Module 1 (Basic Concepts and Demand and Supply Analysis)

Basic economic problems- PPC– 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 –. Production
function – law of variable proportion Cobb-Douglas production function
(CO: Understand the fundamentals of various economic issues using laws and
learn the concepts of demand, supply, elasticity and production function.)
Definition
 As a Science of wealth (Adam Smith) : Study of human behaviour in relation to
wealth.
 As welfare of the people(Marshall): Study of human welfare
 Science of choice(Robinson): Human beings have unlimited wants but the means
to satisfy the wants are scarce , hence we make a choice
Engineering Economics
Application of economic principles and tools in engineering
problems and decisions. It is a branch of micro economics that enables the
engineers to analyse the cost and benefit of different alternatives so that
appropriate decisions can be made. It enables the engineers in:
 Evaluating alternatives in terms of cost and benefit
 Making decision by making use of the limited resources
 Optimising profit by minimising cost
 Forecasting business fluctuations
Scope
Two branches of economics are: micro economics & macro economics
 Micro economics deals with the study of the behaviour of individual units/
small units. Eg. Income of an individual. Macro economics deals with the
study of aggregates or whole of items. Eg. National income
CONCEPTS
 Scarcity : Absence of productive resources.
 Choice: Human beings have unlimited number of wants but the means to satisfy
wants are scarce. Hence arise the problem of choice- priority.
Central problems of an economy

What are the central problems of an economy?

Central problems arise from scarcity or shortages of resources.
What to produce & what in quanties: whether capital goods or consumer goods
to be produced and in what quantities.
How to produce: The choice of technology- whether capital intensive technology
or labour intensive technology is used for producing output.
For whom to produce: Distribution of commodities- PDS (socialist) or price
system(capitalist economy)

Production possibility curve(PPC)

 Production possibility curve is a graphical representation of combination

of two quantities of commodities that can be produced with a given level
of technology and a given amount of resources. Let us suppose that an
economy can produce two commodities, wheat and cloth. Also suppose that

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 the productive resources are being fully utilized and there is no change in
technology

In the diagram, commodity ‘X” is measured along the ‘OX’ axis

and commodity ‘Y’ along the ‘OY’ axis. The curve ‘AF’ is the PPC. It
is a l s o called ‘Transformation curve or PPF (Production possibility
Frontier)

 PPC slopes downward

 PPC is concave to the origin.
 Slope of PPC is defined as the quantity of good Y given up in exchange for
additional unit of good X.
 Point A shows full concentration on production of wheat and F shows on Cloth.
 Any points on the curve shows combination of quantities of two commodities
 A point inside the curve shows underutilization of resources
 A point outside the curve shows unattainable point.
 Point E shows fuller utilization of resources.

 Shifting of PPC:-
 PPC will shift upward (A2F2) when a society discovers some new resources or
there is an improvement in technology.
 PPC shifts downward (A1F1) when there is a natural calamity, resources will be
destroyed

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OPPORTUNITY COST& TRADE OFF

 It is defined as the cost for next best alternative forgone. Moving from Point A to
B will lead to an increase in services (21-27). But, the opportunity cost is that
output of goods falls from 22 to 18.
 Therefore, the opportunity cost of increasing consumption of services is the 4
goods foregone.

Trade off

 Due to the scarcity of resources, human beings are forced to make a choice.
Choice involves a tradeoff between cost and benefits. It means sacrificing
something to obtain some other things. Opportunity cost is the cost involved in
trade off

Utility
The term utility refers to the want satisfying power of a commodity. Utility is essentially
a subjective concept depending upon the intensity of consumer’s desire or want for that
commodity at that time. Thus, utility differs from person to person, place to place and
time to time. Utility is a cardinal concept i.e., it can be measured, the unit of
measurement of utility is utils

