Ravi Gurung

National Institute of Business Management

Chennai - 020

FIRST SEMESTER EMBA/ MBA

Subject : Principles of Economics

Attend any 4 questions. Each question carries 25 marks

(Each answer should be of minimum 2 pages / of 300 words)

1. Discuss Capitalist Economy.

2. How is Economics useful, describe its importance?
3. For whom are the goods produced?Explain.
4. What are the different methods of measuring elasticity of demand?
Explain.
5. Explain the factors governing price elasticity of demand.
6. Explain the features of a Capitalist Economy.

25 x 4=100 marks

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1. Discuss Capitalist Economy.

Answer

Capitalist Economy: Meaning and Features of Capitalist Economy

Capitalism is a free-market form or capitalistic economy may be
characterised as an automatic self-regulating system motivated by self-
interest of individuals and regulated by competitions. Ferguson.
Meaning:
It is one of the oldest economic systems and its origin is at the time of mid-
eighteenth century in England in the wake of Industrial Revolution. It is that
system, where means of production are owned by private individuals, profit
is the main motive and there is no interference by the government in the
economic activities of the economy. Hence, it is known as free market
economy.
According to Karl Marx, in his Das Kapital, the capitalist on an average
takes twelve hours work from the worker and pays him wages equal to six
hours work. According to Ferguson, Capitalism is a free-market form or
capitalistic economy may be characterised as an automatic self-regulating
system motivated by self-interest of individuals and regulated by
competitions.
Main Features of Capitalist Economy:
Capitalist economy has following main features:
(i) Private Property:
In this economy private property is allowed. All means of production like
machines, implements, mines and factories etc. come under private property.
(ii) Price Mechanism:
Capitalist economy is gained by price mechanism. Here prices are
determined by the interaction of demand and supply without the interference
of any kind by the government or any other external forces.
(iii) Freedom of Enterprise:
In this system every individual is independent to his means of production in
any occupation that one likes.
(iv) Sovereignty of that consumer:

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Under this system, consumer plays the most vital role. The entire production
pattern is based on the desires, wishes and the demand of the consumer.
(v) Profit Motive:
The maximization of profit is the main motive of the producer. Profit guides
the production in this type of economy.
(vi) No Government Interference:
Under capitalistic system, government does not interfere in day-to-day
economic activities. This means producers and consumers are free to take
decisions.
(vii) Democratic:
The capitalistic system is more democratic in comparison to other economic
systems as there are more changes to chancel according to new environments
of the economy.
(viii) Self-Interest:
The inspiring force in this system is self-interest. It leads to hard work and to
earn maximum income by satisfying their consumers.
Characteristics of Capitalism
In theory, these private entities both control and derive their income from
their ownership. That gives them both the ability and the incentive to operate
their companies as effectively as possible so they can maximize profit. In
large corporations, the shareholders are the owners. Since there so many,
each one has little control. They elect a board of directors who manages the
company through chief executives. (Source: "Theory of Capitalism," The
Center on Capitalism and Society.)
Capitalism requires a free market economy to succeed. That's where the
components of supply are priced and therefore distributed according to the
laws of supply and demand. Private owners of supply compete with each
other to sell their goods at the highest possible price while keeping their costs
as low as possible.
Here's how the forces of competitive pressure work to keep both prices
moderate, and goods and services provided most efficiently. When demand
increases for a particular good, prices rise thanks to the law of demand.
When competitors realize there is additional profit to be made, they start
producing the item.
This adds to supply, which lowers prices back down to a level where only the
best competitors remain.
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Another important component of capitalism is the free operation of the

capital markets. This market sets the fair price of stocks, bonds, derivatives,
currency and commodities through the laws of supply demand. It allows
companies to raise funds to expand. It distributes profits among the owners,
whether they are private owners, investors, or stockholders.
The government's role in capitalism is to maintain a level playing field. It
prevents unfair advantages obtained by monopolies or oligarchies. It
maintains order with national defense, adjudicates international law, and
maintaining the infrastructure. It can tax the capital gains and income to
accomplish these goals. The government also creates laws and regulations
that ensure the free markets aren't being manipulated, and all information is
distributed fairly. (Source: National Council on Economic Education; St.
Louis Fed.)
Capitalism Advantages
Capitalism ensures that an economy will produce what is most desired at an
acceptable price.That's because consumers will pay the most for they want,
and businesses will produce them to obtain the most profit.
At the same time, production will be as efficient as possible, because the
companies that keep their costs low will receive more profit.
Perhaps most important for economic growth are capitalism's intrinsic
reward for innovation. That obviously includes innovation in more effective
production methods. It also means innovation of new products. As Steve Jobs
said, "You can't just ask customers what they want and then try to give that to
them. By the time you get it built, they'll want something new." (Source:
Harper College, Pure Capitalism, and the Market System)
Capitalism Disadvantages
Capitalism does not provide for those who don't have competitive skills or
ability. This includes the elderly, children, and the developmentally
challenged, as well as their caretakers. Therefore, capitalism requires
additional social mores that value the family unit to keep the society
functioning.
Capitalism does not necessarily promote equality of opportunity. Those
without the proper nutrition, support and education may never make it to the
playing field, even though they have valuable innovative, competitive, or
efficiency skills. (Source: Louis Putterman, "Markets vs Controls," Brown
University.)
In the short term, this is in the best interest of those who are succeeding in
capitalism, since they have fewer threats to compete against. They may also
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start to use their influence, money, and power to further "rig the system" by
creating more barriers to entry. This includes laws and regulations,
educational attainment, and even money itself. In the long term, this can limit
diversity and the innovation it creates. For more, see How Diversity Boosts
Profits.
Capitalism ignores external costs, such as pollution. This makes goods
cheaper and more accessible, but over time can deplete natural resources and
lower quality of life in the affected areas. (Source: Tejvan Pettinger, "Pros
and Cons of Capitalism," EconomicsHelp)
Difference between Capitalism, Socialism, and Communism
Attribute Communism Socialism Capitalism

