ECONOMIC ANALYSIS

UNIT I

OBJECTIVES / GOALS OF BUSINESS FIRMS

Firm & Industry

‘Firm’ is a unit of business control. It is defined as the unit controlling productive operations
by hiring the services of the factors of production and selling those commodities and
services either to other firms, households or to the central authorities. The industry consists
of many firms producing the same commodity and competing in the field. So the important
function of the firm is to execute the decision taken in production and marketing.

Objectives of the Business Firm

Profit maximization

Profits are the primary measure of the success of any business. The firms may not always try
to maximize profits. This may be due to a number of reasons:

(1) Achieving leadership: Firms often like to become leaders in the respective line
of business. They would rather try to attain industrial leadership at the cost of profits.
Leadership may connote either maximum sales or manufacture of maximum product
lines.

(2) For avoiding potential competition: ‘Firms may restrict the profit in order to
discourage other firms from entering the field and competing with them. If the firm
is maximizing profit, it would attract new firms to enter the field of production. In
order to avoid such potential competition, the firms may adopt a policy of profit
restriction.

(3) For preventing Governments’ intervention: Higher profits in business are considered
as a sign of monopoly power. Maximum profit may create an impression that the
firm is exploiting the consumers and this may result in the public demand for
nationalizing the firm or firms. The government may also probe into the financial
structure of the firm; make regulation of prices, profits and dividends. Just to solve
this problem firms may adopt a policy of restricted profits.

(4) For maintaining customer’s good will: In modern business, customer’s goodwill is
valued more than anything else. To maintain this, the firms may adopt the policy of
restricted profit and low price for the commodity. Even in times of increased taxes
and excise duties, firms may not increase the price, but reduce the profit margin and
win goodwill of customers.

(5) For restraining wage demands: Higher profit is an indication of ab1Iiij to pay higher
wages by the firms. Organized Trade Unions advance their arguments on the basis of
higher profits earned by the firm for increasing the wages of labourers, bonus
benefit, etc.

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 (6) For achieving financial soundness and liquidity: Some firms may give greater
importance to financial soundness and liquidity, rather than profit-maximization.
Considerations of maximum profit may result in huge investment in fixed assets and
consequently the liquidity of the firm will be reduced.

(7) For avoiding risks: Profit maximization may involve risks. Business Managers will
avoid taking those risks which may result even in losing their jobs or losing the
image of the firm. Though firms may not aim at profit maximization, they may try
their best to achieve sufficient profit to cover the risk of economic activity. The
businesses try to survive by avoiding losses.

Welfare Goals

Business firms also may have to promote some welfare goals. The beneficiaries of the
welfare goals are (i) Employees and (ii) Society.

Business firms may have to look into the welfare of its workers. They have to provide
welfare activities like housing facilities to workers, medical facilities, and schooling
facilities for their children and better living conditions through better wages, more leisure
and providing cultural activities. In these days of scarcity of essential commodities,
procurement and distribution of these commodities through co-operative organization should
be encouraged by the business firms in the colonies of workers.

Business firms may also provide facilities to the society. Building of hospitals, charitable
dispensaries, parks, libraries, schools, roads and Kalyana Mandapams may be carried
out.

UNIT II

DEMAND

In economics, demand for a commodity refers to the desire backed by the necessary
purchasing power. Further, person should have the willingness to purchase the commodity.
Demand for a commodity arises from

(a) Desire for the commodity,

(b) Ability to pay the price for the commodity and

(c) Willingness to pay the price

Demand is defined as “a desire for a commodity backed by willingness and ability to pay a
price”. The demand should be expressed in terms of quantity at a particular price. The
demand changes with time, say, a day, week, month or year depending upon the nature of the
commodity. Demand is the various quantities of a given commodity or services which
consumers would buy in one market in a given period of time at various prices, or at various
incomes, or at various prices of related goods.

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Demand

(i) It is not mere desire, but desire with the capacity and willingness to purchase.

(ii) Demand is always related to price. The quantity demanded should be expressed only in
terms of the price of that commodity.

(iii) Demand should be referred to per unit of time.

(iv) Demand varies for a commodity with variations in income.

(v)Demand for a commodity varies with variations of prices of related goods.

Demand schedules and Demand curves

A demand schedule is Alfred Marshall’s contribution to the techniques of price theory.

Demand schedule is a table or statement showing how much of a commodity is demanded
(purchased) in a particular market at different prices. It is a list of prices and quantities. A
demand schedule may be individual demand schedule or market demand schedule. Market
demand schedule is the sum total of individual demand schedule.

