THEORY OF DEMAND AND SUPPLY

The demand arises out of the following three things:

i. Desire or want of the commodity.

ii. Ability to pay,

iii. Willingness to pay.

Only when all these three things are present then the consumer presents his demand in the market.

Definitions:

“Demand for a commodity is the quantity which a consumer is willing to buy at a particular price at a
particular time.”

“The demand for anything, at a given price, is the amount of it which will be bought per unit of time
at that price.” -PROF. BENHAM

“By demand, we mean the quantity of a commodity that will be purchased at a particular price and
not merely the desire of a thing.”-HANSEN

Demand Function:

Demand function shows the relationship between quantity demanded for a particular commodity
and the factors influencing it. It can be either with respect to one consumer or to all the consumers
in the market.

A consumer’s demand for a commodity is influenced by the following factors:

1. A consumer’s demand for a commodity is influenced by the price of that commodity. Usually the
higher the price, the lower will be the quantity demanded.

2. A consumer’s demand for a commodity is influenced by the size of his income. In most cases, the
larger the income, the greater will be the quantity demanded.

3. A consumer’s demand for a commodity is influenced by the prices of related commodities. They
may be complementary or substitutes.

4. The tastes of the consumers.

Factors Determining Individual Demand:

Demand is not dependent on price alone. There are many other factors which affect the demand of
a product.

These factors are as follows:

1. Price of the Product:

Demand for a commodity depends on its price. As price rises, for a normal good, demand falls and
vice-versa. However, there are exceptions, i.e., for Giffen goods, as price rises demand also rises.

2. Income of the Consumer:

A key determinant of demand is the level of income i.e., the higher the level of income the higher
the demand for a given commodity. Consumer’s income and quantity demanded are generally
related positively. It means that when income of the consumer rises he wants to have more units of
that commodity and when his income falls he reduces the demand.

In consumer theory, an inferior good is a good that decreases in demand when consumer income
rises i.e., increase in income reduces the demand because the consumer shifts his consumption to
superior goods and forgoes his existing product. Thus reducing its demand.

Cheaper cars are examples of the inferior goods. Consumers will generally prefer cheaper cars when
their income is constricted. As a consumer’s income increases the demand for cheap cars decreases
and demand for costly cars increases.

3. Prices of Related Goods:

Consumption choices are also influenced by the alternative options available to users in the relevant
market place. Market information regarding alternative products, quality, convenience and
dependability all influence choices.

The two products may be related in two ways- Firstly, as complementary goods and secondly as
substitute goods.

Complementary goods are those goods which are used jointly and consumed together like tennis
ball and a racket, petrol and car. The relationship between the price of a product and the quantity
demanded of another is inverse. For example if the price of cars were to rise, less people would
choose to buy and use cars, switching perhaps to public transport-trains. It follows that under these
circumstances the demand for the complementary good petrol would also decrease.

Goods which are perceived by the consumer to be alternatives to a product are termed as substitute
goods. There is direct relationship between the demand for a product and the price of its substitute.
Example- scooter and a motorcycle, tea and coffee.

The increase in price of tea would decrease its quantity demanded and people would switch over to
its substitute commodity coffee.

4. Consumer’s Tastes and Preferences:

Demand for a product is also affected by the tastes and preferences of the consumers. As tastes and
preferences shift from one commodity to the other, demand for the first commodity reduces and
that of the other rises.

5. Expectation of Future Prices:

The current demand of a product also depends on its expected price in future. If future price is
expected to rise, its present demand immediately increases because the consumer has a tendency to
store it at low prices for his future consumption. If, however the price of a product is expected to fall
then he has a tendency to postpone its consumption and as a result the present demand would also
fall.

This is often the case on Budget Day, when consumers rush to fill their petrol tanks prior to an
expected increase in taxation. The reverse is also true, in that an expectation that prices are about to
fall, will decrease current demand, as consumers will await for the expected price reduction.
6. Economic Conditions:

The demand for commodities also depends upon prevailing business conditions in the country. For,
example- during the inflationary period, more money is in circulation and people have more
purchasing power. This causes an increase in demand of various goods even at higher prices.
Similarly, during deflation (depression), the demand for various goods reduces in spite of lower
prices because people do not have enough money to buy.

Factors Determining Market Demand:

Market demand for a commodity means the sum total of the demand of all individuals. Market
demand depends, not only on the prices of the commodity and prices of related commodities but
also on the number of factors.

These are:

1. Pattern of Income Distribution:

If National income is equitably distributed, there will be more demand and vice-versa. If income
distribution moves in favour of downtrodden people, then demand for such commodities, which are
used by common people would increase. On the other hand, if the major part of National income is
concentrated in the hands of only some rich people, the demand for luxury goods will increase.

2. Demographic Structure:

Market demand is influenced by change in size and composition of population. Increase in

population leads to more demand for all types of goods and decrease in population means less
demand for them. Composition of population also affects its demand. Composition refers to the
number of children, adults, males, females etc., in the population.

When the composition changes, for example, when the number of females exceeds to that of the
males, then there will be more demand for goods required by women folk.

3. Government Policy:

Government policy of a country can also affect the demand for a particular commodity or
commodities through taxation. Reduction in the taxes and duties will allow more persons to enter a
particular market and thus raising the demand for a particular product.

4. Season and Weather:

Demands for commodities also depend upon the climate of an area and weather. In cold hilly areas
woolens are demanded. During summer and rainy season demand for umbrellas may rise. In winter
ice is not so much demanded.

5. State of Business:

The levels of demand in a market for different goods depend upon the business condition of the
country. If the country is passing through boom, the trade is active and brisk. The demand for all
commodities tends to rise. But in the days of depression, when trade is dull and slow, demand tends
to fall.
Demand Schedule:

The demand schedule in economics is a table of quantity demanded of a good at different price
levels. Given the price level, it is easy to determine the expected quantity demanded. This demand
schedule can be graphed as a continuous demand curve on a chart where the Y-axis represents price
and the X-axis represents the quantity.

According to PROF. ALFRED MARSHALL, “Demand schedule is a list of prices and quantities”. In other
words, a tabular statement of price-quantity relationship between two variables is known as the
demand schedule.

The demand schedule in the table represents different quantities of commodities that are purchased
at different prices during a certain specified period (it can be a day or a week or a month).

The demand schedule can be classified into two categories:

1. Individual demand schedule;

2. Market demand schedule.

1. Individual Demand Schedule:

It represents the demand of an individual’ for a commodity at different prices at a particular time
period. The adjoining table 7.1 shows a demand schedule for oranges on 7th July, 2009.

2. Market Demand Schedule:

Market Demand Schedule is defined as the quantities of a given commodity which all consumers will
buy at all possible prices at given moment of time. In a market, there are several consumers, and
each has a different liking, taste, preference and income. Every consumer has a different demand.

The market demand actually represents the demand of all the consumers combined together. When
a particular commodity has several brands or types of commodities, the market demand schedule
becomes very complicated because of various factors. However, for a single item, the market
demand schedule is rather simple. Study the market demand schedule for milk in table 7.2.
Demand Curves (Diagram):

The demand curve is a graphic statement or presentation of the relationship between product price
and the quantity of the product demanded. It is drawn with price on the vertical axis of the graph
and quantity demanded on the horizontal axis.

Demand curve does not tell us the price. It only tells us how much quantity of goods would be
purchased by the consumer at various possible prices.

