commodities—cars and computers. Two production possibilities–E and F
are shown. When the economy decides to put more resources for the production of computers,
it must sacrifice some resources from the production of cars. Thus, when 10000 computers are
decided to be produced, 5000 cars cannot be produced as the resources are now diverted to the
production of computers.
Production Computers (in Cars (in
possibilities 000’s) 000’s)

E 5 15
F 10 10

The adjacent Fig. 2.1 derived from the table above, shows the production possibility curve. If
all resources in the economy are utilized in the production of cars, OA units of cars can be produced.
PROBLEMS OF AN ECONOMY 13

On the other hand, if all resources are put in the production of computers, OB units of

UNIT-1
computers would be produced in the economy. Joining points A and B, we get production possibility
curve AB. In case, the economy decides to produce both the commodities by using the available
resources, it can produce various combinations of cars and computers by staying on the curve AB,
such as at E or F. At point E, it can produce OS units of cars and OT units of computers. Similarly,
at F, ON units of cars and OM units of computers can be produced. Thus, the points E, F or any
other point on curve AB show maximum feasible combinations of cars and computers which can
be produced with the resources available. Point C in the figure is not attainable or feasible for
the economy as it is above the production possibility curve AB, i.e., beyond the capacity of the
economy. Again, it will not produce at point D which is though attainable but not desirable,
because in that case the economy’s resources will not be used most effectively.
Y

Production possibility curve

A
E .C
S
Cars

N F
D

O T M B X
Computers
Fig. 2.1

It is, thus, seen that to produce more computers, some units of cars are to be sacrificed, i.e.,
cars can be transformed to computers. The rate at which one product is transformed into another
is called marginal rate of transformation (MRT). Thus, MRT between cars and computers is
the units of cars (in our case, 5000), which has to be sacrificed for the production of computers.
MRT increases, as more of one commodity is produced and less of another. This makes Production
Possibility curve concave to the origin.
Uses of Production Possibility Curve
The production possibility curve has a number of uses. It helps in finding the solution of the basic
problems of production—what and how to produce and for whom to produce goods in the
economy. Besides, whenever government decides to divert its resources, say, from necessaries to
luxuries, it may utilize the concept of production possibility curve. It can also help in guiding the
diversion of resources from current consumption goods to capital goods and increase productive
capacity to attain higher levels of production.
14 INTRODUCTORY ECONOMICS

OPPORTUNITY COST
Opportunity cost is a term which means the cost of something in terms of an opportunity
foregone (and the benefits that could be received from that opportunity), or the most valuable
foregone alternative. In other words, the opportunity cost of a given commodity is the next best
alternative cost or transfer costs. As we know that productive resources are scarce, therefore,
the production of one commodity means not producing another commodity. The commodity that
is sacrificed is the real cost of the commodity that is produced. This is the opportunity cost. Let
us explain this with an example. Suppose a producer can produce a car or a computer with the
money at his disposal. If the producer decides to produce car and not computer, then the real
cost of the car is equal to the cost of computer, i.e., the alternative foregone. Let us take
another example to explain the concept. For example, if a company decides to build hotels on
vacant land that it owns, the opportunity cost is some other thing that might have been done
with the land and construction funds instead. In building the hotels, the company has forgone
the opportunity to build, say, a sporting center on that land, or a parking lot, or a housing
complex, and so on. In simpler terms, the opportunity cost of spending a day for picnic with
your friends could be the amount of money you could have earned if you had devoted that time
to working overtime.
Opportunity cost need not be assessed in monetary terms, but rather, is assessed in
terms of anything that is of value to the person or persons doing the assessing. The
consideration of opportunity costs is one of the key differences between the concepts of
economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing
the true cost of any course of action. The simplest way to estimate the opportunity cost
of any single economic decision is to consider, “What is the next best alternative choice that
could be made?” The opportunity cost of paying for college fee could be the ability to buy
some clothes. The opportunity cost of a vacation in the Goa could be the payment for
buying a motorbike.
It is to be noted that opportunity cost is not the sum of the available alternatives, but rather
of benefit of the best alternative of them.
The concept of opportunity cost can be explained with a diagram that depicts opportunity
cost between any two given items produced by a given economy. It is known in economics as
the production possibility curve, as shown in Fig. 2.1 above. In the imaginary economy discussed
above which produces only cars and computers, the economy will be operating on the PPC if
all resources (inputs) are fully utilized and used most appropriately (efficiently). The exact
combination of cars and computers produced depends on the mechanisms used to decide the
allocation of resources (i.e., some combination of markets, government, tradition, and community
democracy).
The concept of opportunity cost has become very popular in the recent years. The modern
analysis of cost-benefit analysis is based on the theory of opportunity cost only. The cost-benefit
analysis is a guiding tool for entrepreneurial decisions in the modern economy. Although opportunity
cost can be hard to quantify, its effect is universal and very real on the individual level. The
principle behind the economic concept of opportunity cost applies to all decisions, not just economic
ones.
PROBLEMS OF AN ECONOMY 15

Questions for Review

UNIT-1
1. What do you mean by an economic problem? How does an economic problem arise?
2. What are the central problems of an economy?
3. What is a production possibility curve? Explain with the help of a diagram.
4. Give the meaning of the term opportunity cost.
5. Why is the production possibility curve concave to the origin?
6. What do you mean by marginal rate of transformation?
7. Define marginal opportunity cost along a production possibility curve. (NCERT)
8. Give two examples of underutilization of resources. (NCERT)
9. “An economy always produces on, but not inside, a PPC.” Give reasons. (NCERT)
10. Name the factors that lead to the shift of the PPC? (NCERT)
11. Give two examples of growth of resources. (NCERT)
12. Why do technological advances or growth of resources shift the PPC to the right? (NCERT)
13. Name any two central problems facing an economy. (NCERT)
14. What does increasing marginal opportunity cost along a PPC mean? (NCERT)
15. What is the basic problem of an economy?
16. Distinguish between capital-intensive and labour-intensive technique of production.
17. What are the important uses of PPC?
18. Explain the concept of opportunity cost giving example.
16 INTRODUCTORY ECONOMICS

