HUT300 Industrial Economics & Foreign Trade

Module 1 (Basic Concepts and Demand and Supply Analysis)

Scarcity and choice - Basic economic problems- PPC – Firms and its objectives – types of
firms – Utility – Law of diminishing marginal utility – Demand and its determinants – law of
demand – elasticity of demand – measurement of elasticity and its applications – Supply, law
of supply and determinants of supply – Equilibrium – Changes in demand and supply and its
effects – Consumer surplus and producer surplus (Concepts) – Taxation and deadweight loss

1.1 Microeconomics
The subject matter of Economics has been divided into two parts. - Microeconomics
and Macroeconomics. Microeconomics studies the economic behaviour of individual
economic units. It includes analyzing the behaviour of households and firms at the micro
level. It studies the demand of individual consumers for goods and their equilibrium state. It
studies the behaviour of individual firms in regard to the fixation of price and output. It is
concerned with how the individual consumer distributes his income among various products
and services so as to maximize utility. It is concerned with the theories of product pricing,
factor pricing and economic welfare.

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Applications of Microeconomics
1. It is helpful in the formulation of economic policies that will promote the welfare of all.
2. It teaches how a free market economy with its millions of consumers and producers work
to decide about the allocation of resources among the various goods and services.
3. It studies how goods are distributed among the various people for consumption through the
price mechanism.
4. Microeconomic theory shows that optimum welfare is achieved when there is perfect
competition in product and factor markets.
5. It also helps in the formulation of economic policies calculated to promote efficiency in
production to ensure the welfare of the people.

1.2 Scarcity and Choice

Scarcity
Scarcity is one of the fundamental and basic concept in Economics. The scarcity
definition of Economics was put forward by Lionel Robbins. It refers to the lack of resources
to satisfy all human wants.
An economy has to decide how to use its scarce resources to produce various
commodities. If it decide to use more resources in one line of production, then resources must
be withdrawn from the production of some other goods.
Even though it is expected that the problem of scarcity will disappear as an economy
grows, the wealthiest economies in the world, even today face the problem of scarcity as their
present wants run ahead of their increased resources and capacity to produce.

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 The scarcity of resources also compels an economy to decide how the different
commodities should be produced. The method of production adopted should be one that
makes the best possible use of the available resources.

Choice
Choice emanates from scarcity. An economy faces the problem of choice since there
are a large number of wants to be satisfied with limited resources. The economy does not
have the resources to produce all the commodities in abundant quantities to satisfy all of its
people. It has to make a choice regarding the quantity of different commodities that is to be
produced.
A choice also has to be taken regarding who should get how much from the national
output. This means how the national product is distributed among various members of a
society.
Explaining scarcity and choice using the Production Possibility Curve
The problem of scarcity and choice can be explained using the PPC. A, B, C, D, E and
F represent various combinations of machines and wheat available to the economy.
A and F are possibilities where the economy spends all of its resources on either
machines or on wheat. Possibilities B, C, D and E lie in between. The economy must
rationally choose where on the PPC they want to be since all points are mutually exclusive.
Due to the scarcity of resources, the country has to choose at what point on the PPC it should
produce so as to maximize social welfare.

TRACE KTUPossibility
A
B
Machines
5
4
Wheat
0
5
C 3 8
D 2 11
E 1 13
F 0 15

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1.3 Basic Economic Problems
Every economy faces three basic and fundamental economic problems. The economy
must first of all decide what all products are to be produced, how these commodities are
made and finally decide for whom these are to be produced. The issue arises due to the
scarcity of resources and the ever-increasing quantity of products that are demanded.

1. What to produce
The economy has to decide what all commodities and services it will produce. An
economy wants many things but it is not possible to make everything with the available
resources. It also has to settle on the quantity of various products that is to be produced.
Should it produce food or machines? Should scarce resources be used to produce more
electronic gadgets or should it be used to produce electric power plants which will ensure
industrial growth tomorrow?

2. How to produce
The second central problem faced by any economy is to determine the production
techniques that will be used to produce different products. This problem arises because the
same commodity can be produced using different technologies. Should electricity be
generated from coal, oil, thermal or nuclear? Should factories use labour intensive or
capital-intensive techniques? Commodities would be produced by employing those

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techniques which maximize output at the minimum cost.

3. For whom to produce

An economy produces commodities for use and hence it has to decide the final users
of various commodities. It also has to decide as to who gets the benefit of economic activity.
A country may produce a large number of low-cost products meant for all or it may
produce a few products meant for luxurious consumption.
This problem is concerned with the distribution of the national product in a fair and
equitable manner. An answer to this question depends largely on the policies of the
government.
Apart from these fundamental issues, modern economies have to solve three more
basic problems.

4. The problem of economic efficiency

Production is said to be efficient if the resources are utilized in such a way that
through reallocation it is impossible to produce more of one good without reducing the output
of any other.

5. The problem of full employment of resources

Full employment would occur when all the available resources of a country are fully
utilized. Countries go through situations where people are searching for work and factories

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are lying idle but manufacturing does not take place. This is particularly severe during times
of recession.
6. The problem of economic growth
An economy has economic growth only when it’s productive capacity to produce
more and more goods and services increases over time. Such a country will constantly
witness an increase in the standard of life of the people.

