Modern Economic Analysis

Managerial Economics:Prime function of Management:(1). Decision Making (DM):(2). Forward Planning (FP):DM: - Process of selecting one action from two or more alternative courses of action. FP: - Establishing plans for future. Resources - Land, Labour, Capital are limited and can be employed to alternative uses. DM function becomes making choices that will provide the most efficient means of attaining desired objective (Profit maximisation). Managers have to make decisions under uncertainty. Future is uncertain. So, DM and FP becomes complicated. If the knowledge of future is perfect than DM and FP will be perfect. As future is uncertain- business managers rarely has complete information of futuresales, cost, profits, capital conditions. Decisions are made on the basis of past data, current information and estimates about future predicted as best as possible. In fulfilling the function of DM in an uncertainty frame work, economic theory can be pressed into service with considerable advantage. Economic theory deals with number of concepts and principles relativity like -profit, demand, cost, pricing, production, competition, national income.

Definitions of ME:Definition1:- ME is the use of economic modes of thought to analyse business situation. -MC Nair, Merian Definition 2:- ME is the integration of economy theory with business practice for the purpose of facilitating decision making and forward planning. -By Spencer and Siegelmen Definition 3:- ME is a price theory in the service of business executive. -By Watson Definition 4:- ME is the application of economic theory methodology to business administration practice. Summary (1). Link between traditional economics to decision science. (2). It is concerned with DM. (3). It is pragmatic. (4). It is both Conceptual (Idea, thought) and Metrical (Measurable). (5) Goal Oriented.

Nature of ME (1). Micro economic:- Study of a firm. (2). Is concerned with normative micro economics. (3). Makes economic theory more application oriented. (4). Takes the help of macro economics also. Characteristics of ME:(1). Micro economic is character. (2).Takes help of macro economic (to understand and adjust to the environment in which the firm operates). (3). It is pragmatic-(practical oriented). (4). It is prescriptive (giving order or directions) rather than Descriptive(not just describe) (5). It is normative (they ought to have to) rather than positive (descriptive) (6). Both conceptual (takes the help of conceptual frame work to understand and analyse decision problem) and metrical (takes the help of quantitative technique to measure the impact of different factors and policies). (7). It is the study of allocation of scarce resources available to a firm among the activities of that unit, to maximize the benefits. Scope of M.E (1). Demand analysis and forecasting:- estimation of demand (a). Demand determinants (b). Demand distinction (c). Law of demand (d). Exception to rules (e) Demand forecasting (f). Methods of forecasting (g). Forecasting of new and existing product (2). Cost and Production analysis:(a). Cost estimation. (b). Factors causing variation in cost. (c). Cost classification. (d). Cost -O/P relationship (e). Economies and Diseconomies scale. (f). Production function. (g). Cost control.

(3). Pricing Decisions, Policies and practices:(a). Price determination in various (b). Pricing methods (c). Differential pricing (d). Product-line pricing (e). Price forecasting

(4). Profit Management:- Depends upon costs and revenues Measurement of profit Profit policies Techniques of profit planning (break -even analysis). (5).Capital Management:- Planning and controlling capital expenditure, cost of capital, rate of return, selection of projects. Difference between ME and Economics:ME (1). It is application of economics principles to problem of firm. (2). It is micro in character. (3). It deals with firm only. (4). Scope is limited (i.e only firm profits) Economics (1). It is basically body of principles. (2). It is micro and macro in character. (3). It deals with firm and industry. (4). Scope is vast (deals with wages, prices, interest) (5). It builds economic models.

(5). It modifies economic models to select particular situation. (6). Along with certain general economic (6). It is purely based on certain assumptions. assumptions. Certain complex situations are also assumed to solve problems with the help of the subjects (forecasting-stastics ) cost-accounting, mathematics.