Factors of production Everyone Everyone Individuals

are owned by

Factors of production Usefulness to people Usefulness to people Profit

are valued for

Allocation decided by Central plan Central plan Law of demand and

supply

From each according to Ability Ability Market decides

his

To each according to his Need Contribution Income, wealth and

borrowing ability

Capitalism vs Socialism
According to theorists, socialism evolves from, and improves upon,
capitalism That's because the factors of production are directly owned by the
people, distributing goods and services directly to them. That's because the
individual owner, the capitalist, is eliminated.
Today, many socialist-based countries own the companies in the strategically
important oil, gas, and other energy-related resources. The government
collects the profit in lieu of corporate taxes. It also distributes these profits in
government spending programs. These state-owned companies still compete
with private ones in the global free market economy.
Capitalism vs Communism
Communism is an evolution beyond both socialism and capitalism,
according to theorists. That's because everyone in society is provided a
minimum standard of living, regardless of contribution.
It's important to note that most societies in the modern world have elements
of all three, making them mixed economies. Capitalism can also be found in
traditional and command economies.

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Capitalism and Democracy

Economist Milton Friedman suggested that democracy can only exist in a
capitalistic society, but many countries have socialistic economic
components but a democratically-elected government. There are others, like
China and Vietnam, that are communist, but are economically successful
thanks to many capitalistic components. Still others are capitalist and
monarchs, oligarchs, or despots.

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2. How is Economics useful, describe its importance?

Answer:
The Importance of Economics
I would suggest the main importance of economics is helping society decide
on the optimal allocation of our limited resources. The fundamental problem
of economic is said to be scarcity - the idea that wants (demand) is greater
than the resources we have. Frequently we face choices on:
What to produce
How to produce
For whom to Produce
Economics helps to decide on questions like this. More specifically
economics is important in these areas.
How to manage the macro economy.
Economists can advise governments how to manage the economy and avoid
problems such as inflation and unemployment. Both inflation and mass
unemployment can be devastating for society. Economists argue that both
can be avoided through careful economic policies. For example:
Policies to reduce unemployment
Policies to reduce inflation
If economics can help reduce unemployment, then it can make a big
improvement to economic welfare. For example, the mass unemployment of
the 1930s great depression, led to much political instability and the rise of
extremist political parties across Europe.
However, the problem is that economists may often disagree on the best
solution to these problems. For example, at the start of the great depression
in 1930, leading economists in the UK Treasury suggested that the UK
needed to balance the budget; i.e. higher taxes, lower unemployment
benefits. But, this made the recession deeper and led to a fall in demand.
It was in the great depression that John Maynard Keynes developed his
general theory of Employment, Income and Money. He argued that classical
economics had the wrong approach for dealing with depressions. Keynes
argued that the economy needed expansionary fiscal policy. - higher
borrowing and government spending.
2. Overcoming Market Failure.

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Generally it is considered that free markets offer a better solution than a

planned economy (Communist) However, free markets invariable lead to
problems such as
The over production of negative externalities (e.g. pollution)
The underproduction of goods with positive externalities (e.g. education,
health care, public transport).
Non provision of Public Goods
An economist can suggest policies to overcome these types of market
failures. For example
Tax negative externalities
Subsidise public services like health care and education.
The importance of economics is that we can examine whether society is
better off through government intervention to influence changes in the
provision of certain goods.
Some Topical Issues Economists are concerned with
Carbon Tax - should we implement a carbon tax to reduce global warming.
Should we tax fatty foods?
Arguments for Road pricing
Efficiency
Another area where economists have a role to play is in improving
efficiency. For example economists may suggest supply side policies to
improve the efficiency of an economy.
Individual Economics
Economics is also important for an individual. For example, every decision
we take involves an opportunity cost - which is more valuable working
overtime or having more leisure time?
Efficiency v Equity
In classical economics we often focus on maximising income and profit.
However, this is a limited use of economics. Economics is also concerned
with maximising overall economic welfare (how happy are people).
Therefore economics will help offer choices between increasing output and
reducing inequality.
Efficiency v equality
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GDP and Happiness

Conclusion
Economics is important for many areas of society. It can help improve living
standards and make society a better place. Economics is like science in that it
can be used to improve living standards and also to make things worse. It
partly depends on the priorities of society and what we consider most
important.