Table 1 - Individual Demand Schedule

Price of Butter Quantity Demanded

Per Kg (In Rs.) Per Month
20 1
18 2
16 3
14 4
12 5
10 6

It is clear from the schedule that when the price of butter is at Rs.20/-, consumer demands
just one Kg. When the price falls to Rs. 16/-, he has a demand for 3 Kgs. When the price
falls still further to Rs. 10/-, he could demand 6 Kgs.

Market demand schedule is the sum total of individual demand schedules.

Table 2 - Market Demand Schedule

Consumer Total
Price of Butter Individual Quantity
Per Kg (in Rs.) Demand Demanded
A,B,C,…..N (Kg.s)
60 a,b,c,d,…….n 20000
54 e,f,g,h,…..j 25000
48 k,l,m,n,……..p 30000
42 q,r,s,t,…….u 35000
36 v,w,x,…….z 40000
30 a1,b1,c1,….. n1 50000

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In another method of calculation, for market demand schedule, as it will be very difficult to
add up the demand schedules of all persons in the market, the demand schedule of an
average consumer is taken up as the representative consumer schedule. This is multiplied by
the number of consumers in the market to arrive at market demand.

Demand curves can be constructed from the demand schedules. The demand curves are
graphical representation of demand schedule. Demand Curves may be a straight line, or a

Figure 1 - Demand Curves

convex curve or a concave curve, or partly one and partly another. Most actual demand
curves are squiggles rather than straight lines. The imaginary demand curves based on the
imaginary schedules will be a smooth descending curve or straight line indicating that more
quantities will be bought at a lower price than at a higher price, other conditions of demand
remaining the same. In the demand curves, ‘x’ axis represents quality and ‘y’ represents
price.

In addition to individual consumer demand curve and the market demand curve given
already, there are two other demand curves. They are (i) Seller’s Average revenue curve and
(ii) Aggregate demand curve. The seller’s average revenue curve indicates how much a
seller can sell his product in a market at different prices. The aggregate demand curve
indicates the quantities of all goods taken together, which will be bought in the country at
different levels of national income.

LAW OF DEMAND

The Law of Demand studies the relationship between the price of a commodity and the
quantity demanded in the market. When other things being equal, the quantity demanded
extends with a fall in price and contracts with a rise in price. The quantity demanded varies
inversely with the price. A person will purchase more of a commodity when its price falls
and he will purchase less of it when its price rises. The greater the amount to be sold, the
lower must be the price to attract purchasers. Marshall defined the law of demand as “The
greater the amount to be sold, the smaller must be the price at which it is offered in order
that it may find purchasers, or in other words, the amount demanded increases with a fall in
price and diminishes with a rise in price.”

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Factors Influencing Demand

(i) The demand depends upon the number of consumers in the market. Larger the
consumers, larger will be the demand and the number of consumers depends on the size of
the population.

(ii) Demand depends on the level of income and wealth of the consumers. A rise in income
will push up the demand and a decline in income will bring down the demand. This is called
‘income effect’ in consumption.

(iii) Demand depends on tastes, preferences, customs and habits of the consumers. Tastes
and preferences are created or changed by continuous advertisements.

(iv) Existence of substitutes for a commodity will affect the demand for a commodity. If the
price of coffee is high, the demand for tea will go up as tea is a substitute for coffee.

(v) Expectation of the consumer about the future will also alter the demand of the
commodity. If consumers anticipate changes in supply conditions or prices, the demand for
that commodity will also change.

(vi)The demand may change due to changes of weather. Demand for cool drinks, ice-cream
etc., will go up during summer and fall down in winter and demand for umbrella will go up
during the rainy season.

(vii) Demand for prestige goods like diamonds and jewellery will not change as they are
‘status symbols’.

The law of demand operates only if the above things remain unchanged. A change in any
one of the factors will lead to inoperative market.

The demand function for a commodity can be stated as:

Q = f (P, Y, PR, W)

where P= price, Y = income, PR = prices of related goods and W = for wants or tastes. The
main determinants of demand are price of that commodity, prices of other related goods,
income of the consumers and their tastes, etc. If all other things are kept constant, demand
will be the function of price.

Types of Demand

There are three kinds of demand namely Price Demand, Income Demand and Cross
Demand.

