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MODULE-1

Basic Concepts and Demand Supply Analysis

Scarcity definition

Variety of definitions put forward the economists are wealth definition, welfare definition,
scarcity definition and growth definition. Among these, scarcity definition better conveys the
meaning of economics.

Lionel Robbins (1898-1984) defined economics as the “the science which studies human
behaviour as a relationship between ends and scarce means which have alternative uses”.
Here end is wants and means resources, which have alternative uses.

Basic concepts in economics

The most important economic concepts are

i. Scarcity
ii. Choice
iii. Resource allocation

 Scarcity

The starting point of economics is human wants, needs and desires and it is unlimited. No
individual can fully satisfy his wants. The means (resources) which human beings use to
satisfy their wants of fulfil their needs are scarce. In economics, scarcity has to be understood
in the relative sense, the scarcity of means in relation to ends. It is the imbalance between
ends and means (whether to an individual or to a society) that give rise to scarcity.

 Choice

The resources that one uses to satisfy needs are not specific to any particular end (want). The
means have alternative uses. Hence, alternative uses of scarce resources give rise to problem
of choice. Economics not only deal with scarcity but also help us to exercise meaningful
choices, since scarce means can be put to alternative uses.

 Resource allocation

In view of the scarcity of resources and multiplicity of needs, the economic problem lies in
making the best possible use of resources so as to get maximum satisfaction(from the point of
view of consumers) or maximum output(from the point of view of producers or firms). The
allocation of scarce resources among alternative uses is called resource allocation.
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Central Economic problems

Economic problems arise in an economy because of the unlimited wants of human being,
limited means and alternative use of means. The scope of economics involves the
identification of basic economic problems and find out different possible ways to solve those.
Economics is concerned with the efficient allocation of scarce resources. Any individual,
organisation or nation has to make three fundamental types of choices about how to allocate
the scarce resources available to it. Thus fundamental economic problems are

1. What to produce?
2. How to produce?
3. For whom to produce?

 What to produce?

The first problem relates to the type and range of goods to be produced. Since resources are
limited, one must choose between the different alternative combinations of goods and
services that may be produced. Allocation of resources between the different types of goods,
e.g., consumer goods and capital goods, is another major concern to any economy. This can
also be referred to as the problem of choice.

 How to produce?

Having decided on what to produce, the economy must determine the techniques of
production to be used. It is important to the best combination of factors (how much land
labour capital) to create the desired product. There are two types of techniques- labour-
intensive and capital intensive technique. A labour-intensive technique would employ
relatively more labour and less capital. A labour intensive technique would employ relatively
more labour and less capital. On the other hand, capital intensive technique means more
capital and less labour.

This can also be views as the problem of efficiency: efficiency is maximised when the limited
stock of resources yields the maximum possible volume of goods and services, or renders the
maximum benefit to the society.

 For whom to produce?

This means how the national output should be distributed. This is essentially the problem of
distribution. Once the goods are produces, they need to be distributed among the various
economic agents. The distribution of goods can be done equally or on the basis of needs or on
the basis of the contribution of an individual in the production of goods and services.

Trade-off

Scarcity forces us to make choices and every choice involves a trade-off a comparison of
costs and benefits. A Trade off means giving up one good or activity to obtain some good or
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another activity, or accepting less of one thing for more of another. Example, the government
has to decide whether to use more of its resource on agriculture or on industry. So there exist
a trade-off between agriculture and industry. If the government decides to spend more on
industry, it can be said that government trade off agriculture for industry.

Opportunity cost

Since resources are scarce and wants are unlimited, the problem of choice makes it necessary
to sacrifice some of the alternatives against the one selected. Individuals and firms make such
decisions based on expecting greater benefits from one alternative over another. In other
words, there is opportunity cost involved in a choice. Opportunity cost is the benefit forgone
from the next best alternatives that is not selected. In opportunity cost the value is expresses
in terms of satisfaction or benefits received from a forgone activity.