1.4 Production Possibility Curve

The PPC is a graphical representation of the alternative production possibilities facing
an economy. Since the total resources of the economy are limited, it has to decide what to
produce with the limited resources. It has to make a choice regarding the quantity of different
commodities. If there were unlimited resources, the economy could have produced all that it
wanted. It is also referred to as the production possibility frontier since it shows the
maximum that can be produced with the available resources.
For example, consider an economy which produces only two goods, guns and butter.
The guns represent military spending and the butter stands for civilian spending. Here there
are two extreme cases. If all the resources are utilized for butter, then no guns can be
produced and vice versa. The various possibilities of producing the products are represented
by the following schedule.

Possibility Machines Wheat

A 5 0

TRACE KTU B
C
D
4
3
2
5
8
11
E 1 13
F 0 15

In the above schedule A and F are possibilities where the economy either produces
100 percent of machines or 100 percent of wheat. Possibilities B, C D and E lie in between. It
can be seen that for an economy to have more machines it must be willing to sacrifice more
of wheat. For instance, to reach possibility B from A, the economy produces 5 more units of
wheat by sacrificing 1 unit of machine.

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 The curve represents the production possibilities of an economy and shows the
various possible combinations of the two goods. The curve gives the maximum amount of
machines that can be produced in the economy for any given amount of wheat and vice-versa.
The production possibility curve is also known as transformation curve since it shows the
rate of transformation of one product into the other when the economy moves from one
possibility point to the other.
All possible combinations lying on the production possibility curve show the
combinations of the two goods that can be produced using the available resources. Any
combination lying inside the production curve such as P in the figure indicates that resources

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are not being fully employed in the best-known way. Any point outside the production
possibility frontier, such as Q implies that the economy does not have adequate resources to
produce this combination.

Shift of the PPC

A shift of the production possibility frontier indicates economic growth and
development. In the above instance, the production possibility frontier has shifted to GH on
account of improvements in technology or due to an increase in the resources available to the
economy.
The PPC is an important tool that can be used to understand basic concepts like
scarcity, choice, resource allocation, opportunity cost and trade off.

1.5 Firms and its objectives

A firm is a specialised organisation devoted to managing the process of production. It
utilises the factors of production like land, labour, capital and organisation to produce various
goods and services.

Objectives of a firm
Each firm decides its own objectives and evolves strategies to fulfil it. The different
objectives that firm pursue are:

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1. Profit Maximisation
The primary objective of most firms is the maximisation of its profit. No business
firm can survive without earning sufficient profits. Profits bring in the resources needed for
expansion and diversification. It is the monetary benefit given to the shareholders of the firm.
Profit is defined as the difference between total revenue and total costs.
Profit = Total Revenue - Total Costs
The marketing and sales managers try to maximise the total revenue while the production and
manufacturing managers try to minimise the total costs.

2. Sales Maximisation
Firms often try to maximise their sales and increase their share of the market.
According to Prof. Baumol most managers try to maximise sales revenue since their earnings
are more dependent on sales revenue rather than on profits. Such a strategy may be beneficial
in the long run since it increase the monopoly of the company in the market enabling the firm
to sell at higher prices. However, in the long run this may also result in profit maximisation.

3. Growth Maximisation
Firms also work towards maximising their growth rate. A higher rate of growth
automatically increases the level of output of the firm. It will also result in more revenue,
profit, number of employees, market share and number of products. Such firms will be more
dynamic and competitive since they are always on the lookout for better opportunities. They
are also likely to invest more in technology and research.

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4. Welfare Maximisation
A firm may also aim to maximise the welfare of the society. Such a firm tries to
supply good quality products at fair prices. They will take reasonable steps to protect the
environment. Many firms engage in setting up schools, sports complexes charitable
organisations, hospitals and take steps to increase employee welfare.

5. Profit Satisficing
It is the economic strategy of focusing on achieving satisfactory profits rather than
maximising profits. The primary interest of the shareholders is dividends. They are rarely
interested in the day-to-day operations of the company. However, managers do not get a share
of dividends and have less motivation to maximise profits. Hence managers may achieve a
satisfactory level of profits to keep shareholders happy and then focus on other goals like
improvement of working conditions.

6. Stability
Stability is essential for the firm's survival in the long run. A stable firm can easily
handle the changing market dynamics and will have a high level of customer and employee
satisfaction. It will be able to quickly adapt to difficult situations like falling demand for its
products, bad debts, technological obsolescence and declining customer confidence.

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 To conclude the ultimate objective of all firms is profit maximisation. It can be seen
that all of the above objectives go together and a firm which is able to achieve high sales or
rapid growth would be rewarded with high profits. In the long run profit maximisation, sales
maximisation and growth maximisation will converge into a single objective.