Examples of the importance of economics

1. Dealing with a shortage of raw materials. Economics provides a
mechanism for looking at possible consequences as we run short of raw
materials such as gas and oil. Further reading: Effects of a world without oil
2. How to distribute resources in society. To what extent should we
redistribute income in society? Is inequality necessary to create economic
incentives or does inequality create more economic problems?
3. To what extent should the government intervene in the
economy? Should the government provide health care free at the point of use
or is it more efficient to encourage private health care? See also: To what
extent should government intervene in the economy.
4. The principle of opportunity cost. Politicians win elections by
promising more spending and cutting taxes. This is because lower taxes and
more spending is what voters want to hear. However, an economist will be
aware that everything has an opportunity cost. Spend more on subsidising
free university education, and it means higher taxes and lower spending
elsewhere. Giving students 4,000 a year to spend at university may be a
noble ideal. But, is it the best use of public money? Are there not better uses
of money?

5. Social efficiency. The free market leads to countless examples of market

failure. I feel one of the best uses of economics is to provide solutions to
overcoming market failure. For example, driving into the centre of town
creates negative externalities such as pollution and congestion. There is
overconsumption. An economist can suggest a tax on driving into towns to
internalise the externality. Of course new taxes are not popular, but, it would
provide a better solution for society. You may not want to pay 10 a week to
drive into a city centre. But, if it saved you 2 hours of sitting in a jam, then
maybe you would be quite happy to pay it.
6. Knowledge and understanding. One of the principle jobs for economists
is to understand what is happening in the economy and investigate reasons
for poverty, unemployment and low economic growth. For example, in a

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political debate such as Should UK leave the EU? There are many
emotional arguments made about immigration. Economic studies can try and
evaluation the costs and benefits of free movement of labour. Economic
studies can try provide the economic effects of immigration. This can help
people make a decision about political issues.
7. Forecasts. Economic forecasts are more difficult than understanding the
current situation. However, although forecasts are not always reliable, they
can help give decision makers an idea of possible outcomes. For example, in
2003, the UK took a decision about whether to join the Euro. Many
economists suggested the UK could struggle with a common monetary
policy. The Euro was not an optimal currency area with the UK in. This
analysis was a factor in UK government deciding not to join. In retrospect,
the analysis under-estimated the costs of the Euro. But, if it had been taken
on purely political grounds, the UK may have joined.
8. Evaluation. Economics is not a definitive science like Maths. Because of
many unknown variables, it is impossible to be definitive about outcomes,
but a good economist will be aware the result depends on different variables
and there are different potential outcomes. This should help avoid an overly
ideological approach. For example, a government may have the philosophy
free markets are always best, but an economist would be aware of a more
nuanced view that in some markets, like health care, transport, government
intervention can overcome market failure and improve welfare. But, at the
same time, it doesnt mean state intervention is always best.
9. Behavioural theory. Why do people behave like they do? Can
governments subtly nudge people into better behaviour, e.g. banning
cigarette advertising.

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3. For whom are the goods produced? Explain.

Answer:
Obviously goods and services are produced for the people, and more
specifically, for those who have the necessary means to pay for them. One
cannot have everything one requires. If that were possible, there will be no
economic problem. In every society, the production and supply of goods is
always smaller than the demand for them. Hence, the economy should evolve
some method by which it can distribute the goods produced among the
people. In a dictatorship, it may be possible for the government to allocate
goods and services according to the wishes of the dictator or according to
some principle of equal division. In a pure capitalist enterprise economy,
goods and services are distributed among those who can pay for them.
Every economy seeks to solve these three central problems in its own way.
That economy which can solve these problems in the most efficient and
effective manner will be preferred to others.
The For Whom? question of allocation arises because society faces the
fundamental problem of scarcity--wants and needs are unlimited, but
resources are limited. Because society lacks sufficient resources to produce
every good that every person desires, society must decide who receives the
goods and services produced. Does society give all goods to benevolent
economic instructors? Does it distribute production according to shoe size
(with larger feet receiving more goods)? Does it let people with more income
buy more production?
The two primary methods used to answer the For Whom? question are
markets and government. Markets employ voluntary exchanges among
buyers and sellers. Governments make use of laws, rules, and regulations
that are involuntarily imposed on members of society.
Markets
Markets address the For Whom? question by allowing people with more
income to purchase more production. Those who can afford to buy goods are
the ones who receive the goods. But people have more income if they own
and control resources that are more highly valued by society.
Suppose, for example, that Dr. Dowrimple T. Bedside, a skilled medical
doctor, is planning to purchase a new residential domicile. Dan Dreiling, a
skilled drywall installer, is also in the market for a new house. Both have
their eyes on a well-maintained, nicely landscaped, four-bedroom structure
conveniently located near shopping and school.

