UNIT II-MG2452-Engineering Economics and Financial Accounting Notes.pdf

8/10/2019 UNIT II-MG2452-Engineering Economics and Financial Accounting Notes.pdf

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UNIT II

DEMAND

The demand for a commodity is its quantity which consumers are able and willing to buy at

various prices during a given period of time. Demand is a function of Price (P), Income (Y),Prices of related goods(PR) and tastes (T) and expressed as D=f(P,Y,PR,T). When income,

prices of related goods and tastes are given, the demand function is D=f (P). It shows

quantities of a commodity purchased at given prices.

THE VARIOUS TYPES OF DEMAND

i.Price demand: Price demand refers to various quantities of a commodity or service that a

consumer would purchase at a given time in a market at various hypothetical prices. It isassumed that other things, such as consumers income, his tastes and prices of inter- relatedgoods, remain unchanged. The demand of the individual consumer is called individualdemand and the total demand of the entire consumer combined for the commodity or serviceis called industry demand. The total demand for the product of an individual firm at various

prices is known as firms demand or individual sellers demand.

ii.Income demand: Income demand indicates the relationship between income and the quantityof commodity demanded. It relates to the various quantities of a commodity or service thatwill be bought by the consumer at various level of income in a given period of time, other

things equal. The income demand function for a commodity increases with the rises inincome and decreases with fall income. The income demand curve has a positive slope. But

this slope is in the case of normal goods. In the case of inferior goods the demand curve id isbackward sloping

iii.Cross demand: In case of related goods the change in the price of one affects the demand ofthe other this known as cross demand and its written as d=f(pr). Related goods are of two

types, substitutes and complementary. In the case of the substitutes or competitive goods, arise in the price of one good a raises the demand, arise in the price of one good a raises thedemand for the other good b, the price of remaining the same the opposite holds in the case of

a fall in the price of a when demand for b falls.

INDIVIDUAL DEMAND SCHEDULE AND CURVE AND MARKET DEMAND

SCHEDULE

Individuals demand schedule and curve: An individual consumers demand refers to thequantities of a commodity demanded by him at various prices. A demand schedule is a list of

prices and quantities and its graphic representation is a demand curve.

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X axis-quantity demanded

Y axis- priceDD- demand curve

Explanation:

i.The demand schedule reveals that when the price is Rs.P2, quantity demanded is Q2 units. Asthe price decreases to P, the quantity demanded increases t o Q.

ii.The individual demand curve focuses on the effects of a fall or rise in the price of onecommodity on the consumers behavior. They are thesubstation and income effects.

Market demand schedule and curve: In a market, there is not one consumer but many

consumers of a commodity. The market demand of a commodity is depicted on a demandschedule and demand curve. They show the sum total of various quantities demanded by allthe individuals at various prices. Suppose there are three individuals A,B and C in a marketwho purchase the commodity. The demand schedule for the commodity is depicted in tab le

below.

X axis-quantity demandedY axisprice

DD- demand curve

Explanation:

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i.Suppose there are three individuals A,B and C in a market who buy OA,OB and OCquantities of the commodity at the price OP, as shown in panels (A),(B) and (C) respectively.

ii.In the market OQ quantity will be bought which is made up by adding together the quantities

OA,OB and OC.

iii.The market demand curve DM is obtained by the lateral summation of the individual demand

curves DA, DB and Dc

DIFFERENCE BETWEEN CHANGES IN DEMAND AND CHANGES IN

QUANTITY DEMANDED

Change in Quantity demanded: A demand curve is the graphic representation of the law of

demand. Movement along a demand curve is caused by a change in the own price of thecommodity. Such as change is called extension and contraction of demand. This meansmovement on the demand curve resulting in extension of demand. Demand contracts as price

of good increases. This movement on a demand curve is known as change in quantity

demanded. This is be explained with the help of a diagram

X axis -------Quantity of XY axis---------price of X

DD ------------demand curve

Explanation:

The figure shows that as the price increases the demand decreases & as the price decreasesthe demand for the commodity increases.

Change in demand:A shift of the demand curve is brought about by change in factors otherthan the own price eg. It changes in factor like incomes of the consumer prices of substitute

products, percentage of women going out to work etc, this is known as change in demand.

This is explained with the help of a diagram.

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X axis -------Quantity of X

Y axis---------price of XDD ------------demand curve

DD1 ------------Shift in Demand curve

Explanation:

The purchasing power of the consumer increases at each given price he starts buying more ofthe commodity. This tendency of the consumer leads to shifts in this demand curve. Similar

results will emerge if other determinants like price of related goods, tastes, etc, change. Allthe other determinants are therefore, called shift factors, which lead to change in demand.

THE NATURE OF THE DEMAND OR THE VARIOUS DEMAND DISTINCTIONS

i.

Derived demand and autonomous:Those inputs or commodities which are demanded tohelp in further production of commodities are said to have in further production ofcommodities are said to have derived demand. For example, raw material, labour machines

etc are demanded not because they serve only direct consumption need of the purchaser butbecause they are needed for the production of goods having direct demand (say , food ,scooter . building ,etc)

ii.Demand for producers goods and consumers goods: The difference in these two types of

demand is that consumers goods are needed for producing other goods (consumers goods orfurther producers goods)

iii.Demand for durable goods non durable goods: Durable goods whether producers durableor consumers durable are the ones which can be stored and whose replacement can be

postponed. O n the other hand, the non durables are needed as a routine and their demand istheir fore made largely to meet dayto- day needs.

iv.Industry demand and firm or company demand: The term company demand denotes

demand for a particular product of a particular firm Industry demand refers to the totaldemand for the product of a particular industry.

v.Total demand and market segment demand: Demand for the market segments is to be

studied by breaking the total demand into different segments like geographical areas , sub-products, product use, d istribution channels, size of customer groups, sensitivity to price etc.

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The market segments are so demarcated that each segment has its own homogenous demandcharacteristics. Further, each of these market segments must differ significantly in terms of

delivered prices, net profit margins, and number of substitutes, competition, seasonal,patterns and cyclical sensitivity.

vi.Short run demand and long run demand: Short run demand refers to demand with itsimmediate reactions to price changes, Income fluctuations etc. Whereas long run demand is

that which will ultimately exist as a result demand of the change in pricing promotion or

products improvement , after enough time is a llowed to lat the market adjust itse lf to the new

situation.

THE CAUSES FOR THE DOWN WARD SLOPING OF THE DEMAND CURVE

i.Based on the law of diminishing marginal utility: The law of demand is based on the law

of diminishing marginal utility. According to this law, when a consumer buys more units of acommodity, the marginal utility of that commodity continues to decline therefore theconsumer will buy more units of that commodity only when its price falls. When less units

are available, utility and the consumer will be prepared to pay more for the commodity.

ii.

Price effect: With the increase in the price as of the product many consumers will eitherreduce or stop its consumption and the demand will be reduced. Thus to the price effect whenconsumer consume more or less of the commodity, the demand curve slope downward.

iii.Income effect: When the price of a commodity falls the real income o f the consumer

increase because he quantity. On the contrary with the rise in the price of the commodity thereal income of the consumer falls. This is called the income effect.

iv.Substitution effect: The other effect of change in the prices of the commodity is thesubstitution effect. With the falls in the price of a commodity the prices of its substitutes

remaining the same consumer will buy more of this commodity rather that the substitutes. Asa result its demand will increase.

v.Persons in different income groups: There are person in different income groups in everysociety but the majority is in low income group. The downward sloping demand curve

depends upon this group. Ordinary people buy more when price falls and less when pricesrise. The rich do not have any some quantity even at a higher price.

vi.Different uses of certain commodities: There are different uses of certain commodities andservice that are responsible for the negative slope of the demand curve with the increase in

the price of such products they will be used only for more important uses and their demand

will fall.