Depending upon the demand schedule, the demand curve can be as follows:

1. Individual Demand Curve

2. Market Demand Curve

1. Individual Demand Curve:

An Individual Demand Curve is a graphical representation of the quantities of a commodity that an

individual (a particular consumer) stands ready to take off the market at a given instant of time
against different prices. In Fig. 7.1, an Individual Demand Curve is drawn on the basis of Individual
Demand Schedule given above in table 7.1.

2. Market Demand Curve:

A Market Demand Curve is a graphical representation of the quantities of a commodity which all the
buyers in the market stand ready to take off at all possible prices at a given moment of time. In
Figure 7.2 a Market Demand Curve is drawn on the basis of Market Demand Schedule given in Table
7.2.
Both, the individual consumer’s demand curve is a straight line. A demand curve will slope
downward to the right.

It is not necessary, that the demand curve is a straight line. A demand curve may be a convex curve
or a concave curve. It may take any shape provided it is negatively sloped.

Law of Demand:

The law of demand expresses functional relationship between price and the quantity. It has been
universally observed that people buy more quantity of goods when, they are available at a lower
price and the quantity purchased declines with an increase in its price.

“A rise in the price of a commodity or service is followed by a fall in quantity demanded, and a fall in
price is followed by an increase in quantity demanded”. Thus, lower the price, the larger is the
quantity demanded of a commodity and vice-versa.

The law thus, states that other things being equal the quantity demanded varies inversely with price.
Lower the price, greater is the effective demand; higher the price; lesser is the effective demand.

Characteristics of Law of Demand:

The law of demand has three specific characteristics:

1. General Tendency,

2. Relation to Time, and

3. Price and Demand Relationship.

1. General Tendency:

The law simply indicates a general tendency of changes in quantity demanded with the changes in
prices. However, it does not mention any specific propositions of changes in quantity demanded
with changes in prices.

2. Relation to Time:

The law of demand is always related to time, because the price changes from time to time and these
are never fixed. Thus, the co-relation between the prices and the quantities demanded should be
considered for a specific time or at particular instant.

3. Price and Demand Relationship:

The increase or decrease in the prices does affect the quantity demanded at a particular time. Thus,
the change in the quantity demanded cannot be considered without change in prices. It must,
therefore, be noted that the relationship between price and quantity demanded is relative.

Assumptions of Law of Demand:

i. The income of the consumer remains same during the period under consideration.

ii. The prices of related goods remain unchanged during the period.

iii. The preferences and tastes of consumers must remain the same during the period of
consumption.

iv. The quality of similar goods available in the market is almost unchanged.

v. During the period under study, it is presumed that prices are not likely to change in near future.

vi. No substitutes for the commodity in question are available.

Exceptions to the Law of Demand:

There are certain exceptions to the law of demand. It means that under certain circumstances,
consumers buy more when the price of a commodity rises and less when the price falls. In such case
the demand curve slopes upward from left to right i.e. demand curve has a positive slope as is
shown in Fig. 7.5. Many causes can be attributed to an upward sloping demand curve.
1. Ignorance:

Sometimes consumers are fascinated with the high priced goods from the idea of getting a superior
quality. However, this may not be always true. Superior/deceptive packing and high price deceive
the people. This can be called as ‘Ignorance effect’.

2. Speculative Effect:

When the price of a commodity goes up, people may buy larger quantity than before, if they
anticipate or speculate a further rise in its price. On the other hand, when the price falls, people may
not react immediately and may still purchase the same quantity as before, waiting for another fall in
the price. In both the cases, the law of demand fails to operate. This is known as speculative effect.

3. The Giffen Effect:

A fall in the price of inferior goods (Giffen Goods) tends to reduce its demand and a rise in its price
tends to extend its demand. This phenomenon was first observed by SIR ROBERT GIFFEN, popularly
known as Giffen effect.

He observed that the working class families of U.K. were compelled to curtail their consumption of
meat in order to be able to spend more on bread Mr. Giffen, British economist, observed that rise in
the price of bread caused the low paid British workers to buy more bread.

These workers lived mainly on the diet of bread, when price rose, as they had to spend more for a
given quantity of bread, they could not buy as much meat as before. Bread still being comparatively
cheaper was substituted for meat even at its high price.

4. Fear of Shortage:

People may buy more of a commodity even at higher prices when they fear of a shortage of that
commodity in near future. This is contrary to the law of demand. It may happen during times of war
and inflation and mostly in the case of goods which fall in the category of necessities of life like
sugar, kerosene oil, etc.

5. Prestigious Goods:

This is explained by Prof. Thorsfein Vebler Veblen. If consumers measure the desirability of a good
entirely by its price and not by its use, then they buy more of a good at high price and less of a good
at low price, Diamond, Jewellery and big cars etc., are such prestigious goods. In their case demand
relates to consumers who use them as status symbol.

As their prices go up and become costlier, rich people think it is more prestigious to have them. So
they purchase more. On the other hand, when their prices fall sharply, they buy less, as they are no
more prestigious goods. This is known as (Veblen effect) or (Demonstration effect).

6. Conspicuous Necessities:

Another exception occurs in use of such commodities as due to their constant use, have become
necessities of life. For example, inspite of the fact that the prices of television sets, refrigerators,
washing machines, cooking gas, scooters, etc., have been continuously rising, their demand does not
show any tendency to fall. More or less same tendency can be observed in case of most of other
commodities that can be termed as ‘Upper-Sector Goods’.

7. Bandwagon Effect:
The consumer’s demand for a good may be affected by the tastes & preferences of the social class to
which he belongs. If purchasing diamond becomes fashionable, then, as the price of diamond rises,
rich people may increase their demand for diamonds in order to show that they are rich.

8. Snob Effect:

People sometimes buy certain commodities like diamonds at high prices not due to their intrinsic
worth but for a different reason. The basic object is to display their riches to the other members of
the community to which they themselves belong. This is known as Snob appeal.

Movement along a Demand Curve and Shifts in the Demand Curve (Diagrams):

1. Change in Quantity Demanded — Movement along a Demand Curve:

Extension and Contraction of Demand- The quantity demanded of a product does not remain
constant, but keeps on changing due to various factors. If the quantity demanded changes due to
change in price only, it is called expansion and contraction of demand. If price decreases, it results in
expansion of demand and if price increases it results in contraction of demand. This situation is
shown by movement along the same demand curve.

In figure 7.6, we have shown expansion and contraction of demand. At price OP, quantity demanded
is OQ. If price reduces to OP1, the quantity demanded increase to OQ1. This increase of quantity
demanded would be called expansion of demand. If, however, price increases from OP to OP 2, then
quantity demanded decrease in equality would be called contraction of demand.

2. Change in Demand— Shifts in the Demand Curve:

Increase and Decrease of Demand:

If the change in quantity demanded of a product takes place due to any factor, other than price of
the product, then it is called increase or decrease of demand. This phenomenon is shown by a shift
in the entire demand curve. For example- if the income of the consumer rises then his entire
demand curve shifts to right which shows that consumer’s demand for the product has increased for
every given price.
In the figure 7.7 we can say if demand increases due to increase in income then demand curve shifts
to right from DD to D 1D1. If, however, the demand decreases due to fall in income then the demand
curve shifts to left from DD to D2D2.

Kinds of Demand:

The demands can be classified as:

1. Price Demand

2. Income Demand

1. Price Demand:

The price demand refers to various quantities of a commodity or services that are purchased at a
given time and at given prices from the market. However, in such studies, the consumer’s taste, his
income, habit and prices of related goods are assumed to be unchanged. Price demand has inverse
relation with the price i.e., if the price of a commodity increases, its demand decreases and as the
price decreases, its demand increases.

