WHAT IS ECONOMICS

Since the beginning of mankind there has

always been the problem of people wanting

many things and doing some sort of effort that
resulted in the production of some good or
service which satisfied the human want. At the
basic level economics is the study of
relationship between wants, efforts and
satisfaction.
Economics was made compulsory for engineers
in the first decade of 20th century. Institute of
Mechanical Engineers (UK) found that 90% of
the management decisions required some
managerial responsibility and most of them
were basic in nature. Hence, managerial
economics was introduced in engineering and
management subjects.

Economics became a systematic body of

knowledge after Adam Smith who wrote

Wealth of Nations in 1776.
Adam Smith and his followers like J.B. Say, J.S.
Mill, Ricardo etc are called Classical
Economists.
When Classical economics failed to solve the
problem of employment during the period of
great depression, Keynes wrote The General
Theory in 1936, which was the beginning of
Keynesian Economics.

The study of economics can be divided into

following parts:
Consumption
Production
Exchange
Distribution
Public Finance
Another way of dividing economics is to study
economics in two parts:
Micro economics
Macro economics

Definition, nature and scope of

micro economics
Broadly definitions of economics can be

classified as: Wealth definition (Adam Smith),

Welfare definition (Marshall),
Scarcity
definition (Robbins)
Economics is a science as well as an art.
According to one view economics is a
normative science, another view is that it is a
positive science and some consider both
views to be acceptable.
Study of economics covers production,
consumption, exchange, distribution and
public finance. Another way is to divide
economics into micro economics and macro
economics.

Utility Analysis
Marshall and others have given a cardinal

system to explain consumers behaviour

Cardinal system assumes measurement of
utility is possible in terms of number of units,
utility from one commodity is independent of
other and marginal utility of money remains
same.
Utility analysis is explained with the help of
two laws :
Law of diminishing marginal utility
Law of equi-marginal utility

Law of diminishing marginal

utility
As more units of a commodity is consumed

MU goes on diminishing
U
T
I
L
I
T
Y

MU curve

Quantity of commodity

Law of equi-marginal
utility
A consumer gets maximum satisfaction when

marginal utility of money spent on each good

is same. It can be expressed by following
formula also:
MUx MUy
Px
Py
Where MUx is marginal utility of X and MUy is
marginal utility of Y. Px and Py are prices of two
commodities.

Indifference Curve
Analysis
Hicks and Allen gave concept of Indifference Curve
to explain consumers behaviour which is an
ordinal system. Different combinations of two
commodities are considered which give the same
level of satisfaction.
Indifference curve is the locus of all points that
represent combinations of two commodities that
give same level of satisfaction.

Definition. An indifference schedule is a list of alternative

combinations in the stocks of two goods which yield equal
satisfaction to the consumer.

The Indifference Curve

It represents all possible combinations of two goods under

consideration (in this illustration, n apples and bananas), that
give the consumer equal satisfaction.

Properties of Indifference
curve
1. I. curve has negative slope
2. I. curve is convex to origin
3. Higher I. curve has higher level of

satisfaction
4. Two I. curves do not intersect each other
5. I. curves do not touch any axes
6. Two I. curves need not be parallel to each
other

Price Line or Budget Line

It is the locus of all the
combinations of two
commodities
that
can be purchased
when
prices
and
income are known.

OA is the max qt of A
and OB is the max qt
of B that can be
bought, then AB is
price line that shows
all combinations that
can be purchased.
The combination z
can not be bought
and s will not use up
all resources.

Consumers equilibrium
Consumer equilibrium is

attained when, given his budget

constraint, the consumer reaches
the highest possible indifference
curve. This is found where
indifference curve and
price line are tangent to
each other, marginal rate
of substitution is equal to
price ratio of two
commodities and
indifference curve is
convex to origin.

Income Effect
The income effect refers to the
change in demand for a
commodity resulting from a
change in the income of the
consumer, prices of goods
being constant.
Points of consumers
equilibrium at different levels
of income can be joined
together to get incomeconsumption-curve (ICC)

Price Effect
When income and

price of one item

remains same and
price of the other good
changes then the
change in equilibrium
or change in
consumption is price
effect.

Price effect is positive for

normal goods, which

means demand falls with
rise in price and for
Giffen goods it is
negaive, which means
changes in price and
demand are in the same
direction. Locus of
equilibrium at different
prices is priceconsumption-curve (PCC)

Substitution Effect
When price of one good is increased and price
of the other is decreased, income remains
same then consumer substitutes cheaper
good in place of more expensive one to
remain at the same level of satisfaction. This
change in consumption or equilibrium is
known as substitution effect. This is always
positive, which means that cheaper
commodity is always substituted for
expensive commodity.

