Engineering Economics t2

LECTURE 14
EXCEPTIONS TO LAW OF DEMAND

EXCEPTIONS TO LAW OF DEMAND
DEFINITION:
There are certain situations where the law of demand does not apply
or becomes ineffective,
i.e. with a fall in the price the demand falls and with the rise in price
the demand rises are called as the exceptions to the law of demand.
These include the Giffen goods, Veblen goods, possible price changes,
and essential goods.
1. Giffen goods
• Concept introduced by Sir Robert Giffen.
• Goods that are inferior in comparison to luxury goods.
• The unique characteristic of Giffen goods is that as its price

increases, the demand also increases. And this feature is
what makes it an exception to the law of demand.
Example:-
• The Irish Potato Famine is a classic example of the
Giffen goods concept. Potato is a staple in the Irish diet.
• During the potato famine, when the price of potatoes

increased, people spent less on luxury foods such as
meat and bought more potatoes to stick to their diet. So
as the price of potatoes increased, so did the demand,
which is a complete reversal of the law of demand.
2. Veblen Goods
The second exception to the law of demand is the concept of Veblen
goods.
• Concept is named after the economist Thorstein Veblen, who
introduced the theory of “conspicuous consumption“.
• According to Veblen, there are certain goods that become more
valuable as their price increases. If a product is expensive, then its
value and utility are perceived to be more, and hence the demand
for that product increases.
Example-
1) Precious metals and stones such as gold and diamonds
2) Luxury cars such as Rolls-Royce.
As the price of these goods increases, their demand also increases
because these products then become a status symbol.
3. The expectation of Price Change
There are times when the price of a product increases and market
conditions are such that the product may get more expensive. In
such cases, consumers may buy more of these products before
the price increases any further. Consequently, when the price
drops or may be expected to drop further, consumers might
postpone the purchase to avail the benefits of a lower price.
The expectation of Price Change….
Example 1- Price of onions

Consumers started buying and storing more onions fearing
further price rise, which resulted in increased demand.
Example 2- Consumers may buy and store commodities due to a

fear of shortage.
4. Necessary goods and services
• Some commodities are purchased by people even if the

price for the same increases.
• Example:- Necessities such as medicines or basic
staples such as sugar or salt
• The prices of these products do not affect their
associated demand.
5. Change in Income
• The change in income may change the demand for a

product.
• If a household’s income increases, they may purchase
more products irrespective of the increase in their price,
thereby increasing the demand for the product.
• Similarly, they might postpone buying a product even if
its price reduces if their income has reduced. Hence,
change in a consumer’s income pattern may also be an
exception to the law of demand.
Figure 1 Catherine’s Demand Schedule and
Demand Curve
Price of
Ice-Cream Cone
$3.00
2.50
1. A decrease
2.00
in price ...
1.50
1.00
0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity
of cones demanded.
The Market Demand Curve
When the price is $2.00, When the price is $2.00, The market demand at
Catherine will demand 4 Nicholas will demand 3 $2.00 will be 7 ice-cream
ice-cream cones. ice-cream cones. cones.
Catherine’s Demand + Nicholas’s Demand = Market Demand
Price of Ice- Price of Ice- Price of Ice-

Cream Cone Cream Cone Cream Cone
2.00 2.00 2.00
1.00 1.00 1.00
7 13
4 8 3 5
Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones
When the price is $1.00, When the price is $1.00, The market demand at $1.00,
Catherine will demand 8 ice- Nicholas will demand 5 ice- will be 13 ice-cream cones.
cream cones. cream cones.
The market demand curve is the horizontal sum of the individual
demand curves!
Shifts in the Demand Curve
• Change in Quantity Demanded
• Movement along the demand curve.
• Caused by a change in the price of the product.

Changes in Quantity Demanded
A tax on sellers of ice-
Price of Ice-
Cream cream cones raises the
Cones
price of ice-cream cones
B and results in a
$2.00
movement along the
demand curve.
1.00 A
D
0 4 8 Quantity of Ice-Cream Cones
Market Demand Table
Demand of Demand of Demand of Market

Price
individual 'A' individual 'B' individual 'C' Demand
5 20 30 50 100
4 40 60 100 200
3 60 90 150 300
2 80 120 200 400

Deriving the market demand curve from individual
curves: Figure 3.3
Deriving the market demand curve from individual
curves: Figure 3.3, continued
LECTURE 15
ELASTICITY OF DEMAND – PRICE, INCOME AND CROSS ELASTICITY
Contents
• What is elasticity? What kinds of issues can elasticity help us

understand?
• What is the price elasticity of demand?

How is it related to the demand curve?
How is it related to revenue & expenditure?
• What are the income and cross-price elasticities of demand?

Elasticity
 Basic idea:
Elasticity measures how much one variable
responds to changes in another variable.
 One type of elasticity measures how much
demand for products will fall if the price is
raised.
 Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.
19
20
Price Elasticity of Demand
Price Elasticity of Demand (PED) measures how

consumers change their behavior when prices change.
In other words, it identifies the relationship between price and
demand, and how it reacts when prices change.
 There are five types of price elasticity of demand:

Perfectly inelastic, inelastic, perfectly elastic, elastic, and
unitary.
 Price elasticity of demand can be calculated by dividing the

percentage change in quantity demanded by the percentage
change in price.
21
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
 Price elasticity of demand measures how

much Qd responds to a change in P.
 Loosely speaking, it measures the price-

sensitivity of buyers’ demand.
ELASTICITY AND ITS APPLICATION 22

=
P
Example:
P rises
Price elasticity by 10%
P2
of demand P1
equals D
15% Q
= 1.5 Q2 Q1
10%
Q falls
by 15%
=
P
Along a D curve, P and Q
move in opposite directions, P2
which would make price
elasticity negative. P1
We will drop the minus sign D

and report all price Q
elasticities as Q2 Q1
positive numbers.

Calculating Percentage Changes
Standard method (Point elasticity)
of computing the percentage (%) change:
P
B
P1
A
P0
D
Q
Q1 Q0

Problem:
The standard method gives different answers
depending on where you start.
Point elasticity calculation (Point method) gives

rise to different values of elasticity based on where
you start and end,
But elasticity calculation based on average values

between the points (ARC method) where the
average is chosen as denominator, avoids this
problem
 So, we instead use the midpoint method (ARC
elasticity):
end value – start value

x 100%
midpoint
 The midpoint is the number halfway between
the start & end values, the average of those
values.
 It doesn’t matter which value you use as the
“start” and which as the “end” – you get the
same answer either way!