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Although both Dr. Bedside and Dan Dreiling are skilled in their chosen
professions, society places a higher value on the work performed by Dr.
Bedside. While an hour's worth of drywall installation pays Dan Dreiling in
the neighborhood of $30, and hours worth of medical practioning pays Dr.
Bedside a more lucrative $300. The end result is that Dr. Bedside has more
income and a greater ability to purchase the house.
How does this illustrate resource allocation and the For Whom? question.
The higher price paid for Dr. Bedside's labor means he has a greater ability to
purchase goods. In fact, with ten times the income, Dr. Bedside can purchase
ten times the amount of production as Dan Dreiling.
Government
Governments address the For Whom? question by dictating who receives
production and who does not. This can be accomplished either directly
through legal mandates (laws, rules, and regulations) or indirectly through
the collection and spending of tax revenues.
Suppose, for example, that the government of Northwest Queoldiolia, a
quaint and courteous country, decides that left-handed people should have
higher living standards and receive a larger share of the nation's production.

One way to achieve this goal is to pass a law stipulating that for the same
price, left-handed people receive ten percent more goods and services than
right-handed people. For example, a left-handed person would receive a large
pizza for the price of a medium, while a right-handed person would receive a
medium pizza for the price of a medium. Any seller violating this edict
would be subject to criminal prosecution, jail time, and a hefty fine.
How does this address the For Whom? Question? In all likelihood, sellers
will seek to avoid punishment by giving left-handed people more output at
the same price. The end result is that left-hand people will be better off and
be able to consume more goods and services.
Alternatively, the government of Northwest Queoldiolia could place a tax on
right-handed people, then give the resulting revenue to left-handed people.
How does this address the For Whom? question? Prompted by this income
redistribution program, left-handed people would have more income that
could be used to purchase goods and services, while right-handed people
would have less.
For example: Imagine an economy producing two goods normal rice
(priced at Rs 15/kg) and graded rice (priced at R 100/kg). If the economy
decided to cater to the needs of the lower section of the society, then it would
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produce more of normal rice and less of the graded rice. In such a case, the
PPC curve will be as depicted in figure (ii).
On the other hand, if the economy decided to cater to the needs of the higher
section of the society, then it would produce more of the graded rice and less
of the normal rice. In such a case the PPC curve will be as depicted in figure
(i)

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4. What are the different methods of measuring elasticity of demand?

Explain.
Answer:

4 Most Important Methods of Measuring Price Elasticity of Demand

There are four methods of measuring elasticity of demand. They are the
percentage method, point method, arc method and expenditure method.

Image Courtesy : otceconomics.edublogs.org/files/2013/03/V-v21kg4.jpg

(1) The Percentage Method:
The price elasticity of demand is measured by its coefficient Ep. This
coefficient Ep measures the percentage change in the quantity of a
commodity demanded resulting from a given percentage change in its price:
Thus

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Where q refers to quantity demanded, p to price and to change. If Ep> 1,

demand is elastic. If Ep < 1, demand is inelastic, it Ep = 1 demand is unitary
elastic.
With this formula, we can compute price elasticities of demand on the basis
of a demand schedule.

Table 11.1: Demand Schedule:

Price
(Rs.) per Quantity
Combination Kg. of X Kgs. of X
A 6 0
-
5 10
4 20
-
D 3 30
E 2 40

F 1 50
G 0 60
Let us first take combinations and D.

(i) Suppose the price of commodity X falls from Rs. 5 per kg. to Rs. 3 per kg.
and its quantity demanded increases from 10 kgs. to 30 kgs. Then

This shows elastic demand or elasticity of demand greater than unitary.

Note: The formula can be understood like this:

q =q2 q1 where <72 is the new quantity (30 kgs.) and q1 the original
quantity (10 kgs.)
p p2 P1 where p2 is the new price (Rs. 3) and <$Ep sub 1> the original
price (Rs. 5)

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In the formula, p refers to the original price (p,) and q to original quantity
(q1). The opposite is the case in example (ii) below, where Rs. 3 becomes the
original price and 30 kgs. as the original quantity.
(ii) Let us measure elasticity by moving in the reverse direction. Suppose the
price of X rises from Rs. 3 per kg. to Rs. 5 per kg. and the quantity
demanded decreases from 30 kgs. to 10 kgs. Then

This shows unitary elasticity of demand.