It can be seen in Fig. 7.8, when the price of the commodity was OP 1, the quantity demanded was
OQ1. When the price reduced to OP2, the quantity demanded increased to OQ 2. Hence the price and
the quantity demanded of a commodity show an inverse relationship.

2. Income Demand:
The income demand refers to the various quantities of a commodity or service purchased by the
consumers at different income levels. It is assumed that the price of commodity, price of related
goods and consumers’ tastes do not change. Under such conditions, with the increase in income, a
consumer may purchase increased quantity of the commodity even though there may not be any fall
in price.

Fig. 7.9 exhibits the direct relationship between income of a consumer and demand of a commodity.
As can be seen in the figure that as the income of the consumer increases from OI 1 to OI2, the
demand of the commodity increases from OQ1 to OQ2. Similarly when the income increases from
OI2 to OI3, the demand of the commodity raises from OQ2 to OQ3.

3. Cross Demand:

Cross demand refers to the quantity of a commodity which would be demanded as a consequence of
changes in price of related complementary or substitute goods.

(i) In the Case of Substitutes:

A rise in the price of good y (say Coffee) raises the demand for good x (Say Tea), similarly, a fall in the
price of y, (Coffee) the demand for x (Tea) falls. Fig. 7.10. illustrates it.

When the price of good y (Coffee) increases from OP to OP 1 the quantity of good x (Tea) also
increases from OQ to OQ1. The cross demand curve CD for substitutes is positively sloping.

(ii) In the Case of Complementary:

In case of complementary goods such as pant and shirt, pen and ink, car and petrol, etc., a fall in the
price of one good y (Say car) will raise the demand for good x (Say petrol). Conversely a rise in the
price of y (Car) will bring a fall in the demand for x (Petrol). This is illustrated in Fig. 7.11.

When the price of y (Car) falls from OP to OP 1, the demand for x (Petrol) increases from OQ to OQ 1.
The cross demand curve in case of complementary goods CD is negatively sloping.

Inter-Related Demands:

It has been assumed that demand of a particular commodity is quite independent of demand for
other goods. But in actual life, most of the demands are closely inter-related.

From a practical point of view, the inter-related demands can be classified as:

1. Joint Demand

2. Direct Demand and Derived Demand

3. Composite Demand

1. Joint Demand:

When several items are demanded for one particular purpose such demand is known as Joint
Demand. Demand for complementary goods is also known as Joint Demand. For example, for
fabrication of furniture, the items required are wood, nails, varnish, etc.

Thus, whenever the demand of furniture increases, the demand of wood, nails, etc., also increases.
This is called a Joint Demand. Similarly, for the construction of the houses, the demand for bricks,
cement, masons, labourers, etc., will constitute a Joint Demand. The Joint Demand for coffee is
denoted by the given line diagram (Fig. 7.12).

2. Direct Demand and Derived Demand:

Whenever several items are required to make a particular commodity, the demand for various
commodities is termed as the Derived Demand and demand of ultimate commodity is called as
Direct Demand. For example, the demand for building is a direct demand and demands for cement,
bricks, sand, timber, etc., are called as derived demands. It is denoted by the given line diagram (Fig.
7.13).

3. Composite Demand:

A commodity can be used for several purposes and its demand is directly linked to its sweets various
uses such a demand is known as Composite Demand. For example, milk is used for making tea,
coffee, butter, cheese, curd, sweets and for direct consumption. The total demand of milk in the
market is for all such purposes and it is called composite demand, denoted by the given line diagram
(Fig. 7.14).

Elasticity of Demand
1. Elasticity of Demand: The degree of responsiveness of demand to the
changes in determinants of demand (Price of the commodity, Income of a
Consumer, Price of related commodity) is known as elasticity of Demand.
2. It may be of three types: namely,
(a) Price elasticity of Demand.
(b) Income elasticity of Demand,
(c) Cross elasticity of Demand.
3. (a) The degree of responsiveness of quantity demanded to changes in price
of commodity is known as price elasticity of Demand.
(b) It is quantitative statement, i.e., it tells us the magnitude of the change
in quantity demanded as a result of change in price.
4. The degree of responsiveness of demand to change in income of
consumer is known as income elasticity of demand.
5. The degree of responsiveness of demand to change in the price of related
goods (substitute goods, complementary goods) is known as cross elasticity
of demand.

6. Percentage Method/Flux Method for calculating price elasticity of

demand:
According to this method, price elasticity of demand is measured by
dividing the percentage change in quantity demand by the percentage
change in price.
7. There are five degrees of price elasticity of demand.
(a) Unitary elastic demand: If percentage change in the quantity
demanded is equal to percentage change in price of the commodity,
then ED = 1 and the result is known as unitary elastic demand.

Negative sign indicates the inverse relationship between price and the
quantity demanded.
PED = 1 [Unitary elastic demand]
(b) More than unitary elastic demand or elastic demand: If percentage
change in quantity demanded is more than the percentage change in
price of the commodity then, ED > 1 and result is known as more than
unit elastic demand.
(c) Less than unitaíy elastic demand oí inelastic demand: If peícentage change in
quantity demanded is less than the peícentage change in píice of the commodity, then
ED < 1 and the íesult is known as less than unit elastic demand

d) Peífectly elastic demand: If quantity demand changes and píice íemains

constant, then ED = α and the íesult is known as peífectly elastic demand.
e) Peífectly Inelastic demand: If píice is changed ,and quantity demanded
constant,then ED=0 and the íesult is known as Peífectly Inelastic dem

8. ľotal outlay method oí ľotal Revenue Method oí Expendituíe method

foí calculating píice elasticity of demand
(a) ľotal expendituíe method indicates the diíection in which total expendituíe on a
píoduct changes as a íesult of change in píice of the commodity.
(b) Accoíding to this method, theíe aíe thíee bíoad possibilities as shown below:
Case I: Inelastic Demand:
(i) When the total expendituíe (ľotal íevenue) vaíies diíectly with píice, píice
elasticity of demand is less than one (i.e., demand is inelastic).
(ii) In otheí woíds, with the fall in píice, total expendituíe (ľotal íevenue) decíeases oí
with a íise in píice, total expendituíe (ľotal íevenue) incíeases.

Case II: Elastic Demand:

(i) When the total expendituíe (ľotal íevenue) vaíies inveísely with píice, píice
elasticity of demand is gíeateí than one, (i.e. demand is elastic).
(ii) In otheí woíds, with the fall in píice, total expendituíe (ľotal íevenue) incíeases, oí
with a íise in píice, total expendituíe (ľotal íevenue) decíeases.
Case III: Unitaíy Píice Elasticity:
(i) When the total expendituíe (ľotal íevenue) íemains the same, whateveí may be
the change in the píice level, píice elasticity of demand is said to be unity.

