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Nature and Scope of Economics

 What is 'Economics':-

Economics is a social science concerned with the production, distribution and

consumption of goods and services. It studies how individuals, businesses,
governments and nations make choices on allocating resources to satisfy their
wants and needs, and tries to determine how these groups should organize and
coordinate efforts to achieve maximum output.

Economic analysis often progresses through deductive processes, much like

mathematical logic, where the implications of specific human activities are
considered in a "means-ends" framework.

Economics can generally be broken down into macroeconomics, which

concentrates on the behavior of the aggregate economy, and microeconomics,
which focuses on individual consumers.

 Economic problem:-
The economic problem – sometimes called the basic or central economic
problem – asserts that an economy's finite resources are insufficient to satisfy all
human wants and needs. It assumes that human wants are unlimited, but the
means to satisfy human wants are scarce.
Three questions arise from this:

1. What to produce?
2. How to produce? Capital goods or consumer goods
3. For whom to produce?

Problem of allocation of resources

The problem of allocation of resources arises due to the scarcity of resources, and
refers to the question of which wants should be satisfied and which should be left
unsatisfied. In other words, what to produce and how much to produce. More
production of a good implies more resources required for the production of that
good, and resources are scarce. These two facts together mean that, if a society
decides to increase production of some good, it has to withdraw some resources
from the production of other goods. In other words, more production of a desired
commodity can be made possible only by reducing the quantity of resources used
in the production of other goods.
The problem of all economic efficiency
Resources are scarce and it is important to use them as efficiently as possible.
Thus, it is essential to know if the production and distribution of national product
made by an economy is maximally efficient. The production becomes efficient only
if the productive resources are utilized in such a way that any reallocation does not
produce more of one good without reducing the output of any other good. In other
words, efficient distribution means that redistributing goods cannot make anyone
better off without making someone else worse off.
The problem of full-employment of resources
In view of the scarce resources, the question of whether all available resources
are fully utilized is an important one. A community should achieve maximum
satisfaction by using the scarce resources in the best possible manner—not
wasting resources or using them inefficiently. There are two types of employment
of resources:

 Labour-intensive
 Capital-intensive
In capitalist economies, however, available resources are not fully used. In times
of depression, many people want to work but can't find employment. It supposes
that the scarce resources are not fully utilized in a capitalist economy.
The Problem of Economic Growth
Economic growth is the increase in the inflation-adjusted market value of the
goods and services produced by an economy over time. It is conventionally
measured as the percent rate of increase in real gross domestic product, or real
GDP, usually in per capita terms.
An increase in economic growth caused by more efficient use of inputs (such as
labor productivity, physical capital, energy or materials) is referred to as intensive
growth. GDP growth caused only by increases in the amount of inputs available
for use (increased population, new territory) is called extensive growth.
 Demand and its Determinants:-

Demand is an economic principle that describes a consumer's desire and

willingness to pay a price for a specific good or service. Holding all other factors
constant, an increase in the price of a good or service will decrease demand, and
vice versa.
Demand drives economic growth. Businesses want to increase demand so they
can increase profits. Governments and central banks boost demand to end

The five determinants of demand are:

Price. The law of demand states that when prices rise, the quantity of demand falls. That
also means that when prices drop, demand will grow. People base their purchasing
decisions on price if all other things are equal.

The exact quantity bought for each price level is described in the demand schedule. It's
then plotted on a graph to show the demand curve.

If the quantity demanded responds a lot to price, then it's known as elastic demand. If the
volume doesn't change much, regardless of price, that's inelastic demand.

The demand curve only shows the relationship between the price and quantity. If one of
the other determinants changes, the entire demand curve shifts.

Income. When income rises, so will the quantity demanded. When income falls, so will
demand. But if your income doubles, you won't always buy twice as much of a particular
good or service. There's only so many pints of ice cream you'd want to eat, no matter how
rich you are. That's where the concept of marginal utility comes into the picture. The first
pint of ice cream tastes delicious. You might have another. But after that, the marginal
utility starts to decrease to the point where you don't want any more.