Notice that the value of Ep in example (ii) differs from that in example (i)
depending on the direction in which we move. This difference in the
elasticities is due to the use of a different base in computing percentage
changes in each case.

Now consider combinations D and F.

(iii) Suppose the price of commodity X falls from Rs. 3 per kg. to Re. 1 per
kg. and its quantity demanded increases from 30 kgs. to 50 kgs. Then

This is again unitary elasticity.

(iv) Take the reverse order when the price rises from Re. 1 per kg. to Rs. 3
per kg. and the quantity demanded decreases from 50 kgs. to 30 kgs. Then

This shows inelastic demand or less than unitary.

The value of Ep again differs in this example than that given in example (iii)
for the reason stated above.
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(2) The Point Method:

Prof. Marshall devised a geometrical method for measuring elasticity at a
point on the demand curve. Let RS be a straight line demand curve in Figure
11.2. If the price falls from PB(=OA) to MD(=OC). the quantity demanded
increases from OB to OD. Elasticity at point P on the RS demand curve
according to the formula is: Ep = q/p x p/q

Where q represents changes in quantity demanded, p changes in price

level while p and q are initial price and quantity levels.

From Figure 11.2

q = BD = QM

p = PQ

p = PB

q = OB

Substituting these values in the elasticity formula:

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With the help of the point method, it is easy to point out the elasticity at any
point along a demand curve. Suppose that the straight line demand curve DC
in Figure 11.3 is 6 centimetres. Five points L, M, N, P and Q are taken oh
this demand curve. The elasticity of demand at each point can be known with
the help of the above method. Let point N be in the middle of the
demand curve. So elasticity of demand at point.

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We arrive at the conclusion that at the mid-point on the demand curve the
elasticity of demand is unity. Moving up the demand curve from the mid-
point, elasticity becomes greater. When the demand curve touches the Y-axis,
elasticity is infinity. Ipso facto, any point below the mid-point towards the X-
axis will show elastic demand.

Elasticity becomes zero when the demand curve touches the X-axis.

(3) The Arc Method:

We have studied the measurement of elasticity at a point on a demand curve.
But when elasticity is measured between two points on the same demand
curve, it is known as arc elasticity. In the words of Prof. Baumol, Arc
elasticity is a measure of the average responsiveness to price change
exhibited by a demand curve over some finite stretch of the curve.

Any two points on a demand curve make an arc. The area between P and M
on the DD curve in Figure 11.4 is an arc which measures elasticity over a
certain range of price and quantities. On any two points of a demand curve
the elasticity coefficients are likely to be different depending upon the
method of computation. Consider the price-quantity combinations P and M
as given in Table 11.2.

Table 11.2: Demand Schedule:

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Point Price (Rs.) Quantity (Kg)

P 8 10
M 6 12
If we move from P to M, the elasticity of demand is:

If we move in the reverse direction from M to P, then

Thus the point method of measuring elasticity at two points on a demand

curve gives different elasticity coefficients because we used a different base
in computing the percentage change in each case.

To avoid this discrepancy, elasticity for the arc (PM in Figure 11.4) is
calculated by taking the average of the two prices [(p1, + p2 1/2] and the
average of the two quantities [(p1, + q2) 1/2]. The formula for price elasticity
of demand at the mid-point (C in Figure 11.4) of the arc on the demand curve
is

On the basis of this formula, we can measure arc elasticity of demand when
there is a movement either from point P to M or from M to P.

From P to M at P, p1 = 8, q1, =10, and at M, P2 = 6, q2 = 12

Applying these values, we get

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Thus whether we move from M to P or P to M on the arc PM of the DD

curve, the formula for arc elasticity of demand gives the same numerical
value. The closer the two points P and M are, the more accurate is the
measure of elasticity on the basis of this formula. If the two points which
form the arc on the demand curve are so close that they almost merge into
each other, the numerical value of arc elasticity equals the numerical value of
point elasticity.

(4) The Total Outlay Method:

Marshall evolved the total outlay, total revenue or total expenditure method
as a measure of elasticity. By comparing the total expenditure of a purchaser
both before and after the change in price, it can be known whether his
demand for a good is elastic, unity or less elastic. Total outlay is price
multiplied by the quantity of a good purchased: Total Outlay = Price x
Quantity Demanded. This is explained with the help of the demand schedule
in Table 11.3.

(i) Elastic Demand:

Demand is elastic, when with the fall in price the total expenditure increases
and with the rise in price the total expenditure decreases. Table 11.3 shows
that when the price falls from Rs. 9 to Rs. 8, the total expenditure increases
from Rs. 180 to Rs. 240 and when price rises from Rs. 7 to Rs. 8, the total
expenditure falls from Rs. 280 to Rs. 240. Demand is elastic (Ep > 1) in this
case.

