Economics for Managers (EFM)

Subject Code: 4519905

Unit 1
What is economics?
Economics is the social science that is concerned with the production, distribution, and
consumption of goods and services

Definition of Economics
1. "Economics is an enquiry into the nature and causes of wealth of nations."- Adam Smith.

2. Economics is the science which treats of wealth. "-J.B. Say.

In the above definition wealth becomes the main focus of the study of Economics. The
definition of Economics, as science of wealth, had some merits. The important ones are:

(i) It highlighted an important problem faced by each and every nation of the world, namely
creation of wealth.

(ii) Since the problems of poverty, unemployment etc. can be solved to a greater extent when
wealth is produced and is distributed equitably; it goes to the credit of Adam Smith and his
followers to have addressed to the problems of economic growth and increase in the production
of wealth.

The study of Economics as a 'Science of Wealth' has been criticized on several grounds. The
main criticisms leveled against this definition are;

(i) Adam Smith and other classical economists concentrated only on material wealth. They
totally ignored creation of immaterial wealth like services of doctors, chartered accountants etc.

(ii) The advocates of Economics as 'science of wealth' concentrated too much on the production
of wealth and ignored social welfare. This makes their definition incomplete and inadequate.

3. "Economics is a study of mankind in the ordinary business of life. It examines that part of
individual and social action which is most closely connected with the attainment and with the
use of the material requisites of well-being. Thus, it is on the one side a study of wealth and on
the other and more important side a part of the study of the man", Alfred Marshall
4. Robbins gave a more scientific definition of Economics. His definition is as follows:
"Economics is the science which studies human behavior as a relationship between ends and
scarce means which have alternative uses".

The definition deals with the following four aspects:

(i) Economics is a science: Economics studies economic human behaviour scientifically. It

studies how humans try to optimise (maximize or minimize) certain objective under given
constraints. For example, it studies how consumers, with given income and prices of the
commodities, try to maximize their satisfaction.

(ii) Unlimited ends: Ends refer to wants. Human wants are unlimited. When one want is
satisfied, other wants crop up. If man's wants were limited, then there would be no economic
problem.

(iii) Scarce means: Means refer to resources. Since resources (natural productive resources,
man-made capital goods, consumer goods, money and time etc.) are limited economic problem
arises. If the resources were unlimited, people would be able to satisfy all their wants and there
would be no problem.

(iv)Alternative uses: Not only resources are scarce, they have alternative uses. For example,
coal can be used as a fuel for the production of industrial goods, it can be used for running
trains, it can also be used for domestic cooking purposes and for so many purposes. Similarly,
financial resources can be used for many purposes. The man or society has, therefore, to choose
the uses for which resources would be used. If there was only a single use of the resource then
the economic problem would not arise.

5. "Economics is the body of knowledge which relates to wealth "-Prof. Walker.

6. ''Economics investigates the nature of wealth and the laws of production and its
distribution, "-J.S. Mill

7. "The subject treated by political economics is not happiness, but wealth"-Prof. Senior

8. "Economics is the study of how men and society choose, with or without the use of money, to
employ scarce productive resources which could have alternative uses, to produce various
commodities over time and distribute them for consumption now and in the future amongst
various people and groups of society". Paul A. Samuelson

The above definition is very comprehensive because it does not restrict to material well-being
or money measure as a limiting factor. But it considers economic growth over time.

These definitions have, thus, made wealth as the subject matter and central point of economics.
To them, only and only important thing was wealth.

Nature or Meaning of Wealth: The term 'wealth' in these definitions is used to signify those
material goods which are scarce. Material goods are those goods which can be seen and
touched, for example, cloth, furniture, book, gold, silver, etc. Non-material goods or services
are those which cannot be seen or touched, for example, the services of a professor, lawyer,
doctor, dancer, clerk, peon etc. are not considered as wealth and so remain outside the scope of
the study of economics.

There is no one universally accepted answer to the question "What is economics?" Browsing
the web, we will find various answers to the question:

 The Economist's Dictionary of Economics defines economics as "The study of the

production, distribution and consumption of wealth in human society

 "Economics is the study of how individuals and groups make decisions with limited
resources as to best satisfy their wants, needs, and desires".