Uses of ME:(1). ME accomplishes the objective of building a suitable kit from traditional economics. (2). ME also incorporates useful ideas from other disciplines such as psychology, sociologyetc. (3). ME helps in reaching variety of business decisions in a complicated environment(a). what products and services to be produced (b). what inputs and production techniques should be used (c). what o\p to produced, what its price should be (d). what are the best sizes and locations of new plants (e). When should the equipment be replaced (f). How much capital should be allocated (4). ME makes a manager a more competent model builder (5). ME serves as an integrator agent by coordinating different functional areas to make effective decisions (6). ME takes into consideration of integration between firm and society. Limitations of ME:(1). Firms do not continuously seek maximum profit (2). Large firms run by managers (3). Different groups in a firm, different objectives to pursue

(4). Profit maximization is not sole objective other objectives are also important (5). Economic theory- unable to provide satisfactory answers for output, price, cost and revenue policies when firm produces many products simultaneously. FUNDAMENTAL CONCEPTS OF M.E Basic Economic tools in ME:- Principles of ME (1) Opportunity cost principle (2) Incremental cost principle (3) Principle of time perspective (4) Discounting principle (5) Equi-marginal principle (6) Risk and uncertainty (7) Contribution. (1). Opportunity cost:- is the cost of sacrificing an alternative. Definition:- The cost involved in any decision consists of the sacrifices of alternatives required by that decision. If there is no sacrifice, there is no cost. OC represents the benefits or revenue foregone by perusing one course of action rather than another Ex1:- OC of funds invested in ones own business is the amount of interest could have been earned had it invested in bank. Ex2:- OC of putting labour in ones own business is the income and one could have earned by accepting job outside.

UNIT - II
Demand analysis:Demand:- Desire + ability to pay (purchasing power) + willing to spend. Demand is the desire or want backed by willing to pay. Demand for commodity (1). Desire to acquire it. (2). Willingness to pay for it. (3). Ability to pay for it. Definition 1:- The demand for the product refers to the amount of it, which will be bought per unit of time at a particular price. Definition 2:- Demand means various quantities of goods that would be purchased per time period at different prices in a given market.

Determination of demand:(1). Prices of commodity:- Consumer buys more of a commodity when its prices declines and buys less when prices increase. (2). Income of the consumer:- Quantity demand of a good and income of the household move in the same direction, but beyond certain level of income and amount demand of the good remains unchanged even when income changes. (3). Prices related to goods:- Price of one commodity influences the demand of the other commodity. We can say that the two commodities are related. These related commodities are of two types: substitutes and compliments. When the prices of one commodity and the quantity demanded of the other commodity move in the same direction, the two goods are called substitutes eg:- tea and coffee. When prices of one commodity and quantity demanded of the other commodity move up in opposite direction, then the two commodities are said to be complementary to each other eg:-bread and butter. (4). Tastes and preferences:- The change in tastes and preferences of a consumer in favour or against commodity effects demand for commodity. Modern firms not only try to adjust to changes in the market trends and fancies, they also try to influence the market demand with the help of the sales campaigns. (5). Advertisement:- Advertisement is to influence the taste and preference of the consumer in their favour. This increases their sales. More the advertisements, more the demand and vice-versa. (6). Expectations:- Consumers makes two kinds of expectations (a). Related to their future income (b). Related to the prices to the goods and its related goods. Higher income in future, he spends more and the demand for the good increases viceversa. (7). Population (8). Climate or weather conditions (9). Availability (10). Geographic location of buyers Assumptions of Law of Demand:-

(1). The incomes of the consumers do not change. (2). No change in consumers preference. (3). No change in fashion. (4). No change in the price of related goods. (5). No expectations of future price changes or shortages. (6). No change in size, age, composite and sex ratio of population. (7). No change in the range of goods available to consumers. (8). No change in government policies. (9). No change in weather conditions. Law of Demand:- The relation of price of sales is known in economics as the law of demand. The law of demand states that higher the price, lower the demand, and viceversa, other things remaining the same. Definition:- Usually a larger quantity of a commodity will be demanded at a lower price than at a higher price. Demand schedule:- The relationship of price to sales or demand or alternatively, the price-quantity relation, as it is often called is shown arithmetically in the form of a table showing prices and corresponding quantities. This table is known as demand schedule. Demand schedule: Price Rs.5 Rs.4 Rs.3 Rs.2 Quantity demanded 80 units 100 units 150 units 200 units

Demand curve:- The demand curve of a commodity. The curve slopes downward from left to right indicating that when price is less, less is demand and when price falls, more is demanded. This kind of slope is also called as negative slope. The demand curve can be made to tell:(a). At a particular price what is the maximum, a consumer will purchase? (b). For a particular quantity, what shall be the maximum price.