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(ii) Unitary Elastic Demand:

When with the fall or rise in price, the total expenditure remains unchanged;
the elasticity of demand is unity. This is shown in the Table when with the
fall in price from Rs. 6 to Rs. 5 or with the rise in price from Rs. 4 to Rs. 5,
the total expenditure remains unchanged at Rs. 300, i.e., Ep = 1.
(iii) Less Elastic Demand:
Demand is less elastic if with the fall in price the total expenditure falls and
with the rise in price the total expenditure rises. In the Table when the price
falls from Rs. 3 to Rs. 2 total expenditure falls from Rs. 240 to Rs. 180, and
when the price rises from Re. 1 to Rs. 2 the total expenditure also rises from
Rs. 100 to Rs. 180. This is the case of inelastic or less elastic demand, Ep <
1.

Table 11.4 summarises these relationships:

Table 11.4: Total Outlay Method:

Price Ep
Falls Rises >> 1
Rises Falls
Falls Unchanged =1
Rises Unchanged
Falls Falls
Rises Rises << 1

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Figure 11.5 illustrates the relation between elasticity of demand and total
expenditure. The rectangles show total expenditure: Price x quantity
demanded. The figure shows that at the midpoint of the demand curve, total
expenditure is maximum in the range of unitary elasticity, i.e. Rs. 6, Rs. 5
and Rs. 4 with quantities 50 kgs., 60 kgs. and 75 kgs.

Total expenditure rises as price falls, in the elastic range of demand, i.e. Rs.
9, Rs. 8 and Rs. 7 with quantities 20 kgs., 30 kgs. and 40 kgs. Total
expenditure falls as price falls in the elasticity range, i.e. Rs.3, Rs. 2 and Re.
1 with quantities 80 kgs., 90 kgs. and 100 kgs. Thus elasticity of demand is
unitary in the AB range of DD, curve, elastic in the range AD above point A
and less elastic in the BD1 range below point B. The conclusion is that price
elasticity of demand refers to a movement along a specific demand curve.

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5. Explain the factors governing price elasticity of demand.

Answer:

FACTORS GOVERNING PRICE ELASTICITY OF DEMAND

A change in the quantity of a commodity sold in a market may come about
through: (a) change in the average quantity purchased by each consumer, (b)
change in the number of consumers, and (c) change in both. Sometimes, a
change in price is followed by a marked change in the quantity demanded
and consumed; while, in some cases, the effect may be only slight. Why is
the demand for a particular commodity more or less elastic than the demand
for other commodities?

Existence of Substitutes
The most important factor on which elasticity of demand for a product
depends is the existence of substitutes for the product. The demand for
commodity is said to be elastic if the commodity has substitutes and if it can
be easily replaced. Even a small rise in its price will induce buyers to go in
for its substitutes whose prices have remained the same; on the other hand, a
fall in its price will induce more people to buy this commodity than its
substitutes. Most people regard coffee and tea as reasonable substitutes. If
price of coffee rises, it will induce many people to shift to and buy more tea.
Or, suppose there are different brands of cigarettes all of which are
substitutes for each other. The demand for any particular brand will be
elastic, for a rise in price of one brand will induce consumers to shift their
demand to the other brands of cigarettes. An aspect of substitution and its
influence on elasticity of demand relates to the number of uses as well as the
nature of uses of a product. The demand for a product is said to be more
elastic if the product has several uses, rather than only one use. If the price of
a product, which has a number of uses, for example, coal or steel, falls, it
will induce the consumption of the goods in all its uses. Even though the fall
in price may have only a small effect on its consumption for each purpose,
the aggregate effect will be a substantial change in total demand. Again, at a
high price, elasticity, for example, may be used only for lighting where its
utility is high; when its price comes down, the demand for elasticity may
increase, it may be used for cooking, etc. a rise in the price of electricity, on
the other hand, will tend to restrict its consumption only to those uses
possessing the highest utility. It is also possible that the demand for a
commodity which has a variety of uses may be elastic in some uses and
inelastic in some other uses. In India, coal is used by railways for the
generation of steam power and in homes as fuel.