(1) Price demand refers to various quantities of a commodity or service that a

consumer would purchase at a given time at different prices in a market when
other things remain constant. It is assumed that other things like the income of
the consumer, prices of the related goods, etc., remain the same. Further, it also
assumed that the consumers do not expect any further changes in price. The law
of demand relates generally to price demand. The price demand curve will slope
downwards from left to right.

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 (2) Income demand refers to the different quantities of a commodity or service which
consumers will buy at different levels of income when other things remaining the
same. The income demand curve will slopes upwards from left to right showing
that the consumers will buy greater quantity of a commodity as their income
increases. Demand will move in the direction of the income as they are directly
proportional. But in the case of price demand, the relationship between price and
quantity are inversely proportional, and they will move in opposite directions.

Figure 2 - Income Demand Curve for a Normal Commodity

But there is an exception to this. Goods which are inferior will not be purchased in large
quantities even if the income of the consumer rises. In that case, the shape of the curve will
be sloping downwards, i.e.. negative. From the curve we can understand that the consumer
purchases lesser and lesser quantities of this inferior commodity when his income increases.
The consumer, when his income increases, takes to the purchase of superior goods
discarding inferior goods. So the curve slopes downwards. Inferior goods which are
purchased at lower income and purchased in small quantities at high income are called
‘Giffen Goods’.

Figure 3 - Income Demand Curve for an Inferior Commodity

(3) Cross demand refers to the quantities of a commodity or service which will be
purchased with reference to changes, not of that particular commodity, but of
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 other interrelated commodities, other things remaining the same. For example, if
there is a rise in price of coffee, people will demand tea and consequently the
demand for tea will increase though the price of tea remains constant and the
income of the consumers also remains constant. The price effect in one
commodity will have a reaction on the other commodities which are related. The
two related commodities may be substitutes or complementary goods. If they are
substitutes, the increase in demand in one will decrease the demand in the other.
If they are complementary goods, the increase in demand of one will also result
in increase in demand of the complementary commodities. Example: Increase in
demand for tea will reduce the demand for coffee as both are substitutes. Increase
in demand for fountain pens, automatically increases the demand for ink as both
are complementary goods.

Figure 4 - Cross Demand Curve for Substitutes

If the two commodities are substitutes, the cross demand curve of coffee and tea will have a
positive slope. The cross demand curve slopes upwards (positive) showing that more
quantities of a commodity will be demanded whenever there is a rise in price of a substitute
commodity. In the figure, quantity demanded of tea is given on X axis. Y axis represents the
price of coffee which is a substitute for tea. When the price of coffee increases, consumers
will not demand coffee or the demand for coffee becomes less due to the operation of the
Law of demand. But the consumers will go in for ‘tea’ in the place of coffee’. The price of
tea is assumed to be constant. So, whenever there is an increase in price of-one commodity,
the demand for the substitute commodity will increase.

If two goods are complementary, the Cross Demand curve will have a negative slope. The
price demand will have a reaction on the other commodity which is closely related or
complementary. For instance, an increase in demand for pen will necessarily increase the
demand for ink; so also bread and butter, horses and carriages, etc. Whenever there is a fall
in demand of fountain pens due to the rise in prices of fountain pens, the demand for ink will
fall down, not that the price of ink has gone up but because of the price of fountain pen has
gone up. Since both are directly and proportionately related, the demand curve will slope
down.

Figure 5 - Cross Demand Curve for Complementary Goods

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Why does the demand curve slope downwards? (or) What is the economics behind Law
of Demand?

Demand curves slope downwards from left to right. This is because of the inverse
relationship between price and quantity demanded. This is because of:

(a) Operation of the law of diminishing marginal utility:

The additional units consumed or purchased give lesser and lesser utility. The
consumer will never pay a price or money value more than the marginal utility of a
commodity. So the consumer will not buy a large quantity unless the price is low. Eg.
A man derives utility worth Rs.5 from the first mango consumed and utility worth
Rs.3 from the second. If the price of mango is Rs.5 each, he will buy just only one
because the marginal utility derived from that is equal to the price paid, viz., Rs.5.
He will not buy the second mango as the utility contained in the second mango is
only Rs.3 whereas he has to pay Rs.5. A rational consumer will buy more for getting
lesser satisfaction. The sacrifice of the consumer (i.e., price paid) should be equal to
the satisfaction derived. Suppose the price of mango falls to Rs.3 each, the consumer
in discussion will buy two mangoes as the marginal utility and the price are equal.
The Law of Demand is the result of the Law of Diminishing Utility.