 Economics is a social science that studies how society chooses to allocate its scarce
resources, which have alternative uses, to provide goods and services for present and
future consumption.

 "Economics is the social science that examines how people choose to use limited or
scarce resources in attempting to satisfy their unlimited wants."

Scarce and Limited resources: below mentioned are the scarce resources, which are to be
utilised carefully and to get maximum benefit and those are.

1. Land: Land is that factor of production which is freely available from nature. In it, not only
on the surface of soil is included, but also all other free gifts of the nature below the surface and
above the surface are included; for example, forests, minerals, fertility of soil, water, etc.
According to Marshall, "Land means the material and the forces which nature gives freely for
man's aid, in land and water, in air, light and heat." Land is also called a natural resource.

2. Labour [skilled]: Labour is a human factor of production. In it all those mental and physical
activities of man are included which are performed in order to earn money. The services of a
carpenter, black-smith, weaver, teacher, lawyer and doctor, etc., are called as labour according
to economics.

3. Capital: Capital is that man-made factor of production which is used for more production.
Factors like machines, tools, raw materials, buildings, railways, factories, etc., are called capital.
The saving of a man when invested to earn will also be called capital.
Ten principles of economics

There are 10 basic economic principles that make up economic theory and act as a guide for economists. Aside
from standard economic concepts like supply and demand, scarcity, cost and benefits, and incentives, there are
an additional 10 principles to follow in the field.

Let’s take a look at them more closely as well as some examples to illustrate each principle.

1. People face trade-offs

Everyone faces decisions that put one option above the other. Most decisions, especially economic ones,
involve trading off one thing for another.

In society, one of the main trade-offs we experience is between efficiency and equity. Efficiency refers to
something we can get the most out of, especially if the resource is scarce. Equity implies that all members of
society benefit equally from a resource. The theory is that people will make good decisions if they thoroughly
understand both options.

However, what usually ends up happening in life and in economics is that one item, either efficiency or equity,
is chosen above the other. For example, the way students decide to spend their time or how governments
allocate budgets can be examples of the trade-offs people face.
https://www.livemint.com/opinion/columns/india-s-trade-off-save-lives-or-the-informal-economy-
11584898414413.html

2. The cost of something is what you give up to get it

Since people face these trade-offs, a decision requires a comparison of the costs against the benefits of
alternative courses of action. Sometimes, the most obvious action or answer isn’t the first one you would think
of.

Each item has an opportunity cost, in other words, what you’re giving up to get it. So, when facing a decision,
people should understand the opportunity cost involved in that decision and in each action.

For example, some people consider only the cost of an action, but not the time involved. Cooking dinner at
home is cheaper than ordering from a restaurant, but takes up a lot more time than calling to place an order.
https://examples.yourdictionary.com/opportunity-cost-examples.html

3. Rational people think at the margin

In general, economists like to assume that people are rational thinkers. Still, they look at marginal changes to
describe small adjustments to the plan of action. Another way of looking at this is that people make decisions
when they think at the margin, or around the edge of a plan of action.

For example, the decision of whether or not to take an extra class in your semester is an incremental decision
that will have you comparing marginal costs and benefits.
When considering marginal changes, we as consumers are looking for the maximum satisfaction on our
purchases that fit with our budgets and incomes. So, we look for ways to achieve maximum satisfaction within
the constraints of what we are willing to pay for a commodity, and the decisions it takes to get there are
influenced by marginal changes and rational thinking.

https://economictimes.indiatimes.com/markets/expert-view/be-incremental-and-the-multi-baggers-will-fall-in-
over-time-aswath-damodaran-nyu-stern-school-of-business/articleshow/64988515.cms?from=mdr

4. People respond to incentives

This economic principle isn’t surprising but makes a lot of sense when we consider the last few principles.
Since consumers make decisions by comparing benefits and cost, what happens when that scale changes? That’s
where incentives play a part.

Incentives inspire consumers to act by offering up an extra reward to those people who will change their
behavior. Incentives can also be positive or negative, meaning you can incentivize people to do something or
not to do something.