1.6 Types of Firms

1. Sole Proprietorship
It is the type of firm owned, managed and controlled by a single individual or the
proprietor. It is suitable where the nature of the market is limited, localised and where
customers give importance to personal attention. Most of the small businesses are of this
type. The debts of the firm are the personal responsibility of the owner e.g. handicrafts,
jewelry, tailoring etc.
Advantages
a. They require low capital investment and offers personalised service.
b. Such firms are able to take quick decisions and have flexible operations.
c. The partners share profits in the ratio as agreed.
d. There are less legal formalities

2. Partnership firms
These are firms owned by two or more individuals who share profits as well as
liabilities of the firm. It comes into existence through a legal agreement in which terms and

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conditions governing the relationship among partners, the manner of conducting the business
and sharing of profits and losses are specified. Such firms are suitable for small businesses.
e.g. retail trade, small manufacturing units, professional services etc.
Advantages
a. Such firms are able to collect more resources than the proprietorship.
b. Persons with different skill, expertise, managerial talent and resources can come
together to form a business.
c. The partners share among themselves the responsibility of decision making.
d. The partners share profits in the ratio as agreed.

3. Joint Stock Company

It is a business organisation owned by a number of individual stockholders. Today
most of the business activity in the country is carried out by joint stock companies. It has a
separate legal identity and can borrow money and make investments on its own behalf. The
ownership of a company is determined by the ownership of the company's shares. The
shareholders get dividends in proportion to the shares owned by them. They elect directors
and vote on important issues. They are the dominant type of business organisation since they
are an extremely efficient way to engage in business.
A company has two basic forms.
(a) Private Limited Company. The maximum number of shareholders is limited to
fifty. The shares of the company are transferable only among the members and it cannot raise
capital by selling its shares to outsiders.

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 (b) Public Limited Company. There is no limit on the maximum number of members.
It has to annually submit its balance sheet to the Registrar of Joint Stock Companies. It can
invite the public to buy shares by issuing a prospectus. However its business cannot be started
unless the minimum capital laid down as per law has been subscribed.
e.g. Infosys, Microsoft, Tata Motors
Advantages
a. A company is a legal person that can conduct business.
b. The owners have only a limited liability.
c. The shareholders own the corporation but the managers run it, hence decision
making is very quick and precise.
d. Since the number of shareholders is very large, they can collect huge financial
resources.

4. The Cooperatives
The cooperative society is a voluntary association of persons who join together for the
welfare of the members. Their objective is to protect their economic interests and prevent
exploitation. The profit generated is distributed among the members as per the legal
agreement. Here decisions are taken by an elected managing committee e.g. AMUL, Kerala
State Cooperative Bank, KCMMF etc.
Advantages
a. Each member has only one vote irrespective of the amount of capital contributed.
b. The liability of the members is limited to their capital contribution.

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c. Since the producers themselves are members of the society cost of production can
be minimised.
d. The cooperatives enjoy governmental support.

5. The Public Sector

Public sector undertaking (PSU) refers to a government owned company. The primary
objective is to provide services to improve the welfare of the people. In most countries it
includes services like police, military, public roads, infrastructure, education and healthcare.
Advantages
a. Not guided by profit motive.
b. Creation of employment opportunities.
c. Access to huge governmental finances.
d. Investment can be made in sectors which are socially desirable.

1.7 Utility
In ordinary language, utility means usefulness. In Economics, utility is defined as the
power of a commodity or a service to satisfy a human want. Alfred Marshall is the chief
exponent of the utility approach.
Utility is a subjective concept. The same commodity gives different utilities to
different people. Warm clothes have little utility for the people in hot countries. So, utility
depends on the consumer and his need for the commodity.

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Total Utility
Total Utility refers to the sum of utilities of all units of a commodity consumed. For
example, if a consumer consumes 3 cups of coffee, then the total utility is the sum of the
utility from all the three cups.

Marginal Utility
Marginal Utility is the addition made to the total utility by consuming one more unit
of a commodity. For example, if a consumer consumes 3 cups of coffee, the marginal utility
is the utility derived from the 3rd unit. It is the total utility of 3 cups minus the total utility of 2
cups of coffee.

MUn = TUn – TU n-1

Law of Diminishing Marginal Utility

The law of diminishing marginal utility explains an ordinary experience of a
consumer. If a consumer takes more and more units of a commodity, the additional utility he
derives from an extra unit of the commodity goes on declining. i.e. the marginal utility
decreases with the increase in the consumption of a commodity. When marginal utility
decreases, the total utility increases, but at a diminishing rate.
This Law is also known as Gossen’s I Law.

Statement of the law

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The Law states that as a person gets more and more units of a commodity, marginal
utility from each successive unit will go on falling till it becomes zero or negative. According
to Alfred Marshall, “the additional benefit which a person derives from a given increase of
his stock of a thing diminishes with every increase in the stock that he already has”.

Assumptions of the Law

1. The units of the commodity must be of a standard size.
2. All the units of the commodity must be identical in all aspects like taste, quality, colour and
size.
3. The law works only when the process of consumption continues without any time gap.
4. The consumer’s taste, habit or preference must remain the same during the process of
consumption.
5. The consumer is assumed to be rational. As a rational consumer, he wants to maximise the
total utility.
6. Utility is measurable.

Relationship between total and marginal utility

Suppose Mr X purchases the same product one by one continuously. The first unit
gives him higher utility, when he buys the second, the extent of his utility will reduce. If he
continues to take additional units, the utility derived from the third unit will be less than that
of the second one. In this manner, the marginal utility from the extra units will go on

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decreasing. If the consumer continues to take more units, marginal utility falls to zero and
then becomes negative.