Prices of related goods or services. The price of complementary goods or services

raises the cost of using the product you demand, so you'll want less. For example,
when gas prices rose to $4 a gallon in 2008, the demand for Hummers fell.

Gas is a complementary good to Hummers. The cost of driving a Hummer rose along
with gas prices.
The opposite reaction occurs when the price of a substitute rises. When that happens,
people will want more of the good or service and less of its substitute. That's why Apple
continually innovates with its iPhones and iPods. As soon as a substitute, such as a new
Android phone, appears at a lower price, Apple comes out with a better product. Then the
Android is no longer a substitute.

Tastes. When the public’s desires, emotions or preferences change in favor of a product,
so does the quantity demanded. Likewise, when tastes go against it, that depresses the
amount demanded. Brand advertising tries to increase the desire for consumer goods.
For example, Buick spent millions to make you think its cars are not only for older people.

Expectations. When people expect that the value of something will rise, then they
demand more of it. That explains the housing asset bubble of 2005. Housing prices rose,
but people bought more because they expected the price to continue to go up. That drove
prices even further until the bubble burst in 2006. Between 2007 and 2011, housing prices
fell 30 percent. But the quantity demanded didn't increase. Why? People expected prices
to continue falling.

That was due to record levels of foreclosures entering the market. Demand didn't
increase until people expected future prices would, too. For more, see Subprime
Mortgage Crisis Explained.

Number of buyers in the market. The number of consumers affects overall, or

“aggregate,” demand. As more buyers enter the market, demand rises. That's true even
if prices don't change. That was another reason for the housing bubble. Low-cost
and sub-prime mortgages increased the number of people who could afford a house. The
total number of buyers in the market expanded, which increased demand for housing.
When housing prices started to fall, many realized they couldn't afford their mortgages.
At that point, they foreclosed. That reduced the number of buyers, driving down demand.

 Demand Curve:-
The demand curve is a graphical representation of the relationship between the
price of a good or service and the quantity demanded for a given period of time. In
a typical representation, the price will appear on the left vertical axis, the quantity
demanded on the horizontal axis.

 Law of Demand:-

In microeconomics, the law of demand states that, "conditional on all else being
equal, as the price of a good increases (↑), quantity demanded decreases (↓);
conversely, as the price of a good decreases (↓), quantity demanded
increases (↑)". In other words, the law of demand describes an inverse
relationship between price and quantity demanded of a good. The factors held
constant refer to other determinants of demand, such as the prices of other goods
and the consumer's income.[2] There are, however, some possible exceptions to
the law of demand, such as Giffen goods and Veblen goods.

Q. why does Demand Curve slop left to right


1. Law of Diminishing marginal utility

2. Income Effect
3. Substitution Effect

 Law of Diminishing marginal utility :-

The law of diminishing marginal utility is a law of economics stating that as a person
increases consumption of a product while keeping consumption of other products
constant, there is a decline in the marginal utility that person derives from
consuming each additional unit of that product. Marginal utility is derived as the
change in utility as an additional unit is consumed.

Marginal utility may decrease into negative utility, as it may become entirely
unfavorable to consume another unit of any product. Therefore, the first unit of
consumption for any product is typically highest, with every unit of consumption to
follow holding less and less utility. Consumers handle the law of diminishing
marginal utility by consuming numerous quantities of numerous goods.
 Income Effect:-

The income effect represents the change in an individual's or economy's income

and shows how that change impacts the quantity demanded of a good or service.
The relationship between income and quantity demanded is a positive one; as
income increases, so does the quantity of goods and services demanded. For
example, when an individual's income increases, that person demands more
goods and services, thus increasing consumption, all things equal.

The income effect is the change in demand of a good or service brought on by a

change in a consumer's discretionary income. The income effect can be observed
under two scenarios: if a person's aggregate level of income increases or if the
relative price of goods decreases. Both situations increase the amount of
discretionary income available.

For example, a consumer spends 50% of his paycheck on bread and the average
price of bread decreases, he has more free capital to spend on the food, increasing
its demand. Conversely, if the price of bread remains the same but the consumer
receives a pay raise that increases his discretionary income, he is able to purchase
more food and increase its demand.