For example, a positive incentive would be offering employees a bonus if they work extra hours. However, a
negative incentive can be exemplified by extra taxes governments might put on things like fuel that encourage
people to use it less.
https://www.news18.com/news/business/govts-latest-incentive-for-all-employees-reveal-its-desire-for-boosting-
economy-more-maybe-in-offing-3022235.html

https://economictimes.indiatimes.com/news/economy/policy/government-planning-incentives-worth-23-billion-
to-boost-manufacturing/articleshow/78039560.cms?from=mdr

5. Trade can make everyone better off

This one seems obvious, but trade can be a positive for all parties involved. It’s not like a competition where
one side wins and the other loses. In trade, all parties can win by focusing on what they’re best at.

The best example of this is countries that benefit from trading with each other. Most countries don’t have all the
resources they need to function effectively, so they turn to other countries for more or even cheaper resources
that they can trade. It also allows for a wider variety of goods to become available in the country, which
increases competition on a global scale.

When you think about trade between countries, let’s say between the U.S. and Canada, neither side “wins,” but
both benefit in different ways from a trade partnership.

https://www.worldbank.org/en/topic/trade/publication/the-role-of-trade-in-ending-poverty
Photo by Sharon McCutcheon on Unsplash

6. Markets are usually a good way to organize economic activity

A lot of countries used to have a centrally planned economy but are now moving towards market economies.

In a market economy, decisions are made collectively by millions of households and firms that have a stake in
the economy. If you think about it, it’s like a cycle. Households decide where they’ll work, and firms decide
who they want to hire and what to produce. These two parties interact in the market economy where decisions
are guided by self-interest.

Sometimes, the market economy or aspects of it fail, and that’s where governments have to step in to implement
policy. But usually, the interaction between households and firms are guided almost automatically, seemingly
by an ‘invisible hand’ that helps direct economic activity.

The result is that households and firms consider prices when looking at what to buy and sell, and they both look
at costs and social benefits, which ultimately ends in a society’s welfare being increased.
https://www.financialexpress.com/opinion/right-time-to-unleash-major-agriculture-reforms/1928576/
https://www.thehindubusinessline.com/opinion/converging-enam-network-with-private-
mandis/article33863812.ece

7. Government can sometimes improve market outcomes

We touched on the government interfering in the market in the last economic principle in the form of policy
creation, but why does the government need to intervene when we have the invisible hand?

Well, the hand actually relies on the government for protection. The market will only work if certain rights are
enforced, and the hand needs help in organizing economic activity within the market, namely, to promote both
efficiency and equity.
Markets can fail when they fail to allocate resources efficiently, and this happens as a result of externality,
which is when an action produces an impact on the well-being of a bystander, or in this case, of society. An
example of this is pollution and the well-being of the environment. Without the intervention of governments,
the market could have a negative impact without even meaning to.

Additionally, the invisible hand might not focus on how to distribute resources equitably and instead may
reward individuals based on their production.

https://economictimes.indiatimes.com/news/company/corporate-trends/tech-balanced-infra-government-
intervention-key-for-supply-chain-rehaul-say-etilc-members/articleshow/85682876.cms

8. A country’s standard of living depends on country production

As we know, there are different standards of living in different countries, and this is directly correlated to the
country’s productivity.

Not only that, but the changes over time of standards of living can also be quite significant. For example, even
in high-income countries, the Western world has made leaps and bounds in what we consider to be the standard
of living. When compared to lower-income countries, the growth of the standard of living is slower.

This growth can be traced back to the goods and services produced in each country. In places where workers are
able to produce more goods, the standard of living is higher, and vice versa. To increase the living standard,
there need to be public policies that affect it without negatively impacting productivity by way of increasing
education and providing better access to tools and technology.

https://www.investopedia.com/articles/investing/043015/fundamentals-how-india-makes-its-money.asp

9. Prices rise when the government prints too much money

This one is relatively simple. Prices follow inflation, and a high rate of inflation increases costs, so economic
policymakers aim for a lower level of inflation to keep the market moving. In most cases of a high rate of
inflation, the cause is that there’s too much money in circulation. When governments print more money and
there’s more available, its value decreases.

https://www.indiatoday.in/business/story/will-printing-more-money-help-revive-indian-economy-all-you-need-
to-know-1813138-2021-06-10

10. Society faces a short-run trade-off between inflation and unemployment

Another result that occurs when there’s more money circulating is a lower rate of employment. Economists
use the Phillips Curve to trace the correlation between the two, which helps them understand market and
business cycles. The Phillips Curve aims to push inflation and unemployment in opposite directions.