3 CONSUMER BEHAVIOUR

CONSUMER’S EQUILIBRIUM–UTILITY MAXIMIZATION

The theory of demand starts with the examination of the behaviour of the consumers. In our
everyday life we behave in different ways while buying and consuming a good or service. The
simple calculations and human reasoning we undertake while doing any transactions have been
transformed into principles which guide us to attain satisfaction or equilibrium in economic sense.
When we go for shopping, we decide beforehand, what good to buy and how much to spend. It
makes sense as we try to get most of what we are spending. In other words, we always want
more of anything and for that purpose we negotiate and come to an agreed price which we are
ready to pay happily. It is therefore, necessary to be first acquainted with the consumer behaviour,
which forms the basis of the demand theory.
It is assumed that consumers are rational. Given his money income and the prices of
commodities, a consumer always tries to maximize his satisfaction. That is, to get the maximum
welfare (state of well-being) by spending the given money on various commodities. It is assumed
that the satisfaction a consumer gets by consuming a good is measurable (measured in terms of
money), though in real life it is not possible to measure satisfaction because it is psychological
entity. We only feel the level of satisfaction and express the same in different ways. We show
our satisfaction by our behaviour like laughing, jumping in excitement or in any other way. Thus,
we cannot measure satisfaction in quantitative terms as we are capable of measuring time in
seconds, weight in kilograms or length in meters. Further, each consumer is also assumed to be
known of what he wants. Moreover, he has all information regarding market—the goods available,
the prices of the goods at a particular point of time and so on. Every consumer uses this
information in such a way as to maximize his total satisfaction.
To explain consumer’s equilibrium i.e., how a consumer attains maximum satisfaction by
spending his money income on certain units of commodities, it is worthwhile to be familiar with
certain important terms used in explaining various concepts and theories of demand. These are
explained as under:
Utility
Utility is defined as the power of a commodity or service to satisfy a human want. Economists
have leveled the term satisfaction as utility. It is subjective concept and therefore varies from
16
CONSUMER BEHAVIOUR 17

person to person. As already stated, it resides in one’s mind and therefore cannot be measured
in quantitative terms. Though utility and satisfaction are used synonymously, we should note that
utility is the expected satisfaction whereas satisfaction implies ‘realized satisfaction’.
Total Utility

UNIT-2
It is the amount of utility (satisfaction); a consumer gets by consuming all the units of a commodity.
If there are n units of the commodity then the total utility is the sum of the utilities of all n units
of the commodity. Thus, if there are four units of a commodity, then total utility is,
U = U1(n1) + U2(n2) + U3(n3) + U4(n4)
Where U = total utility; U1…….U4 are the utilities of n1…..n4 units of the commodity.
Thus, if by consuming first apple, a consumer gets 12 utils of satisfaction, 10 utils from the
second apple, 9 utils from the third and 7 utils from the fourth apple; then his total utility is,
U = 12 + 10 + 9 + 7 = 38
Thus utilities of various goods are additive. This means that utilities of different commodities
are independent of one another. The utility derived from one commodity does not affect that of
another.
Marginal Utility
Marginal utility is defined as the change in the total utility due to a unit change in the consumption
of a commodity per unit of time. It can also be defined as the addition made to the total utility
by consuming an additional unit of a commodity. For example, if total utility of 3 cups of tea is
18 utils and on consuming the 4th cup it rises to 20; then marginal utility 20-18 = 2 utils. Thus,
by consuming one more cup of tea, the additional utility, a consumer gets is 2 utils. Marginal utility
can be expressed as,
∆TU
MU =
∆Q
Where MU = marginal utility; ∆ΤU = change in total utility; ∆Q = change in the quantity
consumed. ‘Utils’ is the term used by Marshall as a measuring unit of utility. The following
expression can also be used to find marginal utility:
MU = TUn – TUn-1
Where, TUn is the total utility of nth unit of the commodity and TUn-1 utility from the n-1th
commodity. Thus, if TU from the second unit (nth unit) of apple is 13 and TU from the previous
unit (n-1) is 7, then MU is 13 – 7 = 6.
The concept of total utility and marginal utility is shown in the utility schedule below:
Units of apples Total utility Marginal utility

1 7 7–0=7
2 13 13 – 7 = 6
3 18 18 – 13 = 5
4 22 22 – 18 = 4

Contd....
18 INTRODUCTORY ECONOMICS

5 25 25 – 22 = 3
6 27 27 – 25 = 2
7 28 28 – 27 = 1
8 28 28 – 28 = 0

When the consumer takes 1st apple, his total utility is 7 and from the 2nd apple he gets 13
and so on. The third column shows marginal utility, which diminishes as the consumer increases
units of apples. It is seen that when total utility is maximum, marginal utility is zero at 8th unit
of apple. It is also seen that total utility is the sum of the marginal utilities of the 1st, 2nd, 3rd, and
so on. Thus, at 8th unit of apple,
TU = MU1 + MU2 + MU3 + MU4 +…..…+ MUn(8)
28 = 7 + 6 + 5 + 4 +…..…+ 0

LAW OF DIMINISHING MARGINAL UTILITY

One of the very important laws in regard to the satisfaction of human wants is known as law
of diminishing marginal utility. The law explains common feeling of every consumer. Suppose
a person starts consuming apples one after another. The first apple gives him the maximum
satisfaction as he might be in mood of taking some food at that time for meeting his appetite.
As he takes the second apple, he gets less satisfaction because by this time he has already
met some level of appetite. The third and more apples yield him lesser satisfaction or utility.
It means that every time the consumer increases his consumption, he gets less and less
satisfaction. The satisfaction also tends to be zero when the consumer feels totally disgusted
to take any more apples. If he takes more, his satisfaction turns negative or utility now
becomes disutility.
Thus law of diminishing marginal utility states that additional satisfaction a person derives
by consuming a commodity goes on declining as he consumes more and more of a that
commodity. According to Marshall, “The additional benefit which a person derives from a
given increase of his stock of a thing diminishes with every increase in stock that he
already has.”
Two important reasons for diminishing marginal utility are the following:
(a) Each particular want is satiable (can be satisfied): Though there are unlimited
wants, a single want can be satisfied. Thus, when a consumer consumes more and
more of a commodity, his want is satisfied and he does not wish to have any further
increase in the commodity. As such his marginal utility falls when consumption
increases.
(b) Goods are imperfect substitutes for one another i.e., one good cannot be exactly
used in place of another: Satisfaction from any two goods is not same. Different
goods satisfy different wants. If a good could be perfectly substituted for another, it
would have satisfied other wants. Hence, its marginal utility would not have fallen but
increased.
CONSUMER BEHAVIOUR 19