 Substitution Effect:-

The substitution effect is the economic understanding that as prices rise — or

income decreases — consumers will replace more expensive items with less costly
alternatives. Conversely, as the wealth of individuals increases, the opposite tends
to be true, as lower-priced or inferior commodities are eschewed for more
expensive, higher-quality goods and services, known as the income effect.
Although beneficial to some companies like discount retailers, the substitution
effect is generally very negative within an economy, as it limits consumer and
producer choice.

The substitution effect is meant to represent the change in macroeconomic

consumption patterns that arise due to a change in the relative price of goods.
Consumers have the tendency to replace, or substitute, luxury items with cheaper
alternatives when income decreases or prices increase. Conversely, the same
consumers tend to substitute low-cost alternatives with higher-priced goods when
income increases or as the price of luxury goods decreases.

 Equi Marginal utility:-

The law of equi-marginal utility states that the consumer will distribute his money
income between the goods in such a way that the utility derived from the last rupee
spend on each good is equal. In other words, consumer is in equilibrium position
when marginal utility of money expenditure on each goods is the same.

1. The consumer is rational so he wants to get maximum satisfaction.
2. The utility of each commodity is measurable.
3. The marginal utility of money remains constant.
4. The income of the consumer is given.
5. The prices of the commodities are given.
6. The law is based on the law of diminishing marginal utility.
Limitation of the law:-

1. Indivisibility of Goods
2. The Marginal Utility of Money is Not Constant
3. The Measurement of Utility is not Possible
4. Utilities are Interdependent
5. Indefinite Budget Period
 Indifference Curve:-
When a consumer consumes various goods and services, then there are some
combinations, which give him exactly the same total satisfaction. The graphical
representation of such combinations is termed as indifference curve.

Indifference curve refers to the graphical representation of various alternative

combinations of bundles of two goods among which the consumer is indifferent.
Alternately, indifference curve is a locus of points that show such combinations
of two commodities which give the consumer same satisfaction. Let us
understand this with the help of following indifference schedule, which shows
all the combinations giving equal satisfaction to the consumer.

Indifference Schedule

Combination of Apples and(Apple) (Banana)


P 1 15
Q 2 10
R 3 6
S 4 3
T 5 1
As seen in the schedule, consumer is indifferent between five combinations of
apple and banana. Combination ‘P’ (1A + 15B) gives the same utility as (2A + 10B),
(3A + 6B) and so on. When these combinations are represented graphically and
joined together, we get an indifference curve ‘IC1’

Properties of Indifference Curve:

1. Indifference curves are always convex to the origin:

An indifference curve is convex to the origin because of diminishing MRS. MRS
decline continuously because of the law of diminishing marginal utility. when the
consumer consumes more and more of apples, his marginal utility from apples
keeps on declining and he is willing to give up less and less of bananas for each
apple. Therefore, indifference curves are convex to the origin. It must be noted that
MRS indicates the slope of indifference curve.

2. Indifference curve slope downwards:

It implies that as a consumer consumes more of one good, he must consume less
of the other good. It happens because if the consumer decides to have more units
of one good (say apples), he will have to reduce the number of units of another
good (say bananas), so that total utility remains the same.

3. Higher Indifference curves represent higher levels of satisfaction:

Higher indifference curve represents large bundle of goods, which means more
utility because of monotonic preference. Consider point ‘A’ on ICX and point ‘B’ on
IC2 in Fig. 2.5. At ‘A’, consumer gets the combination (OR, OP) of the two
commodities X and Y. At ‘B’, consumer gets the combination (OS, OP). As OS >
OR, the consumer gets more satisfaction at IC2.

4. Indifference curves can never intersect each other:

As two indifference curves cannot represent the same level of satisfaction, they
cannot intersect each other. It means, only one indifference curve will pass through
a given point on an indifference map, satisfaction from point A and from B on
IC1 will be the same.
Similarly, points A and C on IC2 also give the same level of satisfaction. It means,
points B and C should also give the same level of satisfaction. However, this is not
possible, as B and C lie on two different indifference curves, IC1 and
IC2 respectively and represent different levels of satisfaction. Therefore, two
indifference curves cannot intersect each other.
Assumptions of Indifference Curve:-

1. Two commodities:
It is assumed that the consumer has a fixed amount of money, whole of which
is to be spent on the two goods, given constant prices of both the goods.