9. Geometíical Method oí Point Method foí Calculating Píice Elasticity of Demand:

(a) Accoíding to point method, elasticity of demand at any point is measuíed by
dividing the loweí segment of demand cuíve with the uppeí segment of the demand
cuíve at that point. It can be calculated by dividing the loweí segment by uppeí
segment.
Ïactoís Deteímining Píice Elasticity Of Demand Ïoí A Good

ľhey aíe as follows:

1. Natuíe of commodity: Elasticity of demand of a commodity is influenced by its
natuíe.
(a) ľhe demand foí necessities of life (commodities satisfying minimum basic
needs) is less elastic. ľhey aíe íequiíed foí human suívival and they have to be
puíchased
whateveí may be the píice. ľheíefoíe, demand foí necessities of life does not
fluctuate much with píice changes.
(b) Wheíeas, demand foí luxuíy goods is moíe elastic than the demand foí necessities.
When the píice of luxuíies falls, consumeís buy moíe of them and when the píices íises,
demand contíacts substantially.
Please íemembeí the teím “luxuíy” is a íelative teím, as a luxuíy foí a low-income
eaíning woíkeí may be a necessity foí íich employeí.
2. Availability of substitutes/Substitute goods:
(a) If close substitutes foí the commodity aíe available, the demand foí the commodity
will be elastic. ľhe íeason is that even a small íise in its píices will induce the buyeís to
go foí its substitutes. Foí example, Pepsi and Coke aíe consideíed faiíly close
substitutes. If the píice of coke incíeases, Pepsi becomes íelatively cheapeí. Consumeí
will buy moíe of Pepsi and less of íelatively expensive Coke.
(b) Howeveí, the demand foí a commodity (such as salt) having no close substitutes is
inelastic.
3. Income Level:
(a) Higheí income level gíoups have less elasticity of demand foí any commodity as
compaíed to the people with low incomes. It happens because íich people aíe not
influenced much by changes in the píice of goods.
(b) But, pooí people aíe highly affected by incíease oí decíease in the píice of
goods. As the íesult of, demand foí loweí income gíoup is highly elastic.
4. Level of píice/Own píice of a good:
(a) Higheí own píice of a good oí Costly goods like caí, gold etc. have highly elastic
demand as theií demand is veíy sensitive to changes in theií píices.
(b) Howeveí, demand foí inexpensive goods like thíead, needle etc. is inelastic as
change in píices of such goods do not change theií demand by a consideíable
amount.
5. Postponement of Consumption:
(a) Commodities like ice cíeam, soft díinks, etc. whose demand is not uígent, have highly
elastic demand as theií consumption can be postponed in case of an incíease in theií
píices.
(b) Howeveí, commodities with uígent demand like life saving díugs, have inelastic
demand because of theií immediate íequiíement.
6. Numbeí of Uses:
(a) If the commodity undeí consideíation has many alteínative uses, its demand will be
highly elastic. Foí example, electíicity.
(b) As against it, if commodity undeí consideíation has only limited uses, its demand
will be highly Inelastic.
7. Shaíe in ľotal Expendituíe:
(a) If a smalleí píopoítion of consumeí’s income is spent on a paíticulaí commodity, its
elasticity is highly inelastic because lesseí píopoítion of consumeí income is spent on
consumption of these commodities. Demand foí goods like salt, needle, etc. tends to be
inelastic as consum eís spend a small píopoítion of theií income on such goods. When
píices of such goods change, consumeís continue to puíchase almost the same quantity
of these goods.
(b) As against it, if a laígeí píopoítion of consumeí income is spent on the
commodity, elasticity of demand is highly elastic.
8. ľime Peíiod: Píice elasticity of demand foí a commodity also affected by time
peíiod.
(a) Demand is inelastic in the shoít peíiod as consumeís find it difficult to change
theií habits duíing shoít peíiod.
(b) As against it, demand is highly elastic duíing long peíiod as theií is availability of
close substitutes in long peíiod.
9. Habits
(a) ľhe demand foí those goods that aíe habitually consumed is inelastic. ľhe íeason is
that such commodities become a necessity foí the consumeí, and even if píices change,
consumeís continue to puíchase and consume the commodity. Examples of habit-
foíming commodities include alcoholic beveíages, tobacco (in its vaíious foíms)
consumption and even tea and coffee.
(b) As against it, if a peíson is not habitual, demand is elastic.

Supply
Supply is a term in economics that refers to the number of units of goods or
services a supplier is willing and able to bring to the market for a specific price.
The willingness and ability to avail products to the market are influenced by
stock availability and the determiners driving the supply. A change in prices
impacts the market equilibrium too. A price increase will result in more
supplies, and a decrease will result in the opposite effect.

Concept of Supply

In economics, supply refers to the quantity of a product available in the market

for sale at a specified price and time.
In other words, supply can be defined as the willingness of a seller to sell the
specified quantity of a product within a particular price and time period. Here, it
should be noted that demand is the willingness of a buyer, while supply is the
willingness of a supplier.
Meaning of Supply
Supply has three important aspects, which are as follows:

 Supply is always referred in terms of price

The price at which quantities are supplied differs from one location to the
other. For example, fast moving consumer goods (FMCG) are usually
supplied at different prices in different prices.

 Supply is referred in terms of time

This means that supply is the amount that suppliers are willing to offer
during a specific period of time (per day, per week, per month, bi-
annually, etc.)

 Supply considers the stock and market price of the product

Both stock and market price of a product affect its supply to a greater
extent. If the market price of a product is more than its cost price, the
seller would increase the supply of the product in the market. However, a
decrease in the market price as compared to the cost price would reduce
the supply of product in the market.

Supply Definition
Economist has given different supply definition but the essence is same.

Acc. to McConnell

Supply may be defined as a schedule which shows the various amounts of a

product which a particular seller is willing and able to produce and make
available for sale in the market at each specific price in a set of possible prices
during a given period.

Acc. to Anatol Murad

Supply refers to the quantity of a commodity offered for sale at a given price, in
a given market, at given time.

Supply Example
Let us understand the concept of supply with an example.
For example, a seller offers a commodity at 100 per piece in the market. In this
case, only commodity and price are specified; thus, it cannot be considered as
supply.

However, there is another seller who offers the same commodity at 110 per
piece in the market for the next six months from now on. In this case,
commodity, price, and time are specified, thus it is supply.

Classification of supply
Supply can be classified into two categories, which are individual supply and
market supply.

1. Individual supply is the quantity of goods a single producer is

willing to supply at a particular price and time in the market. In
economics, a single producer is known as a firm.

2. Market supply is the quantity of goods supplied by all firms in the

market during a specific time period and at a particular price. Market
supply is also known as industry supply as firms collectively
constitute an industry.

Types of Supply
 Market Supply
 Short-term Supply
 Long-term Supply
 Joint Supply

Types of Supply

 Market supply -explains the overall willingness and ability of all

suppliers to supply the market a particular product on a day-to-day
basis. For example, wheat suppliers A, B, and C may be willing to supply
5, 0, 6 kilos in the market at rs.1 per kilo for a total of 11 kilos. If prices
rise to Rs.2.50, the suppliers may increase to 10, 8, and 15 kilos,
respectively. In total, the market supply amounts to 33 kilos.
 Short-term supply explains that the ability of a purchaser to buy goods
is constrained by the available supplies. Buyers cannot purchase
beyond the supplied products.
  Long-term supply explains the factor of time availability whenever the
demand changes – meaning, the availability of time gives the supplier a
leeway to adjust to a sudden shift in demand.
 Joint supply explains the consequential supply. For example, lamb
production affects meat and wool supply. In case farmers reduce
farming lambs, meat and wool supply will go down, too. Similarly, an
increase will result in the opposite effect.

Determinants of Supply

Determinants of supply are:

1. Price of a product
2. Cost of production
3. Natural conditions
4. Transportation conditions
5. Taxation policies
6. Production techniques
7. Factor prices and their availability
8. Price of related goods
9. Industry structure

Price of a product
The major determinants of the supply of a product is its price. An increase in
the price of a product increases its supply and vice versa while other factors
remain the same.

Cost of production
It is the cost incurred on the manufacturing of goods that are to be offered to
consumers. Cost of production and supply are inversely proportional to each
other.

Natural conditions
The supply of certain products is directly influenced by climatic conditions.
For instance, the supply of agricultural products increases when the monsoon
comes well on time.

Transportation conditions
Better transport facilities result in an increase in the supply of goods.
Transport is always a constraint to the supply of goods. This is because goods
are not available on time due to poor transport facilities.