Elasticity of a Linear Demand Curve
Demand is elastic; When price increases from
Price demand is responsive $4
to to $5, TR declines from
$7 changes in price. $24 to $20.
6 Elasticity is > 1 in this range.

5
4
Elasticity is < 1 in this range.
3
Demand is inelastic; demand is
not very responsive to changes
2 When price increases from
in price.
$2 to $3, TR increases from
1
$20 to $24.
0 2 4 6 8 10 12 14
Quantity
What determines price elasticity?
To learn the determinants of price elasticity,

we look at a series of examples.
Each compares two common goods.
In each example:
 Suppose the prices of both goods rise by 20%.
 The good for which Qd falls the most (in percent) has
the highest price elasticity of demand.
Which good is it? Why?
 What lesson does the example teach us about the
determinants of the price elasticity of demand?
29
Elasticity of Demand
 Why do hotels hike room-rates at weekends and

why do car rental firms charge higher prices at
weekend?
Elasticity Questions…are these products
Price Elastic or Inelastic?
Dell cuts the price of their desktop PCs by 10%

A fall in the price of I-max tickets
An increase in the price of the EconomicTimes
A taxi home from a night-club on a Friday night
A rise in average car insurance premiums
Petrol prices rise by 5% after the budget
Vodafone cuts their mobile phone charges
Aviation surcharge rises by 20% due to a rise in world oil prices

A local leisure club decreases monthly charges by 15% in a bid to
increase the number of members
 In early 2011, Netflix consumers paid about $10 a month for a
package consisting of streaming video and DVD rentals. In July
2011, the company announced a packaging change.
Customers wishing to retain both streaming video and DVD
rental would be charged $15.98 per month – a price increase of
about 60%. In 2014, Netflix also raised its streaming video
subscription price from $7.99 to $8.99 per month for new U.S.
customers. The company also changed its policy of 4K
streaming content from $9.00 to $12.00 per month that year.
 How do the customers react?
32
EXAMPLE 1:
Breakfast cereal vs. Sunscreen
 The prices of both of these goods rise by 20%.

For which good does Qd drop the most? Why?
 Breakfast cereal has close substitutes
(e.g., pancakes, Eggo waffles, etc.),
so buyers can easily switch if the price rises.
 Sunscreen has no close substitutes,

so consumers would probably not
buy much less if its price rises.
 Lesson: Price elasticity is higher when close substitutes are

available.
33
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
 The prices of both goods rise by 20%.

 For a narrowly defined good such as

blue jeans, there are many substitutes
(khakis, shorts, Speedos).
 There are fewer substitutes available for broadly defined goods.

(There aren’t too many substitutes for clothing)
 Lesson: Price elasticity is higher for narrowly defined goods

than broadly defined ones.
34
EXAMPLE 3:
Insulin vs. Luxury Caribbean Cruises
 The prices of both of these goods rise by 20%.

 To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no decrease in demand.
 A cruise is a luxury. If the price rises,
some people will forego it.
 Lesson: Price elasticity is higher for luxuries than for
necessities.
35
EXAMPLE 4:
Petrol in the Short Run vs. petrol in the Long Run
 The price of petrol rises 20%. Does Qd drop more in the short
run or the long run? Why?
 There’s not much people can do in the
short run, other than ride the bus or carpool.
 In the long run, people can buy smaller cars
or live closer to where they work or alternate fuel systems may
develop.
 Lesson: Price elasticity is higher in the
long run than the short run.
36
The Determinants of Price Elasticity:
A Summary
The price elasticity of demand depends on:
 the extent to which close substitutes are
available
 whether the good is a necessity or a luxury
 how broadly or narrowly the good is defined
 the time horizon – elasticity is higher in the
long run than the short run

The Variety of Demand Curves
 The price elasticity of demand is closely related to

the slope of the demand curve.
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 Five different classifications of D curves.…

In reality, ‘perfect elasticity’ and ‘perfect inelasticity’ do
not actually exist and are just hypothetical models.
39
LECTURE 16 &17
 CALCULATION OF PRICE AND INCOME ELASTICITY OF DEMAND,
NECESSITIES, LUXURIES AND RELATION BETWEEN PRICE AND
DEMAND.
40
Inelastic demand
Inelastic demand is where the price elasticity of
demand is less than 1, which means that customers are
largely unreactive to changes in price.
For example, there may be 100 customers who buy a

Ferrari for 10,00,000. If Ferrari was to increase its
prices to 12,50,000 and 99 customers buy it, then the
product is very inelastic. This is because customers do
not care too much about the price.
• May occur as a result of limited substitute goods.
41
“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%
D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
none
P falls Q
Elasticity by Q
: 0 10% 1
Q changes
by 0%

“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
D curve: P
relatively steep
P1
Consumers’
relatively low D
P falls Q
Elasticity by Q Q
: <1 10% 1 2
Q rises less
than 10%

Factors affecting Inelastic price demand
1. Infrequent purchases:-– paying a little extra for a one off purchase
Example : A new mobile with extra features
2. No substitutes:- Consumers are forced to buy a good no matter how much

the price is.
Example: People have little choice but to buy petrol for their cars.
3. Necessities:- Consumers have to pay for certain goods how much ever it
costs.
Example: Consumers have to pay for their medication no matter what it costs.
Without it, they may fall gravely ill and need hospital treatment.
4. Seasonal/Geographical:- Consumers are willing to spend more because of

the seasonal supply, or, the greater satisfaction received during different times of
year, for example, ice cream during the summer.
44
elastic demand
• Consumers are very responsive to the change in
price.
For example, if the nearby store starts charging extra

price and it loses half its customers, we can conclude
that demand is very elastic.
• Consumers are unwilling to spend more and

therefore go elsewhere instead.
• Consumers are extremely price-sensitive and are

happy to shop around to find a good deal.
45
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
D curve: P
intermediate slope
P1
Consumers’
intermediate D
P falls Q
Elasticity by Q Q
: 1 10% 1 2
Q rises by
10%

“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity by Q Q
: >1 10% 1 2
Q rises more
than 10%

“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
D curve: P
horizontal
P2 P1 D
Consumers’ =
price sensitivity:
extreme
P changes Q
Elasticity by 0% Q Q
: infinity 1 2
Q changes
by any %

Factors affecting Elastic price demand
1. Homogeneous product:– For a relatively similar product ,
customers are more likely to shop around and be reactive to
price changes.
Example:- Insurance is a good example. An small variation in

price can lead to consumers going on to the web to look up
comparative prices for a similar policy.
2. More substitutes:- When there are many other products

available, a higher price for one makes the others more appealing.
Example:- There are hundreds of types of chocolates and

chocolate bars. Any price differentiation beyond the normal can
lead to consumers choosing an alternative.
49
3. Low switching costs:- If there is no cost associated with
switching, it makes the decision to purchase a substitute good
more likely; allowing demand to fluctuate more.
Example: If prices go up for KitKats, there is no cost applied if

you no longer buy one. So there is no financial penalty for
buying a substitute.
4. Luxury:- Goods or services that are luxury do not need to be

brought, so consumers can be more sensitive to price.
50
Price Elasticity and Total Revenue
Price Percentage change in Q
=
elasticity of Percentage change in P
demand
Revenue = P x Q
 If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
 The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.