The law can be explained with the help of a table and diagram-3.1 below:
Units (Apples) TU MU

1 10 10
2 18 8

UNIT-2
3 22 4
4 24 2
5 25 1
6 25 0
7 32 –7
8 44 –12

As the consumer goes on consuming more and more units of apples, total utility (TU) increases
but marginal utility (MU) declines continuously and becomes zero at 6th unit. When consumer
consumes further, utility becomes negative. It is to be noted that when TU is maximum, MU is zero.
Let us now derive the MU curve from the above schedule as under. Marginal utility is measured
along Y-axis while units of apples along X-axis. MU is the marginal curve falling downwards from
left to right. This is diminishing MU curve. It is seen in the Fig. 3.1 below, that marginal utility is
zero when the consumer buys 6th apple. As he consumes more, marginal utility becomes negative.

Fig. 3.1

The law of diminishing MU has certain limitations. These are:

1. If units of a commodity consumed are not of same size and shape, the law does not
20 INTRODUCTORY ECONOMICS

hold good. In the illustration explained above, units of apples are assumed to be of same
shape and size.
2. The law does not hold good when there is enough time gap between consumption of
two units. For instance, if we take second apple after a long gap of time, we may feel
hungry and hence satisfaction will increase instead of falling.
3. The taste of consumer should not change for the law to hold good. It means that the
person should consume all units of a good by same desire and pleasure.
4. The law does not apply to money as it is said that more money a person has, the more
he wants.
5. Change in income of the consumer will falsify the law. If money income of the
consumer increases or decreases during the time of consumption of a particular set of
goods, the marginal utility will not fall as said above.
The law of diminishing marginal (additional) utility explains consumer’s equilibrium in case of
a single commodity. A consumer will go on purchasing successive units of a commodity till the
marginal utility of the commodity is equal to price. Thus, for a single commodity x, a consumer
is in equilibrium when the marginal utility of x is equal to its market price (Px). Symbolically,
MUx = P x
In case the price goes down, he will buy more and the marginal utility will come down to
the level of price. If price rises, less will be purchased and the marginal utility rises till it reaches
the new level of price. Thus, equality between marginal utility and price indicates the position of
consumer’s equilibrium when a single commodity is being purchased and consumed.
Questions for Review
1. State the law of diminishing marginal utility.
2. Define total utility.
3. Define marginal utility.
4. How is total utility derived from marginal utilities? (NCERT)
5. What does rationality of consumers mean?
6. Is satisfaction measurable?
7. Define utility.
8. Show that utilities of various goods are additive.
9. Explain law of diminishing marginal utility with the help of diagram.
10. Why does marginal utility diminishes?
11. What are the assumptions of the law of diminishing marginal utility?
12. Does the law apply to money?
13. What is the condition for a consumer’s equilibrium? Explain.
DEMAND AND LAW OF DEMAND 21

UNIT-2
DEMAND AND
4 LAW OF DEMAND

MEANING OF DEMAND
In Economics, Demand means desire to have a commodity backed by enough money to pay for
the good demanded. Thus, in economics we are concerned only with demand, which is effectively
backed up by an adequate supply of purchasing power, i.e., with effective demand. Thus, if a
person desires to buy a car, he should have enough money to buy that; then only demand becomes
effective. It should also be mentioned here that demand is not complete unless the consumer has
willingness to buy a good or service. A person has the desire and enough money but at a particular
point of time, he may not have willingness to buy the good due to sudden change in his taste or
preference. For example, when a person goes to a showroom to buy his dream car but declines
to buy, just because he does not find his preferred colour. Moreover, demand for a good is always
expressed in relation to a particular price and a particular time. Therefore, we may define demand for
a good as the amount of it, which will be purchased per unit of time at a given price. According to
F. Benham, “The demand for anything at a given price is the amount of it which will be bought
per unit of time at that price.” Another good definition of demand, given by Bober is—“the various
quantities of a given commodity or service which consumers would buy in one market in a given
period of time at various prices, or at various incomes, or at various prices of related goods.,”
constitute demand. Demand, in economics, always refers to a schedule. It is not a single quantity. The
quantity which is purchased at some particular price is called the quantity demanded.

MARKET DEMAND
Market demand is the total sum of the demands of all individual consumers, who purchase the
commodity in the market. A market demand schedule is shown as under:
Price A’s B’s C’s Market
(per unit) demand demand demand demand
(A + B + C)
1 8 9 10 27
2 7 6 9 22
4 6 4 8 18

Cont.....
21
22 INTRODUCTORY ECONOMICS

6 5 3 7 15
8 4 2 6 12
10 3 1 5 9

Let us assume that there are three consumers—A, B and C. Their individual demand schedule
is shown in 2nd, 3rd and 4th columns respectively. Market demand is the sum of A’s, B’s and C’s
demand of, say, apples. We find that the market demand schedule also behaves in the same way
as an individual’s demand for a commodity. That is, at lower price, demand is more and vice versa.
A market demand curve is the graphical representation of market demand and is derived by
the lateral/horizontal summation of all individuals’ demand curve in the market as shown in the
Fig. 4.1. As the individual’s demand curve slope downward from left to right, the market demand
curve also slopes downward to the right.
YA B C Market demand
10
9
8
7
6
Price

5
4
3
2
1

O 2 4 6 8 10 14 16 18 20 22 24 26 28 X
Demand

Fig. 4.1

DETERMINANTS OF DEMAND
Demand for a product depends upon a number of factors. The most important of these are—the
price of the product, income of the consumer, tastes and fashion and the prices of related goods.
We can put it in the functional form as:
Dx = f (Px, I, Py, T, F…)
Where Dx = demand of good x; Px, = price of good x; I = income of the consumer; Py = prices
of related goods; T = tastes and F = fashion.
Thus, demand for a commodity depends upon the following factors:
1. Price of the commodity: Price of a commodity is an important factor that determines
demand for a commodity. When price of a commodity rises, consumers buy less and
when prices fall, demand increases. Here, we assume other things (factors) to be
remaining constant, i.e, ceteris paribus.
DEMAND AND LAW OF DEMAND 23

2. Income of the consumer: The demand for goods depends upon the incomes of the
people. The greater the income, the greater will be the demand for a good. More
income means greater purchasing power. People can afford to buy more when their
incomes rise. On the other hand, if income falls, demand for a commodity also
decreases.