(b) Income effect:

The fall in the price of a commodity leads to an increase in the income of the
consumer because he has to spend less for purchasing the same amount of
commodity as before. After having purchased his usual quantity, the consumer finds
some money left with him. This increases the real income. The money so gained can
be used for purchasing some more units of that commodity.

(c) Substitution effect:

When the price of a commodity falls, the particular product will be demanded instead
of demanding costlier things. Consumer will gain out of this. If the price of coffee
falls, it will be used by some people instead of other beverages to some extent. If the
price of a commodity rises, other commodities will be used in its place to some

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 extent. Therefore, a fall in the price of a commodity increases demand and a rise in
its prices reduces demand. Normally, the substitution effect will be stronger than
income effect.

(d) Principle of Different uses: Certain commodities can be put to various uses. If the
price of that commodity is very high, the demand will be restricted and will be
consumed only for important uses. If the price falls, the commodity will be utilized
in less important uses and demand will go up. For example, if the charge for
electricity is too high, it will be used only for important uses. If it becomes cheaper,
the electricity will be used for various purposes. When the price of a commodity
falls, some people who were formerly unable to buy it, would be able to do so.

Exceptions to the Law of Demand or Perverse Demand Curves

The law of demand tells that prices and quantities of a commodity are inversely related.
There are certain peculiar cases in which the law of demand will not hold well. In those
cases more will be demanded at higher prices and less will be demanded at a lower price.
Here, the demand curves will not be in usual shape and they are called exceptional demand
curves or perverse demand curves. Such demand curves can be in the following cases:

(a) Prestige goods:

Articles of prestige value or snob-appeal or articles of conspicuous consumption are

demanded only by the rich people and these articles become more attractive if their
prices go up and they will not conform to the law of demand in the usual sense. This
was found out by Veblen in his doctrine of ‘Conspicuous Consumption’ and hence
this effect is called Veblen effect.

(b) Speculative goods:

In the speculative market, particularly in stocks and shares, more will be demanded
when the prices are rising and less will be demanded when the prices decline.

(c) Giffen effect or Giffen paradox:

Robert Giffen discovered that the poor people will demand more of inferior goods if
their prices rise and demand less if their prices fall. Poor people consuming larger
amount
of inferior cereals will find their real ‘money-income’ falling when the price of
inferior goods rise. Hence, they will reduce the expenditure on other superior items,
conserve their little income and demand more of the inferior commodity. Giffen
goods mean inferior goods.

(d) Demand for Necessaries:

The law of demand does not apply in the case of necessaries of life. Irrespective of
price changes people have to consume the minimum quantities of necessary
commodities.

(e) Scarcity, Inflation, Price Delusion, etc:

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 The law of demand will not operate in times of acute scarcity or shortage of
commodities. People will become panicky and buy more when prices are rising.
When there is hyper-inflation people will demand more, fearing that prices would go
up still further. Some consumers will be deluded by the price under the notion that
high priced articles are superior and low priced articles are inferior. Due to this price
delusion, people will demand more of the commodity, if the price increases. This
holds good in cases of fancy and fashion articles like lipstick, creams, powders and
other articles of personal attraction.

Difference between ‘Change in Demand and Amount Demanded’

If a person buys more because the price has fallen, it is only an extension of demand. This
can be called change in the quantity demanded. But there is no change in the ‘demand’ itself.
Extension and contraction of demand indicate movement along the same demand curve.
Other things are assumed constant and the price change is studied in the form of changes in
the quantity demanded. In the following figure any movement on the demand curve DD
refers to contraction and expansion of the quantities demanded. Thus, amount demanded
changes only with reference to price.

In the figure when the price is OP, OM amount is demanded. When the price falls to OP1,
0M1 amount is demanded.

Figure 6 - Change in Amount Demanded

Apart from price, if other factors like population, tastes, changes in incomes, changes in
trade conditions etc., cause change in demand, it is a change in demand itself. Consequently,
the demand curve shifts either upwards or downwards, as shown below.

Figure 7 - Change in Demand

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Elasticity of Demand

Meaning and definition

The law of demand tells us the direction of change. But it does not tell about the quantum of
change. How much the quantity changes with the change in price is not known. This is
explained by the elasticity of demand. The relationship between small changes in price and
the consequent changes in the amount demanded is known as elasticity of demand. This tells
us the rate of change.

Marshall defined it as follows: “The elasticity (or, responsiveness) of demand in a market is

great or small according to the amount demanded increases much or little for a given fall in
the price and diminishes much or little for a given rise in price.” Marshall introduced this
concept of elasticity of demand in economic theory. Elasticity of demand is related to
extension or contraction of demand for a fall or rise in price. So it is said as Price Elasticity
of Demand.