Quantit Total Utility Marginal

y Utility
1 20 20
2 30 10
3 38 8
4 45 7
5 45 0
6 41 -4

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From the table it is clear that the marginal utility goes on declining when successive
unit of the same product is consumed. The consumer derives 20 units of utility from the first
unit that he consumes. When he consumes the product continuously, the marginal utility falls
to 7 unit for the fourth and becomes zero for the fifth unit. The marginal utility is negative for
the 6th unit. Thus, marginal utility declines at first, reaches zero and then becomes negative.

The relationship between Marginal and Total Utility can be summarised as:
When marginal utility declines, total utility is increasing.
When marginal utility reaches zero, total utility is a maximum.
When marginal utility becomes negative total utility starts declining.

Limitation of the Law

1. Deriving utility is a psychological experience. When it is said that a unit of X gives ten
units of utility, this means that utility can be measured precisely. In reality, utility cannot be
measured.
2. The Law is based on a single commodity consumption mode. That is, a consumer
consumes only one good at a time. In real life, a consumer consumes more than one good at a
time.

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3. According to the Law, a consumer should consume successive units of the same good
continuously. This is an unrealistic assumption.
4. The Law assumes that the marginal utility of money is constant. This assumption has been
severely criticised.
5. As utility itself varies from person to person, marginal utility derived from the
consumption of a good cannot be measured precisely.

Importance of the Law

1. The law of diminishing marginal utility is the foundation for various other economic laws.
For example, the law of demand is the result of the operation of this law. As utility falls, the
consumer is willing to pay only a lower price for successive purchases.
2. This law is a handy tool for the finance minister for increasing tax rate for the rich.
3. Producers are guided by the operation this law. They constantly change the design, the
package of their goods so that the goods become more attractive to the consumers and they
appear as new goods.
4. Consumers are also guided by this law when they make their purchases. They always try to
purchase a wide variety of products.

1.8 Demand
The demand for a commodity at a given price refers to the quantity of it that will be
purchased per unit of time at that price in the market. It is the desire for a product backed by
the ability to pay and willingness to purchase it. It depends mainly on the price at which the

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commodity is sold.

Determinants of Demand (Factors influencing Demand)

1. Price of the product.
2. Level of income of the consumer.
3. Price of related goods.
4. The taste, habits and preferences of the consumer.
5. Changes in technology.
6. Changes in government policy.
7. Population of the region.
8. Advertisement.
9. Climate and weather conditions in the region.

Demand Schedule
It relates the quantity purchased to price. It shows the quantities of a product that is
demanded at different alternative prices. The demand schedule given below shows the
quantities of commodity X that would be demanded at various prices.
Price of X Quantity of X
5 175
10 150
15 125

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 20 100
25 75

Demand Curve
The demand curve is the graphical representation of the demand schedule. It slopes
downward from left to right showing that price of a product and its quantity demanded is
inversely related. It is seen that at a price of OPA the demand is OQA and when price
decreases to OPB the quantity demanded increases to OQB.

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Law of Demand
The law expresses the functional relationship between the price and quantity
demanded of a commodity. It states that more of a commodity will be purchased at a lower
price and less of it at a higher price, other things remaining the same. ‘Other thing remaining
the same’ is known as ceteris paribus and refers to the following assumptions.

Assumptions of the Law

1. The income of the consumer remains constant.
2. There is no change in the consumers taste and preferences.
3. The prices of related goods remain unchanged.
4. The commodity does not have any close substitutes.
5. Consumer does not expect future price increases.
6. The commodity does not have a prestige value.

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Exceptions of the Law
There are certain rare instances where the law of demand will not hold good.

1. Giffen Paradox: Robert Giffen discovered that poor people will purchase more of certain
goods if their prices increase. Such goods are called inferior goods. Inferior goods are those
goods which people buy in large quantities when they are poor and in small quantities when
they become rich.
2. Veblen Effect: Thorstein Veblen has pointed out that some goods are demanded because of
their high price. Such commodities are purchased not because of their usefulness, but because
they confer a status or prestige to the buyer. If the price of diamonds were to become very
cheap, the rich would stop purchasing it.
3. Speculation: If the price of a commodity is increasing and people expect it to go up still
further, they may buy more of the product at higher prices in order to beat the price rise.
4. Bandwagon effect: In some instances, purchase of a commodity is influenced by the social
class of the consumers. A person buys a new product because everyone in his social group
has purchased one.
5. When people link the higher price of products to their better quality, they may buy the
more expensive ones even when cheaper ones are available.

Individual demand & Market demand

Individual demand refers to the quantity of a commodity that a consumer will
purchase at various prices. It shows the individual preferences of the consumer.

Price of X
5
TRACE KTU Quantity of X
6
10 5
15 4
20 3
25 2

Market demand is the sum total of the demands of all the individuals in the market. It
is obtained by adding together the quantities demanded by all individuals at various prices.

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 TRACE KTU
Assume there are only two consumers in the market. Here at a price of Rs.3,
consumer A purchases 15 units of the product while B purchases 20 units. The total demand
of the product in the market is for 35 units as shown by the market demand curve.

Extension and Contraction of Demand (Movement along the demand curve)

If a change in the demand of a commodity is solely due to a change in its price,
demand is said to extend or contract. It is represented by movements along the demand curve.