Demand function:- A mathematical expression of relationship between quatity demanded of the commodity and its determinants is known as demand function. QdX = f (Px , Y , P1, P2 Pn-1, T, A, Ey, Ep, u) Individual demand function: Market demand function: (refer to class notes)

Characteristics of Law of Demand:(1). Inverse relationship:- Price and quantity inversely related. (2). Price an independent variable and demand, a dependent variable under the law of demand:- It is the effect of price on demand which is examined and not the effect of demand on price. (3). Other things remaining same:- There should be no change in the other factors influencing demand except price. (4). Reasons underlying the law of demand:- Law of demand can be explained in terms of two reasons. (i). Income effect:- When price rises, the consumers income is in effect, reduced and he has to control his expenditure on all commodities including the commodity whose price has risen. (ii).Substitution effect:- Falling price of a commodity increases demand and rise in its price reduces demand. Factors which influence market demand:(1). Prices. (2). Distribution of Income and wealth in the community:- If there is equal distribution of income and wealth, the demand for many products of common consumption tends to be greater than in the case of unequal distribution. (3). Community common habits and scale of preference:- demand is influenced by the scale of preference of the buyers in general. (4). Standard of living. (5). Number of buyers in the market and growth of population. (6). Age structure and sex ratio of the population. (7). Future expectations:- Expecting that prices of the commodity will rise in future than present meet demand. (8). Level of taxation and tax structure. (9). Inventions and innovations. (10). Fashions. (11). Climate or weather conditions. (12). Customs:- Deepawali- fire crackers. (13). Advertisements and sales expenditure.

Why demand curve slopes from left to right:Primary cause:- prices decreases people buy more. There are number of causes which are responsible for the price and demand (1). Law of diminishing marginal utility:- According to this economical law based on human being utility of commodities and satisfaction, people utility goes on decreasing by consumption of additional units. (2). Income effect:- When prices of commodities falls the real income of the customers goes up. This is one reason for the demand curve comes from left to right. (3). Substitution effect:(4). New consumers:Change in demand (Due to change in its own price) Shift in demand (Due to change in other factors such as income, prices of related goods etc)

Causes for the shift in demand curve: (1). Population (2). Income of the consumers (3). Price of substitutes and complementaries (4). Tastes and preferences (5). Weather conditions (6). Expectations regarding the future (7). Government policy (8). Changes in distribution of income (9). Educational standards (10). Saving attitudes:- Large saving-- Less money is prepared to spend on goods, therefore demand decreases (11). State of Business:-Business conditions of the country. Country is passing through boom conditions there will be a marked increase in demand on the other hand the level of demand goes down during depression.

(12). Changes in money supply:- Supply of money is increases the additional money increases the purchasing power of the people. Therefore, demand will increases vice-versa. Exceptions of law of demand:- according to law of demand increase in price decreases demand and decrease in price increases demand. But there are certain exceptions of law of demand in which increase in price increases demand and decrease in price decreases demand. Following are the exceptions of law of demand. (a). Giffen paradox:- (Giffen found that in 19th century Ireland, people were so poor that they spent a major part of their income on potatoes and a small part on meat. When the price of potatoes rose, they had to economize on meat even to maintain the same consumption of potatoes. Further, to fill up the resulting gap in food supply caused by a reduction in meat consumption more potatoes had to be purchased because potatoes were still the cheapest food. Thus the rise in the price of potatoes led in increased sales of potatoes. Such cases would occur only when considerable part of the total income is spent on an inferior good). Such goods are called Giffen goods. Sir Robbert Giffen an economist is the first person who contributed the exception to the law of demand. Stating that certain essentials are purchased even though the prices are large. According to him food is essential and even though the prices of food stuff are increased people shall have a tendency to buy more. (b). Veblen goods:- Some expensive commodities like diamonds; luxury cars etc are used as status symbols to display ones wealth. The more expensive these commodities become more will be their value as a status symbol and hence greater will be their demand- such goods are called Veblen goods. (c). Expectations of Change in Prices of the Commodity:- If a household expects the price of a commodity increase, it may start purchasing greater amount of the commodity even at presently increased price. Similarly, if a household expects the price of the commodity to decrease, it may postpone its purchase. Thus the law of demand is violated in such cases. (d). Consumers Psychological Bias or Illusion:- When the consumer is wrongly biased against the quality of a commodity with the price change he may contract this demand with fall in price. Some sophisticated consumers do not buy when there is stock clearance sale at reduced prices thinking that the goods may be of bad quality. (e). Speculation:- In stock market- people tend to buy more shares, when their prices are rising and buy less shares when the price of the shares fall. Why the demand curve slopes from left to right:There are number of causes which are responsible for the curve slope from left to right.