THE REASON FOR THE EXCEPTIONAL DEMAND CURVE

i.War: If a short age is feared in anticipation of war people may start buying for buildingstocks, for hoarding even when the price rises.

ii.Depression:During a depression, the prices of commodities are very low and demand for

them is also less. This is because of the lack of purchasing power with consumer.

iii.

Giffen paradox: If a commodity happens to be necessity of life like wheat a nd its price goesup, consumer are forced to curtail the consumption of more expensive foods like meat and

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fish and wheat being still the cheapest they will consume more for it. The marshallionexample is applicable to developed economies. In the case of underdevelopment economy,

with the fall in the price of an inferior commodity like maize. Consumers will startconsuming more of the superior commodity like wheat. As a result, the demand for maize

will fall .this is what Marshall called giffen paradox which makes the demand curve to have apositive slope.

iv.Demonstration effect: It consumers are affected by the principle of conspicuous

consumption or demonstration effect they will like to buy more of those commodities which

confer distinction on the possessor, when their prices rise. On the other hand, with the fall inthe prices of such articles, their demand falls, as is the case with diamonds.

v.Ignorance effect: Consumers buy more at a higher price under goods the influences of theignorance effect where a commodity may be mistaken for some other commodity, due to its

price, deceptive packing, label, etc.

vi.Speculation: Marshall mentions speculation as one of the important exception to the

downward sloping demand curve. According to him the law of the demand does not apply to

the demand in a campaign between groups of speculators. A group, which desire to upload agreat quantity of a thing on to the market, often begins by buying some of it openly; itarranges to sell a great deal quietly and through unaccustomed channels.

THE VARIOUS DETERMINATS OF MARKET DEMAND

i.Price of the product: The law of demand states that the quantity demanded of a productwhich its consumers users would like to buy per unit of time, increases when its price fallsand decreases when its price increases other factors remaining constant.

ii.Price of the related goods: The demand for a commodity is also affected by the changes

in the price of its related goods. Related goods may be substitutes or complementary goods

iii.Consumer income: Income is the basic determinant of quantity of a product demanded since

it determines the purchasing power of the consumer. That is why higher current disposableincomes spend a larger amount on consumer goods and services than those with lower

income.iv.Consumer taste and preferences:Taste and preferences generally depend on the life style

social customs religious value attached to a commodity, habit of the people, the general levels

of living of the society and age and sex of the consumers taste and preferences. As a result,consumers reduce or give up the consumption of the some goods and add new ones to their

consumption pattern

v.Advertisement expenditure: Advertisement costs are incurred with the objective of

promoting sale of the product. Advertisement helps in increasing demand for the product.

vi.Consumers exceptions: Consumers exceptions regarding the future prices incomes andsupply position of goods, etc p lay an important role in determining the demand for goods andservices in the short run.

vii.Demonstration effect: When new commodities or new models of existing one appear in the

market rich people buy them first.

viii.

Consumer credit facility: Availability of credit to the consumers from to the seller banksrelation and friends, or from other source encourages the consumer to buy more that what

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they is why consumers who can borrow more can consume more than those who cannotborrow. Credit facility mostly affects the demand for durable goods, particularly those which

requires bulk payment at the time of purchase.

ix.Population of the country:The total domestic demand for a product of mass consumptiondepends also on the size of the population. Give n the price, per capita income taste and

preference etc, the larger the population the larger and demand for a product. With an

increase (or decrease) in the size of population and with the employment percentage

remaining the same demand for the product tends to increase (or decrease).

x.Distribution of National Income: The level of national income is the basic determinant ofthe market demands for a productthe higher the national income, the higher the demand forall normal goods and services. A past from its level the distribution pattern of national

income is also an important determinant of a product.

ELASTICITY OF DEMAND

Elasticity of demand may be defined as the ratio of the percentage change in demand to the

percentage change in price. Ep= Percentage change in amount demanded

Percentage change in price

TYPES OF ELASTICITY DEMAND

i.Price e lasticity of demand: Elasticity of demand may be defined as the ratio of thepercentage change in price.

Ep = percentage change in quantity demanded / percentage change in price

ii.Income e lasticity of demand: The income elasticity of demand (Ey) express the

responsiveness of a consumer demand or expenditure or consumption) for any good to thechange in his income .it may be defined as the ratio of percentage change in the quantity

demanded of a commodity to the percentage in income. Thus

Ey = percentage change in quantity demanded / percentage change in income

iii.Cross elasticity of demand: The cross elasticity of demand is the relation between

percentage change in the quantity demanded of a good to the percentage change in the priceof a related good. The cross elasticity good A and good B is

Eba= percentage change in the quantity demanded of B/ percentage change in price of A

TYPES OF PRICE ELASTICITY OF DEMAND

i.Perfectly elastic demand: Where no reduction in price is needed to cause an increase inquantity demanded. This is explained with the help of a diagram.

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Y axis- priceDD1- demand curve

Explanation: Price elasticity of demand is infinity when a small change in price leads to aninfinitely large change in the amount demanded. It is perfectly elastic demand. [E=]

ii.Perfectly in elastic demand: Here a large change in price causes no change in quantity

demanded. It is zero elastic demand [E=0]. This is explained with the help of a diagram.


Y axis- priceDD1- demand curve

Explanation: The figure shows that even if the price decrease from p to p1 there is nochange in the quantity demand. This happens in case of necessities like salt.

iii.Unitary elastic: Where a given proportionate change in price causes an equally proportionatechange in quantity demand. This is explained with the help of a diagram.

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DD1- demand curve

Explanation: Price elasticity of demand is unity when the change in demand is exactlyproportionate to the change in price. [E=1].

iv.Relatively elastic: Where a small change in price causes a more than proportionate change inquantity demanded. The price elasticity of demand is greater than unity [E >1]. This is

explained with the help of a diagram.

X axisquantity demandedY axispriceDDdemand curve

Explanation: The figure shows that there is a small decrease in price from P to P1, but it has

resulted in a large increase in quantity demanded from Q to Q1. It is also known as relativelyelastic demand.

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v.Relatively inelastic demand: Where a change in price causes a less than proportionatechange in quantity demanded. The price elasticity of demand is lesser than unity [E


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Explanation: The curve Ey shows a positive and elastic income demanded. In the case ofnecessities, the coefficient of income of income elasticity is positive but low, Ey=1. Income

elasticity of demanded is low when the demand for a commodity rises less than proportionateto the rise in the income.

ii.Positive but inelastic income demand: It is low if the relative change in quantity demandedis less than the relative change in money income. Ey


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Explanation: The curve Ey shows unitary income elasticity of demand. In the case of

comforts, the coefficient of income elasticity is unity (Ey=1) when the demand for acommodity rises in the same proportions as the increases in income.

iv.Zero income elasticity: A change in income will have no effect on the quantity demanded.The value of the coefficient Ey is equal to zero. This is explained with the help of a diagram.

X axisquantity demandedY axisIncomeDD- demand curve

Explanation: The curve shows a vertical income, elasticity demand curve Ey with zeroelasticityIf with the increases in income, the quantity demanded remains unchanged the coefficient of

income elasticity, Ey=0.

v.Inferior goods: Inferior goods have negative income elasticity of demand. It explains thatless is bought at higher incomes and more is bought at lower incomes. The value of thecoefficient Ey is less than zero or negative in this case. This is explained with the help of a

diagram.

X axisquantity demandedY axisIncomeDD- demand curve

Explanation: The coefficient of income elasticity of demand in the case of inferior goods isnegative. In the case of an inferior good, the consumer will reduce his purchases of it, when

his income increases.