Price Elasticity of Demand

Marshall was the first economist to give a clear formulation of price elasticity as the ratio of
a relative change in quantity to a relative change in price. If E stands for Elasticity, then,

Price elasticity of demand is the ratio of proportionate change in the quantity demanded of a
given commodity to a proportionate change in its price. This means

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E or Elasticity of demand is also called co-efficient of Elasticity of demand. If E is greater
than one, the demand is said to be elastic. If E is less than one, the demand is said to be,
inelastic, and if E happens to be equal to one, the demand is unity.

If a 1% rise in price is followed by a contraction of demand of more than 1 %, the demand is

elastic. Similarly, if a 1 or 2 % fall in price is followed by more than 1% or 2 % extension of
demand respectively, the demand is elastic. On the other hand if a 1% change in price results
in less than 1 % change in quantity demanded, demand is inelastic. If the change in price by
1 % results in change in demand by 1%, the demand is said to be of unit elasticity.

There are some commodities for which demand will be inelastic when compared to other
commodities for which demand will be highly elastic. There are two extremes for elasticity,
viz., completely inelastic (if E happens to be Zero) and perfectly or infinitely elastic if E
happens to be infinity.

(1) Perfectly or infinitely Elastic Demand: In this condition a very small change in price will
result in infinitely large response in the demand. A small rise in price may result in the
contraction of demand even to zero and a small drop in price may result in extension of
demand to unimaginable quantity. Thus E = ∞. This is impractical in life.

Figure 8 - Perfectly or Infinitely Elastic Demand

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The demand curve DD1 is a horizontal straight’ curve showing that at price OP any amount
is demanded and if the price goes up, the consumer stops purchase.
(ii) Perfectly inelastic demand:

Figure 9 - Perfectly inelastic demand

Here the response in demand to change in price is almost nil. Even a large fall in price will
not induce an increase in quantity of demand, nor will a large rise in price prevent the
consumers from buying less. Elasticity E = 0. Such a commodity cannot be found in real
life.

The demand curve DD2 in the above figure shows that a fixed quantity will be purchased
whatever changes take place in price. The curve is vertical straight line showing no change
in the quantity demanded.

(iii) Relatively Elastic Demand: This is a condition when a small change in price will lead to
a very big change in the quantity demanded. In this case, E > 1. It is called relatively elastic
demand.

Figure 10 - Relatively Elastic Demand

This condition can be had in many commodities in the real world. A small fall in the price of
luxury or comfort commodities will expand the demand for that commodity largely. A rise in
price will contract the demand.

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In the figure, DD3 is flatter and the slope is not steep, but gentle. It shows that the quantities
demanded are larger to a change in price. The drop in price P to P1 has made an extension of
ddemand from M to M1 which is comparatively larger than the fall in price.

(iv) Relatively Inelastic Demand:

Figure 11 - Relatively Inelastic Demand

A larger change in price will result in smaller change in the quantity demanded. It is elastic
as E < 1. Commodities that are necessaries of life will have inelastic demand. In this case,
demand curve will be steeper as in the figure.

The demand curve DD4 is steeper showing that in spite of step fall in price, the quantity
demanded has gone up only very little. When price changes from P1 to P2, the quantity has
changed from X1 to X2 which is smaller than P1P2.

(iv) Unit Elasticity of Demand: A change in price will result in exactly equal change in the
quantity demanded. If E = 1, the elasticity is unitary elastic. In the figure, demand curve
DD4 slopes more or less uniformly so that P1P2 is equal to AB. Change in price has created
an equal change in quantity demanded. This type of unit elasticity is very rare.

Figure 12 - Unit Elasticity of Demand

Factors Influencing Elasticity of Demand

The following factors influence elasticity of demand either individually or cumulatively.