Suppose a firm has Rs 100 million at its disposal. It can use that amount for three alternative
purposes.

o To expand the size of the firm

o To set up a new production unit in another city
o Buy shares in another firm

Suppose that the expected annual return from each of the three alternative uses of finance is
give n below

o To expand the size of the firm-20 million

o To set up a new production unit in another city-18 million
o Buy shares in another firm-16 million

All other things being the same, a rational decision for the firm would be to invest money in
alternative 1. It implies that the manager would have to sacrifice the annual return from the
second best alternative. In economics jargon, Rs 18 million is called annual opportunity cost
of an annual income of Rs 20 million. Thus, opportunity cost is the forgone income expected
from the second best opportunity of using the resources.

Production possibility curve

Production possibility curve (PPC) or Production possibility frontier (PPF) is a graph that
shows the different combinations of the quantities of two goods that can be produced (or
consumed) in an economy at any point of time subject to limited availability of resources. It
depicts the trade-off between two goods produced (or consumed). It shows how one good
can be transformed into another good through the transfer of resources from one line of use to
another. Hence, PPC is also called the transformation curve.

Assumptions

1. The economy produces two goods

2. Fixed resources
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3. Fixed technology

With given resources and technology, if the economy wants to increase the production of one
good, it has to sacrifice the production of another good.

The graphical representation of production possibility curve is given below.

A point on the frontier shows efficient utilisation of resources.

A point outside the frontier shows unattainable combination

A point inside the frontier shows underutilisation of resources.

Marginal Utility Analysis

Total and marginal utility

Total utility (TU)refers to the sum total of utility levels out of each unit of a commodity
consumed within a given period of time, or in other words, total satisfaction from
consumption. If a consumer has three apples, his total utility will be the sum of the utility
derived out of each apple.

Marginal utility is the change in total utility due to a unit change in the commodity
consumed within a given period of time i.e. MU=TUn - TUn-1

Law of diminishing marginal utility

Herman Heinrich Gossen was the first to formulate this law in 1854 though the name was
given by Marshall. According to this law, Marginal Utility of a good diminishes as an
individual consumes more units of a good. Marshall states the law thus “the additional
benefits 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”
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Law of diminishing marginal utility is based on certain assumptions, absence of which may
create exception to the law

1. The unit of consumption must be a standard one: too large of too small units would
not validate the law.
2. Consumption must be continuous: gap between consumption of two successive units
will invalidate the law.
3. Multiple units of the commodity should be consumed: in other words, the demand for
the commodity should be of recurring nature. The law normally does not apply to
durable consumer goods like house, car etc.
4. The taste and preferences of the consumer should remain unchanged during the course
of consumption.
5. The good should be normal and not additive in nature: consumption of cigarettes
alcohol etc. are governed by compulsive behaviour and does not follow the rule of
rationality.

Let us explain the law with a simple example. When a person consumes apples; his utility
function for consumption of apples is summarised in the following table. Till he had not
consumed any apple, his satisfaction level was nil; hence his total utility derived was zero.
The very first apple gives him maximum satisfaction i.e., 20 utils. Total utility is increasing
with each successive apple (20, 35, 45, 50....), marginal utility is declining (20, 15, 10, 5 ).
The fifth apple gives him no additional satisfaction and MU for the fifth apple is zero; the
total utility derived from the fourth and fifth people is the same. Any consumption beyond
this point will lead to a fall in total utility from the sixth apple is minus five, which implies
disutility or dissatisfaction out of excess consumption. No rational consumer would continue
consumption till this point.

Table

Unit TU MU
1 20 20
2 35 15
3 45 10
4 50 5
5 50 0
6 45 -5
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In the figure, TU is the total utility curve and MU is the marginal utility curve. Geometrically
the marginal utility curve is the slope of the total utility curve. So long as the TU curve is
rising, the MU curve is falling. When the former reaches the highest point Q, the later
touches the X axis at C where MU is zero and when the TU starts falling from Q and the MU
becomes negative from C onwards.