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DIFFERENT TYPES OF CROSS ELASTICITY OF DEMAND

A.CROSS ELASTICITY OF SUBSTITUTES: In case of substitutes, as the price of one

good increases the demand for the other good also increase at the same t ime.

i.Relatively e lastic: Where a small change in price of good A causes a large change in quantity

demanded of good B. The elasticity of substitutes is greater than unity [E >1].This is


X axisquantity demanded of BY axispr ice of ADDdemand curve

Explanation: The figure shows that there is a small increase in price of good A from a to a1,but it has resulted in a large increase in quantity demanded of B from b to b1. It is also known

as relatively e lastic demand.

ii.Relatively inelastic demand: Where a large change in price of good A causes a small changein quantity demanded of good B. The elasticity of substitutes is lesser than unity [E


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X axis-quantity demanded of good B

Y axisprice of good ADD- demand curve

Explanation: Price elasticity of demand is unity when the change in demand is exactly

proportionate to the change in price. [E=1].

iv.Perfectly in elastic demand: Here a large change in price causes no change in quantity

demanded. It is zero elastic demand [E=0]. This is explained with the help of a diagram.

X axis-quantity demanded of good B.Y axisprice of good A.DD- demand curve

Explanation: The figure shows that even if the price increases from a to a1 there is no

change in the quantity demand. This happens in case of necessities like salt.

v.Unrelated goods: If two goods are not at all related then they have negative elasticity of

demand. This is explained with the help of a diagram.

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X axisquantity demanded of good B.Y axisPrice of good A.DD- demand curve

Explanation: The figure shows that in case on unrelated goods if the price of good Aincrease from a to a1, then the demand for good B will decrease from b to b1.

B.CROSS ELASTICITY OF COMPLIMENTARY GOODS: In case of complimentary

goods, as the price of one good increases the demand for the other good decreases at thesame time.

i.Perfectly elastic demand: Where no reduction in price is needed to cause an increase inquantity demanded. This is exp lained with the help of a d iagram.

X axis-quantity demanded of good BY axisprice of good A

DD- demand curve

Explanation: Price elasticity of demand is infinity when a small change or no change inprice of good A leads to an infinitely large change in the amount demanded of good B. It isperfectly elastic demand. [E=]

ii.Perfectly in elastic demand: Here a large change in price of good B causes no change in

quantity demanded of good B. It is zero elastic demand [E=0]. This is explained with the helpof a diagram.

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DD- demand curve

Explanation: The figure shows that even if the price of good B decreases from a to a1 thereis no change in the quantity demand of good A. This happens in case of necessities like salt.

iii.

Unitary elastic: Where a given proportionate change in price causes an equally proportionatechange in quantity demand. This is explained with the help of a diagram.


DD- demand curve

Explanation: Price elasticity of demand is unity when the change in demand is exactly

proportionate to the change in price. [E=1].

iv.Relatively elastic: Where a small change in price of good B causes a more than

proportionate change in quantity demanded of good A. The price elasticity of demand isgreater than unity [E >1].This is explained with the help of a d iagram.

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X axisquantity demanded of good BY axisprice of good ADDdemand curve

Explanation: The figure shows that there is a small decrease in price from a to a1, but it has

resulted in a large increase in quantity demanded from b to b1. It is also known as relativelyelastic demand.

v.Relatively inelastic demand: Where a change in price causes a less than proportionatechange in quantity demanded. The price elasticity of demand is lesser than unity [E


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DIFFERENT METHODS OF MEASURING ELASTICITY OF DEMAND

1.Total outlay: According to this method, we compare the total outlay of the purchases ortotal revenue, i.e, total value of sales from the point of view of the seller before and after the

variations in price. This is explained with the help of a diagram.

X axis -------Quantity of XY axis---------price of X


Explanation: If the elasticity of demand is equal to unity for all prices of the commodityonly fall in price will cause a proportionate increases in the amount bought, and therefore willmake no change in the total outlay which purchases make for the commodity thus one is the

dividing point. If the elasticity is greater than one it is said to be elastic and it is less than it is

inelastic curve having same elasticity throughout:-

2.Point elasticity: The concept of price e lasticity can be used in comparing the sensitivity of

the different types of goods e.g., luxuries and necessaries) to changes in thei r prices. Theelasticity of demand is always negative because change in quantity demanded is in opposite

direction to the change in price that is a fall in price is followed by rise in demanded and viceversa hence elasticity less than zero.

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Y axis---------price of XDD ------------demand curve

Explanation:

Elasticity is represented by fraction distance from d to a point on the curve divided by the

distance from the other end to that point. Thus elasticity of demand is seen on the points P3,P2and P1 respectively. It is seen that elasticity at a lower point on the curve is less than at a

higher point.

3.Arc elasticity: Arc elasticity is a measure of the average responsiveness to price changes

exhibited by a demand curve over some finite stretch of the curve. This is explained with thehelp of a diagram below.


Y axis---------price of X


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Explanation:-i.Any two points on a demand curve make an arc the area between p and m on the DD curve is

an arc which measures elasticity over a certain range of prices and quantities.ii.On any two points of a demand curve the price elasticitys of demand are likely to be

different depending upon how we calculate them.iii.The closer the two points p and m are, the more accurate will be the measure of elasticity. iv.The arc elasticity is in fact the elasticity of the midpoint between p and m on the demand

curve .v.

If there is no difference between the two points and they merge into each other or coincide,

arc elasticity becomes point elasticity.

THE FACTORS DETERMING PRICE ELASTICITY OF DEMAND

i.Necessaries and conventional necessaries: people buy fixed quantities of such commoditywhatever is the price. The change in the price of wheat may be immaterial for upper classes,

but its consumption will certainly increase among the poor when the price falls. It may be

noted that demand for a necessity life as a whole may be inelastic, but in a competitive

market, demand for the output of any particular firm is highly elastic. If it raises the price abit, it may lose the entire market.

ii.Demand for luxuries is elastic: It stands to reason that lowering of the price of things like

radio will lead to more bring bought i.e. the demand is elastic. Thus for the same article thedemand may be elastic for some people and inelastic for others elastic in one country and

inelastic in another and elastic at one time and inelastic at another.

iii.Proportion of total expenditure: It a consumption good absorbs only a small proportion of

total expenditure, eg, salt the demand will not be much affected by a change in price hence, itwill be inelastic.

iv.Substitutes: The main cause of difference in the responsiveness of the demand for that thereare more completing substitutes for some goods than for others. When the price of tea rises,we may curtail its purchase and take of coffee, and vice versa. In a case like this a change in

price will lead to expansion or contraction in demand.

v.Goods having several uses: Coal is such a commodity when it will be used for severalpurposes e.g, cooking heating and industrial purposes; and its demand will increase. But ,

when the price goes up, it use will be restricted only to very urgent uses and consequentlyless will be purchased when the prices rises the demand will thus contract when wheat

becomes very cheap it can be used even as catt le feed hence demand for a commodity having

several uses is elastic

vi.Joint demand: If for instance, carriages become cheap but the prices of horses continue torule high, demand for carriage will not extend much. In other words the demand for jointly

demanded goods is less elastic.

vii.Goods the use of which can be postponed: Most of us during the war postponed our

purchases where we could e.g. building a house, buying furniture or having a number ofwarm suits. We go in for such things in a large measure when they are cheap demand for

such goods is elastic.

viii.

Level of prices: If a thing is either very experience or very cheap, the demand will be inelastic. If the price is too high, a fall in it will not increase the demand much. If on the other

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hand , it is too low, people will have already purchased as much as they wanted: any furtherfall will not increase the demand.

ix.Market imperfections: Owing to ignorance about market trends the demand for a good may

not increase hen its price falls for the simple reasons that consumers may not be aware of thefall in price.

x.Technological factors: Low price elasticity may be due o some technical reasons. For

example lowering of elasticity may be e lectricity rates may not increase consumption because

the consumers are unable to buy the necessary electric appliances.

xi.Time period: The elasticity of demand is greater in the long run than in the short run for the

simple reasons that the consumer has more time to make adjustment in his scheme ofconsumption. In other word he is able to increase or decrease his demand for a commodity

PRACTICAL APPLICATION (OR) IMPORTANCE (OR) SIGNIFICANCE OF

ELASTICITY OF DEMAND

i.