Demand Function
Mathematical of expression of functional relationship between determinants (such
as price, income, etc., determining variables) and the amount of demand of a
given product.
In composing the demand function for a product, therefore, one should identify
and enlist the most important factors (key variables) which affect its demand. To
suggest a few, such as:
The own price of the product itself (P)
The price of the substitute and complementary goods (Ps or Pc)
The level of disposable income (Yd) with the buyers (i.e., income left after
direct taxes)
Change in the buyers taste and preferences (T)
The advertisement effect measured through the level of advertising
expenditure (A)
Changes in population number or the number of the buyers (N).
Using the symbolic notations, we may express the demand function, as follows:
Dx = f (Px, Ps, Pc, Yd, T, A, N, u)

Demand Schedule
A tabular statement of price/quantity relationship is called

the demand schedule.

Individual Demand Schedule

A Market Demand Schedule (Hypothetical Data)

Market Demand Curve

In graphical terms, a market demand curve for a product

is derived through the horizontal summation of all
individual buyers demand curves for the given product.
Demand Curve
Demand curve refers to the graph of a demand schedule,
measuring price on the Y-axis and quantity demand on
the X-axis. Usually, a demand curve has a downward
slope, representing an inverse relationship between price
and demand.

A Linear Demand Curve

The Law of Demand

The conventional law of demand, however, relates to the

much simplified demand function:
D = f (P)

Demand Curve

Assumptions Underlying the Law of

Demand
No change in consumers income
No change in consumers preferences
No change in the fashion
No change in the price of related goods
No expectation of future price changes or shortages
No change in size, age composition and sex ratio of the population
No change in the range of goods available to the consumers
No change in the distribution of income and wealth of the community
No change in government policy
No change in weather conditions

Exceptions Demand Curve: Upward-sloping Demand Curve

Exceptional Cases
Giffen goods
Articles of snob appeal
Speculation
Consumers psychological bias or Iillusion

ELASTICITY OF DEMAND
It refers to the responsiveness of demand to
any change like change in price, income or
price of another commodity.
Elasticity of demand is measured as the ratio of percentage change in
the quantity demanded of a product to the percentage change in its
price.

Types of Elasticity of
Demand
Price elasticity of demand: Extent or rate of
change in demand due to change in price.
Income Elasticity of demand: Extent or rate of
change in demand due to change in income.
Cross Elasticity of demand: Extent or rate of
change in demand due to change in price of
related good.

Degree of Elasticity of
demand
Each type of elasticity can have five degrees:
1.
2.
3.
4.
5.

Unitary inelastic demand (e=1)

Perfectly inelastic demand (e=0
Highly elastic demand (e>1)
Less Elastic demand (e<1)
Perfectly Elastic demand (e= infinity)

Measurement of Elasticity of
demand
1.Proportionate method: When information is
available about original price, original
quantity and changes in them and the
changes are small then this method is
applied:
El= (P/Q) (Change in Q/ change in P)
2. Total Outlay method: When change in
expenditure on a product before change in P
and after change in P is known, then this
method is applied. There are two cases:

When the price of commodity falls

If total expenditure remains same, e=1
If total outlay falls then, e<1
If total outlay rises then, e>1

When the price of commodity rises

If total expenditure remains same, e=1
If total outlay falls then, e>1
If total outlay rises then, e<1

3. Point method: This method is used when

elasticity has to be measured on a point on
the demand curve. In case of linear demand
curve, elasticity of demand is measured by
dividing the lower segment from the point on
demand curve, by the upper segment of the
demand curve.
In case of non-linear demand curve, a tangent
is drawn at the point on the demand curve at
which elasticity is to be measured and follow
the same formula as in the last case.

4. Arc Method: This is used when information is

available regarding old and new prices and demand at
respective prices and the changes are large. The
formula is similar to the one used in Proportionate
method, only difference is that in place of original
price, new price is added to original price and in place
of original quantity, new quantity is added to original.
5. Revenue Method: If we have information about AR
and MR then elasticity of demand can be calculated
by formula
E= (AR-MR) / AR

Factors affecting Elasticity of

demand
Nature of commodity
Availability of substitutes
Number of uses
Consumers income
Height of price and range of price change
Proportion of expenditure
Durability of the commodity
Complementary goods
Time
Recurrence of demand
Possibility of postponement

Demand Forecasting

Demand forecasting means predicting future marked

demand and its magnitude on the basis of statistical

data and empirical measurement of functional
relationship bet-ween demand and its determinants.
It is required for the following reasons:
Production planning.
Acquiring inputs and provision of finance
Inventory control.
Growth and long-term investment programs

Methods of demand forecasting

1. Survey of potential consumers
2. Experts opinion
3. Statistical methods
4. Econometric methods

Limitations: Reliability of results depends on

many factors: Choice of variables and data;
form of the demand function used; quality of
data available etc.