(1). Substitution effect. (2). Income effect. (3). Law of diminishing marginal utility:- It explains the relation between utility and quantity of a commodity. Utility is the want satisfying power of a commodity. The 1st unit of the commodity gives some amount of utility to the consumer. The 2nd unit of the commodity gives less utility satisfaction, 3rd less and so on. As quantity increases, each successive unit gives less satisfaction than the preceding one. At one stage or the other the consumer will be fully satisfied, as he does not require any more units of the same commodity. (4). New consumers:- When prices of a commodities decrease, there will be new users for the products and promotes additional quantity of demand. When a price of the product is reduced, people who were not able to buy the product at original price will now be able to buy due to its reduced price because now it is within the reach of the new consumers. Classification of Demand:(1). Demand for consumers goods and producers goods:- Consumers goods are the goods for final consumption. Ex:- food items. Demand for consumers goods also termed as direct demand. Producers goods are goods used for production of other goods. (2). Demand for Perishable (non-durable) and durable goods:- Both consumers and producers goods are further divided into perishable and non-perishable goods. Non-durable goods are those goods which can be consumed only once. Ex:- Bread, milk etc. Durable goods are those goods which can be used more than once over a period of time. Ex:- pen. In other words perishable goods are themselves consumed while only the services of durable goods are consumed. (3). Derived and Autonomous Demands:- When the demand for the production is tied to the purchase of some parent production, its demand is called derived. Ex:- The demand of cement is a derived demand, for it is needed not for its own sake but for satisfying the demand of building. Autonomous demand is not derived. It is hard to find a production today whose demand is wholly independence varies widely from production to production. Ex:- the demand for Automotive batteries is fully tied up with the demands of vehicles using these batteries. While the demand for sugar is loosely tied up with demand for drinks. Thus the distinction between derived and autonomous demands is more of the degree than of the kind. (4). Firm\company and industry demands:- Company demand denoted the demand for the productions of a particular company.

While industry demand means the demand for the production of a particular industry. (5). Demands by total market and by market segments:- Total market demand refers to the total demand for a production, whereas the market segment demand refers to demand arising form different segments of the market. (6) Industrial demand and Market demand:(7). Joint demand and Composite demand:- Demand for most of the commodities in real life are independent of each other. But there are certain commodities, the demands for which are interrelated. Interrelation in demand makes markets for physically different goods inter-liked and inter dependent. There are two types of interrelationships exits in demand for such commodities. Joint and complementary demand:- When 2 goods are demanded in conjunction with one another at the same time to satisfy single want, they are said to be joint or complementary demand. Ex:- Pens and ink, car and petrol. Composite demand:- A commodity is said to be in composite demand when it is wanted for several different uses. Ex:- wool- required for clothing, carpet etc. (8). Price demand:- It refers to purchase of various quantities at different prices. (9). Income demand:- It refers to various quantities of a commodity demanded by the consumers at alternative levels of his income. (10). Cross demand:- It refers to various quantities of a commodity (say A) purchased by a consumer in relation to change in the price of a related commodity (substitute or complementary). ELASTICITY OF DEMAND The elasticity of demand is developed by Alfred Marshall. It measures the % change in the quantity demanded due to % change in its determinants. Ed = % change in quantity demanded of good X % change in determinant Z Kinds of elasticity measures (1). Price elasticity of demand. (2). Income elasticity of demand. (3). Cross elasticity of demand. (4). Advertising and promotional elasticity of demand. I). Price elasticity of demand:-

