1. Unit-2 : Application of Supply & Demand, Demand and
Consumer Behavior.
2. Meaning of Elasticity The term elasticity was developed by
Alfred Marshall, and is used to measure the relationship between
price and quantity demanded. Elasticity means responsiveness.
3. Elasticity A measure of a variable's sensitivity to a change
in another variable. In economics, elasticity refers the degree to
which individuals (consumers/producers) change their demand/amount
supplied in response to price or income changes.
4. Elasticity In economics, elasticity is the measurement of
how responsive an economic variable is to a change in another. For
example: "If I lower the price of my product, how much more will I
sell?" "If I raise the price of one good, how will that affect
sales of this other good?" "If we learn that a resource is becoming
scarce, will people scramble to acquire it?"
5. An elastic variable (or elasticity value greater than 1) is
one which responds more than proportionally to changes in other
variables. In contrast, an inelastic variable (or elasticity value
less than 1) is one which changes less than proportionally in
response to changes in other variables. Elasticity can be
quantified as the ratio of the percentage change in one variable to
the percentage change in another variable, when the latter variable
has a causal influence on the former.
6. Elasticity of supply Elasticity of supply refers to the
degree of response of the supply of a commodity to the change in
price Responsiveness of producers to changes in the price of their
goods or services Elasticity of supply is measured as the ratio of
proportionate change in the quantity supplied to the proportionate
change in price. Supply elasticity is defined as the percentage
change in quantity supplied divided by the percentage change in
price
7. Price elasticity of supply The price elasticity of supply
measures how the amount of a good that a supplier wishes to supply
changes in response to a change in price. Elasticity of supply
measures the responsiveness of supply to a change in price. THE
RATIO BETWEEN % CHANGE IN QUANTITY SUPPLIED TO THE % CHANGE IN
PRICE.
8. Price Elasticity of Supply Percentage Change in Quantity
Supplied Percentage Change in Price PES = Remember: Es =
coefficient of price elasticity QS = Quantity Supplied P = Price
PES = % QS % P
9. PEs > 1 supply is elastic PEs < 1 supply is inelastic
PEs = 1 Unitary Elastic PEs= Perfectly Elastic PEs= 0 perfectly
In-Elastic Types of price elasticity of supply
10. Figure 1. Elastic Supply Curve PRICE P1 P2 0 Q1 Q2 S
QUANTITY When the proportionate change in supply is more than the
proportionate changes in price, it is known as elastic supply or
relatively elastic supply.
11. Figure 2. Inelastic Supply Curve PRICE P1 P2 0 Q1 Q2 S
QUANTITY When the proportionate change in supply is less than the
proportionate changes in price, it is known as inelastic supply or
relatively inelastic supply
12. Figure 3. Unitary Supply Curve PRICE P1 P2 0 Q1 Q2 S
QUANTITY When the proportionate change in supply is equal to
proportionate changes in price, it is known as unitary elastic
supply
13. Figure 4. Perfectly Elastic Supply Curve PRICE P1 0 S
QUANTITY We say that supply is perfectly elastic when a 1% change
in the price would result in an infinite change in quantity
supplied.
14. Figure 5. Perfectly Inelastic Supply Curve PRICE P1 P2 0 S
QUANTITY We say that supply is perfectly inelastic when a 1% change
in the price would result in no change in quantity supplied.
15. Problem #1 An individual used to raise 10 bags which sell
on the market at a minimum of $8 each. For some reasons, the market
price per bag reached $10. He decided to raise 20. Let us find out
how elastic or responsive the production was to price.
16. Given variables? Qs1 = 10 P1 = $8 each Qs2 = 20 P2 = $10 Qs
= ? ; P = ? PES = ?
18. Qs 1 PES = = = 4 P 0.25 We conclude that the PEOS is 4 . So
PEOS is used to see how responsive or sensitive is supply of a good
to change in price.