Elastic demand increased
(elasticity = 1.8) revenue due
P lost
to higher P
If P = $200, revenue
due to
Q = 12 and lower Q
$250
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
Price elasticity Percentage change in Q

=
Revenue = P x Q
 If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
 The fall in revenue from lower Q is smaller

than the increase in revenue from higher P,
so revenue rises.
 In our example, suppose that Q only falls to 10
(instead of 8) when you raise your price to $250.

Now, demand is
increased
inelastic:
revenue due
elasticity = 0.82 P to higher P lost
If P = $200, revenue
Q = 12 and due to
$250 lower Q
revenue = $2400.
If P = $250, $200
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
a price increase 10 12
causes revenue to rise.
Computing the Price
Elasticity of Demand
Example: If the price of an ice cream cone

increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones then your
elasticity of demand would be calculated as:
8  10 2
X 2
10 2.20  2
DEMAND AND SUPPLY
Elasticity =
DEMAND AND SUPPLY

Elasticity =
DEMAND AND SUPPLY

Other Elasticities
 Income elasticity of demand: measures the
response of Qd to a change in consumer income
Income elasticity Percent change in Qd

=
of demand Percent change in income
 An increase in income causes an increase in

demand for luxury and normal goods.
 Income elasticity is >1 for luxury products.
 For normal goods, income elasticity > 0 but <1.
 For inferior goods, income elasticity < 0.
Other Elasticities
 Cross-price elasticity of demand:
measures the response of demand for one good to
changes in the price of another good
Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2
 For substitutes, cross-price elasticity > 0
(e.g., an increase in price of beef causes an
increase in demand for chicken)
 For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes
decrease in demand for software)
Cross-Price Elasticities in the News
“As Fuel Costs Soar, Buyers Flock to Small Cars”
-New York Times, 5/2/2008
“Fuel Prices Drive Students to Online Courses”
-Chronicle of Higher Education, 7/8/2008
“Fuel prices knock bicycle sales, repairs into higher gear”
-Associated Press, 5/11/2008
“Camel demand soars in India”
(as a substitute for “fuel-guzzling tractors”)
-Financial Times, 5/2/2008
“High fuel prices drive farmer to switch to mules”
-Associated Press, 5/21/2008
CHAPTER
Income Elasticity of Demand
DEMAND AND SUPPLY

© 2009 South-Western, a part of Cengage Learning, all rights reserved
Income Elasticity of Demand
 The income is the other factor that influences the demand

for a product.
 Hence, the degree of responsiveness of a change in

demand for a product due to the change in the income is
known as income elasticity of demand.
DEMAND AND SUPPLY

INCOME ELASTICITY OF DEMAND
(cont.)
FORMULA:
Y = %  Quantity Demanded
%  Income
Y = Q 2 – Q1 x Y1
Q1 Y2 – Y1
DEMAND AND SUPPLY

Calculate the income elasticity of demand for X
when the income of consumers increases from
200 to 400. then demand increases from 100 to
150 ,What type of product is X
Calculate the income elasticity of demand for Z

when the income of consumers decreases from
200 to 100. then demand increases from 100 to
120 ,What type of product is Z
DEMAND AND SUPPLY

CHAPTER
Cross Elasticity of Demand
DEMAND AND SUPPLY

© 2009 South-Western, a part of Cengage Learning, all rights reserved
 The cross elasticity of demand refers to the

change in quantity demanded for one
commodity as a result of the change in the
price of another commodity.
 This type of elasticity usually arises in the
case of the interrelated goods such as
substitutes and complementary goods.
DEMAND AND SUPPLY

 Elasticity measure that looks at the impact a change in the price of
one good has on the demand of another good.
 % change in demand Q1/% change in price of Q2.
 Positive-Substitutes
 Negative-Complements.
Substitute Goods
 When the cross elasticity of demand for product A relative to a
change in price of product B is positive, it means that in response
to an increase (decrease) in price of product B, the quantity
demanded of product A has increased (decreased). Since A, say
Coke, and B, say Sprite, are substitutes, an increase in price of
product B means that more people will consume A instead of B,
and this will increase the quantity demanded of product A.
Increase in quantity demanded of product A relative to increase in
price of product B gives us a positive cross elasticity of demand.
69
ELASTICITY AND ITS APPLICATION
Complementary Goods
 When the cross elasticity of demand for product A relative to
change in price of product B is negative, it means that the quantity
demanded of A has decreased (increased) relative to an increase
(decrease) in price of product B. As A, say car, and B, say fuel, are
complimentary goods, and an increase in price of B will reduce the
quantity demanded of A. This is because people consume both A
and B as a bundle and an increase in price reduces their
purchasing power and decreases quantity demanded.
70
ELASTICITY AND ITS APPLICATION
CROSS ELASTICITY OF DEMAND
FORMULA:
X = %  Quantity Demanded of
good X
%  Price of good Y
X = QX2 – QX1 x PY1

QX1 PY2 – PY1
DEMAND AND SUPPLY

Price of X Demand Demand Income
for X for Y
25 10 5 100
20 20 10 200
15 30 15 300
10 40 20 400
 Calculate the cross elasticity of demand for Y
when the price of X decrease from 25 to 15. Are
X and Y complements or substitute. Demand
for Y will be from 300 to 150.
DEMAND AND SUPPLY

20  40 10
X
40 20  10
Ep = 20/40 X 10/10
Ep = 0.5
Inelastic demand
DEMAND AND SUPPLY

Q2 Q1 Y1
X
Q1 Y2  Y1
40  20 200
X
20 400  200
 Ep = 20 / 20 X 200 / 200
 Ep = 1
 Since its equal to 1 and positive , so A is Normal
good
DEMAND AND SUPPLY

Qy2  Qy1
Px1
X
Qy1
Px2 Px1
15  5 25
X
5 15  25
Ep = 10/5 X 25/-10
Ep = 2 X -2.5
Ep = - 5 (Complementary Goods )
DEMAND AND SUPPLY