When the price of the good is $3000, demand is for 5 million units. When the price
falls to $2000, demand expands to 6 million. Here the extension in demand is by 1 million.
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When the price of the good rises to $4000, the quantity demanded contracts to 4 million and
the contraction in demand is by 1million.

Increase and decrease in demand (shifts in demand)

In this case factors other than price influence the demand curve. Changes in income,
tastes etc. will cause demand to increase or decrease. Here the demand curve will shift. In the
figure, increase in demand is shown by a shift of the demand curve to the right from DD to
D2D2. The decrease in price causes the curve to shift to the left from DD to D1D1.

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1.9 Elasticity of Demand
The term elasticity expresses the degree of correlation between demand and the
factors influencing it. The law of demand explains that demand will change due to a change
in the price of the commodity. However, it does not explain the magnitude and rate at which
demand changes. The concept of elasticity of demand measures the rate of change in demand.
This concept was introduced by Prof. Alfred Marshall.

Types of elasticity of demand

There are three types of elasticity of demand. (a) Price elasticity (b) Income elasticity and (c)
Cross elasticity

(A) Price Elasticity

It is the degree of responsiveness in quantity demanded due to a change in price. It is
the ratio of the percentage change in quantity demanded to the percentage change in price.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

𝑒𝑝 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

∆𝑄
𝑄
𝑒𝑝 = ∆𝑃
𝑃

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 𝑃 ∆𝑄
𝑒𝑝 = 𝑄
× ∆𝑃

Types of Price Elasticity

1. Perfectly Elastic
Here even very small changes in price causes an infinite change in quantity
demanded. Such commodities have perfectly elastic demand and their demand curve will be a
horizontal line. In such cases, the value of ep = ∞.

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2. Relatively Elastic
Here the percentage change in quantity demanded of a commodity is more than the
percentage change in its price. In such cases the value of ep > 1. e.g. luxuries

3. Unit Elasticity

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 Here the rate of change in demand is exactly equal to the rate of change in price. The
demand curve for such products will be a rectangular hyperbola. In such cases, the value of ep
=1

4. Relatively inelastic
In this type of commodities, the proportionate change in quantity demanded is less
than the proportionate change in its price. In such cases the value of ep < 1. e.g., necessities

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5. Perfectly inelastic

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 Here even very large changes in price does not cause any change in quantity
demanded. Such commodities have perfectly inelastic demand and their demand curve will
be a vertical line. In such cases, the value of ep = 0.e.g., salt, matchbox, rare paintings.

1.10 Measurement of Elasticity

There are four methods for measuring price elasticity
1. Percentage Method

𝑒𝑝 =
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It is the ratio of the percentage change in quantity demanded to the percentage change
in price.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

2. Point Method
This method is used to calculate the price elasticity at any point on a linear demand
curve.
𝐿𝑜𝑤𝑒𝑟 𝑆𝑒𝑔𝑚𝑒𝑛𝑡
𝑒𝑝 = 𝑈𝑝𝑝𝑒𝑟 𝑆𝑒𝑔𝑚𝑒𝑛𝑡

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Elasticity at point C is given by

𝐵𝐶
𝑒𝑝 = 𝐶𝐴

Upon using this method it can be seen that at any point on the lower segment ep < 1
and at any point on the upper segment ep >1.

3. Total Outlay Method

According to this method the change in total outlay or expenditure of the purchaser
before and after the variations in price is estimated.
ep is greater than unity, when, with the fall in price the total amount spent by the
consumer on the commodity increases. On the other hand, if price rises, the total amount
spent will decrease.
ep is less than unity, when, with the fall in price the total amount spent by the
consumer on the commodity decreases.

Price Quantity Total Outlay

Demanded
5 60 300

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6
7
8
50
40
30
300
280
240

In the above instance, elasticity serves as a warning signal to the businessman. He

increases the price hoping to increase his revenue but due to the inelastic demand for his
product, he suffers a decline in his revenue.

4. Arc Method
The demand curves are seldom continuous as there are big gaps in price and quantity.
Hence the points on the demand curve are quite apart and elasticity is measured along an arc
of the demand curve.
Here within the entire demand curve, two points A and B are considered. Upon
joining them an arc is obtained and on average, the elasticity is measured.

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 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
𝑒𝑝 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
÷ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑖𝑐𝑒

𝑄1−𝑄2 𝑃1−𝑃2
𝑒𝑝 = (𝑄1+𝑄2)/2
÷ (𝑃1+𝑃2)/2

∆𝑄 ∆𝑃
𝑒𝑝 = ÷
𝑄1+𝑄2

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𝑃1+𝑃2

(B) Income Elasticity

It is the degree of responsiveness of demand to the change in income.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

𝑒𝑦 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

∆𝑄
𝑄
𝑒𝑦 = ∆𝑌
𝑌

For luxuries, 𝑒𝑦 > 1

For necessities, 𝑒𝑦 < 1

For inferior goods, income elasticity is negative. The consumption of inferior goods decrease
with a rise in income for they are replaced by the superior substitutes at higher levels of
income.