19. What factors affect the elasticity of supply Spare
production capacity: If there is plenty of spare capacity then a
business can increase output without a rise in costs and supply
will be elastic in response to a change in demand. Stocks of
finished products and components: If stocks of raw materials and
finished products are at a high level then a firm is able to
respond to a change in demand - supply will be elastic. The ease
and cost of factor substitution: If both capital and labour are
occupationally mobile then the elasticity of supply for a product
is higher than if capital and labour cannot easily be switched.
Time period and production speed: Supply is more price elastic the
longer the time period that a firm is allowed to adjust its
production levels. In some agricultural markets the momentary
supply is fixed and is determined mainly by planting decisions made
months before, and also climatic conditions, which affect the
production yield.
20. Elasticity of demand refers to the responsiveness of
quantity demanded of a commodity to change in its determinant
Elasticity of Demand The degree to which demand for a good or
service varies with its price. Normally, sales increase with drop
in prices and decrease with rise in prices The demand elasticity
refers to how sensitive the demand for a good is to changes in
other economic variables.
21. Price elasticity of demand Price elasticity of demand is a
measure used in economics to show the responsiveness, or
elasticity, of the quantity demanded of a good or service to a
change in its price. More precisely, it gives the percentage change
in quantity demanded in response to a one percent change in price
(ceteris paribus, i.e. holding constant all the other determinants
of demand, such as income).
22. The Price Elasticity of Demand Price elasticity of demand:
The percentage change in quantity demanded caused by a 1 percent
change in price. Price elasticity of demand: how sensitive is the
quantity demanded to a change in the price of the good. This is a
measure of the responsiveness of quantity demanded relative to a
given price change. % Quantity Ep % Price D = D
23. PED > 1 Demand is elastic PED < 1 Demand is inelastic
PED = 1 Unitary Elastic PED= Perfectly Elastic PED= 0 perfectly
In-Elastic The Price Elasticity of Demand
24. Degrees Of Price Elasticity Of Demand 1) Perfectly elastic
demand 2) Relatively elastic demand 3) Elasticity of demand equal
to unity 4) Relatively inelastic demand 5) Perfectly inelastic
demand
25. Perfectly elastic demand P R I C E y 0 x Perfectly elastic
demand curve D D When the demand for a product changes increases or
decreases even when there is no change in price, it is known as
perfectly elastic demand.
26. Relatively elastic demand Relatively elastic demand curve P
R I C E demand0 x y D D When the proportionate change in demand is
more than the proportionate changes in price, it is known as
relatively elastic demand.
27. Elasticity of demand equal to unity Elasticity of demand
equal to unity curve y x0 demand P R I C E D D When the
proportionate change in demand is equal to proportionate changes in
price, it is known as unitary elastic demand
28. Relatively inelastic demand Relatively inelastic demand
curve XO Y demand D D P R I C E When the proportionate change in
demand is less than the proportionate changes in price, it is known
as relatively inelastic demand
29. Perfectly inelastic demand demand D D Perfectly inelastic
demand curve 0 Y X P R I C E When a change in price, however large,
change no changes in quality demand, it is known as perfectly
inelastic demand
30. Choice and utility theory Utility : An economic term
referring to the total satisfaction received from consuming a good
or service. Total utility: Total utility is the total satisfaction
obtain by a consumer by consuming all units of commodity. Marginal
utility is the additional satisfaction you get for every additional
unit Marginal utility : Marginal utility is a term used in the
field of economics. This term describes the utility of a product or
item. In other terms, it is the marginal use, or the amount of use,
of a good or service.
31. Difference: The difference between total utility and
marginal utility refers to the fact that a marginal utility is in
addition to the total utility. When a consumer increases the total
utility of a good consumed, the additional increase is then
referred to as a marginal utility.
32. Definition of Law of Diminishing Marginal Utility The law
of diminishing marginal utility states that as consumer consumes
more and more units of a specific commodity, utility from the
successive units goes on diminishing.