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Total Utility (TU)
It is the sum of all the utilities that a consumer derives from the consumption of a
certain amount of a commodity.
TUn = U1 + U2 +…… + Un
Marginal Utility (MU)
It is addition to the total utility as consumption is increased by one more unit of the
commodity. Mathematically, it is calculated as:
MUn= TUn- TUn-1
Or Mun= ∆𝑻𝑼/∆𝑿
No: of TU MU
Apple
s
Consumed
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2
8 24 -4
Law of Diminishing Marginal Utility:
 The law states that as a consumer consumes more and more units of a
commodity, the marginal utility goes on diminishing. Theory has been developed
by Prof. Alfred Marshall
 Assumptions of the Theory
 Consumer is Rational
 Commodities consumed are identical
 No time gap between the consumption of goods
 No change in taste and preferences
 Income remains constant
 No change in price of the commodity
The following table and diagram explain this law and the changes in his
marginal utility and total utility.

No: of MU TU
Apple
s
Consumed
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0

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7 28 -2
8 24 -4

Observations
As the consumer has more of the good, the TU increases less than in proportion and
the MU gradually declines but is positive.
When TU is maximum, called saturation point, MU is zero.
When TU falls, MU becomes negative.
STAGE 1
Increasing Returns
TU, MU increases at an increasing rate
Stage 2
Diminishing Returns
MU starts falling
TU increases at a diminishing rate.
At the end of second stage, MU reaches zero and TU reaches at its maximum (Point
M)
Stage 3
Negative Returns
After point M, MU becomes negative. TU starts falling.
Limitations
Most of the assumptions are unrealistic & hence they are the limitations of the law

Theory of Demand

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  It is the desire for a commodity backed by necessary purchasing power. ie, both
ability and willingness to pay.
 Factors affecting Demand
 Price: Inverse relation between demand and price.
 Income: Direct relation- Higher income higher demand
 Taste & preference :Direct relation between demand and likes and dislikes.
 Population: Directly related
 Price of substitutes: an increase in price of a substitute increase the demand for
other
 Price of Complementary goods: an increase in price of one decrease the demand
for the other.
 Conditions of trade: During boom, demand is more and during recession
demand is less.
 Government policy- In favour demand is more, against demand is less.
 Season: Direct relation
 Advertisement Directly related
 Expectation of a change in price and income
 DD= f(P, Y, Ps, Pc, S, T, A….)

 Law of Demand
 Other things remaining the same there is an inverse relation between price and
demand. ie, higher the price, lower the demand and lower the price, higher will
be the demand. Demand Schedule: It is a tabular presentation showing the
different quantities of a good that buyers of the good are willing to buy at
different prices during a given period of time. Demand Curve: The graphical
representation of the demand function is called a demand curve

Why demand curve slopes downwards?

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 A) Price effect: When price increase demand falls & when price falls, demand
increases.
B) Income effect: As income increases demand also increases.
C) Substitution effect
D) Law of diminishing marginal utility
Changes in Demand: 2 types of changes in demand
Change in demand due to change in price – Expansion and Contraction of
Demand
Change in demand due to factors other than price – Increase and Decrease in
demand
Shift in demand curve
 Extension of Demand or Contraction of Demand.
 Expansion or Extension of demand refers to rise in demand due to fall in the
price of the good. Contraction of demand refers to fall in demand due to rise in
the price of the good

Shift: Change in Demand

A shift of the demand curve is caused by changes in factors other than price of the good.
A change in factors causes shift of the demand curve. It is also called change in demand.
In a shift, a new demand curve is drawn. A shift of the demand curve can bring about:
(a) Increase in demand, or (b) Decrease in demand.