THEORY OF
DEMAND AND SUPPLY
MODULE 2
Supply
• The various amounts of a product that producers are
willing and able to supply at various prices during some
specific period
• Demonstrated by the supply schedule and supply curve
2
3 Important aspects …..
• Supply is desired quantity
• Supply is explained with reference to price
• Time during which it is offered for sale is important
3
TYPES OF Supply
• The various amounts of a product that producers are
willing and able to supply at various prices during some
specific period
• Demonstrated by the supply schedule and supply curve
4
Law of Supply and illustrations
• Corn crops are very plentiful over the course of the year and there is
more corn than people would normally buy. To get rid of the excess
supply, producers need to lower the price of corn and thus the price is
driven down for everyone.
• There is a drought and very few strawberries are available. More people
want the strawberries than there are berries available. The price of
strawberries increases dramatically.
• A huge wave of new, unskilled workers come to a city and all of the
workers are willing to take jobs at low wages. Because there are more
workers than there are available jobs, the excess supply of workers
drives wages downward.
5
On the other side
• A popular artist dies and, thus, he obviously will be producing no

more art. Demand for his art increases substantially as people want
to purchase the few pieces that exist.
• A new restaurant opens up in town and gets great reviews. There are
only 12 tables in the restaurant but everyone wants to get a
reservation. Demand for the reservations goes up.
Law of Supply
• Law of supply states that other factors remaining constant, price
and quantity supplied of a good are directly related to each
other. In other words, when the price paid by buyers for a good
rises, then suppliers increase the supply of that good in the
market.
• Direct relationship between the price and quantity supplied
• Increased price causes increased quantity supplied
• Decreased price causes decreased quantity supplied
7
• The above diagram shows the supply curve that is upward
sloping (positive relation between the price and the quantity
supplied). When the price of the good was at P3, suppliers were
supplying Q3 quantity. As the price starts rising, the quantity
supplied also starts rising.
Copyright  2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Microeconomics 7/e by Jackson and McIver 8
Slides prepared by Muni Perumal, University of Canberra, Australia.
Market Supply
Price Quantity supplied

per unit (Rs) per week
a 5 12 000
b 4 10 000
c 3 7 000
d 2 4 000
e 1
1 000

Supply Curve
P
5
a S1
b
4
Price (Rs per unit)
c
3
d
2
e
1
S1
0 Q
2 4 6 8 10 12 14 16
Quantity supplied (000/week)

Change in Supply
• represented as a shift of the supply curve

• caused by changes in determinants of supply other
than price

Increase in Supply
P S1
5 S2
Price (Rs per unit) 4
1
S1
S2
0 Q
2 4 6 8 10 12 14 16

Decrease in Supply
P S3 S1
5
2 S3
1
S1
0 Q
2 4 6 8 10 12 14 16

Non-price determinants of Supply
• Resource price
• Technology
• Prices of other goods
• Expectations
• Number of sellers
• [Note mostly related to changing costs of
production reflecting marginal cost curve]

Variables that Influence Sellers
Variable A change in this variable…

Price …causes a movement
along the S curve
Input Prices …shifts the S curve
Technology …shifts the S curve
# of Sellers …shifts the S curve
Expectations …shifts the S curve
THE MARKET FORCES OF SUPPLY AND DEMAND 15

Changes in Quantity Supplied
• Caused by changes in price only

• Represented as a movement along a supply curve

Movement along a Supply Curve
P S1
5
4
Price (Rs per unit)
Movement along
2
a supply curve
1
S1
0 Q
2 4 6 8 10 12 14 16

Movement along a Supply Curve
P S1
$5
4
Price (Rs per unit)
Movement along
2
a supply curve
1
S1
0 Q
2 4 6 8 10 12 14 16

ELASTICITY OF SUPPLY
1)Perfect Inelastic Supply

Perfect inelastic supply is when the PES formula equals 0.
That is, there is no change in quantity supplied when the price
changes. Examples such as land or painting from deceased
artists.

2) Inelastic Supply
The PES for relatively inelastic supply is between 0 and 1.
That means the percentage change in quantity supplied
changes by a lower percentage than the percentage of price
change. Inelastic goods include nuclear power.

3) Unit Elastic Supply
Unit Elastic Supply has a PES of 1, where quantity supplied
change by the same percentage as the price change.

4) Elastic Supply
A price elasticity supply greater than 1 means supply is
relatively elastic, where the quantity supplied changes by a
larger percentage than the price change.

5) Perfectly Elastic Supply
The PES for perfectly elastic supply is infinite, where the
quantity supplied is unlimited at a given price, but no quantity
can be supplied at any other price. There are virtually no real-
life examples of this

Deriving the market supply curve from individual
curves
Deriving the market supply curve from individual
curves
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia
Market Equilibrium
• Occurs when the buying decisions of

households and the selling decisions
of producers are equated
• Determines the equilibrium price and
equilibrium quantity bought and sold
in the market

Market Equilibrium (cont.)
P
5 S
Equilibrium price
3
1
D
0 2 4 6 7 8 10 12 14 16 18 Q
Units of X (000/week)

P
5
surplus
S
Equilibrium price
3
1
D
0 2 4 6 7 8 10 12 14 16 18 Q

P
5
surplus
S
Equilibrium price
3
shortage
1
D
0 2 4 6 7 8 10 12 14 16 18 Q

How the Law of Supply and Demand
Works
• A company sets the price of its product at Rs 10.00. No one wants the
product, so the price is lowered to Rs 9.00. Demand for the product
increases at the new lower price point and the company begins to
make money and a profit.
• The company could lower the price to Rs 5.00 to increase demand

even more, but the increase in the number of people buying the
product would not make up money lost when the price point was
lowered from Rs 9.00 to Rs 5.00. The company leaves the price set at
Rs 9.00 because that is the point at which supply and demand are in
equilibrium. Raising the price would reduce demand and make the
company less profitable, while lowering the price would not increase
demand by enough to make up the money lost.
30
Shortage (Excess Demand)
• Occurs when the quantity demanded exceeds the

quantity supplied at the current price
• Competition amongst buyers eventually bids up the
price until equilibrium is reached

Surplus (Excess Supply)
• Occurs when the quantity supplied exceeds the

quantity demanded at the current price
• Competition amongst producers eventually causes
the price to decline until equilibrium is reached

Changes in Demand and
Supply
• Changes or shifts will disrupt the equilibrium
• The market will adjust until once again an
equilibrium is reached
• The equilibrium price and quantity traded will
change

Increase in Demand
P D1 D2
S
Equilibrium
price & quantity
rise
D2
D1
0 Q

Decrease in Demand
P D2 D1
S
Equilibrium
price & quantity
fall
D1
D2
0 Q

Increase in Supply
P S1
D1
S2
Equilibrium
price falls & quantity
rises
S1
D1
S2
0 Q