33. Explanation and Example of Law of Diminishing Marginal
Utility: Suppose, a man is very thirsty. He goes to the market and
buys one glass of sweet water. The glass of water gives him immense
pleasure or we say the first glass of water has great utility for
him. If he takes second glass of water after that, the utility will
be less than that of the first one If he drinks 3rd glass of water
the utility declines again and so on.
34. Units Total Utility Marginal Utility 1st glass 20 20 2nd
glass 32 12 3rd glass 40 8 4th glass 42 2 5th glass 42 0 6th glass
39 -3 Schedule of Law of Diminishing Marginal Utility From the
above table, it is clear that in a given span of time, the first
glass of water to a thirsty man gives 20 units of utility. When he
takes second glass of water, the marginal utility goes on down to
12 units; When he consumes fifth glass of water, the marginal
utility drops down to zero and if the consumption of water is
forced further from this point, the utility changes into disutility
(- 3).
35. Curve/Diagram of Law of Diminishing Marginal Utility: In
the figure (2.2), along OX we measure units of a commodity consumed
and along OY is shown the marginal utility derived from them. The
marginal utility of the first glass of water is called initial
utility. It is equal to 20 units. The MU of the 5th glass of water
is zero. It is called satiety point. The MU of the 6th glass of
water is negative (-3). The MU curve here lies below the OX axis.
The utility curve MM/ falls left from left down to the right
showing that the marginal utility of the success units of glasses
of water is falling.
36. Assumptions of Law of Diminishing Marginal Utility The law
is true under certain assumptions as follows: (i) Rationality: The
consumer aims at maximization of utility subject to availability of
his income. (ii) Constant marginal utility of money: The marginal
utility of money for purchasing goods remains constant. (iii)
Diminishing marginal utility: The utility gained from the
successive units of a commodity diminishes in a given time period.
(iv)Utility is additive: The utilities of different commodities are
independent.
37. (v) Consumption to be continuous (vi) Suitable Reasonable
quantity: If the units are too small, then the marginal utility
instead of falling may increase up to a few units. (vii) Character
of the consumer does not change. (viii) No change to fashion,
Customs and Tastes. (ix) No change in the price of the
commodity.
38. Limitations/Exceptions of Law of Diminishing Marginal
Utility (i) Case of intoxicants: The more a person drinks liquor
(alcohol), the more s/he likes it. (ii) Rare collection: If there
are only two diamonds in the world, the possession of 2nd diamond
will push up the marginal utility. (iii) Application to money: It
is true that more money the man has, the greedier he is to get
additional units of it.
39. Law of diminishing return A concept in economics that if
one factor of production (number of workers, for example) is
increased while other factors (machines and workspace, for example)
are held constant, the output per unit of the variable factor will
eventually diminish. The law of diminishing returns is a classic
economic concept that states that as more investment in an area is
made, overall return on that investment increases at a declining
rate, assuming that all variables remain fixed.
40. Law of diminishing return
41. Total, average and marginal product Total product: This is
the quantity of output produced by a given number of workers over a
given period of time. Remember the amount of capital (or machines)
is fixed. Average product: This is the quantity of output per unit
of input. In this model, the input is labour. In other words, we
are dealing with the output per worker, on average. Marginal
product:The addition to total output produced by one extra unit of
input (again, labour). It is the extra output produced at the
margin (i.e. by adding a marginal unit of labour).
42. Example Look at the table below. Let us assume that the
firm in question is making computer laser printers and they have
four machines in the factory (capital = 4). Capital Labour (L)
Marginal product (MP) Total product (TP) Average product (AP) 4 0 -
0 - 4 1 5 5 5.0 4 2 8 13 6.5 4 3 10 23 7.7 4 4 11 34 8.5 4 5 10 44
8.8 4 6 7 51 8.5 4 7 4 55 7.9 4 8 1 56 7.0 4 9 -2 54 6.0
43. Remember that capital is fixed in the short run. I have
assumed that capital is fixed at 4 units (or machines, in this
case). The second column shows the progressive addition of units of
labour. The third column shows marginal product (MP). Each figure
represents the output produced as a result of adding an extra
worker.