UNIT-2
3. Prices of related goods: Related goods are of two types—substitute and complements.
Substitute goods can be interchangeably used. For example, tea and coffee are substitute
goods. If tea is dearer, one can use coffee and vice versa. Complementary goods are
demanded together as bread and butter or car and petrol.
When price of a substitute for a good falls, the demand for that good declines and when
price of substitute rises, the demand for that good increases. In case of complementary
goods, the change in the price of any of the two goods also affects the demand of the
other. For instance, if demand for two-wheelers fall, the demand for petrol also goes
down.
4. Taste and preferences of the consumer: These are important factors, which
affects the demand for a product. If tastes and preferences are favourable, the
demand for a good will be large. On the other hand, when any good goes out of
fashion or people’s tastes and preferences no longer remain favourable, the demand
decreases.

DEMAND SCHEDULE AND DEMAND CURVE

A demand schedule is a tabular statement that shows the different quantities of a commodity that
would be demanded at different prices. It expresses what quantities of a good will be purchased
at different possible prices. A demand schedule is shown as below:
Price of apples per unit Quantity demanded
(in Rs.) (in nos.)

8 5
6 7
4 8
2 10

It is clear from the table, that when price of an apple is Rs. 8/- the consumer demands 5
apples and when price falls to Rs. 2/- each, demand of apples goes up to 10 units. Thus, price
and quantity demanded shows inverse relationship.
On the basis of the above demand schedule, we can derive an individual’s demand curve.
A Demand curve is the graphical representation of the demand schedule. This is shown in
Fig. 4.2 below. Prices of apples are measured along Y-axis and quantities demanded along X-axis.
A, B, C and D are the different combinations of price and quantity demanded. Joining these points,
we get the demand curve dd sloping downwards to the right, indicating inverse relationship
between price and quantity demanded.
24 INTRODUCTORY ECONOMICS

10
d
9
A
8
Prices of
7 B
apples
6
5 C
4
3 D
2
d
1

0 1 2 3 4 5 6 7 8 9 10 X
Quantity of apples demand

Fig. 4.2

LAW OF DEMAND
The law of demand expresses the functional relationship between price and quantity demanded
of a good. It is one of the most important laws of economic theory. According to this law, other
things remaining constant (ceteris paribus), if the price of a commodity falls the quantity demanded
of it will rise and if price of the good rises quantity demanded will fall. Thus, there is inverse
relationship between price and quantity demanded. Thus, we buy more units of apple when its
price comes down from Rs. 4 per unit to Rs. 2 per unit. Law of demand only applies when certain
conditions are met, which have been mentioned as under.
Assumptions of the law
The law of demand assumes the following:
1. Incomes of consumers do not change. If consumer’s income increases or decreases,
the law will not hold good.
2. People’s tastes and preferences remain unchanged; and
3. Prices of substitutes and complements do not change.
The law of demand can be explained with the help of a demand schedule and through a
demand curve. A demand schedule is shown as under.
Price of apples per unit Quantity demanded
(in Rs.) (in nos.)
8 5
6 7
4 8
2 10
It is seen in the table that when the price of the commodity is Rs. 8/- per unit, consumers
buy 5 units only and at Rs. 2/- per unit, they buy 10 units of the commodity. Thus, as price goes
DEMAND AND LAW OF DEMAND 25

down, consumers buy more of a commodity and vice versa. The demand curve drawn from this
schedule is shown in Fig. 4.3. Along x-axis, quantity is measured and along y-axis price of the
commodity is measured. By joining various points or combinations of price and quantity demanded,
we get a curve ‘dd’ falling downwards from left to the right. This is known as the demand curve.
The demand curve clearly indicates that price is inversely related to quantity demanded. As price

UNIT-2
falls, demand rises and it shrinks when price rises. It is to be noted here that we have assumed
‘other factors’ to be constant. Thus, any changes in these factors such as tastes, fashion, income
or prices of related goods etc, will falsify the law of demand. In that case, the demand curve will
not behave in the manner stated above. For instance, if income of consumer rises at the time when
price of goods have risen, demand will not go down. Rather, it may increase. We do not bother
of rise in price of goods when our income also increases.
Y

10
d
9
A
8
Prices of
7 B
apples
6
5 C
4
3 D
2
d
1

0 1 2 3 4 5 6 7 8 9 10 X
Quantity of apples demand
Fig. 4.3

Why does the Law of Demand Operate?

Demand curve by and large slopes downward to the right. This is because of operation of the
law of diminishing marginal utility. When the price of a commodity decreases, new demand is
created. Also that existing buyers buy more. As the particular commodity has become cheaper,
some people will purchase it in preference to other commodities. If the law of diminishing marginal
utility is true, the demand curve must slope downwards. This is because only a downward sloping
demand curve represents increase in demand due to fall in the prices of a commodity. Further,
when price of a commodity falls, real income of the people increases. In other words, they are
able to buy more goods and services now with the same amount of money they have. This is
called income effect.
Likewise, when the commodity is cheaper, it tends to be substituted for other commodities,
which are dearer. This is called substitution effect. Both income effect and substitution effect
together increase the capacity of the consumers to buy more of a commodity, when its price
comes to low level.
Another reason for downward sloping demand curve is that when a commodity becomes
cheaper, it can be put to more uses or not so urgent uses. This also makes demand to be greater
when price falls.
26 INTRODUCTORY ECONOMICS