1. Nature of commodity:

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 Demand for goods depends on nature of commodity and their degree of necessity,
comfort or luxury. The demand for necessaries such as rice, wheat, salt, etc., will be
inelastic. People would demand a minimum quantity whatever be the price.
Demand for comforts and luxuries may not have inelastic demand.
In necessities having substitutes, demand will be elastic and commodities with no
substitutes will have inelastic demand.
In case of diamonds, any minor change in price will not affect its demand.
What is luxury to one group may be comfort for another group and necessity for
another group.
2. Uses of the commodity:
If a commodity has only one use, a change in price will not affect the demand much.
So it will not affect the demand so it will have inelastic demand. If it has a number of
uses, change in price will affect its demand. It will have elastic demand. In case of
price rise, the commodity will be demanded only for essential uses.
3. Existence of substitutes:
Commodities with substitutes will have elastic demand and goods with no substitutes
will have inelastic demand. When price of a commodity rises, people would demand
substitutes. If a commodity does not have substitute at all eg. salt, any change in
price will not affect demand so demand will be inelastic.
4. Postponement of demand:
If demand cannot be postpones, it will have inelastic demand. eg. demand for rice
and medicines. If demand can be postponed eg. fruits, the demand will be elastic.
More will be purchased when price comes down.
5. Amount of money spent:
If consumer spends only a little amount on a particular commodity, its demand will
be inelastic. Eg. expenditure on salt and match boxes. In case of items like clothing
or food, a large proportion of income is spent. So demand will be elastic.
6. Habits:
If consumers are addicted to some habits and customs, then demand will be inelastic.
Eg. smoking a particular brand of cigar. But if rise in price is for a long time, even
addicts would try to find some alternative.
7. Range of prices of commodities:
At a very high range of prices, the demand will be inelastic. Also at a very low range
of prices, demand will be inelastic. Eg. When price of a car is .10,00000, neither a
drop in .1000 or rise in .2000 will affect its demand. Only in middle range of price,
demand would be elastic or moderate.
8. Time factor in elasticity:
Demand for a commodity may be for a day, a week, a month, a year or for several
years. Demand for any commodity will be inelastic during short period and
comparatively elastic during long period. If price of a commodity falls, demand may
not rise immediately as it will take some time for consumers to know about it. As in
short time, they may be able to change their habit or pattern of expenditure. Similarly
a rise in price will not immediately reduce the quantity demanded during short time.
Consumers find it very difficult to make adjustments with substitutes.

Income elasticity of demand

The relation between changes in income of the consumer and consequent change in quantity
demanded is called income elasticity of demand. Income elasticity of demand tells us the
responsiveness of consumer towards changes in his income. Benham defines it as “the

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percentage increase in a person’s demand for a good due to a percentage increase in his real
income.”

Eg. if daily income of a consumer rises from .200 to .204 and his purchase of a commodity
X increases from 50 to 60 units, then income elasticity of X is

Ei = 10

Income elasticity can be classified in to

1. Zero income elasticity of demand:

Here a given increase in consumers money income will not evoke any increase i
n the quantity demanded of a commodity. Ei = 0
2. Negative income elasticity of demand:
Here an increase in money income of the consumer will lead to decrease in the
quantity purchased of a commodity. It’s possible in case of inferior goods. Ei < 0
3. Unitary income elasticity of demand:
Here the proportionate of income spent on commodity remains exactly the same after
the increase in income. Ei = 1
4. Income elasticity of demand greater than one:
When consumer spends a larger proportion of his increased income on the
commodity when he becomes richer. So Ei> 1. This will apply for luxuries.
5. Income elasticity of demand less than one:
When consumer spends less proportionate of his increased income for purchase, Ei <
1. This will apply for necessaries.

Figure 13 - Income elasticity

Cross elasticity of demand

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It tells us the extent of change in quantity demanded of commodity A due to change in price
of commodity B which may be a substitute or a complementary for commodity A.

Substitutes

Figure 14 - Substitutes

If A and B are substitutes, if B’s price increases, consumers will buy commodity A. if price
of B falls and A remains constant, then demand for A will be contracted. If A and B are
perfect substitutes, then cross elasticity will be infinity. The cross elasticity will vary
between infinity and zero depending upon the degree of substitution between the two
commodities. The cross elasticity is positive in case of good substitutes. If they are perfect
substitutes, then cross elasticity is infinity. For close substitutes, Ec will be very high. In
poor substitutes, it will be very low eg. a monopoly product.

As the price of B increases, the quantity demanded of A increases.

Unrelated goods

If A and B are unrelated, and are not substitutes, then cross elasticity will be zero. As the
change in price of A will not affect the demand for B. here the cross elasticity is zero.

Figure 15 - Unrelated products

In the figure, quantity demanded of A remains unaltered due to change in price of B.

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Complements

Figure 16 - Complementary goods

Here a rise in the price of one will lead to fall in the quantity demanded. Cross elasticity will
be negative. If it is jointly demanded goods, cross elasticity will be negative.

Quantity demanded of A increases as the price of B decreases. Both are complementary

goods.

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