Decrease in Supply
P S2
D1
S1
Equilibrium
price rises & quantity
falls
S2
S1 D1
0 Q

Both Demand & Supply Increase
P D1 D2 S1 Quantity will
S2 increase but
price change will
be in determinant
S1
D2
D1
S2
0 Q

Demand or Supply change
• Increase in D: P increases; Q decreases

• Decrease in D: P decreases; Q increases
• Increase in S: P decreases; Q increases
• Decrease in S: P increases; Q decreases

Both Demand & Supply change
• Demand increases and supply increases;
Q must rise but P??
• Demand increases and supply decreases;
P must rise but Q??
• Demand decreases and supply increases;
P must fall but Q??
• Demand decreases and supply decreases;
Q must fall but P??
40
Both Demand & Supply change
• The overall change in the

indeterminate side of the market, i.e.
P or Q depends on the relative shifts
in DD and SS.

MODULE 3 - PRODUCTION
Dr.Yogesh Kumar Jain, School of Management

Module 3
 Production function, Factors of Production,
Law of Variable Proportion and Returns to
Scale
 Cost and its classification, short and long run
cost curves, cost behavior, cost concepts and
decision making, breakeven analysis
 Calculation of costs and Break even point
 Production function, in economics, equation that
expresses the relationship between the quantities
of productive factors (such as labour and capital)
used and the amount of product obtained.
It states the amount of product that can be
obtained from every combination of factors,
assuming that the most efficient available
methods of production are used.
 The production function can thus answer a variety of
questions.
 It can, for example, measure the
marginal productivity of a particular factor of
production (i.e., the change in output from one
additional unit of that factor).
 It can also be used to determine the cheapest
combination of productive factors that can be used
to produce a given output.
 Production function, a mathematical expression or
equation that explains the relationship between a
firm’s inputs and its outputs:
 A production is purely an engineering concept. If
you plug in the amount of labor, capital and other
inputs the firm is using, the production function tells
how much output will be produced by those inputs.
 Production functions are specific to the product.
Different products have different production
functions.
Factory Production: Manufacturing companies use their production
function to determine the optimal combination of labor and capital to
produce a certain amount of output.
The amount of labor a farmer uses to produce a
bushel of corn is likely different than that
required to produce an automobile.
Firms in the same industry may have somewhat
different production functions, since each firm
may produce a little differently.
One pizza restaurant may make its own dough
and sauce, while another may buy those pre-
made. A sit-down pizza restaurant probably uses
more labor (to handle table service) than a
purely take-out restaurant. We can describe
inputs as either fixed or variable.
 Fixed inputs are those that can’t easily be increased
or decreased in a short period of time.
 In the pizza example, the building is a fixed input.
Once the entrepreneur signs the lease, he or she is
stuck in the building until the lease expires. Fixed
inputs define the firm’s maximum output capacity.
 This is analogous to the potential real GDP shown by
society’s production possibilities curve, i.e. the
maximum quantities of outputs a society can produce
at a given time with its available resources. Fixed
inputs do not change as output changes.
Variable inputs are those that can
easily be increased or decreased in a
short period of time.
The pizzaiolo can order more
ingredients with a phone call, so
ingredients would be variable inputs.
The owner could hire a new person to
work the counter pretty quickly as
well. Variable inputs increase or
decrease as output changes.
Meaning of production -The term production means
transformation of physical “inputs” into physical “outputs”
. The term “inputs” refers to all those things which are
required by a firm to produce a particular product.
In addition to four factors or production, inputs also includes

raw materials, power, fuel, transport, warehousing, banking,
etc.
Thus the term “inputs” has a wider meaning in economics.
What we get at the end of the productive process is called as
“Outputs”. In short output refers to finished products.
Meaning of Production Function- production function expresses
the technological or engg relationship
between physical inputs and physical outputs.
A production function can be expressed in the form of a

mathematical model
Q = f (L, N, K, etc)
Where Q = Quantity of output
LNK, etc = various factor inputs like land, labour,
capital, etc.
The rate of output Q is thus a function of the factor inputs

LNK etc. employed by firm per unit of time.
 Factors of production is an economic concept that
refers to the inputs needed to produce goods
and services. The factors are land, labor,
capital, and entrepreneurship. The four factors
consist of resources required to create a good or
service, which is measured by a country’s gross
domestic product (GDP).
 In factors of production, the word “production”
refers to a process of transforming inputs into
outputs, which are finished products that can
be sold as a good or service.
 In order to do so, the input will go through a
production process and various stages to reach
the hands of consumers.
 The factors of production are resources that are the building
blocks of the economy; they are what people use to produce
goods and services. Economists divide the factors of production
into four categories: land, labor, capital, and entrepreneurship.
The first factor of production is land, but this includes any