Exceptions to the Law of Demand

There are a few exceptions to the law of demand. It means those conditions when the law does
not hold good. These are:
1. There are certain goods called as Giffen goods. In case of such goods, the law of
demand does not hold good. Sir Francis Giffen observed that when Irish potato prices
increased in bad years, people curtailed spending on other commodities and increased
their spending on potatoes. Because with high potato prices and no increase in their
money incomes, they were now too poor to afford meat and other foodstuffs. So they
had to sustain themselves by eating more potatoes. That is people demanded more
potatoes when their prices increased and vice versa. This is called Giffen Paradox.
(Also see note on Giffen goods at the end of this chapter.)
2. In case of conspicuous consumption, as observed by Thorstein Veblen, the demand
curve does not slope downwards. Sometimes people buy some products to show their
status in the society. The possession of such commodities, they feel, may confer a
higher level of social status on their holder. These goods are diamonds and other
precious stones etc. Rich class buys such goods at very high price to show that they
belong to a prestigious class. (Also see note on Veblen goods at the end of this
chapter.)
3. The law of demand also not applies to a commodity whose quality is judged by its high
price. At high prices, some people buy more of such commodity than at lower price
thinking that high priced are better than those priced lower. This is out of sheer
ignorance that people act in such a way.
4. Speculation (a guesswork or prediction of a future event and act accordingly) is another
exception to the law of demand. If the price of commodity is increasing and people
expect a further rise in the price, they will tend to buy more of the commodity at higher
price than they did at the lower price. It is observed that when there is a hike in edible
oil prices recently, some people purchased more of it in the expectation that future
prices will be even more.

MOVEMENT ALONG AND SHIFTS IN DEMAND CURVE

A distinction between movement along the demand curve and shifts in the demand curve is very
important while studying demand theory. Movement along the demand curve takes place when
there is a change in price of a good, other things remaining same. This is also termed as a change
in Quantity demanded. That is changes in demand due to a change in the price of a commodity,
other things being equal. In other words, when either due to increase or decrease in the price of
a good, the demand increases, then it is seen that the demand curve remain the same; only the
equilibrium position on the demand curve is changed. This is called extension and contraction in
demand. Thus when quantity demanded of a good rises due to the decrease in price alone, it is
said that extension of demand have taken place. And quantity demanded falls due to rise in price;
it is called contraction in demand. The extension and contraction in demand is illustrated in the
Fig. 4.4.
DEMAND AND LAW OF DEMAND 27

Y
D
A
R

UNIT-2
Price

B
Q
C
P D

Q N M S X
Quantity

Fig. 4.4

Assuming other factors such as tastes, income and price of related goods constant, demand
curve DD is drawn. At OQ price, OM of the commodity is demanded so that the equilibrium point
is at B. If price falls to OP, the quantity demanded increases to OS but the consumer remains
on the same curve DD; only equilibrium position moves from B to C. In case of rise in price to
OR, demand shrinks to ON and the equilibrium position also moves to the left from B to A. This
is called contraction in demand. The extension and contraction in demand take place only due to
changes in the price of a commodity, other factors remaining same.
Now let us explain shifts in the demand curve. A demand curve either shifts to the right or
left, due to changes taking place in other factors and not price of the commodity. The change in
the position of the demand curve due to these changes can be termed as the increase and
decrease in demand. When due to changes in the factors such as tastes, fashion, price of related
commodities, income etc, the demand curve shifts upwards or to the right, increase in demand is
said to have taken place. Similarly, when less is demanded at the same price due to changes in
other factors, it is called decrease in demand. Here, the demand curve gets shifted leftward. Thus
increase in demand is due to the following factors:
1. Taste and fashion/preferences are more favourable for the good.
2. Income of the consumer increases.
3. Price of substitutes has risen.
4. Price of complementary goods has declined.
5. Propensity to consume of the people has increased.
6. Numbers of consumers have increased.
Likewise, decrease in demand may take place due to the following reasons:
1. Taste and fashion/preferences are not favourable for the good.
2. Income of the consumers has fallen.
3. Price of substitutes has fallen.
4. Price of complementary goods has risen.
5. Propensity to save of the people has increased.
28 INTRODUCTORY ECONOMICS

Increase and decrease in demand (shifts in the demand curve) is shown in the Fig. 4.5. DD
is the demand curve when price is OP. At this price, ON quantity is bought. When consumer’s
income falls, price remaining same, demand curve shifts to the left as D" D". The consumer buys
less of the same commodity, i.e, ON" now. When income rises, price remaining same, consumer
is able to buy more, i.e., ON'. In such case, the demand curve shifts to the right as D' D'.

Y
D’’ D D’

A B C
P
Price

D’
D
D’’

O N’’ N N’ X
Quantity
Fig. 4.5

A NOTE ON GIFFEN GOODS

Giffen goods have positive price elasticity of Y
demand. We know that for most products, price
elasticity of demand is negative. In other words, M
price and demand pull in opposite directions;
Commodity demanded of Y

price goes up and quantity demanded goes

C
down, or vice versa. Giffen goods are an
exception to this. When price goes up the IC 1
quantity demanded also goes up, and vice versa.
In order to be a true Giffen good, price must be
the only thing that changes to get a change in A
demand. Giffen goods are named after Sir B
Robert Giffen, who was attributed as the author
IC 0
of this idea by Marshall in his book Principles
of Economics. The classic example given by O Xc Xa Xb N P X
Marshall is of inferior quality staple foods whose Commodity X (Giffen good)
demand is driven by poverty, which makes their
purchasers unable to afford superior foodstuffs.
As the price of the cheap staple rises, they can
no longer afford to supplement their diet with
DEMAND AND LAW OF DEMAND 29

better foods, and must consume more of the staple food. Marshall wrote in the 1895 edition
of Principles of Economics:
“As Mr. Giffen has pointed out, a rise in the price of bread makes so large a drain on the
resources of the poorer labouring families and raises so much the marginal utility of money
to them, that they are forced to curtail their consumption of meat and the more expensive
farinaceous foods: and, bread being still the cheapest food which they can get and will take,