44. The fourth column gives total product (TP). This is
calculated quite easily by adding, cumulatively, the marginal
products. The first worker makes 5 units, so the total is 5. The
second worker adds a further 8 units, so the total is now 13 (5 +
8), and so on. In fact, you can work out the marginals from the
totals. Take the sixth worker, for example. His marginal product is
7. This can be calculated by taking the TP from six workers and
subtracting the TP from five workers (51 - 44). Algebraically: MP6
= TP6 TP5. (i.e. 7 = 51 44).
45. The fifth column gives average product (AP). The figures in
this column represent output (or product) per worker. The average
product once the eighth worker has been added is 7. This was
calculated by taking the TP with eight workers and dividing by the
number of workers (also eight). Algebraically:
46. Notice that the point at which diminishing marginal returns
sets in is to the left of the point where diminishing average
returns begins. Also, the total product keeps rising even though
the marginal, and the average, product is falling. This is not hard
to understand. Just because the marginal product is falling, it is
still positive. Hence, these extra workers may well be adding less
than previous workers, but they are still contributing to the grand
total. Total product keeps rising, albeit at a diminishing rate. It
is only when the marginal product is negative, with the addition of
the ninth worker that total product starts to fall. Finally, notice
that the marginal product curve cuts the average product curve at
its highest point, where it is momentarily flat. It is important
that you understand why this happens because this concept is
applied to the cost and revenue curves.
47. Definition: Consumer surplus is defined as the difference
between the consumers' willingness to pay for a commodity and the
actual price paid by them, or the equilibrium price. An economic
measure of consumer satisfaction, which is calculated by analyzing
the difference between what consumers are willing to pay for a good
or service relative to its market price. A consumer surplus occurs
when the consumer is willing to pay more for a given product than
the current market price. Consumer Surplus
48. Consumer surplus is the difference between what consumers
are willing to pay for a good or service (indicated by the position
of the demand curve) and what they actually pay (the market price).
The level of consumer surplus is shown by the area under the demand
curve and above the ruling market price
49. Consider the demand for public transport shown in the
diagram. The initial fare is price P for all passengers and at this
price, Q1 journeys are demanded by local users. At price P the
level of consumer surplus is shown by the area APB. If the bus
company cuts price to P1 the demand for bus journeys expands and
the new level of consumer surplus rises to AP1C. This means that
the level of consumer welfare has increased by the area PP1CB.
50. Indifference curve A diagram depicting equal levels of
utility (satisfaction) for a consumer faced with various
combinations of goods. Definition: An indifference curve is a graph
showing combination of two goods that give the consumer equal
satisfaction and utility. Each point on an indifference curve
indicates that a consumer is indifferent between the two and all
points give him the same utility. Indifference curve, in economics,
graph showing various combinations of two things (usually consumer
goods) that yield equal satisfaction or utility to an
individual.
51. As an example, consider the diagram above. This consumer
would be most satisfied with any combination of products along
curve U3. This consumer would be indifferent between combination
Q1a, Q1b, and Q2a, Q2b
52. The above diagram shows the U indifference curve showing
bundles of goods A and B. To the consumer, bundle A and B are the
same as both of them give him the equal satisfaction. In other
words, point A gives as much utility as point B to the individual.
The consumer will be satisfied at any point along the curve
assuming that other things are constant
53. Characteristics of indifference curve 1) An indifference
curve is always negatively sloping downward from left to
right.
54. 2) An indifference curve is always convex to the
origin.
55. 3) Indifference curve to the right represent higher level
of satisfaction
56. 4) Two or more than two indifference curve never
intersect/cross each other.
57. 5) Another additional property of an indifference curve is
that an indifference curve never touches "X" axis or "Y" axis.
58. 6. Indifference curves are infinite: Sample pictures of
indifference curves may show you one or two indifference curves.