Production Function

It refers to the physical relationship bet-ween the use of the

inputs (factors of production) and resulting output of a
product.
Short-run Production Function
In the factor combinations of an input, at least one factor
re-mains fixed in the process of production.
Law of Variable Proportion
The law pertaining to the return to a variable factor input.

 Total Pro-duct

Total quantity of output produced by the given use

of input in the production system, per un-it of time.
Average Product
Total quantity of pro-duct divided by the total units
of input employed. It is per factor unit product.
Marginal Product
The addition made to the total product associated
with a one-unit change in a particular single in-put
labour

Statement. Using the concept of marginal product,

the law may be stated as follows:

During the short period, under the given state of
technology and other conditions remaining
unchanged, with the given fixed factors, when the
units of a variable factor are increased in the
production function in order to increase the total
product, the total product initially may rise at an
increasing rate and, after a point, it tends to increase
at a decreasing rate because the marginal product of
the variable factor in the beginning may tend to rise
but eventually tends to diminish.

The Product Curves

Return to Scale

Output resulting on account of a proportional

increase in the whole set of inputs.
Output Elasticity
The percentage change in output quantity divided
by the percentage change in input quantity.

Returns to Scale

Output Elasticity

Output elasticity is defined as the ratio of the

percentage change in quantity produced to the
percentage change in factor input.
Isoquant
The same specific output quantity most efficiently
produced by the different input combinations of two
factors; say, labour and capital.

Equal Product Curves

Risk-Return Indifference Curve

Ridge Line

A graphical bound suggesting the limit be-yond which

marginal products becoming negative.
Isocost Line
The budget line of the firm expressed in terms of constant
costs.
Least-Cost Combination

Types of Production Costs and their

Measurement
In economic analysis, the following types of costs are

considered in studying cost data of a firm

Total Cost (TC)
Total Fixed Cost (TFC),
Total Variable Cost (TVC)
Average Fixed Cost (AFC),
Average Variable Cost (AVC),
Average Total Cost (ATC), and
Marginal Cost (MC).

 Marginal Costs

The additional costs relating to each successive

unit-wise increment in total output. It is measured
on the ratio of change in total cost to one unit
change in total output.
Symbolically, thus, MC = where, D denote change
in output assumed to change by 1 unit only.
Therefore, output change is denoted by D1.

The Short Run Total Costs Schedule of a Firm (Hypothetical Data)

Short Run Total Cost Curves

Short-run Average cost (SAC) Curve

U shaped indicating declining SAC in the beginning, then

remaining constant for a while and then rising.
Short Run Average Cost Curves

Relationship between AC and MC Curves

 Costs Function

It is mathematical expression of functional relationship between the costs and

out-put level.
Cost Function of a Hosiery Mill
Joel Dean (1941), estimated the total cost behaviour of a hosiery knitting mill in
the U.S. by fitting a simple regression equation of the form: TC = b1 + b2 to
the data, thus:
TC =
2953.59 + 1.998Q
(6109.83)
where,
TC = total cost in dollars
Q = output in dozens of pairs
(parenthesis represent the standard error of estimate)

Long-Run Average Costs Curve

It relates to the cost-output relation in the long-run.

It is a flatter U-shaped curve.
Derivation of the LAC Curve

The LMC and the LAC Curves

Internal Economies-Diseconomies and the LAC Curve

The Effect of External Economies

The Effect of External Diseconomies

Minimum Efficient Scale

It refers to the lowest point on the long-run

average cost curve, implying optimum use of
factor-input and minimum average cost.

Revenue curves of firms

The amount of money received from the sale of products of a firm is known as revenue
Following are the main concepts of revenue:
Total Revenue: It is the total sales receipts of a firm. TR= P X Q
Average Revenue: It is the revenue earned from sale of one unit of product. It is same
as price of a product.
Marginal Revenue: It is the change in total revenue from a unit change in the output
sold.

Industry Demand and Firm Demand under Perfect

Competition