Taxation: The tax will no doubt raises the prices but the demand being in elastic, peoplemust continue to buy the same quantity of the commodity. Thus the demand will notdecrease.

ii.Monopoly prices: In the same manner, the businessman, especially if he is a monopolist,will have to consider the nature of demand while fixing his price. In case I is in elastic, it will

pay him to him to change a higher price and sell a smaller quantity. If, on the other hand, thedemand is elastic he will lower the prices, stimulate demand and thus maximize hismonopoly net revenue

iii.Joint products: In such cases separate costs are not ascertainable the producers will be

guided mostly by demand and its nature fixing his price. The transport authorities fix theirrates according to this principle when we say that they charge what the traffic will bear

iv.Increasing returns: When an industry is subject to increasing returns the manufacturerlowers the price4 to develop the market so that he may be able to produce more and take full

advantage of the economies of large scale production.

v.Output: Elasticity of demand affects industrial output reduction in price will certainly

increases the sale in the market as a whole.vi.Wages: Easticity of demand also exerts its influence on wages. If demand for a particular

type of labour is relatively inelastic, it is easy to raise wages, but not otherwise.

vii.Poverty in plenty: The concept of elasticity explains the paradox of poverty in the midst of

plenty. This is specially so if produce is perishable. A rich harvest may actually fetch lessmoney a poor one.

viii.Effect on the economy: The working of the economy in general is affected by the nature ofconsumer demand. It affects the total volume of goods and services produced in the country.

It also affects producers demand for different factors of production their allocation andremuneration.

ix.Economies policies: Modern governments regulate output and prices. The government can

create public utilities where demand is inelastic and monopoly element is present.

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x.International trade: The nature of demand for the internationally traded goods is helpful indetermining the quantum of again of gain accruing to the respective countries. Thus is how it

determines the terms of trade.

xi.Price determination: The concept of elasticity of demand is used in explaining thedetermination of price under various market conditions.

xii.Rate of foreign exchange:With fixing the rate of exchange, the government has to consider

the elasticity or otherwise of its imports and exports.

xiii.Relation between price elasticity average revenue and marginal revenue: Thisrelationship enables us to understand and compare the conditions of equilibrium under

different market conditions.

xiv.Price determination: Price determination is forced to be profitable if elasticity of demand inanother. The monopolist can charge a higher price in the market where elasticity of demand isless and a lower price where elasticity of demand is greater

xv.

Measuring degree of monopoly power: The less is the elasticity of demand higher will bethe price and wider the difference between the marginal cost and greater the monopolypower, and vice versa.

xvi.Classification of goods as substitutes and complements: Goods are classified as substituteson the basis of cross elasticity. Two commodities may be considered as substitutes if cross

elasticity is positive and complements when elasticity is negative.

xvii.Boundary between industries: Cross elasticity of demand is also useful in indicating

boundaries between industries. Goods with high cross elasticitys constitute one industry,where as goods with lower elasticity constitute different industries.

xviii. Market forms: The concept of cross elasticity help[s to understand different market formsinfinite cross elasticity indicates perfect market forms infinite cross elasticity indicates

perfect competitions, where as zero or hear zero elasticity indicates pure monopoly and highelasticity indicates imperfect competition

xix.Incidence of taxes: The concept of elasticity of demand is used in explaining the incidenceof indirect taxes like sales tax and excise duty. less is the elasticity of demand higher the

incidence, and vice versa. In case of inelastic demand the consumer have to buy thecommodity and must bear the tax.

xx.

Theory of distribution: Elasticity of demand is useful in the determination of relative sharesof the various factors determination of relative shares of the various factors of production is

loss elastic, its share in the national dividend is higher, and vice versa. If elasticity ofsubstitution is high the share will be low.

SUPPLY

The supply of a commodity means the amount of that commodity which producers are able

and willing to offer for sale at a given price. The supply curve is explained with the help of adiagram.

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X axis-----Quantity Supplied

Y axis------Price

Explanation: The figure shows that as the price of a commodity increases from P to P1, thesupply also increases from Q to Q1. It means that price & supply are directly related.

Reserve Price

If the price falls too much, supply may dry up altogether. The price below which the sellerwill refuse to sell is called Reserve Price. At this price, the seller is said to buy his ownstock.

Law of Supply

Other things remaining the same, as the price of a commodity rises, its supply increases; andas the price falls, its supply declines.

Supply function

Supply function of a firm or an industry (a group of firms) is an algebrate expression relating

the quantity of a commodity which a seller is willing and able to supply. The supply functioncan be written as: x=f (Px, FE, FP, PR, W, E, N) Where certain important determinants of supply are: Product price (Px), Factor productivitiesor State of Technology(FE), Factor prices(FP), rises of other products related in

production(PR), Weather, strikes and other short-run forces(W), Firms expectations aboutfuture prospects for prices, costs, sales and the sate of economy in general(E), Number (N)

Limitations of Law of Supply

i.Future Prices: When the price rises and the seller expects the future price to rise further,supply will decline as the seller will be induced to withhold supplies so as to sell later and

earn larger profits then.

ii.Agricultural Output: Law of supply may not apply in case of agricultural commodities as

their production cannot be increased at once following price increase.

iii.Subsistence Farmers: In underdeveloped countries where agriculture is characterised withsubsistence farmers, law of supply may not apply.

iv.Factors other than Price not Remaining Constant: The law of supply is stated on theassumption that factors other than the price of the commodity remain constant.

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FACTORS INFLUENCING SUPPLY

i.Goals of firms: The supply of a commodity depends upon the goals of firms.

ii.Price of the commodity: The supply of a commodity depends upon the price of thatcommodity. Ceteris paribus the higher the price of the commodity the more profitable it will

be to make that commodity. One expects, therefore, that the higher the price, the greater will

be the supply.

iii.Prices of all other commodities:The supply of a commodity depends upon the prices of allother commodities. Generally, an increase in the price of other commodities will make

production of the commodity whose price does not rise relatively less attractive than it waspreviously. We thus expect that ceteris paribus, the supply of one commodity would fall as

the price o f other commodities rises.

iv.Prices of factors of production: The supply of a commodity depends upon the prices of

factors of production. A rise in the price of one factor of production will cause a large

increase in the costs of making those goods which use a great deal of that factor, and only asmall increase in the cost of producing those commodities which use a small amount of thefactor.

v.State of technology:The supply of a commodity depends upon the state of technology.

vi.Time factor: Time factor can also determine elasticity of supply. Time can be broadlyclassified into three categories: Market period is the one where supply is fixed as no factor of

production can be altered.

vii.Short period is the time period when it is possible to adjust supply only by changing thevariable factors like raw-material, labor, etc., and Long period where supply can be changed

at will because all the factors can be changed.

viii.Agreement among the producers: Supply may be consciously decreased by agreement

among the producers.

ix.To raise price:Supply may also be destroyed to raise price.

x.Taxation on output or imports: Supply may also be affected by taxation on output or

imports. Government may also restrict production of certain commodities on grounds ofhealth (e.g., opium in India).

xi.Political disturbances or war may also create scarcity of certain goods.

CHANGE IN SUPPLY AND SHIFT IN SUPPLY

Change in supply means increase or decrease in quantity supplied at the same price. This is


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X axis-----Quantity SuppliedY axis------PriceSS- Supply Curve

Explanation: The figure shows that as the price of a commodity increases from P to P1, thesupply also increases from Q to Q1. It means that price & supply are directly related. The

movement of the supply is along the same curve. In other words increase in supply is knownas extension of supply & decrease in supply is known as contraction of supply.

SHIFT IN SUPPLY CURVE

Shift in supply means shifting the entire supply curve due to various reasons other than pricelike changes in technology, government policies etc. This is explained with the help of adiagram.

X axis-----Quantity SuppliedY axis------Price

Explanation: The figure shows that as the price of a commodity does not change but still the

supply curve shifts from SS TO S1S1 OR S2S2. It means shifting the entire supply curve isdue to various reasons other than price like changes in technology, government policies etc.