However, the fact is that you can draw an infinite number of
indifference curves between two indifference curves.
59. 7. Indifference curves are not influenced by market or
economic circumstances. An indifference curve is purely a
subjective phenomenon and it has nothing to do with the external
economic forces. Indifference Map : A set of indifference curves
which shows different combinations is called an indifference
map.
60. Marginal rate of substitution : In economics, the marginal
rate of substitution is the rate at which a consumer is ready to
give up one good in exchange for another good while maintaining the
same level of utility.
61. The marginal rate of substitution (MRS) is calculated
between two goods placed on an indifference curve, displaying a
frontier of equal utility for each combination of "good A" and
"good B". The marginal rate of substitution is always changing for
a given point on the curve, and mathematically represents the slope
of the curve at that point. MRS is calculated using the following
formula: MRS= YX Good A Good B
62. Budget line A budget is defined as a financial plan. Its a
good idea to have a plan, a budget for your home and your business.
A budget is a financial plan , expressed numerically , prepared in
a year prior to the execution year. A budget line is a line showing
the alternative combinations of any two goods that a consumer can
afford at given prices for the goods and a given level of
income
63. Budget constraint Budget line :A graphical depiction of the
various combinations of two selected products that a consumer can
afford at specified prices for the products given their particular
income level. When a typical business is analyzing a two product
budget line, the amounts of the first product are plotted on the
horizontal X axis and the amounts of the second product are plotted
on the vertical Y axis
64. The budget line is the total amount of money a consumer is
has to spend on 2 goods. The price of the goods and the income of
the consumer are the constraints that limit the consumer from
buying how much he really wants. He has to decide on the correct
combination of the goods to buy and this would happen where the
budget line is tangent to the indifference curve. Indifference
curve showing budget line An individual should consume at (Qx,
Qy).
65. Shift in budget line Budget line is drawn with the
assumptions of constant income of consumer and constant prices of
the commodities. A new budget line would have to be drawn if either
(a) Income of the consumer changes, or (b) Price of the commodity
changes.
66. 1. Effect of a Change in the Income of Consumer: If there
is any change in the income, assuming no change in prices of apples
and bananas, then the budget line will shift. When income
increases, the consumer will be able to buy more bundles of goods,
which were previously not possible. It will shift the budget line
to the right from AB to A1B1, as seen in Fig. 2.9. The new budget
line A1B1 will be parallel to the original budget line AB.
67. 2. Effect of change in the relative Prices (Apples and
Bananas): If there is any change in prices of the two commodities,
assuming no change in the money income of consumer, then budget
line will change. It will change the slope of budget line, as price
ratio will change, with change in prices.
68. (i) Change in the price of commodity on X-axis (Apples):
When the price of apples falls, then new budget line is represented
by a shift in budget line (see Fig. 2.10) to the right from AB to
A1B. The new budget line meets the Y- axis at the same point B,
because the price of bananas has not changed. But it will touch the
X-axis to the right of A at point A1, because the consumer can now
purchase more apples, with the same income level. Similarly, a rise
in the price of apples will shift the budget line towards left from
AB to A2B.
69. (ii) Change in the price of commodity on Y-axis (Bananas):
With a fall in the price of bananas, the new budget line will shift
to the right from AB to AB1 (see Fig. 2.11). The new budget line
meets the X-axis at the same point A, due to no change in the price
of apples. But it will touch the Y-axis to the right of B at point
B1, because the consumer can now purchase more bananas, with the
same income level. Similarly, a rise in the price of bananas will
shift the budget line towards left from AB to AB2.
70. A2 A A1 BB1 B B2 A
71. Utility maximization The process or goal of obtaining the
highest level of utility from the consumption of goods or services.
The goal of maximizing utility is a key assumption underlying
consumer behavior studied in consumer demand theory. Economics
concept that, when making a purchase decision, a consumer attempts
to get the greatest value possible from expenditure of least amount
of money. His or her objective is to maximize the total value
derived from the available money