Definition:- The degree of responsiveness of quantity demand to change in price. It thus represents the rate of change in the quantity demanded due to change in price. The extent of response of demanded for a commodity to a given change in price, other demand determinants remaining constant, is termed as the price elasticity of demand. The price elasticity of demand may be defined as the ratio of the relative change in demand and price variables. Since the relative change of variables can be measured either in terms of % change or proportional change, the price elasticity co-efficient can be measured alternatively as ep = The proportional change in quantity demanded The proportional change in price Change in quantity demanded Quantity demanded ` Change in price Price Q2 - Q1 = Q1 (P2 - P1) P1 = Q * P Q P
`

Q1 = Stands for quantity demanded before price change Q2 = Stands for quantity demanded after price change P1 = Stands for price demanded before price change P2 = Stands for price demanded after price change The price elasticity is negative emphasizing the inverse relationship Ex:- If Q1 = 2000 Q2 = 2500 P1 = 10 P2 = 9 than ep = = - 2.5 Interpretation:- 1% reduction in price will result 2.5% increase in quantity demanded. Types of price elasticity:(1). Perfectly elastic demand - where no reduction in price is needed to cause an increased in demand. 2500 -2000 2000 a 9 -10 10

(2). Perfectly inelastic demand - where change in price, causes no change in quantity demanded

(3). Demand with unity elastic - where a given proportionate change in prices causes an equal proportionate change in quantity demanded.

(4). Relatively elastic demand - where a reduction in price leads to more than proportionate change in demand curve

(5). Relatively inelastic demand - where a reduction in price leads to less than proportionate increase demand

Summary Type Perfectly elastic Perfectly inelastic Unity elastic Relatively elastic Relatively inelastic Numerical expression 0 1 >1 <1 Description infinite zero one more than one less than one Shape of curve Horizontal Vertical Hyperbola Flat Steep

Factors influencing elasticity of demand:(1). Nature of commodity:- According to the nature of satisfaction the goods gives, they may be classified into luxury, comfort or necessary goods. Luxury and comforts are price elastic (price constant) necessary goods are price inelastic (demand constant) Ex:- demand for food grains, cloth, salt etc is generally inelastic and furniture, TV, car are elastic. (2). Availability of substitutes:- Where there exists a close substitute in the relevant price range, its demand will tend to be elastic. But in respect of commodities have no substitutes, there demand will be some what inelastic. (3). Income level:- Larger the income, the demand for over all commodities tends to be relatively inelastic. (4). Extent of use:- A commodity having variety of uses has a comparatively elastic demand. Ex:- steel can be used for many purposes. A slight fall in its price will bring forth demand and has demand inelastic. On the other hand, a commodity having limited use will have a comparatively inelastic demand.

(5). Proportion of income spent on the commodity:- Where an individual spends only a small part of his income on the commodity. The price change does not materially affect his demand for the commodity. Ex:- match box, salt etc the demand is inelastic. (6). Durability of the commodity:- In the case of durable goods, the demand generally tends to be inelastic in the short run eg:- furniture, bicycle, radio. In case of non-durable commodities the demand in relatively elastic eg:- milk, vegetables. (7). Influence of habit and custom:- There are certain articles which have a demand on account of conventions customs or habit and in these case elasticity is less. Ex:- cigarettes have inelastic demand to a smoker. (8). Range of price change:- In case of high priced commodities a change in price do not bring much change in demand, but in the case of low priced commodities the change in price will bring a large change in demand. (9). Complementary goods:- Goods which are jointly demanded have less elasticity. Ex:ink and petrol have inelastic demand for this reason. (10). Time:- in short period, demand in general will be less elastic, while in the long period, it becomes more elastic. This is because it takes some times for the news of a price change to become known to all the buyers. (11). Recurrence of demand:- if the demand for a commodity is of recurring nature, its price elasticity is higher than that of a commodity which is purchased only once. (12).Urgency of demand:- when the demand for the production is postponable, it will tend to be price elastic. In the case of consumption goods which are urgently and immediately require their demand will be inelastic. II). Income elasticity of demand:Income elasticity may be defined as the degree of responsiveness of quantities demanded to a given change in income. The income elasticity of demand can be measured by the following formula ey = proportionate change in quantities demanded proportionate change in income = Q2- Q1 Q1 Y2 - Y1 Y1 = Q. Y `

Y Q Q1 = Quantities demanded before change in income Q2 = Quantities demanded after change in income Y1 = Income before change in income Y2 = Income before change in income Ex:- If a consumers demand for a commodity increases from 100 units per week to 200 units per week. When income rises form 3000 to 4000. Find the income elasticity of demand. Ans. = 3 Types of income elasticity:(1). Zero income elasticity:- Here change in income will have no effect on the quantities demanded eg:- salt ey = 0

(2). Negative income elasticity:- An increase in income may lead to a reduction in quantities demanded such goods are called inferior of goods. ey < 0

(3). Unity income elasticity:- It indicates that % change in quantity demanded is equal; to % change in money income here ey = 1.