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ELASTICITY OF SUPPLY

It can be defined as the degree of responsiveness of supply to a given change in price.The formula to find out the elasticity of supply is:

Es = percentage change in quantity supplied / percentage change in price

TYPES OF ELASTICITY OF SUPPLY

i.Perfectly elastic supply:Where no change in price is needed to cause an increase in quantity

supplied. This is exp lained with the help of a d iagram.

X axis-quantity supplied

Y axis- priceSS- supply curve

Explanation: The elasticity of supply is infinity when a small change in price leads to aninfinitely large change in the quantity supplied. It is perfectly elastic supply. [E=]

ii.Perfectly in elastic supply: Here a large change in price causes no change in quantitysupplied. It is zero elastic supply [E=0]. This is explained with the help of a diagram.

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X axis-quantity suppliedY axisprice

SS- supply curve

Explanation: The figure shows that even if the price increases from p to p1 there is nochange in the quantity supplied.

iii.Unitary elastic: Where a given proportionate change in price causes an equally proportionate

change in quantity supplied. This is explained with the help of a diagram.


SS- supply curve

Explanation: Elasticity of supply is unity when the change in supply is exactly proportionateto the change in price. [E=1].

iv.Relatively elastic: Where a small change in price causes a more than proportionate change inquantity supplied. The price elasticity of supply is greater than unity [E >1].This is explained

with the help of a diagram.


SS- supply curve

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Explanation: The figure shows that there is a small increase in price from P to P1, but it hasresulted in a large increase in quantity supplied from Q to Q1. It is also known as relatively

elastic supply.

v.Relatively inelastic Supply: Where a large change in price causes a less than proportionatechange in quantity supplied. The elasticity of supply is lesser than unity [E


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vii.He knows the exact prices of various commodities and their utilities are not influenced byvariations in their price.

viii.

There are no substitutes.


X axisQuantity demandedY axisUtilityTU-Total UtilityDMU-Diminishing Marginal Utility

Explanation:

i.With the increases in the number of units consumed per unit of time, TU increases but at adiminishing rate.

ii.

The downward sloping Mu curve shows that marginal utility goes on decreasing asconsumption increases.

iii.At 4 units consumed, the TU reaches its maximum level the point of saturation and mu

becomes zero.beyond this MU become negative and TU begins to decline .

IMPORTANCE OF THE LAW OF DIMINISHING MARGINAL UTILITY

i.

Taxation: Progressive system of taxation, imposing a heavier burden on the rich people, is apractical application of this principle in the field of public finance. Richer a person thehigher is the rate of the tax he has to pay since to him the marginal utility of money is less.

ii.Price determination: The law explains why with increase in its supply, the value of a

commodity must fall. It thus forms a basis of the theory of value.

iii.Household expenditure: The law of diminishing marginal utility governs our daily

expenditure. Since one knows that a larger purchase will mean lower marginal utility, onewill restrict their purchase of a particular commodity, because they cannot afford to waste our

limited resources.

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iv.Downward sloping demand curve: It is this law which tells us why demand curve slopedownwards. It is due to this law that smaller utility lines cut larger portions of the

commodity line, i.e., X-axis.

v.Value-in-use and value-in-exchange: It also explains the divergence between value-in-useand value-in-exchange.

vi.Socialism: The marginal utility to the rich of the wealth, that they might lose, is not so great

as the marginal utility of the wealth which is transferred to the poor.

vii.Basis if some economic laws: Some very important laws of economics are based on the lawof diminishing marginal utility, ex. Law of demand, the concept of consumers surplus, theconcept of elasticity of demand, the law of substitution, etc. These laws and concepts haveultimately been derived from the law of diminishing marginal utility.

LIMITATIONS OF DIMINISHING MARGINAL UTILITY

i.

Utility cannot be measured cardinally: The basis of the utility analysis- that it ismeasurable- is defective because utility is a subjective and psychological concept whichcannot be measured cardinally. In really, it can be measured ordinally.

ii.Single commodity model is unrealistic: The utility analysis is a single commodity model inwhich the utility of one commodity is regarded independent of the other. Marshall

considered substitutes and complementary as one commodity, but it makes the utility analysisunrealistic.

iii.Money is an imperfect measure of utility: Marshall measures utility in terms of money, butmoney is an incorrect and imperfect measure of utility because the value of money often

changes.

iv.Marginal utility of money is not constant: The fact is that a consumer does not buy only

one commodity but a number of commodities at a time. In this way when a major part of hisincome is spent on buying commodities, the marginal utility of the remaining stock of money

increases.

v.Man is not rational: This assumption is also unrealistic because no consumer compares the

utility and disutility from each unit of a commodity while buying it. Rather, he buys themunder the influence of his desires, tastes or habits. Moreover, consumers income and pricesof commodities also influence his purchases. Thus the consumer does not buy commodities

rationally. This makes the utility analysis unrealistic and impracticable.

vi.Utility analysis does not study income effect, substitution effect and price effect: Theutility analysis does not explain the effect of a rise or fall in the income of the consumer on

the demand for the commodities. It thus neglects the income effect. Again when with thechange in the price of one commodity there is a relative change in the price of the othercommodity, the consumer substitutes one for the other. This is the substitution effect which

the utility analysis fails to discuss.

vii.Utility analysis fails to clarify the study of inferior and giffen goods: Marshalls utilityanalysis of demand does not clarify the fact as to why a fall in the price of inferior and giffen

goods leads to a decline in its demand.

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viii.The assumption that the consumer buys more units of a commodity when its price falls

is unrealistic: It may be true in the case of food products like oranges, bananas,

apples, etc. but not in the case of durable goods.

ix.It fails to explain the demand for Indivisible goods: The utility analysis breaks down in thecase of durable consumer goods like scooters, transistors, radio, etc. because they areindivisible. The consumer buys only one unit of such commodities at a time so the it is

neither possible to calculate the marginal utility of one unit nor can the demand schedule and

the demand curve for that good be drawn. Hence the utility analysis is not applicable to

indivisible goods.

THE LAW OF EQUI- MARGINAL UTILITY

It is also called as the law of substitution, or the law of indifference, or the law of maximum

satisfaction. It is called the law of substitution because when we substitute the more usefulone. It is known as the law of maximum satisfaction, because through its application we areable to maximize our satisfaction. According to the law of equi- marginal utility, it is only

when marginal utilities have been equalized, through the process of substitution. That one

gets maximum satisfaction.

Assumptions of law of equi- marginal utility

i.The utility analysis is bases on the cardinal concept which assumes that utility is measurableand additive like weights and length of goods.

ii.Utility is measurable in terms of money.iii.The marginal utility of money is assumed to be constant.iv.

The consumer is rational who measures, calculates, chooses and compares the utilities of

different units of the various commodities and aims at the maximization of utility.v.He has full knowledge of the availability of commodities and their technical qualities.

vi.

He possesses perfect knowledge of the choices of commodities open to him and his choicesare certain.

vii.

He knows the exact prices of various commodities and their utilities are not influenced by

variations in their prices.viii.There are no substitutes.


X axisQuantity demanded

Y axisIncomeUa-Total Utility of aUb-Total Utility of b

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Explanation:i.The curve Ua slopes downwards from left to right. This curve shows the marginal utility of

the money spent on commodity A.ii.The curve Ub which slopes downwards from right to the left.

iii.This curve shows the marginal utility of the money spent on the good B.iv.Suppose our hypothetical consumer has rs.10 to spend on the two goods a and b it will be

clear from the diagram that if he spend rs.6 on a good and rs.4 on b good , the marginal

utilities of both goods are equal (cd=ef)

v.

In this way , he will derive maximum satisfaction and any other arrangement will only

reduce the aggregate satisfactionvi.Suppose the consumer spends Re.1 more on the goods a and consequently Re.1 less on the

good b. as a result, the marginal utilities will become unequal (gh is greater than qr). In this

case the gain in utility is less than before. the gain in utility and loss thereof are shown in theshaded area

vii.Hence we may conclude that the consumer will get maximum satisfaction and will be inequilibrium if the marginal utilities of money spent on the various goods that he rays equal.