2. Non Satiety:
It is assumed that the consumer has not reached the point of saturation.
Consumer always prefer more of both commodities, i.e. he always tries to move
to a higher indifference curve to get higher and higher satisfaction.

3. Ordinal Utility:
Consumer can rank his preferences on the basis of the satisfaction from each
bundle of goods.

4. Diminishing marginal rate of substitution:

Indifference curve analysis assumes diminishing marginal rate of substitution.
Due to this assumption, an indifference curve is convex to the origin.

5. Rational Consumer:
The consumer is assumed to behave in a rational manner, i.e. he aims to
maximize his total satisfaction.

 Price Consumption Curve:-

The price consumption curve is the curve that results from connecting tangents of
indifference curves and budget lines (optimal bundles) when income and the price
of good y are fixed, and the price of x changes.
When good x and good y are complements, as real income increases, you buy
more of both goods, making the PCC positively sloping.

When good x and good y are substitutes, as real income increases, you buy more
of one good (in this case good x) and less of the substitute (good y), making the
PCC negatively sloping.

Derivation of the Demand Curve:

 Macro and Microeconomics:-
Macroeconomics is a branch of economics dealing with the performance,
structure, behavior, and decision-making of an economy as a whole, as opposed
to individual markets. This includes national, regional, and global economies.
Macroeconomics involves the study of aggregated indicators such as GDP,
unemployment rates, and price indices for the purpose of understanding how the
whole economy functions, as well as the relationships between such factors as
national income, output, consumption, unemployment,
inflation, savings, investment, international trade and international finance.
Microeconomics, on the other hand, is the branch of economics that is primarily
focused on the actions of individual agents, such as firms and consumers, and
how their behavior determines prices and quantities in specific markets. One of
the goals of microeconomics is to analyze market mechanisms that establish
relative prices among goods and services and the allocation of limited resources
among many alternative uses. Significant fields of study in microeconomics
include general equilibrium, markets under asymmetric information, choice
under uncertainty, and economic applications of game theory.

 Capitalism Economy:-
Capitalism is an economic system in which capital goods are owned by private
individuals or businesses. The production of goods and services is based on
supply and demand in the general market (market economy), rather than through
central planning (planned economy or command economy). The purest form of
capitalism is free market or laissez-faire capitalism, in which private individuals are
completely free to determine where to invest, what to produce or sell, and at which
prices to exchange goods and services, without check or controls. Most modern
countries practice a mixed capitalist system of some sort that includes government
regulation of business and industry.

Functionally speaking, capitalism is simply one process by which the problems of

economic production and resource distribution might be resolved. Instead of
planning economic decisions through centralized political methods, as with
socialism or feudalism, economic planning under capitalism occurs via
decentralized and voluntary decisions.

 Socialistic Economy:-
Socialist economics refers to the economic theories, practices, and norms of
hypothetical and existing socialist economic systems.
A socialist economic system is characterized by social ownership and democratic
control of the means of production, which may mean autonomous cooperatives or
direct public ownership; wherein production is carried out directly for use. Where
markets are utilized for allocating inputs and capital goods among economic units,
the designation market socialism is used. When planning is utilized, the economic
system is designated a planned socialist economy. Non-market forms of socialism
usually include a system of accounting based on calculation-in-kind or a direct
measure of labor-time as a means to value resources and goods.

 Elasticity of Demand:-
 Price elasticity of demand :-
(PED or Ed) is a measure used in economics to show the responsiveness,
or elasticity, of the quantity demanded of a good or service to a change in its
price, ceteris paribus. More precisely, it gives the percentage change in quantity
demanded in response to a one percent change in price (ceteris paribus).
Price elasticities are almost always negative, although analysts tend to ignore the
sign even though this can lead to ambiguity. Only goods which do not conform to
the law of demand, such as Veblen and Giffen goods, have a positive PED.