UNIT-2
they consume more, and not less of it.”
There are three necessary preconditions for this situation to arise:
1. The good in question must be an inferior good,
2. There must be a lack of close substitute goods, and
3. The good must comprise a substantial percentage of the buyer’s income.
If precondition no-1 is changed to “The good in question must be so inferior that the income
effect is greater than the substitution effect” then this list defines necessary and sufficient
conditions. This can be illustrated with a diagram above. Initially the consumer has the choice
between spending their income on either commodity Y or commodity X as defined by line
segment MN (where M = total available income divided by the price of commodity Y, and N =
total available income divided by the price of commodity X). The line MN is known as the
consumer’s budget constraint. Given the consumer’s preferences, as expressed in the
indifference curve IC0, the optimum mix of purchases for this individual is point A. If there is
a drop in the price of commodity X, there will be two effects. The reduced price will change
relative prices in favour of commodity X, known as the substitution effect. This is illustrated by
a movement down the indifference curve from point A to point B (a pivot of the budget constraint
about the original indifference curve). At the same time the price reduction causes the
consumers’ purchasing power to increase, known as the income effect (a outward shift of the
budget constraint). This is illustrated by the shifting out of the dotted line to MP (where P =
income divided by the new price of commodity X). The substitution effect (point A to point B)
raises the quantity demanded of commodity X from Xa to Xb while the income effect lowers
the quantity demanded from Xb to Xc. The net effect is a reduction in quantity demanded from
Xa to Xc making commodity X a Giffen good by definition. Any good where the income effect
more than compensates for the substitution effect is a Giffen good.
A 2002 preliminary working paper by Robert Jensen and Nolan Miller made the claim that rice
and noodles are Giffen goods in parts of China. In 1991, Battalio, Kagel, and Kogut proved that
quinine water is a Giffen good for lab rats. Some types of premium goods (such as expensive
French wines, or celebrity endorsed perfumes) are sometimes claimed to be Giffen goods. It
is claimed that lowering the price of these high status goods can decrease demand because
they are no longer perceived as exclusive or high status products. However, the perceived
nature of such high status goods changes significantly with a substantial price drop. This
disqualifies them from being considered as Giffen goods, because the Giffen goods analysis
assumes that only the consumer’s income or the relative price level changes, not the nature
of the good itself. If a price change modifies consumers’ perception of the good, they should
be analyzed as Veblen goods.

VEBLEN GOOD
A commodity is a Veblen good if people’s preference for buying it increases as a direct function
of its price. The definition does not require that any Veblen goods actually exist. However, it is
claimed that some types of high-status goods, such as expensive wines or perfumes are
Veblen goods, in that decreasing their prices decreases people’s preference for buying them
30 INTRODUCTORY ECONOMICS

because they are no longer perceived as exclusive or high status products. The Veblen effect
is named after the economist Thorstein Veblen, who invented the concepts of conspicuous
consumption and status-seeking.
The Veblen effect is one of a family of theoretically possible anomalies in the general theory
of demand in microeconomics. The other related effects are:
1. The snob effect: preference for good decreases as the number of people buying it
increases;
2. The bandwagon effect: preference for good increases as the number of people buying
it increases;
3. The counter-Veblen effect, in which preference for good increases as its price falls.
The concept of the counter-Veblen effect is less well known, was introduced by Lea. [(Lea, S.
E. G., Tarpy, R. M., & Webley, P. (1987). The individual in the economy. Cambridge: Cambridge
University Press.]
None of these effects in itself predicts what will happen to actual demand for the good (the
number of units purchased) as price changes - they refer only to preferences or propensities
to purchase. The actual effect on demand will depend on the range of other goods available,
their prices, and their substitutability for the goods concerned. The effects are anomalies within
demand theory because the theory normally assumes that preferences are independent of
price or the number of units being sold. They are therefore collectively referred to as interaction
effects.

Questions for Review

1. What do substitute goods mean?
2. What do complementary goods mean?
3. What is increase in demand?
4. What is contraction in demand?
5. Distinguish between increase in demand and extension in demand.
6. When does a consumer buy more of a commodity at a given price?
7. Mention any one determinant of demand for a commodity other than its price.
8. Why does demand curve slope downwards from left to right?
9. Define demand.
10. What is demand schedule?
11. Explain law of demand. Illustrate your answer with appropriate diagram.
12. What factors influence the demand for a commodity?
13. What are Giffen’s goods?
14. What is the shape of a demand curve?
15. What happens to demand when there is a contraction in demand?
16. What factors determine demand?
17. What are inferior goods?
18. State the relationship between demand & price.
19. Give an example of a pair of commodities that are substitutes of each other. (NCERT)
20. Give an example of a pair of commodities such that one of them is complementary in consumption
to the other. (NCERT)
DEMAND AND LAW OF DEMAND 31

21. If the price of good X rises and it leads to an increase in demand for good Y, how are the two
goods related? (NCERT)
22. If the price of good X rises and it leads to decrease in demand for good Y, how are the two
goods related? (NCERT)
23. What is meant by cross price effects? (NCERT)

UNIT-2
24. How will an increase in the price of coffee affect the demand for tea? (NCERT)
25. How will an increase in the price of tea affect the demand for sugar? (NCERT)
26. Give two examples of normal goods and two examples of inferior goods. (NCERT)
27. How does an increase in income affect the demand curve for a normal good? (NCERT)
28. How does an increase in income affect the demand curve for an inferior good? (NCERT)
29. How the market demand curve is derived from the individual demand curves? (NCERT)
30. What are the determinants of market demand curve? (NCERT)
31. What is market demand?
32. Give examples of substitute goods.
33. Give examples of complimentary goods.
34. What is demand curve?
35. What is meant by the phrase—‘Ceteris paribus’?
36. What are the assumptions of law of demand?
37. Explain the terms-Income effect and Substitution effect.
38. What are the important exceptions to the law of demand?
39. What is Giffen Paradox?
40. What is conspicuous consumption?
41. Distinguish between movement along the demand curve and shifts in the demand curve.
42. What is meant by a change in quantity demanded?
43. What do you mean by extension in the demand curve?
44. Distinguish between extension and increase in demand curve.
45. Distinguish between contraction and decrease in demand curve.
46. What are the causes of increase in the demand curve?
47. What are the causes of decrease in the demand curve?
48. Show with the help of diagrams, shifts in the demand curve and movement along then demand
curve.
32 INTRODUCTORY ECONOMICS