Taxation policies
Government’s tax policies also act as a regulating force in supply. If the rates
of taxes levied on goods are high, the supply will decrease. This is because
high tax rates increase overall productions costs, which will make it difficult
for suppliers to offer products in the market.

Production techniques
The supply of goods also depends on the type of techniques used for
production. Obsolete techniques result in low production, which further
decreases the supply of goods.

Factor prices and their availability

The production of goods is dependent on the factors of production, such as
raw material, machines and equipment, and labour.

Price of related goods

The prices of substitutes and complementary goods also influence the supply
of a product to a large extent.

Industry structure
The supply of goods is also dependent on the structure of the industry in
which a firm is operating. If there is monopoly in the industry, the
manufacturer may restrict the supply of his/her goods with an aim to raise
the prices of goods and increase profits.

Supply Function
Supply function is the mathematical expression of law of supply. In other
words, supply function quantifies the relationship between quantity supplied
and price of a product, while keeping the other factors at constant.

The law of supply expresses the nature of the relationship between quantity
supplied and price of a product, while the supply function measures that
relationship.
The supply function can be expressed as:

Qs = f (Pa, Pb, Pc, T, Tp)

Where,
Qs = Supply
Pa = Price of the good supplied
Pb = Price of other goods
Pc = Price of factor input
T = Technology
Tp = Time Period

According to the supply function, the quantity supplied of a good (Qs) varies
with the price of that good (Pa), the price of other goods (Pb), the price
of factor input (Pc), the technology used for production (T), and time period
(Tp)

Law of Supply: Schedule, Curve, Function,

Assumptions and Exception

Law of supply expresses a relationship between the supply and price of a

product. It states a direct relationship between the price of a product and its
supply, while other factors are kept constant.

For example, in case the price of a product increases, sellers would prefer to
increase the production of the product to earn high profits, which would
automatically lead to increase in supply.

Similarly, if the price of the product decreases, the supplier would decrease
the supply of the product in market as he/she would wait for rise in the price
of the product in future.

The statement given for the law of supply is as follows:

“Other things remaining unchanged, the supply of a commodity expands with
a rise in its price and contracts with a fall in its price.”

The law of supply can be better understood with the help of supply schedule,
supply curve, and supply function.

Supply Schedule:

Supply schedule shows a tabular representation of law of supply. It presents

the different quantities of a product that a seller is willing to sell at different
price levels of that product.

A supply schedule can be of two types, which are as follows:

i. Individual Supply Schedule:
Refers to a supply schedule that represents the different quantities of a
product supplied by an individual seller at different prices.

Table-8 shows the supply schedule for the different quantities of milk
supplied in the market at different prices:

ii. Market Supply Schedule:

Refers to a supply schedule that represents the different quantities of a
product that all the suppliers in the market are willing to supply at different
prices. Market supply schedule can be drawn by aggregating the individual
supply schedules of all individual suppliers in the market.

Table-9 shows the market supply schedule of a product supplied by

three suppliers. A, B, and C:

Supply Curve:
The graphical representation of supply schedule is called supply curve. In a
graph, price of a product is represented on Y-axis and quantity supplied is
represented on X-axis. Supply curve can be of two types, individual supply
curve and market supply curve. Individual supply curve is the graphical
representation of individual supply schedule, whereas market supply curve is
the representation of market supply schedule.

Figure-14 shows the individual supply curve for the individual supply
schedule (represented in Table-8):
In Figure-14, the supply curve is showing a straight line and an upward slope.
This implies that the supply of a product increases with increase in the price
of a product.

Figure-15 shows the market supply curve of market supply schedule

(represented in Table-9):

The slope of market supply curve can be obtained by calculating the supply of
the slopes of individual supply curves. Market supply curve also represents
the direct relationship between the quantity supplied and price of a product.

Assumptions in Law of Supply:

The law of supply expresses the change in supply with relation to change in
price. In other words the main assumption of law of supply is that it studies
the effect of price on supply of a product, while keeping other determinants of
supply at constant.

Apart from this, there are certain assumptions that are necessary
for the application of law of supply, which are as follows:
i. Assumes that the price of a product changes, but the change in the cost of
production is constant. This is because if the cost of production rises with
increase in price, then sellers would not supply more due to the reduction in
their profit margin. Therefore, law of supply would be applicable only when
the cost of production remains constant.

ii. Assumes that there is no change in the technique of production. This is

because the advanced technique would reduce the cost of production and
make the seller supply more at a lower price.

iii. Assumes that there is no change in the scale of production. This is because
if the scale of production changes with a period of time, then it would affect
the supply. In such a case, the law of supply would not be applicable.

iv. Assumes that the policies of the government remain constant. If there is an
increase in tax rates, then the supply of product would decrease even at the
higher price. Therefore, for the application of law of supply, it is necessary
that government policies should remain constant.

v. Assumes that the transportation cost remain the same. In case the
transportation cost reduces, then the supply would increase, which is invalid
according to the law of supply.

vi. Assumes that there is no speculation about prices in future, which

otherwise can affect the supply of a product. If there is no speculation about
products, then the economy is assumed to be at balance and people are
satisfied with the available products and do not require any change.

Exception to Law of Supply:

According to the law of supply, if the price of a product rises, then the supply
of the product also rises and vice versa. However, there are certain conditions
where the law of supply is not applicable. These conditions are known as
exceptions to law of supply. In such cases, the supply of a product falls with
the increase in price of a product at a particular point of time.

For example, there would be decrease in the supply of labor in an

organization when the rate of wages is high. The exception of law of supply is
represented on the regressive supply cure or backward sloping curve. It is
also known as exceptional supply curve, which is shown in Figure-16:
In Figure-16, SMS1 is the exceptional supply curve for labor. In this case,
wages are regarded as the price of labor. It can be interpreted from the graph
that as the wages of a worker increases, its quantity supplied that is working
hours decreases, which is an exception to the law of supply.

Some of the exceptions of law of supply are as follows:

i. Speculation:
Refers to the fact that the supply of a product decreases instead of increasing
in present when there is an expected increase in the price of the product. In
such a case, sellers would not supply the whole quantity of the product and
would wait for the increase in price in future to earn high profits. This case is
an exception to law of supply.

ii. Agricultural Products:

Imply that law of supply is not valid in case of agricultural products as the
supply of these products depends on particular seasons or climatic conditions.
Thus, the supply of these products cannot be increased after a certain limit in
spite of rise in their prices.

iii. Changes in Other Situations:

Refers to the fact that law of supply ignores other factors (except price) that
can influence the supply of a product. These factors can be natural factors,
transportation conditions, and government policies.

Shifts in supply

The position of a supply curve will change following a change in one or more
of the underlying determinants of supply. For example, a change in costs, such
as a change in labour or raw material costs, will shift the position of the supply
curve.
Rising costs

If costs rise, less can be produced at any given price, and the supply curve will
shift to the left.

Falling costs

If costs fall, more can be produced, and the supply curve will shift to the right.

Any change in an underlying determinant of supply, such as a change in the

availability of factors, or changes in weather, taxes, and subsidies, will shift
the supply curve to the left or right.
Price is the worth that buys a finite amount, weight, or another match of goods
or services. In other words, it also expresses the value of the goods produced
and the services rendered by factors of production such as land, labor, and
capital. Thus, the determination of prices is of great significance in an
economy.

Introduction to Determination of Prices

Determination of Prices means to determine the cost of goods sold and
services rendered in the free market. In a free market, the forces of demand
and supply determine the prices.

The Government does not interfere in the determination of the prices.