FIRM

A firm is a for-profit business organization—such as a corporation, limited liability company (LLC),

or partnership—that provides professional services.

Types of Firm

I Private Sector

[Link] proprietorship or sole trader

This type of firm controlled by a single individual responsible for all expenses and
responsibilities and owns all assets. Although it is uncommon for single proprietorship
companies to function as firms, it does occur.
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[Link] stock Companies.

The capital is raised by selling shares of different values. Persons who purchase the shares are called
shareholder. The managing body known as; Board of Directors; is responsible for policy making
important financial & technical decisions. Advantages of joint stock companies are:

Larger Capital – With a joint-stock company, the capital of the company is divided up and
sold to shareholders. This means that there is no limit on how much money can be raised.
Unlike a corporation, there are also no restrictions on who can buy shares in the company.

Limited Liability – With a joint-stock company, the shareholders have limited liability.
The protection and responsibility of the company are divided between its shareholders.

Economies of Scale – Economies of scale refers to the cost advantages that a large
company has over smaller companies. The larger the production, the lower the per-unit-cost
will be. A joint stock company offers economies of scale to their shareholders

 Scope for Growth and Expansion – Joint stock companies has the potential for growth and
expansion that is not available to other types of corporations. People can purchase shares in a
joint stock company with the expectation that the company will grow over time and make
significant profits.

Disadvantages

Difficult to Form – Joint Stock Companies are difficult to form for a variety of reasons.
One reason is that many individuals need to approve the company’s formation. If even one
person objects, the company cannot be formed. Moreover, there are a lot of legal issues that
also need to be addressed.
Lack of Secrecy – The Company will have to disclose information about its operations,
finances, and other sensitive matters because they are expected to be open and transparent
with their shareholders.

Delays in Decision Making – One of the disadvantages of Joint Stock Company is that
decision making is usually delayed. This can be seen in the case when there are people who
are not willing to compromise on their ideas and it makes it difficult for them to make
decisions.

Another disadvantage of Joint Stock Company is that there is a high chance for internal
conflict between the board members when interests are not aligned. Lastly, one more
disadvantage is that decision making might be blocked by different levels of power within the
company.

Separation between Management and Ownership – Joint stock companies have many
disadvantages. One of the major disadvantages is that the owners don’t often have a say in how their
company is managed. Instead, a board of directors or other body decides on this for them. Sometimes,
this can lead to mistakes being made that could be harmful for the company’s success.

C Partnership Organisations

A partnership is a kind of business where a formal agreement between two or more people is made who
agree to be the co-owners, distribute responsibilities for running an organization and share the income
or losses that the business generates.

II Public Sector
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Public enterprises, or state-owned enterprises, are self-financing commercial enterprises that

are under public ownership which provide various private goods and services for sale and
usually operate on a commercial basis.

III Joint sector

Joint Sector refers to a form of partnership between the public sector (government) and the private
sector (private enterprises) in the context of the economy. It is an extension of the concept of a
mixed economy, where both public and private enterprises coexist and contribute to economic
development.

Objectives of a Firm

Profit Maximisation

Growth maximisation

Revenue Maximisation

Sales maximisation

Utility maximisation

DEMAND AND SUPPLY ANALYSIS

DEMAND

Since human wants are unlimited and means to achieve them are limited, people have to
prioritise their wants. Every want, need or desire cannot be termed as demand. Demand is
defined as that want, need or desire which is backed by willingness and ability to buy a
particular commodity, in a given period of time.

Demand is an effective desire, as it is backed by the willingness to pay and ability to pay the
price of the commodity. Effective demand always is attributed with a price and particular
point of time. Thus demand is the quantity of a commodity which consumers are willing to
buy at a given price for a particular unit of time (a day, a week, a month, six months and so
on).