5 ELASTICITY OF DEMAND

MEANING OF PRICE ELASTICITY OF DEMAND

Elasticity, roughly, means responsiveness. What response demand of a commodity shows when
there is either increase or decrease in its price, is explained with the help of elasticity. Managers
have great advantages by knowing elasticity of the products he is selling. Greater response means
greater elasticity and small response indicates less elasticity. A manager is very interested in
knowing whether sales will increase by 4 percent, 10 percent or more by cutting down price by
8 percent. Elasticity of demand, thus, measures the degree of responsiveness of demand to a
change in price of the commodity. Prof. Alfred Marshall had introduced the concept of elasticity
of demand in the economic theory. In his words, “The elasticity (or responsiveness) of demand
in a market is great or small according as the amount demanded increases much or little
for a given fall in price and diminishes much or little for a given rise in price.” We may
thus define elasticity of demand as the ratio of the percentage change in quantity demanded to
the percentage change in price.
Demand may be elastic or inelastic. When due to a small change in price, there is a great
change in demand, it is said that demand is elastic. If a 5 percent cut in prices of car results in
an increase in 30 percent in sales, demand is said to be highly elastic. In other words, demand
has responded greatly. On the other hand, if a great change in price is followed by a small change
in demand, it is inelastic demand. For example, the demand for salt is said to be inelastic because
same quantity of it will be purchased even if price rises or declines. Whereas, demand for a car
is elastic because a small rise/fall in price may greatly reduce/increase its demand. Price elasticity
of demand is expressed as under:
Percentage change in demand
Ep =
Percentage change in price
There are five cases/kinds of price elasticity of demand. These are as follows:
1. Perfectly Inelastic Demand: Demand for a commodity will be said to be perfectly
inelastic, if the quantity demanded does not change at all in response to a given change
in price. If 10 percent change in price results in zero percent change in demand, it is
exactly inelastic demand. The demand curve, in this case, is vertical straight line
perpendicular to Y-axis as shown in Fig. 5.1.
32
ELASTICITY OF DEMAND 33

Y D

Perfectly inelastic demand

UNIT-2
Price

O D X
Demand

Fig. 5.1

2. Inelastic or less than Unit Elastic Demand: Demand for commodity will be said
to be inelastic (or less than unit elastic) if the percentage change in quantity demanded
is less than the percentage change in price. If 10 percent change in price results in 6
percent change in demand, it is inelastic demand. This is shown in Fig. 5.2.
Y

D
Inelastic demand
Price

O X
Demand

Fig. 5.2 Y

D
3. Unitary Elastic Demand: Demand Unit elastic demand
for a commodity will be said to be unit
elastic if the percentage change in
quantity demanded equals the
Price

percentage change in price. If 10

percent change in price results in 10
percent change in demand, it is unit
elastic demand. The demand curve in D
such case is called rectangular hyper-
O X
bola shown in the adjacent Fig. 5.3. Demand

Fig. 5.3
34 INTRODUCTORY ECONOMICS

4. More than Unit Elastic: Demand for a commodity will be said to be more than unit
elastic if a change in price results in a significant change in demand for this commodity.
If 10 percent change in price results in 14 percent change in demand, it is elastic
demand. Figure 5.4 below shows elastic demand.
Y

D
Elastic demand
Price

O X
Demand

Fig. 5.4

5. Perfectly Elastic Demand: Demand for a commodity is said to be perfectly elastic,

when a small change in its price results in an infinite change in its quantity demanded.
If 10 percent change in price results in (α) percent change in demand, it is exactly
elastic demand. In this case, demand curve is horizontal straight line parallel to X-axis
as shown in Fig. 5.5. The first and the last cases are rare in real life.
Y

Perfectly elastic demand

Price

D D

O X
Demand

Fig. 5.5

Thus, we can summarize the types of elasticity in the table below:

Percentage change Percentage change Types Coefficient
in price in demand of elasticity
10 0 Perfectly inelastic e=0
10 6 Inelastic e<1

Contd....
ELASTICITY OF DEMAND 35

10 10 Unit elastic e= 1
10 14 Elastic e >1
10 α Perfectly elastic e= α

The table shows how a 10% change in price of a good influences quantity demanded. If there

UNIT-2
is no change or zero change in quantity demanded, elasticity is perfectly inelastic. Likewise, if the
change is relatively less, demand is inelastic. In case of same change and more changes in
demand, elasticity is unitary and elastic demand respectively. When there is very great change,
demand is perfectly elastic.

MEASUREMENT OF PRICE ELASTICITY OF DEMAND

It is very important to know to what extent demand is responsive, that is elastic or inelastic. For
this purpose measurement of elasticity is necessary. The important methods to measure elasticity
are the following:
1. Percentage method.
2. Arc method.
3. Total outlay method.
4. Point/Geometrical method.
5. Revenue method.
Total Outlay/Expenditure Method
Elasticity of demand for a commodity can be measured with the help of the Total Outlay/
expenditure incurred by a household on the purchase of a commodity. Total outlay is (TQ = p × q)
where TQ stands for total outlay, p and q for price and quantity respectively. This method provides
us with three different measurements of the elasticity of demand, which are as follows:
(1) Less than Unit Elastic (e < 1)
(2) Unit Elastic (e = 1)
(3) More than Unit Elastic (e > 1)
Total outlay method to measure elasticity of demand was primarily used by Prof. Marshall.
According to this method, elasticity is measured by comparing the total money spent by the
consumer on the goods before and after the changes in price. Elasticity can be measured for the
following three situations:
1. Unit elasticity (e = 1): When the total money, outlay, or expenditure (TE) remains
unchanged even after a change in the price of the commodity, elasticity is said to be
unitary. Take for instance the following example, where TE remains the same. It is
seen that when price falls to Rs 2 per unit, total expenditure does not change.
Price (Rs. Per unit) Quantity (Q) Total Expenditure (TE)
5 10 50
2 25 50
36 INTRODUCTORY ECONOMICS

2. More than unit elastic (e > 1): When the total money expenditure rises with a fall
in price and falls with a rise in price, it is the case of elasticity greater than one or
elastic demand. This will be clear from the table. When price falls from Rs. 5 to
Rs. 2 per unit, total expenditure rises from Rs. 50 to Rs. 60. Thus there is inverse
relationship between price and total expenditure.
Price (Rs. Per unit) Quantity (Q) Total Expenditure (TE)
5 10 50
2 30 60
3. Inelastic demand (e < 1): When the total money expenditure rises with an increase
in price and falls with a fall in price, it is the case of inelasticity of demand or elasticity
less than one. The adjacent table shows this case. In this case, when price decreases,
total expenditure also declines. Thus price and total expenditure have direct relationship.
Price (Rs. Per unit) Quantity (Q) Total Expenditure (TE)
5 10 50
2 15 30
The Fig. 5.6 below also depicts how price elasticity can be measured with the help of total
outlay method. Demand is unit elastic over the price range R and Q; inelastic over the price range
S and R and elastic over the price range P and Q.
Y A