However, in some cases, the Government may intervene in determining the
prices. For example, the Government has fixed the minimum selling price for
the wheat.

Factors affecting Determination of Prices

The factors which affect the price determination of the product are:

1] Product Cost

Product cost is one of the most important factors which affect the price. It
includes the total of fixed costs, variable costs and semi-variable costs
incurred through the production, distribution, and selling of the product.
Fixed costs refer to those costs which remain fixed at all the levels of
production or sales. For instance, rent, salary, etc.

Variable costs attribute to the costs which are directly related to the levels of
production or sales. For example, the costs of basic material, apprentice costs,
etc. Semi-variable costs take into account those costs which change with the
level of activity but not in direct proportion.

2] The Utility and Demand

Habitually, end user demands more units of a product when its price is low
and vice versa. On the other hand, when the demand for a product is elastic,
little variation in the price may result in large changes in quantity demanded.
While, when it is inelastic a change in the prices does not affect the demand
significantly. In addition, the buyer is ready to pay up to that point where he
perceives utility from the product to be at least equal to the price paid.

3] The extent of Competition in the Market

The next consistent factor affecting the price of manufactured goods is the
nature and degree of competition in the market. A firm can fix any price for its
product if the degree of competition is low. However, when there is
competition in the market, the price is fixed after keeping in mind the price of
the substitute goods.

4] Government and Legal Regulations

The firms which have a monopoly in the market, habitually charge a high price
for their products. In order to protect the interest of the public,
the government intervenes and regulates the prices of the commodities. For
this purpose, it declares some products as indispensable products. For
example, Life-saving drugs, etc.

5] Pricing Objectives

Another consistent factor, affecting the price of an item for consumption or

service is the pricing objectives. Profit Maximization, Obtaining Market Share
Leadership, Surviving in a Competitive Market and Attaining Product Quality
Leadership are the pricing objectives of an enterprise. By and large, firm
charges higher prices to cover high quality and high cost if it’s backed by the
above objective.

6] Marketing Methods Used

A range of marketing methods such as circulation system, quality of salesmen,

marketing, type of wrapping, patron services, etc. also affects the price of
manufactured goods. For instance, an organization will charge sky-scraping
revenue if it is using the classy material for wrapping its product.
Meaning of Production:
Since the primary purpose of economic activity is to produce utility for
individuals, we count as production during a time period all activity which
either creates utility during the period or which increases ability of the society
to create utility in the future.

They are artificial entities created by individuals for the purpose of organising
and facilitating production. The essential characteristics of the business firm
is that it purchases factors of production such as land, labour, capital,
intermediate goods, and raw material from households and other business
firms and transforms those resources into different goods or services which it
sells to its customers, other business firms and various units of the
government as also to foreign countries.

Definition of Production:

According to Bates and Parkinson:

“Production is the organised activity of transforming resources into

finished products in the form of goods and services; the objective of
production is to satisfy the demand for such transformed resources”.

According to J. R. Hicks:

“Production is any activity directed to the satisfaction of other peoples’

wants through exchange”. This definition makes it clear that, in
economics, we do not treat the mere making of things as production.
What is made must be designed to satisfy wants.

What is not Production?

The making or doing of things which are not wanted or are made just for the
fun of it does not qualify as production. On the other hand, all jobs which do
aim at satisfying wants are part of production.

Those who provide services Such as hair-dressers, solicitors, bus drivers,

postmen, and clerks are as much a part of the process of satisfying wants as
are farmers, miners, factory workers and bakers. The test of whether or not
any activity is productive is whether or not anyone will buy its end-product. If
we will buy something we must want it; if we are not willing to buy it then, in
economic terms, we do not want it.
Importance of Exchange:

So from our above definition it is clear that many valuable activities such as
the work done by people in their own houses and gardens (the so-called do it
yourself exercise) and all voluntary work (such as free coaching, free-nursing,
collection of subscription for a social cause such as flood-relief or earthquake-
relief) immensely add to the quality of life but there is no practical way of
measuring their economic worth (value).

Three Types of Production:

For general purposes, it is necessary to classify production into three main
groups:

1. Primary Production:

Primary production is carried out by ‘extractive’ industries like agriculture,

forestry, fishing, mining and oil extraction. These industries are engaged in
such activities as extracting the gifts of Nature from the earth’s surface, from
beneath the earth’s surface and from the oceans.

2. Secondary Production:

This includes production in manufacturing industry, viz., turning out semi-

finished and finished goods from raw materials and intermediate goods—
conversion of flour into bread or iron ore into finished steel. They are
generally described as manufacturing and construction industries, such as the
manufacture of cars, furnishing, clothing and chemicals, as also engineering
and building.

3. Tertiary Production:

Industries in the tertiary sector produce all those services which enable the
finished goods to be put in the hands of consumers. In fact, these services are
supplied to the firms in all types of industry and directly to consumers.
Examples cover distributive traders, banking, insurance, transport and
communications. Government services, such as law, administration,
education, health and defence, are also included.

Output:

Any activity connected with money earning and money-spending is called an

economic activity. Production is an important economic activity. It results in
the output (creation) of an enormous variety of economic goods and services.
Factors of Production:
Production of a commodity or service requires the use of certain resources or
factors of production. Since most of the resources necessary to carry on
production are scarce relative to demand for them they are called economic
resources.

Resources, which we shall call factors of production, are combined in various

ways, by firms or enterprises, to produce an annual flow of goods and
services.

Table 5.1: A Classification of Factors of Production:

Each factor gets a reward on the basis of its contribution to the production
process, as shown in the table.

In fact, the resources of any community, referred to as its factors of

production, can be classified in a number of ways, but it is common to group
them according to certain characteristics which they possess. If we keep in
mind that the production of goods and services is the result of people working
with natural resources and with equipment such as tools, machinery and
buildings, a generally acceptable classification can readily be derived. The
traditional division of factors of pro-duction distinguishes labour, land and
capital, with a fourth factor, enterprise, some-times separated from the rest.

The people involved in production use their skills and efforts to make things
and do things that are wanted. This human effort is known as labour. In other
words, labour represents all human resources. The natural resources people
use are called land. And the equipment they use is called capital, which refers
to all man-made resources.

Píoduction Ïunction (Shoít Peíiod And Long Peíiod)

1. ľhe íelationship between physical input and physical output of a fiím is geneíally
íefeííed to as píoduction function.
ľhe geneíal foím of píoduction function is, q = f ( x1, x2)

wheíe, q = output, x1 = 1 input like labouí, x2= anotheí input like machineíy

2. Vaíiable factoís íefeí to those factoís, which can be changed in the shoít íun.
ľhey vaíy diíectly with the output. Foí example, Labouí, íaw mateíial, etc.
3. Ïixed factoís íefeí to those factoís which cannot be changed in the shoít íun.
ľhey do not vaíy diíectly with the output. Foí example, Capital, land, plant and
machineíy, etc.
4. A shoít peíiod íefeís to the peíiod of time in which a fiím cannot change some of its
factoís like plant, machineíy, building, etc. due to insufficiency of time but can change
any vaíiable factoí like labouí, íaw mateíial, etc. ľhus, in shoít íun, theíe will be some
factoís of píoduction that aíe fixed at píedeteímined levels, e.g., a faímeí may have fixed
amount of land.

5. A long peíiod is a time peíiod duíing which a fiím can change all its factoís of
píoduction including machines, building, oíganization, etc. In otheí woíds, it is a
peíiod of time duíing which supplies can adjust itself to change in demand. Note:
Mind, heíe the teíms long peíiod and shoít peíiod aíe functional and do not íefeí to a
calendaí month oí a yeaí. ľhis distinction depends meíely upon how quickly factoí
inputs can be change by píoduceís in an industíy.
6. Shoít íun píoduction function can be defined, when application of one factoí is
vaíied while all the otheí factoís aíe kept fixed (constant). ľhe law that opeíates heíe,
is known as “law of íetuíns to a factoí”.