Determinants of demand

1. Price of the product

The single most important determinant of demand is the price of the product. With all other
determinants of demand remaining unchanged, if the price of the product falls, its quantity
demanded will rise and vice versa.

2. Income of the consumer

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Normally income bears a positive relationship with demand, i.e., when income increases;
demand also increases due to increase in consumer’s paying capacity.

But it may not happen always. Engel point out that as income increases, the proportion of
income spent on food decreases. This gave rise to a categorisation of goods into normal
goods and inferior goods. Normal goods have a positive relation between their demand and
income; inferior goods have a negative relation between their demand and income.

Inferior goods are low quality goods which people stop consuming with rise in income and
replace them with better ones. Thus increase in income increases demand for higher quality
food items, higher class of travel in train and air, demand for tourism etc.

3. Price of related goods

Goods bear two types of relationship-they can be complements or substitutes. An increase in

the price of a commodity increases the demand for its substitute (tea and coffee) and reduces
the demand for its complement. In other words, price of any commodity has a positive impact
on demand for its substitute and negative impact on the demand for its complements.

4. Taste and preferences

Taste and preferences have such effect that in spite of fall in price, demand may not rise and
in spite of increase in price, demand may not decrease. Age, gender, education, profession,
social cultural norms, advertising etc. play a role in developing tastes and preferences.

5. Advertising

Advertising has gained remarkable ground as a determinant of demand, especially in the

modern age of cutthroat competition among brands.

6. Future expectation

If the consumer expects his income to increase or price to fall in future, will postpone
demand; on the other hand, if they expect price to increase in future will hasten the purchase.
For example, purchase of cars and other durables increases before the budget is announced if
consumers fear that prices may rise after budget.

7. Population

Size of the population, age distribution, rural urban distribution and gender distribution affect
aggregate demand. If size of the population is constantly increasing, more food items and
other goods and services will be needed in the country. Age distribution determines what
kinds of commodities will be demanded.

8. Economic growth

If an economy is growing, it will have increased demand for goods of better quality.
Consumers will have higher paying capacity and greater willingness to pay a higher price for
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quality. Then the producer produce more of that commodity add variety to their existing
product.

Demand function

When we express the relation between demand and its determinants mathematically,

it is known as demand function. The demand for the product, (Dx) =f(Px, Y, PO,T,A, Ef, N)

Where, Px price of the commodity X

Y=Income of the consumer

Po=Price of related goods

T=Tastes and preference of the consumer

A=Advertising

Ef=Future expectations
N=Population and economic growth

Law of demand

Law of demand explains the relationship between the quantity demanded and price of a
commodity. It states that other things remaining constant, (ceteris paribus) when the price of
a commodity rises, the demand for that commodity falls and when the price of a commodity
falls, the demand for the commodity rises. In other words demand for a good is inversely
proportional to its price. Then demand function can be stated as following to illustrate the law
of demand

Dx=f (Px)

Demand for good x is the function of price of good x

The reasons behind law of demand are price effect, substitution effect, income effect and law
of diminishing marginal utility.

Price effect: explains why a fall in price results in rise in demand and vice versa. A fall in the
price of commodities which have multiple uses would induce a consumer to put it to
alternative uses. If it is cheap, people start using it for all purposes. Example: electricity can
be used for lighting, cooling, cooking, heating, running machines etc.
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Substitution effect: when the price of a commodity falls, it becomes cheaper to its substitute
which is more expensive and its price has not changed. As a result, demand for the
commodity rises. On the contrary, when price of this commodity raise, other substitutes
become less expensive.

Income effect: when the price of a particular commodity falls, the consumer’s real income
rises, though money income remains the same.

Law of diminishing marginal utility: as per this law consumer purchases a commodity till its
marginal utility is equal to price. If the price falls he will purchase more.

Exceptions to Law of Demand

Law of demand states that, when price increases, demand falls and when price falls demand
increases. But sometimes, there are cases this equation does not apply, i.e. with a fall in price,
demand also falls and with a rise in price, demand also rises. This is a situation which is
contrary to the law of demand. The following are the exceptional cases.