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(C) Cross Elasticity
It is the degree of responsiveness of demand to the change in the price of related
commodities. The relationship between two commodities x and y may be substitutive or
complementary.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑋

𝑒𝑐 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌

∆𝑄𝑥
𝑄𝑥
𝑒𝑐 = ∆𝑃𝑦
𝑃𝑦

If two commodities are substitutes, ec will be positive.

If they are complementary, ec will be negative.
If the commodities are unrelated, ec will be zero.

Applications of Elasticity of Demand

1. Taxation: The finance minister will tax those commodities with inelastic demand to ensure
a stable revenue. As a result of the tax, even when price increases people will continue to
purchase the commodity.
2. Determination of employee salary: Salaries are likely to be high in places where the

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demand for workers is inelastic.
3. International Trade: If the demand for a country’s exports is elastic, its trade will always be
under pressure and the terms of trade may turn unfavorable.
4. Poverty in Plenty: The concept of elasticity explains the paradox of poverty in the midst of
plenty since demand is inelastic for perishable agricultural products. A rich harvest may
actually fetch less money to the farmer.
5. Monopoly price: A monopolist often has an inelastic demand for his product and is able to
charge a high price.

1.11 Supply
Supply refers to the quantity of a product that will be offered for sale at a particular
price at a certain time. The main factor influencing supply is price.

Determinants of supply
1. Production Costs: If the cost of production increases due to an increase in the price of raw
materials, supply will decrease.
2. Production Technology: Improvements in technology lowers the cost of production and
increases supply.
3. Number of producers of the product.
4. Improvement in transport facilities

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5. Mass Production: If products are mass produced in factories, production costs will be
lower and more will be supplied into the markets as companies try to sell all of the output.
6. Taxation: A higher rate of taxes on output will result in less being produced by the
manufactures.
7. Other Factors: Many factors like political instability, war, climatic factors and natural
calamities reduce supply.
8. International Trade: If a country encourages trade more of various products are likely to be
available.

Supply schedule
The supply schedule relates the quantity supplied of a commodity to its market price.
It shows the various quantities of a commodity that will be offered for sale at different prices.

Price of X ($) Quantity of X

(units)
1 2
2 4
4 8
5 10

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Supply curve
The supply curve is the graphical representation of the supply schedule. It is
positively sloped showing that the price of a product and its quantity supplied is directly
related.

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 It is seen that at a price of $2 the supply is 4 units and when price increases to $6 the
quantity supplied also increases to 12 units.

Law of Supply
The law of supply states that less of a product will be supplied at a lower price and
more of it at a higher price, other things remaining the same. It establishes a direct
relationship between price and supply.

1.12 Equilibrium (Determination of equilibrium price in the market)

Consumers purchase a product because it gives them utility and will try to buy it at
the lowest possible price. Manufacturers sell a product to maximize their profit and will try to
sell at the highest possible price. Thus, the two opposing forces of demand and supply
interact to bring about an equilibrium price.

The market equilibrium comes at that price and quantity where the forces of demand
and supply are in balance. At the equilibrium price, the amount that buyers want to buy is
exactly equal to the amount that sellers want to sell and there is no tendency for the price to

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rise or fall. The equilibrium price is also called the market clearing price.

Price (Rs) Demand (units) Supply (units) Market Status

30 100 300 Surplus
20 200 200 Equilibrium
10 300 100 Shortage

The market is in equilibrium at the point at which the demand and supply curves
intersect. Suppose price is increased to Rs.30. At this price there is a surplus of the product
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and price has the tendency to fall. If price is decreased to Rs.10, there is a shortage of the
product and price has the tendency to rise. The market is in equilibrium at a price of Rs.20
when quantity supplied becomes equal to quantity demanded. Neither the seller nor the buyer
has any tendency to change the price.

1.13 Changes in demand and supply and its effects

1. Rise in Demand
A rise in demand will cause the demand curve to shift upwards and to the right resulting
in higher prices. It may occur due to:
1. Increase in the price of substitutes.
2. Decrease in the price of complementary goods.
3. Increase in the level of income.
4. Changes in taste and preferences in favour of the product.
5. Expectation of future scarcity.

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2. Fall in Demand
A fall in demand will cause the demand curve to shift downwards and to the left
resulting in lower prices. It may occur due to:
1. Decrease in the price of substitutes.
2. Increase in the price of complementary goods
3. Decrease in the level of income
4. Changes in taste and preferences against the product.
5. Expectation of future surpluses.

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3. Rise in Supply
A rise in supply will cause the demand curve to shift downwards and to the right
resulting in lower prices. It may occur due to:
1. Decrease in the price of related goods.
2. Decrease in the cost of production.
3. Increase in the level of technology and skill.
4. Favourable unplanned factors like good weather conditions.

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4. Fall in Supply
A fall in supply will cause the demand curve to shift upwards and to the left resulting
in higher prices. It may occur due to:
1. Increase in the price of related goods.
2. Increase in the cost of production.
3. Unfavourable unplanned factors like bad weather conditions.