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Even if the price of coal rises, the railways will continue to use it; but
consumers may give it up and take to alternative domestic fuels. In other
words, the demand for the commodity in those uses where marginal utility is
high will be inelastic, while in those uses where the marginal utility is low,
the demand will be elastic. The demand for necessities is inelastic, while
demand for luxuries is usually elastic. This is so because certain things which
are essential in life will demand whatever be their price. Hence, a rise or fall
in the price of an essential commodity does not ordinarily affect, in any
appreciable manner, the amount of goods bought. On the other hand,
comforts and luxuries can be easily given up and, therefore, a rise in their
prices will result in the reduction of the demand for them, while a fall in their
prices will lead to the expansion of demand for them. It is not always true,
however, that the demand for luxuries is always elastic and that of
necessaries always inelastic. In the case of high priced luxuries like
diamonds, the demand will be comparatively inelastic because the price is so
high that only the very rich can buy them. A change in their price either way
will not affect the demand for them. Similarly, in the case of such luxuries as
cars, scooters, television sets etc., the demand will tend to be elastic, since
the demand for then comes under more or less conventional necessaries and
hence those who want to buy them will do so whether price rises or falls. To
a large extent, goods are considered necessary because they do not have
suitable substitutes. Salt is a necessity because there is no substitute for salt.
It is possible to argue that demand for salt is inelastic, not because it is
necessary but because there is no good substitute for it. It is true that to a
large extent the possibility of substitution shows or reveals whether a
commodity is a necessity or a luxury.

In this connection it may be argued that demand for a commodity is said to

be elastic if the demand for it can be postponed. The demand for woollen
goods may be postponed, if their price goes up but the demand for rice or
wheat cannot be so postponed. Hence the demand for the former is said to be
inelastic. But then the commodity whose demand cannot be postponed is a
necessary commodity, while that commodity the demand for which can be
easily postponed usually is a luxury, or semi luxury or comfort
.

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6. Explain the features of a Capitalist Economy.

Answer:

Features of a Capitalist Economy

The capitalist system is an economic order in which all means of production
(land, labour, capital and organization) are privately owned and managed and
in which production takes place for private profit. The profit motive is the
driving force behind all economic activity in the capitalist system. As the
economy is based on free enterprise and the government does not interfere in
the working of the economy, the system has come to be known as free
enterprise economy or laissez faire economy. The basic features of a
capitalist economy are as follows:

(i) The System of Private Property: In a capitalist economy all means of

production are privately owned, i.e., they belong to private individuals,
institutions and companies. The system of private property implies that the
owner of a property can use it in any way he likes, subject, of course, to the
rules and laws of the State. A farmer can leave his land uncultivated if he so
likes or can use it for cotton cultivation or for the grazing of sheep. He may
use the land himself or he may hire it out to some one else. The State, of
course, can place certain restrictions on the rights and powers of the owner of
property. For instance, owners of business may be asked to follow the
minimum safety provisions prescribed by law to protect the lives of workers
working under them. A company may be prevented from producing obscene
books or from manufacturing harmful drugs, and so on. But subject to the
general restrictions and regulations imposed by the State, the owners of
property are free to utilize them in any way they deem fit. The chief merits of
private property are the pride and pleasure of ownership and consequently
personal interest in the property, initiative to put it to the best use etc. It is
correctly said: The magic of property turns even sand into gold.

(ii) Economic Freedoms: The capitalist system is based on a number of

economic freedoms. Individuals and business units are free to consume
whatever they like. Free choice of consumption determines the nature and
volume of goods and services which should be produced. It is possible that
consumers choice may not be properly exercised. Most of the common
people are easily led by advertisements. Too much income may be spent on
liquor and drugs and cinemas and too little on food. Freedom of consumption
implies freedom of production too. The economy produces goods and
services to satisfy the wishes and preferences of the consumers. Thus,
freedom of choice of consumers and freedom of production are basic to
capitalist economy. There is freedom of enterprise in a capitalist system. The

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individual is free to choose any job he likes, subject, of course, to his won
ability, education and experience. He is also free to choose one job in
preference to another, move from one industry to another or one region to
another. He has the freedom to join a trade union and demand and obtain
higher wages, shorter hours of work; and so on. Freedom of enterprise also
implies that a person is free to invest his savings in whatever industry he
chooses or in whatever form he wants to keep it. Subject to the limitations of
his own ability and capital and any restriction placed by the State, any
individual is free to start any business he likes or exploit any new invention
or process he can secure. Freedom of enterprise is related to freedom of
private property, of which we have already spoken. It is freedom of
enterprise which leads to the apparent unplanned character of the capitalist
economy.

(iii) Perfect competition: Competition is act of striving for something that is

sought by another at the same time; it is the basis of the free market
mechanism- when there is freedom in choosing an economic activity, there is
intense competition in the preference of the same or alternative activity.
Workers complete with one another and hence only the best gets the jobs.
Producers compete in obtaining factors of production and only those who can
pay more will get possession of the factors; this also implies that the factor
units will get maximum prices for their services. Sellers compete in selling
their products and their competition will lower the prices. Consumers
compete in buying goods and thus help to raise the prices. Competition plays
a special role in a capitalist economy. The keener the competition, the lower
the profits. In fact, under perfectly competitive conditions, all excess profits
will be competed away and only normal profits, which are only
compensation for managerial labour, exist. From the point of view of public
welfare, competition serves as regulator and reducer of prices, as an
incentive to improved productive efficiency, as a guarantee that we shall get
what we want, and as a protector of the freedom of production. However,
there is a continuous tendency in the capitalist economy to eliminate
competition so that profits may be earned. Monopolistic tendencies are,
therefore, inherent in a competitive economy. But competition must be
maintained if exploitation is to be avoided and prices are to be maintained at
cost levels. Further, competition is necessary to keep individual initiative
alive and it is competition which makes for maximum efficiency. Because of
competition, only those who are able to produce and sell at the lowest prices
are able to remain in the market. Hence, competition compels every producer
to be efficient and economic; it has no place for the inefficient and wasteful
producers. There is, thus a constant and continuous effort made to maximize
efficiency in production. George Halm, the well-known economist, has
expressed this admirably: Only the constant renewal of the acquisitive urge
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through elimination of profits by competition that guarantees the constant

