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Chapter 1

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Basic Concepts of Economics (Supply & Demand)


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Economics Definition

Adam Smith: Economics is an enquiry into the nature & causes of the wealth of nations.

Samuelson: It is the study of how societies use scarce resources to produce valuable commodities and distribute them 4/20/12 IETR Ch 1. people. 22 among differentBasics of

Economics Definition

Dr. Alfred Marshall: Economics is a study of mans action in the ordinary business of life. It enquires about the income and how it is used.

Benham: Economics is a study of the factors affecting the size, distribution and Basics of stability of a 4/20/12 IETR Ch 1. 33

The Economic Problem

1. Multiple wants but scarcity of resources. 2. Opportunity Cost: It is the price that must be paid in order to satisfy a particular want when productive resources are scarce. 3. Free and Scarce goods.
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Demand

Definition: Demand in Economics is the desire for something along with the willingness and ability to pay a certain price to possess the object of desire. For demand the necessary conditions are:
1. 2. 3.

Desire. Willingness to pay. Ability to pay.


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Law of Demand

The 1st Law of demand states that all other things remaining constant, a greater quantity will be demanded if the price is lowered. Exceptions:
1.

Essential goods or goods consumed in small amount (e.g. Salt) are usually unaffected by price change.

Anticipating higher price may lead to people buying the product in larger 4/20/12quantity, thus increasing the 66 IETR Ch 1. Basics of demand.
2.

Effects of Price Rise

Income Effect: When price rises, people may not be able to afford a commodity. i.e. the purchasing power of their income has reduced. The size of income effect is directly proportional to the part of the income spent on the good. Substitution Effect: If substitute of a product isIETR Ch 1. Basics ofpeople will available, 4/20/12 77

Demand Curve

The relationship between the market price of a good and the quantity demanded of that good is called as the demand curve or demand schedule. Quantity demanded and price change are inversely related to each other. The curve is downward sloping in nature hence this is also known as The Law Of Downward Sloping 4/20/12 IETR Ch 1. Basics of 88

Demand Curve

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1.

The price of related goods: Substitute goods or Complementary goods. Tastes: A highly desirable good is more in demand. E.g.: Fashionable clothes. The number and price of substitute goods.
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Factors influencing Demand

2.

3.

4.

The number and price of 4/20/12 IETR Ch 1. Basics of Complementary goods.

Elasticity of Demand

Elasticity of Demand is the sensitivity or responsiveness of demand to the changes in price. In simple words, it is the steepness of the slope of the demand curve. Types of elasticity of demand:
1. 2. 3.

Price Elasticity. Income Elasticity. Cross Elasticity. IETR Ch 1. Basics of


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1. Price Elasticity of Demand

It is the responsiveness of demand to the changes in price. Price elasticity of demand gives the measure of how much the quantity demanded of a good changes when its price changes.

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Elastic Demand (e>1)

The demand is said to be elastic when a change in price causes a proportionately larger change in the quantity demanded. It is exhibited by Luxurious or Consumer goods like cars, TVs, laptops etc. E.g. If the price of LCD TVs increases, there will be a significant decrease in 4/20/12 quantity demanded. IETR Ch 1. Basics of 1313 the

Perfectly Elastic Curve

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Inelastic Demand (e<1)

The demand is said to be inelastic when a change in price causes a proportionately smaller change in the quantity demanded. It is exhibited by essential goods such as salt, food, LPG. E.g. If the price of salt triples, the quantity demanded will still remain more or less same.
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Perfectly Inelastic Demand

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Unit Elasticity (e=1)

Unit elasticity is seen when the quantity demanded changes in same proportion as the price. The shape of the demand curve is neither horizontal nor vertical but a Rectangular Hyperbola.

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Unit Elasticity (e=1)

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Factors affecting price elasticity of demand:


1. Availability and price of substitute. 2. Degree of necessity 3. Utility or number of uses of the commodity. 4. New Purchasers buying due to a fall in price. 5. Durability of goods. 6. Proportion of Income involved.
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Problem: The price of an article has decreased from Rs. 400 to Rs. 350. Due to this the quantity sold has increased from 800 to 1000. Calculate the coefficient of elasticity and comment on its nature.

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Problem:
The price of an article has decreased from Rs. 400 to Rs. 350. Due to this the quantity sold has increased from 800 to 1000. Calculate the coefficient of elasticity and comment on its nature.

Solution: % change in price=12.5% % change in quantity=25% ep= 25/12.5= 2


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2. Income Elasticity of Demand:


It is the ratio of percentage change in quantity demanded to the percentage change in the income.

E.g. For a 20% rise in a consumers income if an 8% rise in a products demand is seen then income elasticity of demand is given as:

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Factors affecting Income elasticity of demand:


1.

Degree of necessity: In a developed country, rise in income will lead to a rise in demand for luxury items such as cars but the demand for basic goods such as vegetables etc. will increase only slightly. Demand for certain goods actually decreases when peoples income increases. Eg. When income rises, people may switch to butter or ghee instead of using vegetable 4/20/12 IETR Ch 1. Basics of 2323 oil.

1.

3. Cross Elasticity of Demand:


It is the measure of the responsiveness of demand for one product with respect to the change in price of another product. Cross elasticity enables us to predict how much the demand curve for the first product shift when the price of second product changes.

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Example of Cross elasticity

If Tea (X) is a substitute for Coffee (Y), then an Increase in price of coffee will lead to an increase in demand for Tea.

Other examples: Petrol and Sale of cars, Ghee and butterofetc. 2525 4/20/12 IETR Ch 1. Basics

4. Promotional Elasticity of Demand

It is also known as advertising elasticity of demand. It is an indicator of how the demand is influenced by its promotional activities. It is defined as the percentage change in sales divided by the percentage change in advertising expenses.
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Supply

In economics, supply is the amount of some product producers are willing and able to sell at a given price all other factors being held constant.

Law of Supply: It states that, all other factors remaining constant, as the 4/20/12 2727 price of aIETR Ch 1. Basics of service good or

Supply Curve

The relationship between the market price of a good and the amount of that good that producers are willing to produce and sell is known as supply curve or supply schedule. Quantity supplied and price change are directly related to each other. The curve is upward sloping in nature. This is obvious because sellers want 4/20/12 2828 to sell their IETR Ch 1. Basicsin more products of

Supply Curve

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Factors affecting supply curve


1.

Cost of Production: At higher cost of production, less profit will be made at any price. Thus, firms cut back production by switching to alternative products.
1. 2.

Change in input prices. Change in Technology.


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Factors affecting supply curve


2. Natural and unpredictable events: Calamities, weather changes, wars, machinery breakdowns. 3. The aims of Producers.
4.

Expectations of future price changes. Profitability of Goods in joint


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Price elasticity of supply

Price elasticity of supply (PES) is defined as the responsiveness of the supply of a given good to a change in the price of that good, when other things remain constant.

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Equilibrium of Supply and Demand

When supply and demand are equal (i.e. when the supply curve and demand curve intersect) the economy is said to beat equilibrium. The equilibrium price is the price where the quantity demanded matches the quantity supplied.
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Equilibrium

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Disequilibrium
1.

Excess Supply: If the price is set too high, excess supply will be created within the economy.

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Disequilibrium
2. Excess Demand: Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good whileproducers are not making enough of it.

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