IMPORTANCE OF THE LAW OF EQUI-MARGINAL UTILITY

i.

It applies to consumption: Every consumer, if he is wise wants to get maximum satisfactionout of his limited resource. In arranging his expenditure to that end he must substitute thething till marginal utilities are equalized. In this way, the consumers satisfaction ismaximized.

ii.Its application to production: To the business man the manufactures the law is of specialimportance. He works towards the most economical combination of the factors of productionemployed by him for this purpose; he will substitute one factor for another till their marginal

productivities are made the same. In case he finds that marginal productivity of one factor,say labour is greater than that of capital it will pay him to substitute the former for the latter

in this way he will be able to maximize his profit.iii.Its application to exchange:In all our exchanger this principle work for exchange is nothing

else but substitution of one thing for another. The substitutional character of our exchange is

sufficient to basic economic principle.

iv.Price determination:This principle has an important bearing on the determination of value.When there is scarcity of a commodity the law of substitution to our help. We commodity,the law substitution comes to our help. We start substituting the less, scarce goods for the

more scarce ones. The scarcity of the latter is thus relived and its price comes down.

v.Its application to distribution: In distribution we are concerned with the determination of

the rewards of the various agents of productions, determination of rent wages interest andprofit these shares are determined-- according to the principle of marginal productivity. The

use of each agent of producing is pushed by the entrepreneur to the margin of profitablenesstill the marginal product in each case in the same in case it is not the same the law of

substitution will come into play to equalize their marginal productivity this is how the law ofsubstitution proves useful in the field of distribution of the national dividend among thevarious agents of production.

vi.Public finance: Public expenditure of the government conforms to this law even a

government is under the necessity of deriving maximum amount of the benefit from its publicexpenditure it must try to maximize welfare of the commodity. For this purpose it must cut

down all wasteful expenditure.

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LIMITATION OF THE LAW OF EQUI MARGINAL UTILITY

i.The law of equi marginal utility involves very careful calculation of the exceptedsatisfaction: The fact is that most of our expenditure is governed by habit . there is not much

of conscious calculation and careful weighing of the utilities.ii.Not applicable in case of small purchases: Only in the case of big expenditure a prudent

persons goes through a certain amount of thinking here we may take it that this expenditure

does roughly conforms to the law of maximum satisfaction but not applicable in case of small

purchases

iii.Law will not hold good in irrational purchases: All the rational and prudent persons areexcepted to act upon this law consciously or un consciously.

iv.Ignorance of consumer: The consumer may not be aware of other more useful alternatives.

Hence, no substitution does not operate.

v.Incapable of rational consumption: People are sometimes slaves of customs or fashion and

are incapable of rational consumption. Without being rational and calculating, a consumer

cannot substitute one thing for another.vi.

Goods are not divisible into small bits: Another limitation arises from the fact that goodsare not divisible into small bots to enable consumers to equalize marginal utilities cannot beequalisied.

vii.Resource are unlimited: The law of substitution has no place when the resource are

unlimited as in the case of free goods in such cases there is no need to re-arrange expenditurebecause no price is to be paid whatever the quantity used.

viii.No definite budget period:There is no definite budget period in the case of individuals

ix.

It rest on same questionable assumptions: The difference curve approach to the theory ofconsumers equilibrium is based on this basic criticism of the marshallian analysis.

THE CONCEPT OF INDIFFERENCE CURVE TECHNIQUE (OR) THE PRINCIPLEOF DIMINISHING MARGINAL RATE OF SUBSTITUTION

An indifference curve represents satisfaction of a consumer from tow commodities. It isdrawn on the assumptions that for all possible points or combinations of the tow commodities

on indifference curve the total satisfaction or utility remains the same. Hence, the consumer isindifferent as to the combinations lying on an indifference curve. It is an iso utility curve.

INDIFFERENCE MAP

A set of indifference curves is called an indifference map. This is explained with the help of adiagram.

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X axisGood XY axisGood YIC1-IC5Indifference Curves

MARGINAL RATE OF SUBSTITUTION

The marginal rate of substitution shows at what rate a consumer is willing to substitute one

commodity for another in his consumption pattern. This is explained with the help of adiagram.

X axisGood XY axisGood YICIndifference Curve

Explanation:

The figure shows that the consumer sacrifices of Good Y in every step in order to consumemore of Good X which is otherwise called as Marginal rate of substitution.

Assumptions of Indifference Curve

i.Completeness: We assume that the consumers scale of preferences is so complete that he isable to choose any one of the two combinations o commodities presented to him or is

indifferent between them.

ii.Non-satiation: A consumer prefers more to less.

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iii.Consistency or Transitivity: If a consumer regards Q better than R and R better than S,obviously he will prefer Q to S, if this choice is open. Consumers choice has to beconsistent.

iv.Continuity or Substitutability: Unless one combination can be substituted for another, theconsumers preference will not be possible.

v.Convexity: The indifference curve is convex to the origin and shows the diminishing rate of

marginal rate of substitution to be explained presently.

This can be explained with the help of diagram.


IC- indifference curve

Explanation:

i.If the consumer were a point A on the curve IC, he would be just as satisfied as at point B or

at point C or at point D and so on.ii.

These combinations give him the same satisfaction. If we join the points A, B, C, D and Ewe get a continuous curve IC, each point on it showing equal satisfaction or the indifference

of the consumer towards the various combinations.iii.

This is an indifference curve. Each point on it shows a combination of apples and mangoes

which yields the same total satisfaction to our consumer.

PROPERTIES OF INDIFFERENCE CURVE

i.Downward sloping (or) negatively sloped: To begin with, an indifference curve slopesdownwards from left to right. It is because when the consumer decides to have more units ofone of the two goods, he will have to reduce the number of the units of the other good,if he is

to remain on the same indifferences curve.i.e., if level of his satisfaction is to remain the

same.

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ii.Non- intersecting: The second property or characteristic of indifference is that no two suchcurves will never cut each other.

iii.Convexity: The third property of indifference curve is that they are normally convex to the

origin. The implication of this convexity rule is that as we have more and more of good x andless and less of y. the marginal rate of substitution of x and y goes on falling.

APPLICATIONS OF INDIFFERENCE CURVE TECHNIQUE

i.Application in consumption: The indifference curve technique can be used by thehouseholder in setting his purchase plan. A consumer endeavors to reach an equilibrium

position, i.e., a position in which he derives maximum satisfaction from his scheme of

purchases.

ii.Measurement of National Income: The indifference curve technique also lends itself formeasuring nat ional income. National income is the aggregate value of the net output of aneconomy. Each individual attaches the same relative importance to the commodities as their

price ratio. National income is produced by the members of the community and so also it is

consumed by them.

iii.Rationing: Rationing is another field in which the indifferent curve technique can be applied.Suppose in rat ioned commodity is allotted to each individual.

iv.Cost of living index: If the combinations of good purchased in two successive years are

allotted on the indifference curve, it can be shown whether the standard of living has risen offallen.

v.Price discrimination: It can be shown with the help of indifference curves that twoindividuals will derive greater satisfaction from the purchase of two commodities on a single

price system instead of under price discrimination.

vi.Taxation: Direct Vs Indirect Taxes: In the field of taxation too the indifference curve

technique can be usefully employed.

vii.Effect of a subsidiary: Suppose the low-income groups are supplied by the govt. somenecessaries (say, housing accommodation) at subsidized rates, (i.e., lower prices). Mostwelfare states like to help poor citizens in this manner.

viii.Effect of Taxation on willingness to work: A tax may induce a man to work more or work

less.

ix.Effect of increase in wages on supply or labour: In the case of poorly-paid workers, and

rise in the wage rate will not lead to a reduction in working time; it will only result in largerincome which will be utilized in purchasing more goods.

x.Other uses of Indifference curve: The use of indifference curve technique is not merelyconfined to the cases mentioned above. This technique is how being very widely used in

almost the entire economic theory.