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 Exceptions to law of Demand

 Giffen Paradox: Giffen goods are inferior goods. In the case of Giffen goods DD
is strengthened with a rise in price & weakened with a fall in price.
 Veblen effect:Veblen goods are high priced commodities. In the case of veblen
commodities high price determines demand.
 Necessaries of life
 Bandwagon effect: A person purchase a new product because every one in his
social group has purchased it.
 Sheer ignorance
 Expectation of a rise in future
 Speculative goods: Bonds & shares
ELASTICITY OF DEMAND

 Change in demand as a result of change in price (price elasticity), income

(income elasticity) and change in price of other goods (cross elasticity of
demand).
 PRICE ELASTICITY OF DEMAND(ep)
 ep= ∆Q/ ∆P* P/Q ie, percentage change in demand as a result of percentage
change in price.
 Q= change in demand; P= change in price; P= initial price; Q= initial demand

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 3. Suppose a company produces electric bulbs and its demand curve is given as
P=500-0.1Q. If the company wants to sell 4500 bulbs what price would be
charged by the company? At that price what will be the price elasticity of
demand? Comment on elasticity.
 P=500-0.1Q
 Therefore Q= 5000-10P
 Q= 4500
 That is 4500= 5000-10P
 10P= 5000-4500=500
 10P= 500, So P=50
 Demand function= Q= 5000-10P
 ep= 50/4500*-10= -0.11 (inelastic demand)

FIVE DEGREES OF PRICE ELASTICITY

 Perfectly elastic: ep=∞ Unit elastic: ep=1

 Perfectly inelastic: ep=0 Inelastic= ep‹1, Elastic= ep›1

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 METHODS OF CALCULATION
 Percentage method: ep=∆Q/∆P* P/Q
 Expenditure method: Number of units consumed*price
 a) If expenditure increase with a fall in price and decrease with a rise in price
ep›1
 If total expenditure remains same irrespective of a change in price ep=1
 If total expenditure decreases with a fall in price & increase with an increase in
price , then ep‹1
Elasticity on a straightline Demand Curve

FACTORS AFFECTING PRICE ELASTICITY

i)Nature of the commodity
Luxury items: Elastic Demand
Necessaries: Inelastic Demand

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ii) Number of uses: More uses goods – elastic demand
iii) Time: Long run: elastic; short run: inelastic demand
iv) Income Spend: Larger income spend – more elastic demand
V) Availability of substitute: more elastic demand

Uses

 Useful for govt to impose tax on inelastic demanded goods to increase income
 Useful for producers to fix price for commodity- a high price for inelastic
demanded goods
 Useful to the policy makers:
 Useful for trade union in bargaining wages

 Income elasticity of demand is the percentage change in quantity demanded

divided by the percentage change in income.
 ei= ∆Q/ ∆I* P/I

1)Suppose a consumer purchases 10 units of a commodity when his monthly income is

Rs 20000. When his monthly income increases to Rs 25000 he purchases 12 units of it.
Estimate income elasticity of demand and interpret the result.
Ans:
Q=10.Q1=12, Y=20000, Y1=25000.
ΔQ= 12-10=2, ΔY= 25000 – 20000 = 5000 EY = (2/5000) x (20000/10) = 0.8
As EY is 0.8, it is less income elastic demand.
As the sign of income elasticity is positive, it is a normal good
 Cross Elasticity of Demand
ec=Qx/PY* PY/QX
ec= percentage change in demand for X as a result of a percentage change in price of Y

Cross elasticity of demand is;

Zero – if commodities are not related

Positive --- if commodities are substitutable
Negative --- if commodities are complementary

Numerical example:
A consumer purchases 50 units of commodity X when its price is Rs 8 per unit. In the
next month he purchased 60 units at the same price. This was due to an increase in the
price of another commodity Y from Rs. 10 to 12. Calculate cross elasticity of demand
and interpret the result.
Ans: PY= 10, P1Y=12, QX=50, Q1X =60, ΔQX=60-50=10, ΔPY=12-10=2 EC=(10/2)×
10/50= 1
Since EC=1, it is unit cross elasticity of demand. As the sign is positive, X and Y are
substitute goods.