Giffen’s goods

Sir Robert Giffen of England observed that in the 19 thcentury low-paid British workers were
purchasing more bread when its price was rising. They consume bread and meat as their diet.
When the price of bread was falling, instead of buying more bread they were buying less. He
was puzzled by this paradox of buying more at rising prices and buying less when prices were
falling. Bread was the staple food of low wage earners. These people purchase more of bread
when its price rises. When the price was falling, instead of buying more they tried to buy less
of bread and use the savings for the purchases of meat. This behaviour is called Giffen’s
paradox.

Conspicuous consumption

The goods, which are purchased for ‘snob appeal’, are called goods for conspicuous
consumption. They are also called as Veblen goods because the economist Veblen coined this
term. According to Veblen, some people buy a commodity for the sake of enhancing their
prestige and status in the society. The examples of such commodities are diamonds,
jewellery, luxury car etc. They are prestige goods. They would like to hold it only when they
are costly and rare.

Demand schedule and demand curve

Demand schedule is the list or tabular statement of the different combinations of price and
quantity demanded of a commodity. The following table gives the hypothetical demand
schedule for coffee at a local coffee shop, showing different price levels of a cup of coffee
and their corresponding quantities of cup demanded every month, ceteris paribus.
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Demand schedule

Price Demand

15 50

20 40

25 30

30 15

35 10

Demand curve
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Demand curve shows the relationship between price of a good and the quantity demanded by
consumers. Due to the negative relationship between price and quantity demanded and the
law of diminishing marginal utility, the demand curve has a negative slope and is convex to
the origin. For the sake of simplicity, it is normally shown as a downward sloping line.

Market demand is simple summation of the demand by all the consumers in the market at a
given price and given point of time. To draw the market demand curve, we add up the
individual demand curve by using a process called horizontal summation.

Change in demand

The change in demand arises due to the change in any of the factors other than price such as
income, tastes and preference, or prices of other goods. Forex. Suppose the earlier monthly
income of the consumer was Rs.20, 0000 and now it increase to Rs.30, [Link] when
consumer’s income increases it increases their purchasing power with no change in price.
Now at the same price consumers can purchase more quantity of goods. Alternatively, if the
income of the consumer falls at the same price the demand falls.

When demand increases without any change in price, the demand curve will shift to the right
and with a reduction in demand the curve will shift to left.

Price

Quantity
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Increase in demand refers to an increase in quantity demanded at each price. In other words,
larger quantity of a commodity is demanded at the same price.

A decrease in demand refers to fall in the quantity demanded at each price. In other words,
lesser quantity of a commodity is demanded at the same price.

SUPPLY

In a market economy, while buyers of a product constitute the demand side of the market,
sellers of that product make the supply side of the market. Supply refers to the quantities of a
good or service that the seller is willing and able to provide at price, at a given point of time,
ceteris paribus.

Determinants of supply

1. Price of the commodity

Supply is positively related to price of the commodity. With all other things remaining the
same, if the price of the product rises, suppliers would find it profitable to sell more.

2. Cost of production

Production requires the transformation of various inputs into output and involves cost that
included prices of inputs (wages, rent, interest, price of raw materials, etc). If the cost of
production rises due to rise in the price of raw materials, supply will definitely be reduced.

3. State of technology

Technology bears a positive relationship with supply. An improved technology reduces cost
of production per unit of output, enhances productivity and thus increases the supply of the
product.

4. Number of firms

With increase in the number of producers of a particular product, the supply of the product in
the market will increase.

5. Government policies

Government policies related to taxes and subsidies on certain products also have an effect on
supply as they increase or decrease the cost. Such effects may be either negative (taxes) or
positive (subsidies).

Supply function

When we express mathematically the relation between supply (dependent variable) and its
determinants (independent variable), the functional representation is termed supply function.