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1.14 Consumer surplus
Consumer surplus is the amount a buyer is willing to pay for a good minus the
amount the buyer actually pays for it. It is the gap between the utility of a good and its market
value. The surplus arises because the consumer receives more value than he pays for.
Consumer surplus can be measured using the demand curve. The demand curve measures the
price buyers are willing to pay for the good. The difference between this willingness and the

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market price is each buyer's consumer surplus. The total area below the demand curve and
above the price measures the consumer surplus of all buyers in the market.
In the example, the price of the good is Rs.18. All the buyers who were willing to buy
at prices above Rs. 18 are better off because they now pay only Rs.18 for the good. The total
consumer surplus is given by the shaded area.

Applications of Consumer Surplus

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1. The concept of consumer surplus is useful in evaluating many government projects. A
toll-free road or a bridge should be built if its consumer surplus is more than its costs.
2. This concept points to the enormous privileges enjoyed by citizens in modern times. Each
person enjoys a wide variety of enormously valuable goods that are purchased at very low
prices.
3. It is a measure of the economic wellbeing of a society. A larger consumer surplus provides
buyers with immense benefits.
4. It is used in evaluating the loss to the consumer from taxes.
5. It is used to evaluate the gain from subsidies.

1.15 Producer surplus

Producer surplus is the amount a producer is paid for a good minus the producer cost. It
measures the benefit that sellers of a product receive. It is the area above the supply curve but
under the price line. Here the price of the good is $5 while producers are willing to supply it
from $2 onwards. The total producer surplus is shown by the shaded area.

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1.16 Taxation
A tax is a compulsory contribution imposed upon persons to meet the expenses of the
government. All countries impose different types of taxes to generate revenue. In most poor
countries, taxes are the major source of income for the government. The money thus
collected is utilized for running the government and for developmental activities.
In the words of Prof. Dalton, a tax is a compulsory contribution imposed by the public
authority, irrespective of the service rendered to the taxpayer, in return for which no specific
and direct quid pro quo is rendered to the payer.
The State has the right to tax. Refusal to pay the tax is punishable. The phrase
‘without quid pro quo’ means the absence of any direct and proportional benefit to the
taxpayer from the government.

Direct and Indirect taxes

Taxes can broadly be classified into

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 a. Direct taxes
b. Indirect taxes

Direct taxes
A direct tax is one whose burden is borne by the person on whom it is levied. The
relation between the tax-payer and the revenue authorities is direct and personal. The burden
of the tax cannot be transferred to some other person. In such a tax the impact and incidence
of the tax is on the same person.

Impact of taxation refers to the immediate burden of the tax. It refers to the person
who has to pay the tax to the authorities. Impact is on the person who is responsible for the
payment of the tax.

Incidence of taxation refers to the ultimate burden of the tax. It refers to the person on
whom the burden of the tax ultimately falls. It is the final resting place of the tax burden.

In the case of a direct tax like income tax the impact and incidence of the tax is on the
same person. He cannot transfer the tax to some other person.
E.g. Income tax, wealth tax, gift tax, property tax

Advantages
1. They are economical since the cost of collection is low.
2. They are progressive in nature.
3. They are equitable due to the presence of exemption limit.
4. They are certain. The money burden of the tax is known in advance.

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5. Direct taxes create civic consciousness. The tax payer feels that he is contributing towards
the State expenditure. He tries to ensure that money is not wasted by the government.

Indirect taxes
Here the tax is levied on one individual but the burden falls on another. The tax
depends on the value of the particular commodity purchased. There is an indirect relation
between the tax-payer and the revenue authorities since the taxes are collected unofficially
through the merchants.

In the case of indirect taxes, the impact and incidence are on different persons. For
example, the excise duty on cement is paid by the producers but ultimately, they transfer it to
the consumer by increasing the price of the product by an amount equal to the tax.
E.g. value added tax, customs duty, service tax etc.

Advantages
1. Indirect taxes are convenient.
2. Tax evasion is not possible.
3. They are socially desirable since harmful products can be taxed at high rates.
4. Taxation of certain commodities will discourage their production. In this way resources
used for the production of luxuries can be diverted to the production of necessities.
5. Income from them goes on increasing with increase in industrial output.

1.17 Principles of taxation (Canons of Taxation)

Canons of taxation refer to principles laid down as a direction to the tax authorities.
Governments should ensure that their taxes follow the canons.

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1. Canon of Equity. Every person will pay taxes according to his ability to pay. It lays the
moral foundation of the tax system. There should be equality in the sacrifice of each person
who pays the tax.
2. Canon of Certainty. The tax payer should know in advance how much tax he has to pay.
The time and manner of payment must also be known. The tax payer should be able to see
why he has to pay a particular amount. The government should also be sure of the amount
that will be collected as tax so that it can follow its financial programme.
3. Canon of Convenience. Since the tax payer makes a sacrifice at the time of payment, the
mode of payment should be made as convenient as possible. Taxes on consumers are
convenient. They are paid when purchases are made and consumers make no special
arrangement for paying a tax. The price of the product includes the tax also.
4. Canon of Economy. Cost of tax collection should be kept to the minimum. Taxes should
also not retard industrial development. If income taxes are high, savings are likely to suffer.
Similarly, taxes on raw materials raise the price of the finished products and weaken the
competitive power of companies.
5. Canon of Simplicity. Tax payer should understand the details of the tax without the
assistance of experts.
6. Canon of diversity. A single tax will not be enough. There should be a wise mixture of
direct and indirect taxes so that all persons who can afford to may contribute to the state
revenue.
7. Canon of elasticity. The various taxes and their rates must be varied according to the level
of income of the people and the requirements of the country.