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 Theory of supply
Supply means quantity offered for sale. The important factors affecting supply are:
Price: Directly related
Goal of the firm: Profit, sales, max market etc
Price of inputs (cost): minimum cot maximum profit
Price of other commodities: If the price of other goods are high then production and
supply of them become attractive
State of technology: directly related

 Law of Supply states that there is a direct relation between price and supply of
commodities keeping other factors constant.
 Supply curve is an upward sloping one showing the positive relation between
price and supply

Equilibrium Price:
Equilibrium Price is that price at which quantity supplied and demanded are equal.
That is, Quantity Demanded = Quantity Supplied, (QD=QS)
Equilibrium Price can be explained with the help of a schedule and diagram.

This schedule shows that when price is Rs 3, the quantity demanded and supplied are
equal, it is 30 units. Therefore 3 is the Equilibrium Price and 30 is the equilibrium
quantity.
In the diagram, demand curve ‘DD’ intersect the supply curve ‘SS’ at point ‘E’. Where,
QD = QS. QD &QS= 30.
Changes in demand and supply, and its effects on equilibrium:
1. Increase in demand:

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 When demand increases the demand curve shifts rightward (D2D2), and
equilibrium price as well as equilibrium quantity increases. The new equilibrium
point is E2, price is P2, and quantity is

2. Decrease in supply:
When supply decreases, supply curve shifts leftwards (D1D1), and the new
equilibrium point is E1, and equilibrium price increases to OP1 and equilibrium
quantity decreases to OQ1.

3. Demand and Supply increase equally:

When there is an equal increase in demand and supply there will not be any
change in equilibrium price but equilibrium quantity increases.

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Numerical Example:
Demand f unction of a product is given as D=50-2P and supply function S=20+3P. What
will be the equilibrium price and quantity of the product? Find the excess demand of
the product when price equals Rs. 3.
Ans: At equilibrium point, Demand=Supply That is, 50-2P=20+3P,
5P= 30.
Therefore, P=6
Thus equilibrium price of the product is Rs. 6
To find equilibrium quantity, substitute equilibrium price in equations. When
equilibrium price is substituted in demand function we get;
D=50-2×6=38, S=20+3×6=38
Thus equilibrium quantity of the product is 38

When P=3, D=50-2×3=44, S=20+3×3=29

Therefore excess demand when P=3 is 15 (44-29=15)

Production Function
Production function refers to the functional relationship between inputs and output.
In other words, it is the transformation of inputs in to output.

Types Production function: Two types.

I I. Short run Production function &
II II. Long run Production function

Short run Production function Or Law of Variable Proportion

Or Production Function with One Variable input.

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Law of Variable Proportion analyses the changes in output with one variable factor by
keeping other factors constant. This happens in the short run. Hence it is Short run
Production function.
When more and more units are produced with one variable factor and other fixed factors,
TP (Total product), MP (Marginal product) and AP (Average product) passes through
three Stages; This can be explained with the help of a table

Units of TP AP MP Stages
labour
1 2 2 2 I stage
2 6 3 4
3 12 4 6
4 16 4 4 II stage
5 18 3.6 2
6 18 3 0
7 16 2.28 -2 III stage

Stages I - Increasing Returns:-

During this stage TP increases at an increasing rate. MP and AP are also rising. MP is
higher than AP. First stage continues till MP=AP.
Stages II – Diminishing Returns:-
During this stage TP increases at a diminishing rate. But MP and AP are falling. This stage
ends when TP is maximum and MP=0. (i.e., when MP touches the X axis.)
Stages III –Negative Returns:-
During this stage TP declines and MP becomes negative (below the X axis).
The law can be explained with a diagram.

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Laws of Returns to Scale or Fixed proportion or
Long run Production function:-
In the long run all factors are variable. Therefore output can be increased by increasing
the quantities of all factors in the same proportion.
• • Since in the long run all factors are increased in the same (Fixed) proportion,
long run production function is also called Fixed Proportion. It is also called Returns to
Scale.
• o Initially the producer gets increasing returns to scale (Decreasing cost),
• o Then constant returns to scale (Constant cost), and
• o Finally decreasing returns to scale (Increasing cost).