Sx= (Px, C,T, G, N)

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Px =Price of the product

C =Cost of production (wages, interest, rent, price of raw materials)

T =State of technology

G =Government policies regarding tax and subsidies

N =other factors like number of firms

Supply function represents the quantity of the commodity that would be supplied at a price,
level of technology, input prices and all other factor. Supply function can also be simplified
by holding constant the value of all variables other than price of the good

S=f(P)

Supply is the function of price.

Law of supply

The law of supply is expressed generally in terms of price quantity relationship. Law of
supply states that other things remaining the same, the higher the price of a commodity, the
greater is the quantity supplied. It means that price and quantity of a commodity is positively
related.

Supply schedule and supply curve

Supply schedule of a commodity is a list or a tabular statement of the different combinations

of price and quantity supplied of that commodity.

Supply curve represents the quantities supplied of commodity at different price levels. The
supply curve has a positive slope. The positive slope or upward movement of supply curve is
caused by sellers desire to make larger profits.

Supply schedule

Price Supply

15 10

20 15

25 30

30 45

35 60
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Supply curve

Change in supply

Change in supply is associated with change in factors like cost of production, technology etc.
It causes a shift in supply curve upward or downward. Forex. if a seller uses a new machine
instead of the old one it increases the productivity and with the new machine more can be
produced and supplied at the same price. So the curve shifts to right. If there is any cost of
production, producers will decrease production and supply of goods decreases. Then the
supply curve shift to left side.
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Market equilibrium
Equilibrium refers to a state of balance hat can occur in a model showing tendency of no
change. In the context of market analysis, equilibrium refers to state in which the quantity
demanded of a commodity equals its quantity supplied. The equality of demand and supply
produces an equilibrium price.

Market equilibrium

Price Supply Demand

15 10 50

20 15 40

25 30 30

30 45 15
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Market equilibrium can be depicted graphically by plotting the demand curve with supply
curve. The point of intersection E shows equilibrium price, because here demand is just equal
to supply. Any point above E or below it create disequilibrium in the market and two forces
of demand and supply will keep on changing till the point of intersection is attained.

ELASTICITY OF DEMAND AND SUPPLY

Elasticity of demand

The law of demand do not give the idea that when price decreases, at what per cent the
quantity demanded increases. So the magnitude of change in demand as result of change in
price can be measured with the help of the concept elasticity. The elasticity of demand is the
measure of responsiveness of demand for a commodity to the change in any of its
determinants viz, price of the commodity, price of the substitutes and complements,
consumers income and consumer expectation regarding prices. Interdependence of two
variables can be measured with the help of elasticity.

Elasticity of demand= Percentage change in quantity demanded

Percentage change in the determinant of demand.

There are various types of elasticity of demand

1. Price elasticity of demand

2. Income elasticity of demand

3. Cross elasticity of demand

4. Promotional elasticity of demand

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Price Elasticity of demand

Price elasticity of demand is considered to be the most important determinant of all

elasticity’s demand. Price elasticity of demand measures the responsiveness of demand for a
product to the changes in the price of the product, when all other variables are constant. Thus
price elasticity of demand is,

ep= Percentage change in demand for a commodity

Percentage change in the price of the commodity

∆𝐷 𝑃
ep= 𝑋
∆𝑃 𝐷

∆𝐷 =Change demand, P-Initial Price, D-Initial demand

∆P = Change in price

Degrees of price elasticity of Demand

The following are the different degrees of price elasticity

 Perfectly elastic demand(ep=α)

 Highly elastic demand(ep>1)
 Unitary elastic demand(ep=1)
 Relatively inelastic demand(ep<1)
 Perfectly inelastic demand(ep=o)
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Determinants of Price Elasticity Demand:

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The elasticity of demand varies from commodity to commodity depending on the nature of
the commodity. While the demand for some commodities is highly elastic, for some it is
highly inelastic. The main determinants of price elasticity are

 Nature of the commodity

 Alternative uses of commodity
 Proportion of income spent on the commodity
 Time
 Durability of the commodity
 Items of addiction

Nature of the Commodity

Nature of the commodity means luxury goods or necessities. Necessities have inelastic
demand and luxury goods have elastic demand.