(4). High income elasticity:- The quantity demanded of good X increased by a larger % change in money income i.e % change in quantity demanded is more than % change in money income. ey > 1

(5). Low income elasticity:- % change in quantity demanded is less than % change in money income. ey < 1

Luxury goods - jewellery, diamonds, automobile- luxury good have high elasticity of demand. But necessary goods are (ex:- salt, sugar, matchbox) have low income elasticity of demand. The income elasticity helps us in classifying the commodities (1). when ey is +ve - commodity is normal type. (2). when ey is -ve - commodity is inferior. (3). when ey is +ve and ey >1 - commodity is a luxury. (4). when ey is +ve and ey <1- commodity essential. (5). when ey = 0 - commodity is neutral. III) Cross elasticity of demand:Cross elasticity of demand as the rate of % change in demand for one good to the % change in the price of some other related goods (substitutes and complements)

exy =

qx qx py py

= qx py

py qx

The cross elasticity tends to be higher when tow goods satisfy the same wants equally well. Substitutes:- The cross-elasticity of demand is highly positive and tends to be infinity i.e (0 < exy < )

Complementary goods:- The cross-elasticity of demand will be highly negative and tends to infinity i.e (- < exy < 0)

IV). Advertising and Promotional elasticity of demand. Advertising elasticity of demand measures the response of quantity demand to change in expenditure on advertising and other scales promotion activities. The point formula for advertising the elasticity of demand is Where Q = quantity of goods X sold A= units of advertising expenditure on goods X The arc elasticity formula in this case can be written as

A = (Q/ A) * (A/Q) Factors influencing Advertising and Promotional elasticity of demand: Sale of different goods reacts differently to the same doses of advertising expenditure. Even the same commodity may not respond the same way to different levels of advertising expenditure. This implies that advertising elasticity of demand differs between products and also between different levels of sales of the same product. The advertising elasticity of demand is affected by a number of packages. They are 1. Stage of product market. The advertising elasticity is different for new and old products, and also for the products with an established market and a growing market. 2. Effect of advertising in terms of time The time lag in response to advertisement varies. It may be delayed in some cases, depending upon the general economic environment and the media chosen. It also depends upon the type of the product. It is likely to take longer in the case of durable goods because the buyers will go for purchase only after the existing article has been used up. Also, advertising through various media and by various firms may have cumulative effect after some time. Thus the difference in time lag of response for various commodities also makes advertising elasticity f demand different for different products. 3. Influence of advertising by rivals Advertising elasticity of demand depends upon effectiveness of advertising. The latter, inturn, depends upon how the other commodities react to the advertising campaign of this firm. The firm may resort to advertising to defend itself against the other competitors efforts to come out the sales of their products. The importance of rival move will depend a great deal upon the advertising campaign by rivals done in the present and in the past. How much additional output this firm can sell by resorting to advertisement depends upon its own media and level of advertisement with respect to those of its rivals.

Methods used for measurement of elasticity of demand:(1). Percentage method = Q . P P Q (2). Arc method:change in demand initial demand + present demand 2 change in determinants initial price + present price 2 Q2 - Q1

Ed =

Q2 + Q1 2 P2 - P1 P2 + P1 2

Q = Q2 + Q1 = Q . P1 + P2 P P Q1 + Q2 P2 + P1

(3). Mathematical method:- By use of differential calculus dQ . P dP Q (4). Outlay method or expenditure method or revenue method or unity method:- In this method elasticity is measured in terms of the total money spent on a commodity. Example:Price in Rs. (P) 6 5 4 3 2 1 Demand in units (Q) 100 200 300 400 500 600 Total expenditure (P * Q) 600 1000 1200 1200 1000 600 Name of elasticity elastic demand e >1 unitary demand e=1 inelastic demand e<1