Increasing returns to scale: means that increase in input brings more than
proportionate increase in output. That is 5% increase in input leads to more than 5%,
increase in output.
Constant returns to scale: means that increase in input brings equal and proportionate
increase in output. A 5% increase in input leads to 5%, increase in output.
Decreasing returns to scale: means that increase in input leads to less than
proportionate increase in output. That is 5% increase in input leads to less than 5%,
increase in output.

Inputs(capital Total Marginal Returns to

&labour) Product(TP) Product(MP) Scale
1L+1K 10 10 IRS
2L+2K 28 18
3L+3K 38 10 CRS
4L+4K 48 10
5L+5K 58 10
6L+6K 66 8 DRS
7L+7K 72 6
8L+8K 76 4

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COBB-DOUGLAS PRODUCTION FUNCTION

 Production function is the technical relation between input and output.

β α
 Symbolically we can express it as: A K L
 Where A= factor productivity: K= capital: L= Labour: α and β are output
elasticity of labour and capital respectively
 If α + β =1 = (CRS)
 α + β› 1 = (IRS)
α + β1‹ 1 = (DRS)

MPL= α× (Q/L)
Where, MPL- Marginal product of Labour
Q/L is Average product of Labour (APL).
✓ MPK= β × (Q/K)

MPK -Marginal product of Capital.

Q/K is Average product of capital (APK).

Numerical Examples:-
1. In the production function Q= 2L 1/2 K1/2., if L=36

a) How many units of capital are needed to produce 60 units of output?

b) Determine the % increase in output if labour increased by 10%, keeping capital
constant.
Ans: a) 60=2 ×6 K1/2

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60= 12 K1/2
K1/2=60/12=5
K=25
b) L=36+3.6= 39.6
Q= 2×39.6 1/2×251/2
= 62.92, =63
% increase in output= ( ΔQ/Q) × 100
(63-60)/60 × 100= 5%

2. Suppose the production function is given as Q= 2K 1/2 L1/2. L=36, and K= 16.
a) What will be the output?
b) What is MPL and APK?
c) Find the number of units of capital required to produce 40 units of output, if L=25.
Ans: Q= 2K 1/2 L1/2, L=36, and K= 16.
a) Q=2×4×6=48
b) MPL= α× (Q/L)= 1/2 × (48/36) =2/3

APK= Q/K =48/16=3

c) When Q=40 and L=25,

40= 2× K1/2 × 25 ½
40= 2× 5 K1/2
K1/2= 40/10=4
K=16

3. If production Q= 5L 1/2 K1/2,

a) Find maximum possible output with 100 units of labour and ioo units of capital
b) Find average productivity of labour.
4) A firm’s production function is given as Q = 2 L1/2 K1/2. What will be the output when L =
25
and K = 9? Suppose the firm increases the number of units of capital to 16 and they want to
produce 80 units of output. What should be the number of units of labour?
5) a) In a production function, Q = 2 L1/2 K1/2. If L = 36, how many units of capital are
needed to
produce 60 units of output?
b) In the production function, Q = 2 L1/2 K1/2 determine the percentage increase in output if
labour is increased by 10% assuming capital is held constant.

6) Suppose the production function is given as Q = 3L1/2 K1/2. Find average and marginal
product
of labour when Labour equals 36 and K (capital) equals 16.
7) Assume the production function Q = 2L1/2 K1/2
i) If L = 100, K = 200, what is the maximum quantity that can be produced?
ii) If the firm changes the amount of labour and capital by 10 times what will happen to the
output? Why?
8) Assume the production function Y = 2K1/4 L3/4, where K= L = 1,
i) How much output is produce? ii) If labour is decreased by 10% how much K needed to
increase to produce the same level of output.
9) Consider the production function Y = K1/3 (H*L) 2/3, with K =10, H = 10, L = 5.
i) Find the average productivity of labour (APL) ii) what is the APL if H is increased to 12.
10) Given below is the production function of Firm A
Q = 100 K0.3L0.7 ,
The firm use 20 units of Labour (L) and 10 units of Capital (K).Calculate the output.

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