In this factoí íatio that is, land-labouí íatio changes. Foí example, on 5 acíes of land, 10
labouí can be employed. So, initially factoí íatio will be 5: 1, when we employ anotheí
labouí, the factoí íatio changes to 5: 2. So, factoí íatio changes duíing shoít
peíiod.
7. Long íun píoduction function can be defined as, when application of all the
factoís is vaíied (changed) in the same factoí píopoítion, the law that opeíates in such
a situation is known as law of íetuíns to scale’.

ľotal Píoduct, Aveíage Píoduct and Maíginal Píoduct

1. ľotal píoduct oí total íetuín to an input: It íefeís to total volume of goods and
seívices píoduced by a fiím with the given input duíing a specified peíiod of time.
In a shoít peíiod of time if a fiím wants to incíease its total píoduct, then it can do so by
incíeasing the vaíiable factoís of píoduction only because fixed factoís of píoduction
íemain fixed and do-not fluctuate with the fluctuation in píoduction.
Howeveí, in the long peíiod, incíease in all the factoís of píoduction can incíease level of
output.

i) To calculate Total Product, we have to add Marginal Product.

(ii) To calculate Total Product, we have to use this farmula:

Total product=APL x Units of variable factor

2. Average product or Average return to an input: It is per unit total

product of variable factors. It is calculated by dividing the total Product by the
units of variable factor.
3. Marginal Product or Marginal Return to an Input: It is an addition to the
total product when an additional unit of a variable factor is employed.

Returns to Scale and Returns to Factor

Returns to a factor and returns to scale are two important laws of production.
Both laws explain the relation between inputs and output. Both laws have
three stages of increasing, decreasing and constant returns. Even then, there
are fundamental differences between the two laws.

Returns to a factor relate to the short period production function when

one factor is varied keeping the other factor fixed in order to have more
output, the marginal returns of the Variable factor diminish. On the other
hand, returns to scale relate to the long period production function when a
firm changes its scale of production by changing one or more of its factors.

Assumptions:
We discuss the relation between the returns to a factor (law of diminishing
returns) and returns to scale (law of returns to scale) on the assumptions that:

(1) There are only two factors of production, labour and capital.

(2) Labour is the variable factor and capital is the fixed factor.

(3) Both factors are variable in returns to scale.

(4) The production function is homogeneous.

Explanation:

Given these assumptions, we first explain the relation between constant

return to scale and returns to a variable factor in terms of Figure where OS is
the expansion path which shows constant returns to scale because the
difference between the two isoquants 100 and 200 on the expansion path is
equal i.e.,

OM = MN. To produce 100 units, the firm uses ОС + OL quantities of capital

and labour and to double the output to 200 units, double the quantities of
labour and capital are required so that ОС 2 + OL2 lead to this output level at
point N. Thus there are constant returns to scale because OM = MN.

To prove that there are decreasing returns to the variable factor, labour, we
take ОС of capital as the fixed factor, represented by the CC line which is
parallel to the X-axis relating to labour.

This is called the proportional line. Keeping С as constant, if the amount of

labour is doubled by LL2 we reach point Y which lies on a lower isoquant 150
than the isoquant 200. By keeping С constant, if the output is to be doubled
from 100 to 200 units, then OL3 units of labour will be required. But OL3 >
OL2. Thus by doubling the units of labour from OL to OL 2 with constant C the
output less than doubles.

It is 150 units at point K instead of 200 units at point P. This shows that the
marginal returns of the variable factor, labour, have diminished when there
are constant returns to scale.
COST AND REVENUE
A producer has to work very hard to produce a good or service. He has to
make a lot of effort in the process. In the beginning, the producer must
arrange money to organize the production activity. We have already said that
various factors in the form of land, labour, and capital are required to produce
goods. These factors are not available for free. The producer must purchase
them in the right quantity needed for production. Similarly, raw materials and
other things have to be purchased and stored. To purchase these things, the
producer must be ready to pay the price for them.

Once the goods or services are produced, the producer sells them in the
market to various consumers. At this time, the consumers pay price to the
producer to purchase the goods and services. With this the producer starts
earning money. So, in order to produce goods and services, the producer first
incurs expenditure to purchase factors of production and then receives money
from the consumers by selling those goods and services to them.

MEANING OF COST

In order to understand the meaning of cost let us take the example of a farmer
who is producing rice/paddy. You know that, it normally takes 5 to 6 months
to produce rice. The production of rice involves the following:

(i) getting the land for cultivation

(ii) using labour to prepare the land and make it suitable for growing the crop.
This includes tilling the soil, sowing seed, fertilizing and irrigating the land
and finally harvesting.

(iii) Transporting rice to godown/mandi.

let us say, that the farmer hires 5 acres of land on rent.

Suppose, he has to pay Rs. 5,000 as rent to the owner of the land for the
whole period he uses it.

The farmer also needs labourers to work on the field for 5 months. Let us say
the farmer hires 4 labourers. In the first two months he uses the labourers to
till the soil, sow seeds, transporting the seedlings and planting them by hand,
fertilising and irrigating the field. In order to hire a labourer, the famer must
pay wage. The wage rate prevailing in the market on an average is say, Rs. 75
per worker per day. When the farmer used only two labourers for two months
to look after the standing crop. When the time of harvesting arrives, he again
hires 4 labourers for 15 days.

What is the total amount paid to the labourers by the farmer?

First, 4 labourers work for two months or sixty days. So at Rs. 75 per worker
it comes to 75 × 4 × 60 = Rs.18,000.

Then two labourers work for two months. This comes to 75 × 2 × 60 =

Rs.9000.

Finally 4 labourers worked for 15 days. This comes out to be 75 × 4 × 15 =

Rs.4,500.

The total money paid to the labourers was 18,000 + 9,000 + 4.500 =
Rs.31,500

To grow the crop, the farmer uses some raw materials such as seeds, water,
fertilizer, pesticicdes etc. for which he spends, say, Rs. 3,000.

He also uses tractor for which he pays rent of Rs. 2500.

After harvesting the farmer produces, say, 30 quintals of rice.

Now, calculate the total money spent by the farmer to produce rice?

We can do it in the following manner.

Items Expenditure (Rs.)

Rent paid to Landlord 5,000
Wages to labour 31,500
Raw materials 3,000
Service of Tractor 2,500

Total 42,000

We can say that, the farmer spent Rs.42,000 to produce 30 quintals of

rice.
Definition of Cost

Cost is defined as the money expenditure incurred by the producer to

purchase (or hire) factors of production and raw materials to produce goods
and services. In a way, cost is a kind of sacrifice made by the producer. In this
example, the sacrifice was made in terms of making payments; such as wages
to labourers, rent for the use of land and tractor and incurring expenditure on
raw materials etc.

TYPES OF COST

From the example above we can distinguish between following types of costs.

(a) Fixed cost

(b) Variable cost

(c) Explicit cost

(d) Implicit cost

Let us discuss them one by one.

(a) Fixed Cost

In the above example, we said that the farmer paid Rs. 5,000 as rent to the
owner of the land. Once the land is procured for cultivation, the farmer must
pay rent for it, even if he does not produce any thing on it. The land is also
fixed factor of production here. Because, whether or not the farmer cultivates
on the entire 5 acres of land, he has to pay rent for the whole 5 acres. This is
fixed. So fixed cost is defined as the expenditure, on hiring or purchasing of
fixed factors/ inputs, which are compulsory and has nothing to do with the
amount of production of the good or service. Similarly, rent paid for the use of
tractor is also a fixed cost.