supply of those energies without which the unplanned economy could not
work properly. Without the protection through competition, the capitalist
economy would become stagnant, unproductive and exploitative.

(iv) Individual initiative and profit motive. The capitalist economy is based
on profit motive and individual initiative. Producers are not concerned about
the welfare of the community or of the interests of any particular group. They
take into account only their costs of production and the anticipated prices for
their products. They will get a profit if their calculations are correct; if not,
they will incur losses. The profit motive encourages productive activity,
enterprise and risk-taking. It determines the character of business and
economic activity, for resources will continuously shift from less profitable
to more profitable uses. It is responsible for efficiency in production. The
profit motive is based on, and is related to, the assumption of risk. There are
all kinds of risks, which have to be borne by a modern business firm.
Changes in market conditions and consumer preferences, strikes and
lockouts, cyclical fluctuations, technological changes, new processes and
products etc.- all these may drive an organizer from the market. At the same
time, new taxes may deprive him of all his anticipated profits. Such risks are
the price of industrial progress. The greater the risk the greater is the
possibility of profit. The businessman who risks his money must also control
the business. He who bears the risk shall exercise the control is regarded
as the golden rule of capitalism. Related to the profit motive is the
characteristic of individual initiative. In fact, the profit motive is the
characteristic of individual initiative. In fact, the profit motive has no
meaning and private property is useless unless the individual has the freedom
to use his property in anyway he likes, that is, the way he thinks will be the
most profitable. Individual initiative extends to every sphere of economic
activity. Individual initiative and economic freedom are, however, restricted
by the Government in the interests of public health, social justice etc.

(v) The Role of Price Mechanism: There is no conscious regulation or central

direction of economic activity; everything seems automatic. The capitalist
economy is unplanned and uncoordinated and rests on the independent but
interdependent individual decisions and actions of crores of persons.
Production is conducted as a result of the decisions of numerous isolated
entrepreneurs. But production is influenced by millions of individual
consumers who make their decisions without consulting one another. The
capitalist system may appear to be an unplanned economy but, in fact, there
is planning and coordinating mechanism in the form of the pricing process,
which controls all the aspects of economic activity. The price mechanism
guides the consumers and indicates to them what goods and services they
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should produce, in what quantities and how they should produce them. It
solves the problem of who will consume the goods and services produced by
the economy. Thus, the capitalist economy, apparently unplanned,
coordinated and unregulated, is perfectly coordinated by the price
mechanism.

(vi) The role of the Government In the classical analysis, the government
was not expected to interfere with the working of the market mechanism.
Apart from defence and maintenance of law and order, the government was
to perform only three economic functions:

(a) Establish a uniform economic framework within which the individual

could function more efficiently and more effectively eg. Coinage, weights
and measures, uniformity in standards of quality, etc. (b) Provide certain
facilities which private enterprise, by itself, will not provide or will provide
only inadequately e.g., Educational facilities, public health etc; and (c)
Resolve conflicts among individuals and protects the weak from the
exploitation of the rich. However, in the 20th century, government has to
play a more important role in economic activities mainly due to (a) the
growing belief that government should promote and assist economic
advancement (b) the technological changes which revealed the unreality of
laissez-fare assumptions and which had necessitated the expansion of
government regulations and (c) the failure of the laissez-faire economic
system. Since the capitalist economy has not maximized welfare and has also
been responsible for such difficulties as unemployed, monopoly and
inequality of incomes, the government stepped in to interference with the
working of the system and to help it function correctly and smoothly. At
present, government control and regulation are extremely common and have
taken many forms, such as minimum wage laws, anti-monopoly legislation,
regulation of public utilities, credit controls, laws to regulate trade and
commerce etc.

Further, the government can also use fiscal policies to remove unemployment
and maintain full employment. The government may take over those sectors
of the economy which may easily overcome its regulation and control.
Finally, the government provides certain collective services without which
modern community life would be unthinkable and which, by nature, cannot
be left to the private sector. We mean here national defence, law and order,
administration of justice etc. The capitalist economy of modern days is not
an absolutely free or laissez-faire capitalism but a mixed system of private
initiative and public control.

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