natural resource used to produce goods and services. This
includes not just land, but anything that comes from the land.
Some common land or natural resources are water, oil, copper,
natural gas, coal, and forests.
 Land resources are the raw materials in the production
process. These resources can be renewable, such as forests,
or nonrenewable such as oil or natural gas. The income that
resource owners earn in return for land resources is called
rent.
 and is a broad term that includes all the natural resources that can
be found on land, such as oil, gold, wood, water, and vegetation.
Natural resources can be divided into renewable and non-renewable
resources.
 Renewable resources are resources that can be replenished, such as
water, vegetation, wind energy, and solar energy.
 Non-renewable resources consist of resources that can be depleted
in supply, such as oil, coal, and natural gas.
 All resources, whether it is renewable or non-renewable, can be used
as inputs in production in order to produce a good or service. The
income that comes from using land and its natural resources is
referred to as rent.
 Besides using its natural resources, land can also be utilized for
various purposes, such as agriculture, residential housing, or
commercial buildings. However, land differs from the other factors
of production because some natural resources are limited in quantity,
so its supply cannot be increased with demand.
 The second factor of production is labor.
 Labor is the effort that people contribute to the
production of goods and services.
 Labor resources include the work done by the waiter
who brings your food at a local restaurant as well as
the engineer who designed the bus that transports you
to school.
It includes an artist's creation of a painting as well as
the work of the pilot flying the airplane overhead. If
you have ever been paid for a job, you have
contributed labor resources to the production of goods
or services. The income earned by labor resources is
called wages and is the largest source of income for
most people.
 The following are several characteristics of labor in terms of
being a factor of production:
 First, labor is considered to be heterogeneous, which refers to
the idea of how the efficiency and quality of work are
different for each person. It differs because it depends on an
individual’s unique skills, knowledge, motivation, work
environment, and work satisfaction.
 Additionally, labor is also perishable in nature, which means
that labor cannot be stored or saved up. If an employee does
not work a shift today, the time that is lost today cannot be
recovered by working another day.
 Also, another characteristic of labor is that it is strongly
associated with human efforts. It means that there are
factors that play an important role in labor, such as the
flexibility of work schedules, fair treatment of employees, and
safe working conditions.
 Labor as a Factor of Production
 Labor as a factor of production refers to the effort that
individuals exert when they produce a good or service. For
example, an artist producing a painting or an author writing
a book. Labor itself includes all types of labor performed for
an economic reward, such as mental and physical exertion.
The value of labor also depends on human capital, which is
determined by the individual’s skills, training, education, and
productivity.
 Productivity is measured by the amount of output
someone can produce in each hour of work.
 The income that comes from labor is referred to as wages.
Note that work performed by an individual purely for his/her
personal interest is not considered to be labor in an economic
context.
 The third factor of production is capital.
 Think of capital as the machinery, tools and buildings
humans use to produce goods and services.
 Some common examples of capital include hammers,
forklifts, conveyer belts, computers, and delivery vans.
Capital differs based on the worker and the type of
work being done.
 For example, a doctor may use a stethoscope and an
examination room to provide medical services. Your
teacher may use textbooks, desks, and a whiteboard to
produce education services. The income earned by
owners of capital resources is interest.
 Capital, or capital goods, as a factor of production,
refers to the money that is used to purchase items that
are used to produce goods and services. For example, a
company that purchases a factory to produce goods or
a truck that is purchased to do construction are
considered to be capital goods.
 Other examples of capital goods include computers,
machines, properties, equipment, and commercial
buildings. They are all considered to be capital goods
because they are used in a production process and
contribute to the productivity of work. The income that
comes from capital is referred to as interest.
 Below are several defining characteristics of capital as a
factor of production:
 Capital is different from the first two factors because it
is created by humans. For example, capital goods like
machines and equipment are created by individuals, unlike
land and natural resources.
 Additionally, capital is also a factor that can last a long
time, but it depreciates in value over time. For example, a
building is a capital good that can endure for a long
period of time, but its value will diminish as the building
gets older.
 Capital is also considered to be mobile because it can be
transported to different places, such as computers and
other equipment.
 The fourth factor of production is entrepreneurship.
 a person who combines the other factors of
An entrepreneur is
production - land, labor, and capital - to earn a profit.
 The most successful entrepreneurs are innovators who find new ways
produce goods and services or who develop new goods and services to bring to market.
Without the entrepreneur combining land, labor, and capital in new ways, many of the
innovations we see around us would not exist.
 Think of the entrepreneurship of Henry Ford or Bill Gates.
 Entrepreneurs are
a vital engine of economic growth helping to build
some of the largest firms in the world as well as some of the
small businesses in your neighborhood.
 Entrepreneurs thrive in economies where they have the freedom to start businesses and buy
resources freely. The payment to entrepreneurship is profit.
 Entrepreneurship as a factor of production is a
combination of the other three factors. Entrepreneurs
use land, labor, and capital in order to produce a
good or service for consumers.
 Entrepreneurship is involved with
establishing innovative ideas and putting that into
action by planning and organizing production.
Entrepreneurs are important because they are the ones
taking the risk of the business and identifying potential
opportunities. The income that entrepreneurs earn is
called profit.
Laws of production
Short run
Long run
Law of Variable Proportion
(only labour input is made variable)
Assumptions : Isoquant Analysis Returns to Scale
1. Only one factor is variable while (two variable inputs) (all inputs are variable
others are constant. Assumptions: Assumptions:
1. There are only 1. All factor
2. All units of variable factor are 2 factor inputs inputs are
homogenous. i.e. variable but
Labour and enterprise is
3. Technology is constant Capital fixed
2. Technology is 2. Technology is
constant constant
The Law of Variable Proportion
This is one of the most fundamental laws of production.
It gives us one of the key insights to the working out of the
ideal combination of Fixed inputs and Variable inputs.
Additional units of the variable inputs on the fixed inputs

certainly mean a variation in output.
Statement of the Law

As the quantity of different units of only one factor input are
increased to a given quantity of fixed inputs, the Total, Average
and Marginal output varies in different proportions.
The old name of this law is the Law of Diminishing Returns.

The Law of Variable Proportion states that as the
quantity of a factor is increased while keeping other
factors constant, the Total Product (TP) first rises at an
incremental rate, then at a decremental rate and lastly
the total production begins to fall.
In other words, as one of the factors in production

makes some variation in its quantity, keeping all the
other factors constant, the ratio between all the factors
starts varying, which further influence the level of
output.
Assumptions
The law of variable proportion works under the following situations:
Constant State of Technology
The first assumption is that the state of technology given for the
situation remains unchanged. In case, the technology gets improved,
then the marginal product may rise rather than diminish.
Other Factors also remain fixed
This means that there should some inputs or factors given in a certain
situation which should remain fixed in terms of their quantity. By
changing the factor proportions, we can understand the effects on
the output. However, the law would not work if all the factors are
altered in proportions.
Possibility of Varying the Proportions of Factors
The third assumption is that the law can only work if there is the
scope for varying proportions of factors as fixed proportions might
not yield effective results.
Imagine, you are standing at your favourite ice cream
parlour and eagerly waiting to gobble it up, and you
start eating the scoops one after the other continuously.
At first, your satisfaction level is at its highest peak and
After having 3 or 4 scoops, your level is still increasing,
but now at a diminishing rate.
Eventually, a point will come when you will be almost
close to being satisfied and full, there would be lesser
chances for you to eat another scoop. This is exactly
what the Law of Variable Proportion means.
Terminologies Description
Production Function As we know, production implies

the transformation of physical inputs into
physical outputs. Therefore, the
production function explains the
interrelationship between the factor input and
output.
Total Product (TP) Total Product (TP) is also known as total
output.
Following varied values of a physical
variable input
along with a fixed amount of input,
this process gives us the value of TP.
Average Product (AP) Average Product equals the Total Product (TP)
divided by the Total Number of Variable
Inputs.
In other words, AP is the output per unit.
Marginal Product (MP) Marginal Product or output is derived
when the producer employs additional
units of inputs in variable factors.
Which further means, that it is a rate at which
the TP rises.
What are the Stages of Law of
Variable Proportion?
In order to understand this in detail, let
us take an example. Imagine you own a
land wherein you produce rice by
employing more and more
labour (variable factors).
The table given below explains the
situation further:
Why is it called the Law of Variable Proportions?
As one input varies and all others remain constant, the factor
ratio or the factor proportion varies. Let’s look at an example
to understand this better:
Let’s say that you have 10 acres of land and 1 unit of labour
for production. Therefore, the land-labour ratio is 10:1. Now,
if you keep the land constant but increase the units of labour
to 2, the land-labour ratio becomes 5:1.
Therefore, you can see, the law analyses the effects of a