Availability and proximity of substitutes

One of the most important determinants of price elasticity of demand is the availability of its
substitutes. The closer the substitutes, greater will be the elasticity of the demand for the
commodity. For instance tea and coffee are close substitutes. If the price of these goods
increases (coffee) then the other commodity (tea) becomes cheaper. Therefore, consumers
buy more of the relatively cheaper good (tea) and less of the costlier one. The elasticity of
demand for both these goods will be higher. Besides, wider the range of substitutes, the
greater will be the elasticity. Sugar and salt do not have close substitutes and hence their price
elasticity is lower.

Alternative uses of the commodity

If the commodity can be put in to more than one uses, it would be relatively price elastic For
example electricity is used for various purposes; when it is relatively cheap, it is used for
various purposes, otherwise its use is restricted to the most immediate purpose. Decrease in
the price of multi-use commodity encourages the extension of their use. So such commodities
have higher elasticity of demand.

Proportion of income spent on a commodity

The proportion of income spent on a commodity is very small, its demand will be inelastic
and vice versa. Examples of such commodities are salt, match box, salt, books etc. which
claim only very small proportion of consumer’s income. Demand for these goods is generally
inelastic because increase in the price does not substantially affect consumer’s budget.

Time

Demand for any commodity is usually more price elastic in the long run. The consumers take
time to adjust their consumption pattern to accommodate substitutes in their consumption
bundles. A shift from petrol driven automobiles to CNG driven ones is a typical example. It
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may not be feasible for consumers to switch from petrol driven cars in the short run, but they
would gradually shift to CNG driven vehicles in the long run.

Items of addiction

Items of intoxication and addiction are relatively price inelastic. For example cigarettes, if
their price rises, smokers may not be able to promptly cut down their consumption of
cigarettes and may thus not respond instantly to an increase in price.

Income elasticity of demand

The income elasticity of demand is the measure of percentage change in demand for a
commodity due to a percentage change in the consumer’s income, ceteris paribus.

ei = percentage change in demand

Percentage change in income

If the demand for the commodity is denoted by DX and the consumers income by I then,

∆𝐷 𝐼
ei= 𝑋
∆𝐼 𝐷

∆𝐷𝑥=Change demand, I-Initial Income, D-Initial demand

∆I = Change in Income

Income elasticity will be negative for inferior goods. An inferior good is an economic term that
describes a good whose demand drops when people's incomes rise.

Classification of goods on the basis of income elasticity of demand

Normally income elasticity sign is positive. This is because when income increases, the
consumer would increase the consumption of good.

 A good is said to be a normal good when the income elasticity is positive but less than
unity
 A good is said to be a superior good when the income elasticity is positive and
exceeds unity
 A good is said to be an inferior good when the income elasticity is negative, i.e, when
the consumer’s income increases demand for the good falls.
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Cross elasticity of demand

Price of some related products also causes a variation in the demand for a commodity. Cross
elasticity of demand measures the responsiveness of demand for one product to the change in
the price of another.

ec= Percentage change in demand of x

Percentage change in the price of y

If the demand for good x is denoted by Dx and price of good y by Py, then the cross elasticity
between two goods can be shown by
𝑃Y
e =∆𝐷𝑥 𝑋
c
∆𝑃Y 𝐷𝑥

∆𝐷𝑥=Change demand for X, 𝑃𝑦-Initial Price of Y, D-Initial demand

∆𝑃𝑦 = Change in price of Y

NOTE: Cross elasticity is zero for unrelated

goods. Positive for substitutes and negative for
complementary goods.