(a). When the amount spent (expenditure) increases with the fall in price (or decreases with the rise in price) than the elasticity is greater than unity i.e the demand is elastic. (b). When the amount spent remains same with the increase or decreases in the price then the elasticity is equal to unity i.e the demand is unity. (c). When the amount spent decreases with the fall in price (or increase with the rise in price) than elasticity is less than unity i.e the demand is inelastic. Graphical measure:As the demand curve represents the change in quantity in relation to change in price. e = lower segemnet of demand curve = BC upper segment of demand curve AC

Previous question paper problems Prob1). Estimate the price and income elasticity by using the following information. Q = 700 - 2 P + 0.02 Y With P = 25, Y = 5000 where Q - Quantity demanded, P - Price, Y - Income. Price elasticity:p = dQ . P dP Q dQ = - 2 dP P = 25 Q = 700 - 2(25) + 0.02(5000) Q = 750 Therefore, p = dQ . P = -2 dP Q
*

25 = - 0.006 750

Interpretation: With every 1 % increase in price the demand of the quantity decreases by 0.006%. Income elasticity of demand:y = dQ . Y dY Q = dQ = 0.02 dY Therefore, y = 0.02 * 5000 = 0.133 750 Conclusion: 1% rise in income leads to 0.133% increase in demand Prob2). Estimate the income and cross elasticities of demand for B and P given the demand function for B. Qb = 2425 - 5 Pb + 1.5 Pp + 0.1Y Y = 5000, Pb = 100, Pp = 50 where Q - Quantity demanded, P - Price, Y - Income. Sol:- Income elasticity:y = dQ . Y dY Q

dQ = 0.1 dP Qb = 2425 - 5(100) + 1.5(50) + 0.1(5000) = 2500 Therefore, y = 0.1 5000 = 0.2 2500 Conclusion: 1% rise in income leads to 0.2% increase in demand Cross elasticity of demand:*

xy = dQ . Pb dPb Q = dQ = 1.5 dPb Therefore, xy = 1.5 * 50 = 0.03 2500 Interpretation: With every 1 % increase in price of related good(Pp) the demand of the quantity (Qb) increases by 0.03%. The good p is a substitute of good b Prob3). Given the demand function Q = 10 - 5 P find out the price elasticity if P = Rs.10 and interpret the result. Sol:Q = 10 - 5P P = Rs. 10 Q = 10 - 5(10) = 10 - 50 = - 40 p = dQ . P dP Q = dQ = - 5 dP p = - 5 . 10 = 1.25 40 Interpretation:- With every 1 % increase in price the demand of the quantity increases by 1.25%. The given product under consideration is luxury good as demand is increasing with the increase in the price. Prob4). Given the income demand function Q = 1000 + 0.5 Y. find out the income elasticity interpret the result, if the level of income is Rs.2,000. Sol:y = dQ . Y

dY Q Q = 1000 + 0.5(2000) = 2000 dQ = 0.5 dY y = 0.5 Interpretation:- with every 1 % increase in income the quantity demand will increase by 0.5%. Applications of elasticity of demand:(1). To Businessman:- The concept of elasticity of demand is used while deciding pricy policy, the businessman has to know the likely effect of price changes on the demand for this product in the market. He has to understand by what extent the price reduction will increase in demand and to what extent his revenue would increase and what amount of profit it fetches. (2). To the government:- To determine fiscal policy the concept of elasticity of demand is very important. The government will consider the elasticity of demand while selecting the commodities for taxation. Tax composition on commodities for getting substantial revenue becomes worthwhile only if the taxed goods have an elastic demand. Generally taxes are levied on commodities like kerosene, cigarettes, sugar etc, which have an elastic demand. (3). To international trade:- The concept of elasticity of demand is also useful in formulating export and import policies of a country. (4). To policy makers:- The concept of elasticity of demand is useful in solving the mystery of how farmers remain poor despite a bumper crop. Since agriculture productions particularly food grains have an elastic demand. When there is a bumper crop it can be sold only by cutting prices substantially. Hence, the total income of farmers will be lower in spite of bigger crop. (5). To trade unions:- Price elasticity of demand is useful to trade unions when they find that demands for their industrys product is fairly inelastic, will bargain for a higher wage to workers and use the producer to cut the price and increase sales which will compensate for his loss in total profit.