change in the factor ratio on the amount of out and hence
called the Law of Variable Proportions.
Significance of the three stages
Stage I
A producer does not operate in Stage I. In this stage, the marginal
product increases with an increase in the variable factor.
Therefore, the producer can employ more units of the variable to
efficiently utilize the fixed factors. Hence, the producer would
prefer to not stop in Stage I but will try to expand further.
Stage III
Producers do not like to operate in Stage III either. In this stage,
there is a decline in total product and the
marginal product becomes negative.
In order to increase the output, producers reduce the amount of
variable factor. However, in Stage III, he incurs higher costs and
also gets lesser revenue thereby getting reduced profits.
Stage II
Any rational producer avoids the first as well as third stages of
production. Therefore, producers prefer Stage II – the stage of
diminishing returns. This stage is the most relevant stage of
operation for a producer according to the law of variable
proportions.
From this above table and graph of the Law of Variable
Proportion,
Up to 3 units of labour employed, the TP is rising at an increasing rate

(2,6,12). This constitutes Stage 1 of the law, which is the Stage of
Increasing Returns. Therefore, during the first stage, the TP curve
increases significantly.
Beyond the 3rd unit of labour, the TP starts rising at a diminishing rate
(12,16,18), which means the TP curve rises at a slower rate. This
eventually makes the marginal product (MP) starting to fall.
Constituting the second stage of the Law of Variable Proportion which
is called the Stage of Diminishing Returns.
After the employment of 6 units of labour, the TP starts to fall,
indicating the 3rd stage which is the Stage of Negative Returns. Even
after employing 6 units of labour, it fails to yield the marginal
product, that is when the MP comes to zero. Eventually, the TP curve
starts sloping down and the marginal product goes to negative in the
x-axis.
Now arises a Million Dollar Question.
Which stage of the Law of Variable Proportion should a firm
operate in? Is it Stage 1, 2 or 3? Let’s have you a simple answer
to this question.
As a rational firm, the optimal utilization of both the fixed and
variable inputs would take place only in Stage 2 of the Law of
Variable Proportion. That is the only time when all the inputs
are used in an economical way. Additionally, the MP and AP of
both the inputs are positive yet diminishing. Whereas, is a firm
operates in the first stage, the marginal product of the fixed
input (land) is still in a negative form. This is because the lesser
units of labour are using the land in large proportion, thereby
yielding no marginal product.
Forming the basis of a number of doctrines in Economics, one can
understand its role in the study of the Theory of Production..
BASIS OF Law of Variable Law of Returns to
proportion scale
DIFFERENCE
Time period Applies in the short run Applies in the Long run
Variable & Fixed Only one variable input All factor inputs are
Factors factor is changed all other changed
input factors are simultaneously. No
unchanged distinction like fixed
factor inputs and
variable factor inputs.
Stages 1. Increasing returns to 1. Increasing returns to
factor scale
2. Diminishing returns to 2. Constant returns to
factor scale
3. Negative returns to 3. Decreasing returns
factor to scale
Optimum stage Stage 2 is considered to be There is no stage which
the optimum stage of is the best in the long
production. run.
TOTAL PRODUCT (TP) is defined as the total quantity of
goods produced with a given inputs.
in short run TP can be increased by employing more units of a
variable factor, where as in the long run all input factors can be
increased.
AVERAGE PRODUCT (AP) is defined as the amount of output

produced per unit of variable factor
AP=total product/input of variable factor.
MARGINAL PRODUCT (MP) is defined as the change in TP

resulting from the employment of additional unit of a variable
factor. symbolically
MP = CHANGE IN TOTAL PRODUCT/CHANGE IN VARIABLE INPUT

SYMBOLICALLY MP = TPn – TPn-1 difference between TP of the
Present and TP of the previous.
Y
STAGE- 2
STAGE- 3
Units Total Avera Marginal 70 - STAGE- 1 DIMINISHING
RETURNS NEGATIVE
of Produ ge product (MP) INCREASING
ct
RETURNS
variabl Produ 60 - RETURNS
e input (TP) ct
LEVEL OF OUTPUT
(Labou (AP) Stage I 50 -
r) Increasing
1 10 10 10 Returns 40 -
2 24 12 14 To Factor TP
30 -
3 39 13 15 Stage I I
Diminishing
4 52 13 13 Returns 20 -
5 61 12.2 9 To Factor AP
10 -
6 66 11 5
Stage III O I I I I I I I I I I X
7 66 9.1 0 Negative
1 2 3 4 5 6 7 8 9 10
8 64 8 -2 Returns
UNITS OF VARIABLE FACTOR
To Factor McGraw-Hill/Irwin Colander, Economics
MP
Behaviour of TP, AP and MP – Law of Variable Proportions
TOTAL PRODUCT MARGINAL AVERAGE
(TP) PRODUCT (MP) PRODUCT (AP)
Stage I : Increases Increases and Increases (but
at an increasing reaches its slower than MP)
rate. maximum
Stage II : Increases Starts diminishing Starts diminishing
at a diminishing and becomes equal
rate and becomes to zero
maximum.
Stage III : Reaches Keeps on declining Continues to
its maximum, and becomes diminish but must
becomes constant negative. always be greater
and then starts than zero.
declining.
Applicability of the Law of Variable
Proportions:
The law of variable proportions is universal as it
applies to all fields of production. This law
applies to any field of production where some
factors are fixed and others are variable. That is
why it is called the law of universal application.
PRACTICAL IMPORTANCE OF THE LAW
1. It helps to work out the most ideal combination of factor

inputs or the least
cost combination of factor inputs.
2. It is useful to a businessman in the short run production

planning at the micro level.
3. The law give guidance that by making continuous

improvements in science and technology, the producer can
postpone the occurrence of diminishing returns.
LAWS OF RETURNS TO SCALE
The law of returns to scale refers to long run production
function wherein all factors of production becomes Variable.
There is no distinction between fixed inputs and variable inputs.
Statement of the law

As a firm in the long run increases the quantities of all factors of
production the output may rise initially at a more rapid rate then
the rate of increase in input, then the output may increase in the
same proportion of input and ultimately the output increases less
than proportionately.
This law has three stages as shown in the table:

1. Increasing Returns to Scale
2. Constant Returns to Scale
3. Decreasing Returns to Scale
STAGE 1 – INCREASING RETURNS TO SCALE
When the increase in output is more than proportional to the increase in input, it is
referred as law of increasing to scale.
For example, if labour and capital are increased by 15% and output increases
by 25%.
This increase is due to the expansion of the business firm with large scale
production and it enjoys economies of scale.
STAGE 2 – CONSTANT RETURNS TO SCALE

When the increase in output is proportional to the increase in inputs, it is referred
as law of constant returns to scale.
For example, 10% increase in labour and capital will result in an equal
proportion of 10% increase in the output.
This is due to the reason that as a firm expands its output, a stage comes when all
economies have been fully exploited.
STAGE 3 – LAW OF DECREASING RETURNS TO SCALE
When an increase in the output is less than proportional to the increase in
inputs, it is referred as Decreasing Returns to Scale.
For example, if all factors inputs are increased by 5% the output will
increase by 3%.
This is due to diseconomies of scale, lack of coordination, difficulties of

management, etc. Hence due to diseconomies of scale, the management has
to use inputs in greater proportions, thus giving rise to decreasing returns to
scale.
LAW OF RETURNS TO SCALE
SCALE TOTAL MP
PRODUCT
(TP)
1L + 3C 2 2 I Stage
2L + 6C 5 3 INCREASING
RETURNS
3L + 9C 9 4
4L + 12C 14 5
II Stage
5L + 15C 19 5 CONSTANT
6L + 18C 24 5 RETURNS
7L + 21C 28 4 III Stage
DECREASING
8L + 24C 31 3
RETURNS
9L + 27C 33 2
McGraw-Hill/Irwin Colander, Economics 53
Y
7—
6—
MARGINAL PRODUCT
5— CONSTANT
B C
4---
3---
2---
A D
1---
O X
2 I 3I 4I 5 I 6 I 7 I 8 I 9
SCALE
McGraw-Hill/Irwin Colander, Economics 54
Production Function It studies the functional relationship between physical
inputs and physical outputs. It is expressed as Qx = F(L,K)
Where, Qx = Quantity of output, F = Function, L = Labour, K = Capital
Different Periods in Production

Market period It is the period during which production factors can not be
changed at all. Hence, the production function is written as Qx = F(L,K), where
both labour and capital are taken as fixed.
Short period It is a time period in which the producer can change only the
variable factors of production while the fixed factors_of production remains
constant. The production function is written as Qx = F (L, K), where labour is
taken as a variable and capital as fixed factor .
Long period It is a time period when the producer has enough time to change
both fixed and variable factors of production, infact all factors are variable in
the long-run. The production function is written as Qx = F (L, K) where both
labour and capital are variable in nature.
Total Product- It is the sum total of output corresponding to each
unit of the variable factor used in the process of production.
Marginal Product (MP) It is an additional
output produced by the use of an
additional unit of the variable factor, fixed
factor remaining constant.
Average Product (AP) It is per unit output of the variable
factor.
Returns to a Factor It refers to the behaviour of output

when only one variable factor of production is increased
fixed factors remaining constant. This is a short-run
phenomenon.
Returns to Scale It refers to change in physical output of a

good on account of increase in all inputs required to
produce a good simultaneously in the same proportion.
This is a long-term phenomenon.
Relationship between Total Product and Marginal Product
When MP increases, TP increases at an increasing rate.
When MP reaches at its maximum, TP changes its slope termed
as point.of inflexion.
When MP falls but remains positive, TP increases at a diminishing
rate.
When MP is zero, TP is maximum.
When MP becomes negative, TP start to fall.
Relationship between Marginal Product and Average Product
When AP increase, MP > AP.
When AP is maximum MP = AP.
When AP decreases, MP < AP.
MP can become zero or negative, however AP can never be
zero.

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LECTURE 14

EXCEPTIONS TO LAW OF DEMAND

• Concept introduced by Sir Robert Giffen.

• Goods that are inferior in comparison to luxury goods.

• The unique characteristic of Giffen goods is that as its price

• During the potato famine, when the price of potatoes

Example 1- Price of onions

Example 2- Consumers may buy and store commodities due to a

• Some commodities are purchased by people even if the

• The change in income may change the demand for a

Price of Ice- Price of Ice- Price of Ice-

2.00 2.00 2.00

1.00 1.00 1.00

Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones

• Change in Quantity Demanded

• Movement along the demand curve.

• Caused by a change in the price of the product.

Demand of Demand of Demand of Market

2 80 120 200 400

• What is elasticity? What kinds of issues can elasticity help us

• What is the price elasticity of demand?

• What are the income and cross-price elasticities of demand?

Price Elasticity of Demand (PED) measures how

 There are five types of price elasticity of demand:

 Price elasticity of demand can be calculated by dividing the

 Price elasticity of demand measures how

 Loosely speaking, it measures the price-

ELASTICITY AND ITS APPLICATION 22

We will drop the minus sign D

ELASTICITY AND ITS APPLICATION 24

ELASTICITY AND ITS APPLICATION 25

Point elasticity calculation (Point method) gives

But elasticity calculation based on average values

end value – start value

ELASTICITY AND ITS APPLICATION 27

6 Elasticity is > 1 in this range.

To learn the determinants of price elasticity,

 Why do hotels hike room-rates at weekends and

Dell cuts the price of their desktop PCs by 10%

Aviation surcharge rises by 20% due to a rise in world oil prices

 How do the customers react?

 The prices of both of these goods rise by 20%.

 Sunscreen has no close substitutes,

 Lesson: Price elasticity is higher when close substitutes are

 The prices of both goods rise by 20%.

 For a narrowly defined good such as

 There are fewer substitutes available for broadly defined goods.

 Lesson: Price elasticity is higher for narrowly defined goods

 The prices of both of these goods rise by 20%.

Petrol in the Short Run vs. petrol in the Long Run

ELASTICITY AND ITS APPLICATION 37

 The price elasticity of demand is closely related to

ELASTICITY AND ITS APPLICATION 38

For example, there may be 100 customers who buy a

• May occur as a result of limited substitute goods.

ELASTICITY AND ITS APPLICATION 42

ELASTICITY AND ITS APPLICATION 43

2. No substitutes:- Consumers are forced to buy a good no matter how much

4. Seasonal/Geographical:- Consumers are willing to spend more because of

For example, if the nearby store starts charging extra

• Consumers are unwilling to spend more and

• Consumers are extremely price-sensitive and are

ELASTICITY AND ITS APPLICATION 46

ELASTICITY AND ITS APPLICATION 47