 Income Elasticity of Demand:-

In economics, income elasticity of demand measures the responsiveness of the
quantity demanded for a good or service to a change in the income of the people
demanding the good, ceteris paribus. It is calculated as the ratio of the percentage
change in quantity demanded to the percentage change in income.
 Cross Elasticity of Demand:-
In economics, the cross elasticity of demand or cross-price elasticity of
demand measures the responsiveness of the quantity demanded for a good to a
change in the price of another good, ceteris paribus. It is measured as
the percentage change in quantity demanded for the first good that occurs in
1. Unitary Elastic Demand:
At the mid-point of the demand curve, i.e. at point B, the lower and upper
segments (BD and BE) are exactly equal.

LS-Lower Segment, US-Upper Segment

Thus, elasticity at point B = LS/US = BD/BE = 1

2. Highly Elastic Demand:

At every point above f the mid-point B but below E, i.e., between E and B, the
elasticity will be greater than one. It happens because lower segment is greater
than the upper segment.

So, Ed at point A = LS/US = AD/AE > 1 (as AD>AE)

3. Less Elastic Demand:
At every point below the mid-point B but above D, i.e., between B and D, the
elasticity will be less than one. It happens because lower segment is less than
upper segment. So, Ed at point C = LS/US = CD/CE <1 (as CD < CE).

4. Perfectly Elastic Demand:

At any point on the Y-axis (like point E), elasticity is equal to infinity because at
this point, there is no upper segment of demand curve. So, Ed at point E =
LS/US= ED/0 = ∞ (as any number, when divided by zero, gives infinity).

5. Perfectly Inelastic Demand:

At any point on the X-axis (like point D), elasticity is equal to zero because at
this point, there is no lower segment of demand curve. So, Ed at point D = LS/US
= 0/ED = 0 (as zero, when divided by any number, gives zero).

 Total outlay method:-

1. When, as a result of the change in price of a good, the total expenditure on
the good remains the same, the price elasticity for the good is equal to unity.

2. When, as a result of increase in price of a good, the total expenditure made

on the good falls or when as a result of decrease in price, the total
expenditure made on the good increases, we say that price elasticity of
demand is greater than unity.

3. When, as a result of increase in the price of a good, the total expenditure

made on the good increases or when as a result of decrease in its price, the
total expenditure made on the good falls, we say that price elasticity of
demand is less than unity.
 Percentage Method:-
Percentage method is one of the commonly used approaches of measuring price elasticity of
demand under which price elasticity is measured in terms of rate of percentage change in
quantity demanded to percentage change in price.

For an example: When the price of a commodity was Rs 10 per unit, its demand in the market
was 50 units per day. When the price of the commodity fell to Rs 8, the demand rose to 60
units. Here, price elasticity of demand can be calculated as
 Point Method:-

According to this method, elasticity of demand will be different on each point of a

demand curve. Thus, this method is applied when there is small change in price
and quantity demanded of the commodity.

According to this method, price elasticity of demand (PED) is mathematically

expressed as-

However, the method of calculating PED depends upon the nature of the demand curve.
These methods are explained below.

1. If the demand curve is of linear nature, PED is simply calculated by applying the
expression given above, i.e.

2. If the demand curve is of non-linear or convex nature, then a tangent line is drawn at
the point of which the PED is to be measured. Then PED is once again calculated as
 Arc Method:-

Any two points on a demand curve make an arc, and the coefficient of price elasticity of
demand of an arc is known as arc elasticity of demand. This method is used to find out price
elasticity of demand over a certain range of price and quantity. Thus, this method is applied
while calculating PED when price or quantity demanded of the commodity is highly changed.

The average of price and quantity demanded is calculated as

Once the average value of price and quantity demanded are determined, PED at point C can
be calculated by applying following formula

ΔQ = change in quantity demanded = Q2 – Q1

Q1 = initial quantity demanded

Q2 = new quantity demanded

ΔP = change in price = P2 - P1

P1 = new price

P2 = initial price