(b) Variable Cost

In the above example, the farmer paid Rs.31,500 towards wage for labourers
and Rs.3000 for purchase of raw materials. How much of wage was paid
depends on how many labourers the producer hired. Labour as a factor of
production can be changed. In the example, we said that the producer used 4
labourers during the first two months and only 2 labourers for the next two
months. This is because in the beginning the amount of work was more and
more labourers were required. Accordingly more amount of money, i.e
Rs.18000, was paid. But when the amount of work was less during the next
two months, only 2 labourers were hired and accordingly the wage bill also
decreased to Rs.9000. Hence, payment towards wages can be changed. So it is
called variable cost. We can define variable cost as the expenditure on variable
factors/inputs, such as labour, which can be changed.

(c) Explicit

Cost Both the rent and wages paid by the farmer and the expenditure on raw
materials incurred by him are also called explicit cost. Explicit cost is defined
as the money expenditure incurred by the producer on both fixed and variable
factors of production and raw materials etc. These are direct payments and
are properly calculated and recorded separately. Bills, money receipts or
vouchers etc exist with respect to such expenditure by the producer.

(d) Implicit Cost

Besides purchasing factors of production and raw materials, the producer

also uses his own factors and materials for producing goods and services. For
this he does not pay any money to himself. But he bears this expenditure
indirectly. Suppose, a farmer uses his own tractor to cultivate land. Had he
hired a tractor from somebody else, he would have paid rent for this. In that
case it would have been called explicit cost of the farmer. Let us say the rent
for using the services of a tractor is Rs. 3000 for a particular period of time. So
the farmer can earn Rs.3000 if he gives his tractor on rent. Otherwise, if he
uses it for himself, then he will consume a value of Rs. 3000 for the purpose of
production. In this case, it will be called implicit cost of the farmer. So implicit
cost is the cost of self supplied factors. The value of such cost has to be
calculated on the basis of market value.

TOTAL AND AVERAGE COST

Total cost is the sum of total fixed cost and total variable cost which are
given explicitly.

Average total cost or simply the average cost is the ratio of total cost to
the total output.
We can also write,

Total Cost (TC) = Total Fixed Cost + Total Variable Cost

Average Cost (AC) = Total Cost/Total Output.

Average Cost is the cost per unit of output.

Marginal Cost (MC)

If the producer wants to increase output, then he has to engage extra

units of labour. Extra units of labour will lead to extra expenditure on
wage paid to the labour. As a result the total cost of production will
increase. In short, increase in total output will lead to increase in total
cost of production. In this context marginal cost is defined as
increase in the total cost due to increase in one extra unit of output.

Example:

Suppose a tailor makes 10 pieces of shirts by incurring a total cost of Rs.

1110. Then he increased shirt production to 11 pieces for which he
incurred Rs. 1199 as total cost.

What is the marginal cost?

Ans:

Here increase in output is 11-10 = 1 unit. Because of increase in output

by one unit cost.
REVENUE

Revenue is another very important concept in economics. In fact the

study of cost is not complete, if we do not talk about revenue.

What is revenue?

Definition of Revenue

Revenue is defined as the amount a person receives by selling a certain

quantity of the commodity. You know that a commodity can be
purchased in the market by paying a certain price. So revenue can be
calculated by multiplying price and quantity of the commodity.

Hence we can write

Revenue = Price of the Commodity × Quantity of the Commodity

During a given period of time, the seller sells certain quantity of the
commodity.

So the total amount of money received by the seller during that time
period is called total revenue. We denote it as TR where TR stands for
total revenue. Let us denote price as ‘P’ and quantity as ‘Q’ then

we can write

Total Revenue = Price × Quantity or TR = P × Q

Example:

Continue with the example of the farmer in our section on “Cost”. Think
that the farmer produced 30 quintals of rice. Let us say that the price of
rice is Rs. 1600 per quintal in the market. If the farmer sells all this rice
then he will earn 1600 × 30 = Rs. 48,000.
So his total revenue will be Rs. 48,000. From this example, we can also
say that revenue is the money receipts of the producer or seller from the
sale of his output.

Another term used for “total revenue” is total sales proceeds. Because
revenue is received by selling a commodity. It is also called total sales
proceeds from that Commodity.

You must remember that each and every commodity has its own price. A
retailer sells different commodities to the buyers. Take the example of a
provision store or a staitionary shop. A seller sells various items in a
provision store; such as rice, wheat, wheat flour, different varieties of
dal, biscuits, edible oil etc. You will even find varities of rice such as
basmati, parmal, cella etc; there are different types of edible oils, such as
refined vegetable oil, sunflower oil, mustard oil, soyabean oil, etc; and so
on. A retail shopkeeper sells so many different kinds of goods as well as
different types of the same good. So what will be his total revenue, say,
after a time period of one week?

The answer is very simple. First make a list of the prices of the goods
he sold during the week. Second, make a list of respective quantities of
the goods. Third, find the total revenue of the shopkeeper for the given
week. We can illustrate this in the following way.

Illustration

Consider that the shopkeeper has sold 100 kg of basmati rice, 70 litres of
sun flower oil, 100 packets of biscuits and 150 kg of wheat flour in the
given week. The prices are Rs. 35 per kg of Basmati rice, Rs. 90 per liter
of sunflower oil, Rs. 10 per packet of biscuit and Rs. 22 per kg of wheat
flour.

We can calculate the total revenue of the shopkeeper in the following

manner.

i)Total revenue from rice = 35 × 100 = Rs. 3500

(ii) Total revenue from oil = 90 × 70 = Rs. 6300

 (iii) Total revenue from flour = 22 × 150 = Rs. 3300

(iv) Total revenue from biscuit = 10 × 100 = 1000

Total Revenue from all goods = Rs. 14,100

So the shopkeeper’s total revenue from all goods during the given
week is Rs. 14,100.

AVERAGE AND MARGINAL REVENUE

Average Revenue (AR)

Average Revenue is denoted as AR. It is calculated from the total

revenue.

The formula for average revenue is given as

Average Revenue = Total Revenue/Quantity sold

Symbolically, AR = TR/Q

Take the case of a single commodity, we know that

TR = P × Q

So AR = P × Q/Q = P

Average Revenue and Price of the commodity are one and the same.

Marginal Revenue (MR)

Marginal Revenue (MR) is defined as increase in total revenue due to

one unit increase in the sale of the quantity of output.

Refer to the above example. Let the vendor increased the sale to 21 kg.
In that case the total revenue or TR becomes 50 × 21= Rs.1050. Earlier
when the sale of output was 20 kg, TR = Rs. 1000. Hence MR = 1050-
1000 = Rs. 50.

We can show it in the table below:

Sale of output Price or AR TR MR

(Kg) (Rs. Per Kg) (Rs.) (Rs.)

20 50 1000 -

21 50 1050 50

USE OF REVENUE AND COST

Both revenue and cost are important concepts in economics. While cost
is the expenditure incurred to produce a good or service during the
production process, revenue is the money received by the producer by
selling that good or service. So cost symbolizes sacrifice made by the
producer and revenue symbolizes gains for the producer. By getting the
required revenue from sale of the commodity the producer is able to
recover the cost he has incurred earlier. In that case we say that the
producer earned his due share which is called profit. We can define that
profit is the surplus of revenue over the total cost of production.

Profit = Total Revenue – Total Cost.