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CRITICISM (OR) DRAWBACKS OF INDIFFERENCE CURVE ANALYSIS

i.Old wine in new bottles: It substitutes the concept of preference for utility. It replacesintrospective cardinalism by introspective ordinalism.

ii.Away from Reality: The fact that the indifference hypothesis, the more complication of thetwo psychologically, happens to be more economical logically, affords no guarantee that it is

nearer to the truth.

iii.Cardinal Measurement implicit in I.C Technique: The cardinal measurement of utility isimplicit in the difference hypothesis when we analyze substitutes and complements.

iv.Midway house: Indifference curves are hypothetical because they are not subject to directmeasurements,

v.Fails to explain the observed behavior of the consumer: Knight argues that the observedmarket behavior of the consumer cannot be explained objectively with the help of the

indifference analysis.

vi.

Indifference curves are non-transitive: The consumer is indifferent not because he hascomplete knowledge of the various combinations available to him but because of his inabilityto judge the difference between alternative combinations.

vii.The consumer is not rational: The indifference analysis, like the utility theory, assumes that

the consumer acts rationally.

viii.Combinations are not based on any principle: Since the combinations are made

irrespective of the nature of goods, they often become absurd.

ix.

Limited analysis of consumers behavior: Further, the assumption that the consumer buysmore units of the same good when its price falls is unwarranted.

x.Failure to consider some other factors concerning customer behavior: The indifferencecurve analysis does not consider speculative demand, interdependence of the preferences of

consumers in the form of Snob, Veblen and Band wagon effects, the effects of advertising ofstocks, etc.

xi.Two-goods Model Unrealistic: Again the two-goods model on which the indifferenceanalysis is based makes the theory unrealistic because a consumer buys not two but a large

number of commodities to satisfy his innumerable wants.

xii.Fails to explain consumers behavior in choices involving risk or uncertainty: Another

serious criticism leveled against the preference hypothesis is that it fails to explain consumerbehavior when the individual is faced with choices involving risk of uncertainty of

expectations.

xiii.Based on unrealistic assumption of perfect competition: The indifference curve technique

is based on the unrealistic assumptions of perfect competition and homogeneity of goodswhere as in reality the consumer is confronted with differentiated products and monopolistic

competition.

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xiv.All commodities are not divisible: When indivisible goods are taken in a combination theycannot be substituted without dividing them. Thus the consumer cannot get maximum

satisfaction from the use of individual goods.

CONSUMER SURPLUS

The excess of the price which he would be willing to pay rather than go without thing, over

that which he actually does pay, is the economic measure of this surplus satisfaction. It may

be the called consumers surplus.This is explained with the help of a diagram.

X axis-Units of commodityY axisprice that the consumer is willing to pay

Explanation:

The figure shows that at OA price OM units of commodity is sold, but sometimes theconsumer is also willing to buy even less commodity i.e OM1 at a high price of OA1 rather

than going without buying that commodity & this is called as consumer surplus.

IMPORTANCE OF PRACTICAL UTILITY OF CONSUMERS SURPLUS

i.

Conjectural Importance: It enables is to compare and advantages of environment and

opportunities, or conjunctural benefits.

ii.Public Finance: The finance minister considers while proposing fresh taxation, how muchthe people are willing to pay for a thing and how they will be affected by a rise in priceresulting from the imposition of a tax.

iii.Monopoly Value: Similarly, a businessman, especially a monopolist, will find that he can

easily raise price of his product if the commodity is yielding surplus of satisfaction to theconsumers.

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iv.Value-in-use and Value-in-exchange:The doctrine of consumers surplus, therefore, clearlybrings out the d istinction between value- in-use and value-in-exchange. It is large where the

value-in-use is large even though the value-in-exchange may be small.

v.Benefits from International trade: The larger this surplus, the more beneficial isinternational trade.

vi.Cost-Benefit Analysis: The concept of consumers surplus is found useful in working outcost-benefit analysis of an investment.

DIFFICULTIES OF CONSUMER SURPLUS (OR) DIFFICULTIES OF

MEASUREMENT OF CONSUMER SURPLUS

i.A complete list of demand prices is not available: As we do not know what prices we areprepared to pay for every one of the units, the whole of the consumers surplus cannot beascertained.

ii.

Necessaries: Consumers surplus in the case of necessaries of life and conventionalnecessaries is indefinite and immeasurable.

iii.Consumers circumstances: Some consumers are rich while others are poor. A rich man is

prepared to pay much more for a thing than go without it. This difference in the consumerscircumstances makes the measurement of consumers surplus difficult and in exact.

iv.Consumers sensibilities: Every consumer has his own tastes and sensibilities. Some desirea commodity more ardently than others, and are, therefore prepared to offer more. This

difficulty is also met, as in the above case, by the idea of average.

v.

Change in marginal utility of money: As we o on buying a commodity, less and lessamount of money is left with us. Hence, the marginal utility of each unit of money increases.But, when we measure consumers surplus, we do not make any allowance for this change inthe marginal utility of money.

vi.Change in earlier units: There is the further difficulty, viz., that with every increase in thepurchase of a commodity, the urgency of the need for the earlier purchase is d iminished andtheir utility decreases. This decrease in the utility of earlier units is not taken into account

when calculating the consumers surplus. To measure consumers surp lus precisely, it issuggested that the earlier parts of the list of demand prices should be continually redrawn.

vii.

Substitutes: Then, there is the difficulty arising out of the presence of substitutes.

viii.Commodities used for distinction: In such cases, ex: diamonds, the fall in price will notlead to increase in demand. The demand for them, therefore, may fall off. Hence, a fa ll in

price in such cases will not increase consumers surplus.

THE EFFECT OF PRICES ON CONSUMER EQUILIBRIUM (OR) DERIVE PRICE

CONSUMPTION CURVE

Price consumption curve: Now we shall describe how a consumers equilibrium shifts as aresult of a change in the price o f one of the goods, while his income and the price of the other

good remain the same (i.e., the price effect). This can be explained with the help of a diagram

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X axis-Good X

Y axis- MoneyPCC---Price Consumption curve

Explanation:

i.With a certain fixed income and given market prices of the two goods X and Y represented

by the price-income line ML1, the consumer is in equilibrium at point P1.

ii.Suppose the price of X falls, income and price of Y remaining unchanged, so that new price-income line becomes ML2, the consumer will be in equilibrium a point P2 on the higherindifference curve C2. In this position, he will be buying OH2 of commodity X.

iii.If the price of X falls further, so that the relevant price line is ML3, the consumer will be in

equilibrium at point P3 and will be buying OH3 of commodity X.

iv.When all the points such as P1,P2,P3,P4 are joined together we have the price consumption

curve shows how the consumption of commodity X changes as its price changes, theconsumers income and price of Y remaining the same.

THE SUBSTITUTION EFFECT ON CONSUMERS EQUILIBRIUM

Substitution effect: Substitution effect means he changes in the quantity of a good

purchased which is due only to the change in relative prices, money income remainingconstant. This is be explained with the help of diagram.

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X axis-Good X

Y axis- Good Y

Explanation:

i.The consumer is in equilibrium at point Q where the given price line PL is tangent to

indifference curve C1.

ii.When the price of X falls while the price of Y remains the same, the price line will shift toPH (because now more of X is purchased) and the consumer will be in equilibrium at R,where the new price line PH touches the indifference curve C2.

iii.To find out the substitution effect, we draw a hypothetical price line AB parallel to the price

line PH so that it (i.e., AB) should touch the indifference curve C1.

iv.

With price line AB, the consumer is in equilibrium at T on indifference curve C1.

v.At the point T, he gets the same satisfaction as at Q, because both Q and T are situated as on

the same indifference curve C1.

vi.Movement from Q to T on the same indifference curve C1 is due only to the relative fall in

the price of X.

vii.At the point T, the consumer buys MK more (at q he bought OM but at T h b uys OK) of Xthan at Q as X is now relatively cheaper.

viii.