Promotional elasticity of demand

Promotional elasticity of demand is a measure of the responsiveness of demand for a

commodity to the change in outlay on advertisements and other promotional efforts.

eA= Percentage change in demand

Percentage change in the outlay on advertisements and other promotional efforts.

∆𝐷 𝐴
eA= 𝑋
∆𝐴 𝐷

∆𝐷𝑥=Change demand for X, 𝐴-Initial Advertisement expenditure, D-Initial demand

∆𝐴 = Change in advertisement expenditure

Promotional or advertisement elasticity of demand plays an important role in the marketing

decisions of any firm. A low promotional elasticity would indicate that demand changes less
as compared to a change in advertisement outlay of the firm. In such cases for increasing the
demand for its product, the firm will have to incur relatively much high expenditure on
advertisements.

ELASTICITY OF SUPPLY
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The elasticity of supply (es) measures the degree of responsiveness of quantity supplied of
any commodity to a given change in price of the commodity.

Elasticity of Supply=Proportionate change in quantity supplied of commodity X

Proportionate change in the price of commodityX

Supply has different degrees of elasticity namely,

 Perfectly elastic supply (es=α)

 Perfectly inelastic supply(es=0)
 Relatively elastic supply (es>1)
 Relatively inelastic supply (es<1))
 Unitary elastic supply (es=1)

Perfectly elastic (es=α)

This is one extreme of the elasticity range, when elasticity equal to infinity. In this case, at
prevailing price unlimited quantities of the commodity can be supplied, and even the smallest
increase in price would result in huge increase in quantity supplied. However, if price is
reduced by eve n a small amount the quantity supplied will dip to zero.

The perfectly elastic supply curve is a horizontal line, parallel to the x axis. However, in real
world its application can see in very short run market of durable goods or stock market.

 Perfectly inelastic (es=0)

This is the extreme in which elasticity is equal to zero es=0 irrespective of price. The quantity
supplied is totally unresponsive to change in price. The shape of a perfectly elastic curve is
vertical, parallel to the price axis. At all price levels, say op 1 and op2 the quantity supplied
remains constant.

 Relatively elastic supply(es>1)

When es>1,a proportionate change in quantity supplied is more than a given change in price.

 Relatively inelastic(es<1))

When es<1,the proportionate change in quantity supplied is less than a proportionate change
in price.

 Unitary elastic(es=1)

When a given proportionate change in price brings about an equally proportionate change I
quantity supplied, in that case the supply of the commodity is unitary elastic.

Consumer surplus
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Consumer surplus, also known as buyer’s surplus, is the economic measure of a customer’s excess
benefit. It is calculated by analyzing the difference between the consumer’s willingness to pay for a
product and the actual price they pay, also known as the equilibrium price. A surplus occurs when the
consumer’s willingness to pay for a product is greater than its market price.

Consumer’s Surplus = The price a consumer is ready to pay – The price he actually paid

The point where the demand and supply meet is the equilibrium price. The area above the supply level
and below the equilibrium price is called product surplus (PS), and the area below the demand level
and above the equilibrium price is the consumer surplus.

Producer surplus
Producer surplus represents the difference between the price a seller receives and their willingness
to sell for each quantity. Each price along a supply curve also represents a seller's marginal cost of
producing each unit of production. Therefore the difference between what the price that the seller for
each unit, and what it cost for the seller to produce that last unit, represents the seller's benefit from
the price they are getting.
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The sum of consumer and producer surplus is called social surplus.

Taxation and Deadweight loss

The term deadweight loss of taxation refers to the measurement of loss caused by the
imposition of a new tax. This results from a new tax that is more than what is normally paid
to the government's taxing authority. This theory suggests that imposing a new tax or raising
an old one can backfire, resulting in insufficient or no gains in government revenues due to
the decline in demand for the goods or services being taxed. A deadweight loss, therefore,
disrupts the balance between supply and demand. English economist Alfred Marshall is
widely credited as the originator of deadweight loss analysis.