P e>1

Q B

E=1
Price

R C
S e<1

O X
Total outlay/expenditure

Fig. 5.6

Percentage Method
Price elasticity of demand can also be measured with the help of percentage method or proportionate
method. According to this method, percentage change in price is compared with the percentage
change in demand. Elasticity is the ratio of the percentage change in quantity demanded to the
percentage change in price as expressed below:
ELASTICITY OF DEMAND 37

Percentage change in demand

Ep =
Percentage change in price
change in quantity demanded
quantity demanded
= change in price

UNIT-2
price
∆q ∆p
= ÷
q p
∆q ∆p
= ×
q p
∆q ∆p
ep = .
p q

Where, ep = price elasticity; ∆q = change in quantity demanded; ∆p = change in price;

p = price; q = quantity.
Note: The elasticity of demand is always negative. This is because price and quantity are
inversely related. But by convention, for the sake of simplicity, the minus sign is dropped in
economics.

Arc Method
This is another important method to measure price elasticity of demand. In this method, we take
the averages of original and new prices and quantities to measure elasticity. This method is used
when there is a big change in price so that an arc is formed on the demand curve. It can be
measured by using the formula shown below:
∆q
q′ + q′′
= 2
∆p
p′ + p′′
2
∆q ∆p
= ÷
q ′ + q′′ p′ + p′′
∆q p′ + p′′
ep = .
∆p q ′ + q′′
Where, p' = original price; p'' = new price; q' = original quantity; q'' = new quantity.
Point/Geometrical Method
This method measures elasticity using demand curve. It is, therefore, also called as geometrical
method of measuring elasticity. The diagram below illustrates how to find different types of
38 INTRODUCTORY ECONOMICS

elasticity on a demand curve. DD is the straight line demand curve (constant slope). Elasticity is
measured as under,
Lower segment of the demand curve
E = Upper segment of the demand curve

All five cases are shown in the Fig. 5.7 below. We find that elasticity of demand falls steadily
as we move from D'' toward D.
Y

E= 
D”

E>1
S
Price

e=1
R

e<1
T
e=0

O D X
Demand
Fig. 5.7

For instance, let us find elasticity at point R using the above expression.
RD
E = =1
RD′′
3 RD = RD''
Similarly, elasticity at different points is shown as under:
D′′D
At D': E = =∝
0
SD
At S: E = >1
SD′′
TD
At T: E = <1
TD ′′
0
At D: E = =0
DD′′

Revenue Method
Revenue is the amount that a firm earns by selling its products. It is measured by multiplying price
with total quantity/units of product sold. Thus, TR = Quantity × Price. Elasticity can be measured
using the concepts of average and marginal revenue shown as under.
ELASTICITY OF DEMAND 39

Average revenue
E = Average revenue − Marginal revenue

Income Elasticity of Demand

It is the ratio of the percentage change in the amount spent on the commodity to a percentage

UNIT-2
change in the consumer’s income, price remaining constant. That is,
Proportionate change in demand
Ie =
Proportionate change in income

Cross Elasticity of Demand

The responsiveness of demand to a change in the prices of related commodities (substitutes
and complementary) is called cross elasticity of demand. It is responsiveness of demand for
commodity X to a change in price of commodity Y and is represented as follows:
Proportionate change in demand of X
Cc =
Proportionate change in price of good Y

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

Elasticity of demand differs from commodity to commodity. The various factors upon which
elasticity depends are the following:
1. Substitute goods: A commodity will have elastic demand if there are good substitutes
for it. This is because when price of a good rises, a consumer will not buy the good
but purchase its substitute.
2. Nature of commodity: All necessities like salt, rice etc that have no substitutes/or less
substitutes will have an inelastic demand. People have to purchase such commodities
for their sustenance. Therefore, there will be some demand despite the changes in
price. Demand for luxury goods, on the other hand, will be elastic. If prices of such
commodities rise even a little, consumers refrain to buy. At the same time a little
lowering of price of such commodities attract a large number of consumers.
3. Number of uses of commodity: The larger the number of uses to which a commodity
can be put, the higher will be its elasticity. Therefore the demand of such goods will
have elastic demand. For example, milk can be used for various purposes such as for
making curd, cake, sweets etc. When its price goes down, demand increases but a little
rise in its price makes demand fall greatly.
4. Possibility of postponement of consumption: If there is a possibility of postponement
of consumption of a commodity then demand will be elastic otherwise inelastic. Demand
for certain goods can be postponed for sometime such as computers, printers, scanners
etc. People may wait till they become cheaper. Therefore, their demand is elastic. But
the demand for food or electricity cannot be postponed. As such their demand is
inelastic.
40 INTRODUCTORY ECONOMICS

5. Percentage of income spent: The elasticity of demand is also influenced by the

percentage of income spent on the purchase of a commodity. If the percentage is very
less then the demand will be inelastic. For instance, we spend a very less amount of
our total money income on things like agarbatties (incense sticks), matches, pens,
pencils etc. If prices of such commodities rise also, our demand is not reduced. Thus,
demand of such goods is inelastic.
6. Fashion: Commodities, which are in fashion, will have inelastic demand. Fashion minded
people do not compromise with price. Even if price is high, some people will demand
more just because goods are in fashion.
7. Change in taste: A habitual commodity or a commodity for which consumers have
developed a taste will have inelastic demand. A chain smoker always requires a
cigarette, whatever the price may be. Likewise, a habitual paan (betel nut) chewer
cannot leave his habit, in spite of rise in price. In such cases, therefore, demand is
elastic.
8. Price of the commodity: Very high priced or very low priced goods have low elasticity
whereas moderately priced commodities are quite high-elastic. If a good is very expensive,
demand will not increase much even if there is little fall in its price. And demand will
not increase even at very low prices, because people have already purchased their
requirement at low prices.
Questions for Review
1. What is the shape of the perfectly inelastic demand curve?
2. What is the shape of the unitary elastic demand curve?
3. What is the shape of the perfectly elastic demand curve?
4. Define price elasticity of demand for a commodity and state its importance.
5. When is demand said to be inelastic?
6. How would you measure price elasticity of demand by the total outlay method? Explain.
7. Define price elasticity of demand. How can it be measured?
8. What will be the shape of demand curve when the demand is unitary elastic?