1.18 Goods & Services Tax

GST is one indirect tax for the whole nation which will make India one unified single

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market. It is the tax system that is now being followed by several countries around the world.
It is an indirect tax reform which aims to remove tax barriers between states and create a
single market. It is a tax only on the value added at each stage. This system of input tax
credit in GST allows sellers to claim the tax already paid, which reduces the final burden on
the end consumer.
Advantages
1. GST will result in the creation of a common national market.
2. By avoiding the cascading effect of taxes, GST will result in gains for the end consumer.
3. It will result in a reduction in multiplicity of taxes.
4. It will ensure that indirect tax rates are common across the country,
5. It will bring about transparency in the tax system.
6. To traders, it means a simpler tax regime and ease of payment since the payment can be
done online.
7. It will improve the collection of taxes and boost the development of Indian economy by
removing the indirect tax barriers between the different States in India.
8. By allowing input tax credit, it will reduce the burden of taxes, and this is expected to
bring down prices.
9. GST is mainly technology driven, hence chances of malpractices are minimized.

1.19 Deadweight Loss

The fall in consumer and producer surplus that results due to a tax is the deadweight
loss. When a new tax is introduced, the price paid by the buyers rises and the price received
by sellers falls. There is a loss in the real income of both buyers and sellers. As the price of a
good increases due to the introduction of a new tax, buyers reduce their purchases and the
sellers are able to sell less of the good than before. Thus, the size of the market shrinks.
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 TRACE KTU
In the figure, initially at the equilibrium point, price is Rs.14 and quantity is 10 units.
The consumer surplus is shown by A+B+C while producer surplus is D+E+F. A new tax of
Rs. 6 is introduced on the buyers and sellers. The effective price of the good is now Rs. 20.
Due to the increase in price, the seller is able to sell only 5 units. The effective price received
by the seller is now only Rs. 8 since he has to pay a tax of Rs.6. The tax reduces consumer
surplus by the area B+C and producer surplus by the area D+E. The tax revenue of the
government is given by B+D. Since the fall in producer and consumer surplus exceeds tax
revenue, the tax is said to impose a deadweight loss, given by the area C+E.

Problems:-

1. Suppose hotels and homes have the following demand for ornamental lights.

Price No. Of units purchased by No. Of units purchased by

hotels homes
150 2100 1000
200 2000 800
250 1900 600
300 1800 400

(a) As the price of tickets rises from 200 to 250, what is the price elasticity of demand for (i)
hotels and (ii) homes?
(b) Why might hotels have a different elasticity than homes?

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2. A company had spent Rs. 3 crores on advertisement in the previous year and its sales of
mobiles were 150 lakh units in that year. In this year, it increased its outlay on advertisement
to 4 crores and sales jumped to 280 lakh units. Calculate the advertising elasticity of the
company. Is it profitable for the company to spend more on advertising?

3. When the price of product Y was reduced from Rs.10 to Rs.9, the quantity demanded of X
fell from 1000 units to 800 units. Calculate the cross elasticity of demand for X. Are the two
products substitutes or complements?

4. The supply equation for selling a product is as follows: Q = -5 + 2P. How many units can
be sold if the price is Rs.4 per unit? At what price will the manufacturer be no longer willing
to sell any unit?

5. The price of a matchbox was Rs. 3 a box, and Mr. X brought 10 boxes. Later, the price
went up to 3.75 a box, and he is now willing to buy 8 boxes. Is his demand for matchboxes
elastic or inelastic?

6. When the income of a consumer was Rs. 5000 per month, the quantity demanded of a
commodity was 25 kgs. When his income increased to 5500, his demand increased to 30 kgs.
Calculate the income elasticity of demand.

7. If a consumer's elasticity of demand for coffee is constantly (-) 0.9, and he buys 4 cups
when the price is`$1.50 per cup, how many will he buy when the price is $1.00 per cup?

8. A shopkeeper decides to sell eggs for $4 a dozen. He sells 50 dozen, and decides that he

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can charge more. He raises the price to $6 a dozen and sells 40 dozen. What is the elasticity
of demand? Assuming that the elasticity of demand is constant, how many would he sell if
the price were `$10 a dozen?

9. Which of the following goods are likely to have elastic demand, and which are likely to
have inelastic demand?
• Cooking oil • Pepsi • Chocolate • Water • Medicine • Wall Painting
• Text book • Diesel •ultra slim laptops

10. An individual spends all his income for two goods X and Y. If with the rise in the price of
good X, quantity demanded of good Y remains unchanged, what is price elasticity of demand
for X?

11. Why would a government tax on cigarettes be an ineffective method to decrease

consumption of cigarettes?

12. A shop charges $10 per kilo for chocolates. The elasticity of demand for chocolate in the
town is 2.5. If the shop wants to increase its total revenue, what advice will you give and
why?

13. A 10 percent increase in income brings about a 15 percent decrease in the demand for
a good. Is the good a normal good or an inferior good? Explain your answer.

14. If the cross elasticity of demand between products X and Y is -1.4, then are the two
commodities substitutes or complements? Explain your answer.

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 TRACE KTU

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