This MK is the substitution effect which involves movement from Q to T.

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THE EFFECT OF INCOME ON CONSUMERS EQUILIBRIUM (OR) DERIVE THE

INCOME CONSUMPTION CURVE

Income Consumption curve: Income effect is the effect on the quantity demanded

exclusively as a result of change in money income, all prices remaining constant. This is beexplained with the help of diagram.

X axis-Good X

Y axis- MoneyICC---Income Consumption curve

Explanation:

i.

With price-income lineL1M1, the consumer is in equilibrium at point P1.

ii.Now suppose the income of the consumer increases so that his new price- income line is

L2M2. As a result of this increase in income, the consumer will move to a new equilibriumposition, at the point P2, on a higher indifference curve C 2 and will be buying OH2 of

commodity X and OQ2of commodity Y.

iii.Thus we get various points of equilibrium such as P1, P2, P3 for different levels of income,

prices of the commodities remaining the same. If the points P1, P2, P3, P4, etc., are joinedtogether by a line passing from the origin, we get, what is called Income consumption curve

(ICC).

CONSUMERS EQUILIBRIUM (OR) MAXIMISING SATISFACTION

The consumer is said to be in equilibrium when he obtains the maximum possible satisfaction

from his purchase, gives the prices in the market and the amount of money he has for makingpurchases.

Assumption:

i.

Our consumer has an indifference map showing his scale of preferences for variouscombinations of the two goods.

ii.He has a given and constant amount of money to spend on the goods and if he does not spendit on one good, he must spent it on the other.

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iii.Prices of the goods in the market are given and constant.

iv.Each of the goods is homogeneous and divisible and

v.The consumer acts rationally, that is, he tries to maximize his satisfaction.

TWO CONDITIONS OF EQUILIBRIUM:

i.The price line should be tangent to an indifference curve or MRS of one commodity foranother should be equal to their relative prices.

ii.

At the point of equilibrium an indifference curve must be convex to the origin.

This can be explained by the diagram.

X axisGood xYaxisGood yIC1,IC2,IC3,IC4, - Indifference curve

Explanation:

i.The consumer will be in equilibrium at the point p. the consumer will maximize his

satisfaction and be in equilibrium at a point where the price line touches (or its tangent to) anindifference curve.

ii.

Any combination other than p on the given price line can be shown to give less satisfactionto the consumer, for all other points on the price line must lie on indifference curves of a

lower order than that on which p lies.

FORECASTING

Forecasting is the process of estimating the future, based on the analysis of their past and

present behaviour. A forecast tries to define wheat one believers will happen in the future. Itsaim is to provide information for planning and decision making.

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FEATURES OF FORECASTING

i.Relates to future events: Forecasting relates to future events which are needed for planningprocess.

ii.Best use of available data: Forecasting uses the best available data and makes the bestinformed guess. There will be errors involved, so that all forecasts should state a plus or

minus margin of error.

iii.Take account of discontinuities:The further away the forecast the less accurate it is likelyto be. In all forecasts, it is important to take account of discontinuities, which can affect thedata trend.

iv.Statistical tools and techniques: The analysis of various factors may require the use of

various statistical tools and techniques.

v.Feedback mechanism:All forecasting system should include a feedback mechanism where

the actual results are compared with the forecast values and the forecasting system is

modified to make it more accurate in future.

IMPORTANCE OR NEED OF FORECASTING OR APPLICATIONS OF

FORECASTING WITHIN INDUSTRY

i.Inventory control/production planning: forecasting the demand for a product enables us tocontrol the stock of raw materials and finished goods, plan the production schedule, etc

ii.Investment policy: forecasting financial information such as interest rates, exchange rates,share prices, the price of gold, etc. This is an area in which no one has yet developed a

reliable (consistently accurate) forecasting technique (at least if they have or they havent toldanybody)

iii.Economic policy: forecasting economic information such as the growth in economy,unemployment, the inflation rate, etc is vital both to government and business in planning for

the future.

iv.Compel to think ahead: The process of making forecast and their review by authorities

compel them to think ahead, looking to the future, and providing for it.

v.Disclose the areas where necessary control is lacking: Preparation of the forecast may

disclose the areas where necessary control is lacking in the organization for its future courseof action.

vi.Helps to unity and coordinate plans: Forecasting, especially when there is participation

throughout the organization, helps to unity and coordinate plans.

vii.Helps in promotion of organization: Forecasting certainly helps in promotion of

organization by achieving its objectives in best possible way, since forecasting of futureevents is of direct relevance in achieving an objective.

viii.Key to planning process: Forecasting is the essential step in planning process. So, it is a key

to planning process. Planning decides the future course of action but forecasting to decide it.Therefore, forecasting generates the planning process.

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LIMITATIONS OF FORECASTING

i.Based on wrong assumptions:Forecasting is based on some assumptions. It assumes thatevents do not change rapidly or haphazardly but change on a regular pattern. These

assumptions may not hold good for all conditions or situations.

ii.Indicate the trend of future happening: they are not always true: Forecasts merelyindicate the trend of future happening: they are not always true. This is so because of thefactors taken into account for making the forecast. These factors are affected by human who

are highly unpredictable. Period of forecasting is also one of the factors affecting the forecast.Degree of error increases with increases in period of forecast.

iii.Time and cost factor: Another important of forecasting is time and cost factor, forecastingrequires past data and information. The collection and proper arrangement of such

information and data requires lot of time and money. Moreover, it requires lot of calculations

and selection of proper calculation method which requires lot of manpower and money.Therefore, most of the smaller organizat ion does not go for formal system forecasting.

VARIOUS TYPES OF FORECASTING

i.Long-range forecast:The long-range forecast usually covers a period of three to more years

and is used in areas such as planning for new products, facility location or expectation,research and development, and capital expenditures.

ii.Short- range forecast:The short- range forecast covers a time span of up to one year, butoften it is less than three months. It is used in areas such as purchasing, planning, job

assignments and scheduling, and levels of work force.

iii.Medium-range forecast: The medium-range forecast usually covers a time period from

three months to three years and finds applications in many areas including sales planning,budgeting, and production planning.

VARIOUS STEPS IN FORECASTING

i.Determine the objective:Determine the forecast applications and objective.

ii.Choose the items:Choose with care the items to be forecasted.

iii.Time horizon:Determine the forecast time horizon ( i.e., long, short, or medium)

iv.Forecasting models:Chose appropriate forecasting models.

v.Collect data: Collect the appropriate data required to make the forecasting underconsideration.

vi.Validate forecasting model:Validate the forecasting model with care.

vii.Relevant forecasts: Make all relevant forecasts.

viii.Implement results:Implement the appropriate results.

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VARIOUS METHODS OF FORECASTING

A.Qualitative Method: The qualitative methods provide forecasts that incorporate factorssuch as the decision makers emotions, personal experiences, and intuition. Some examplesof the qualitative methods are jury of executive opinions, Delphi method, consumer market

survey, and sales force opinion composite

i.Jury of Executive Opinion: This is the simplest method, in that the executive of theorganization each provides an estimate of future volume, and the president provides aconsidered average of these estimates.

ii.Delphi Method: The Delphi method makes use of a panel of experts, selected based on the

areas of expertise required. The Delphi method is an exercise in group communication amonga panel of geographically dispersed experts. The technique allows experts to dealsystematically with a complex problem or task.

iii.Consumer Market Survey: This method is mainly useful for predicting the sales forecastwhen it is introduced in the market. For a new product, there will be no historic or past dataavailable to forecast. In this method, field surveys are conducted to gather information on theintentions of the concerned people.

iv.Sales Force Opinion Composite: In this method, members of the sales force estimate sales

in their own territory, regional sales managers adjust these estimates for their opinion orpermission of individual sales people, and the general sales mangers massages the figuresto account for new products or factors of which individual salesman are unaware.

v.Scenario Building: In this method, the parameters of

Documents

UNIT II-MG2452-Engineering Economics and Financial Accounting Notes.pdf