Policymakers can impact inflation and unemployment by altering how much money is printed, as well as the
amount of government taxes. Therefore, the policies that are implemented by governments and policymakers
have a direct impact on the market and economy and can severely impact the rates of inflation and
unemployment.
https://www.thehindu.com/business/Economy/is-the-indian-economy-staring-at-stagflation/article30595793.ece

The market forces of supply and demand

Microeconomics studies how households and firms make decisions and how they interact in markets.
Macroeconomics studies the economy as a whole.

Microeconomists use the theory of supply and demand to understand:

1. How buyers and sellers in an individual market for a particular good behave.
2. How the interactions between those buyers and sellers work to determine the quantity of the
good that gets produced and the price at which the good gets bought and sold.
3. How various events impact on quantities and prices in markets for individual goods.

A course in the Principles of Microeconomics looks at the theory of supply and demand in great detai
l, tracing out its many implications.

But, as we will see, macroeconomists often need to rely on the theory of supply and demand as well.
And for that reason, we’ll begin this course in the Principles of Macroeconomics with a quick look at
the theory of supply and demand.

Class Activity
Take up your favorite product for your individual consumption. Write down the current price of the same and
the quantity that you demand or purchase at that price. Then reduce the price by equal amount and your
expected quantity demanded and increase the price by equal amount and write your expected quantity
demanded.

Outline
1. Demand
A. The Demand Curve
B. Shifts in the Demand Curve
2. Supply
A. The Supply Curve
B. Shifts in the Supply Curve
3. Supply and Demand
A. Equilibrium
B. Analyzing Changes in Equilibrium
i. A Change Due to a Shift in Demand
ii. A Change Due to a Shift in Supply

Demand
Let’s begin by considering the behavior of buyers in a particular market for a particular good: ice cre
am.
The Demand Curve
The quantity demanded of any good is the amount of that good that buyers are willing and able to
purchase.
Although there are many factors that determine the quantity demanded of any good, one chief determi
nant of the quantity demanded is the price of the good.

Ask yourself: suppose the price of an ice cream cone goes up -

does that make you more likely or less likely
to buy an ice cream cone on any given day? Does that price increase mean you will buy more or f
ewer ice cream cones over the course the next year?

For most people and most goods, a higher price means a smaller quantity demanded.

This is what microeconomists call the law of demand: the idea that, all other things being equal (“cet
eris paribus,”as Ancient Romans and modern scientists would say), the quantity demanded of a good f
alls when the price of that good rises.

A demand schedule is a table showing the relationship between the price of a good and
the quantity demanded.

A demand curve is a graph showing the relationship between the price of a good and the quantity d
emanded.
Microeconomists have adopted the convention that, in a supply-‐and-‐
demand diagram, the quantity of the good is measured along the horizontal (x) axis and the price of
the good is measured along the vertical (y) axis.
The law of demand says that the demand curve slopes downward.
Figure 1 shows an example of an individual buyer’s demand schedule and demand curve.

Figure 2 shows how the demand for a good in the market as a whole gets determined by adding up
the demands of all individual buyers.

Shifts in the Demand Curve The downward-‐

sloping demand curve summarizes how the quantity demanded changes as the price rises or falls, hold
ing everything else constant.
The demand curve shifts to the left or to the right when some event occurs to change the quantity d
emanded at any given price.
Figure 3 illustrates how a demand curve shifts to the left or to the right.
Why might the demand curve for ice cream shift?

1. Income rises, so that people can afford more ice cream cones at any given price.
2.The prices of goods that are close substitutes for ice cream change. Suppose, for instance, that the
price of frozen yogurt goes up. Then some people who used to buy frozen yogurt will switch to ice
cream instead. The quantity of ice cream demanded goes up at any given price.
3. “Tastes” change.People decide they like ice cream more, so that they buy more at any given price.

Upward shift in demand curve

Downward Shift in demand curve

A shift in the demand curve is the unusual circumstance when the opposite occurs. Price
remains the same but at least one of the other five determinants change. Those determinants
are:

1. Income of the buyers.

2. Consumer trends and tastes.
3. Expectations of future price, supply, needs, etc.
4. The price of related goods. These can be substitutes, such as beef
versus chicken. They can also be complementary, such as beef and Worcestershire
sauce.
5. The number of potential buyers. This determinant applies to aggregate demand only.

Supply
Now let’s consider the behavior of sellers in a particular market for a particular good: ice cream.

The Supply Curve

The quantity supplied of any good is the amount of that good that sellers are willing and able to
produce and sell.
Although there are many factors that determine the quantity supplied of any good, one chief determin
ant of the quantity supplied is the price of the good.

Ask yourself: suppose you own and operate an ice cream stand and the price of an ice cream cone g
oes up - does that make you more or less willing to work harder to make and sell more
ice cream cones?
For most business owners producing and selling most goods, a higher price means a larger
quantity supplied.
This is what microeconomists call the law of supply: the idea that, all other things being equal, the
quantity supplied of a good rises when the price of that good rises.
Class Activity
Imagine that you are the seller or manufacturer of your favourite product. Write the number of units you are
willing to supply at current price of the product as a seller or manufacturer. Then reduce the price by equal
amount and your expected quantity supplied and increase the price by equal amount and write your expected
quantity supplied.

A supply schedule is a table showing the relationship between the price of a good and
the quantity supplied.

A supply curve is a graph showing the relationship between the price of a good and the quantity su
pplied.

The law of supply says that the supply curve slopes upward.
Figure 5 shows an example of an individual seller’s supply schedule and supply curve.
Figure 6 shows how the supply of a good in the market as a whole gets determined by adding
up the supplies of all individual sellers.

Shifts in the Supply Curve The upward-‐

sloping supply curve summarizes how the quantity supplied changes as the price rises or falls,
holding everything else constant.

The supply curve shifts to the left or to the right when some event occurs to change the quantity sup
plied at any given price.
Figure 7 illustrates how a supply curve shifts to the left or to the right.

Why might the supply curve for ice cream shift?

1.Input prices rise, so that it costs more to make and sell and ice cream cone. Then sellers will prod
uce fewer ice cream cones at any given price. Note that input prices include not just the price of in
gredients like milk and sugar, but also the “prices” of
hiring workers (wages) and renting or buying buildings and land to run the business.
2. “Technologies” can change. If a new machine makes it easier and less time-‐
consuming to make and sell ice cream cones, then sellers will be willing to supply more ice cream at
any given price.

Upward shift in supply curve

Downward Shift in supply curve

To summarise

There are a number of factors that cause a shift in the supply curve: input prices, number of sellers, technology,
natural and social factors, as well as expectations. We will look at each of them in more detail below.

Input prices
Firms use a number of different inputs to produce any kind of good or service (i.e. output). When the prices of
those inputs increase, the firms face higher production costs. As a result, producing said good or service
becomes less profitable and firms will reduce supply. That is the supply curve shifts to the left (i.e. inward). By
contrast, a decrease in input prices reduces production costs and therefore shifts the supply curve to the right
(i.e. outward).

For example, your favorite restaurant needs several ingredients to make a burger: buns, meat, lettuce, tomatoes,
BBQ sauce, and so on. Now, imagine the price of meat increases. That means the restaurant faces higher costs
for every burger it produces. If the price of the burger remains the same, this results in a smaller profit for the
restaurant. Because of this, the restaurant will produce fewer burgers and focus on other dishes that are more
profitable. Therefore the supply of burgers decreases, as the price of meat increases.

If the price of meat increases a lot, some restaurants may even decide to shut down and go out of business,
because they cannot earn profits anymore. This reduces supply even further. By contrast, if the price of meat
decrease, it becomes more attractive to sell burgers, which results in an increase in supply. Hence, supply is
negatively correlated to the price of the inputs used in production.

Number of Sellers
The number of sellers in a market has a significant impact on supply. When more firms enter a market to sell a
specific good or service, supply increases. That is the supply curve shifts to the right. Meanwhile, when firms
exit the market, supply decreases, i.e. the supply curve shifts to the left. This may seem pretty obvious, but
nevertheless, it is an important factor to keep in mind.

To give an example, let’s say there is only one burger restaurant in the entire economy. We’ll call it First
Burger. Demand for burgers is high, so First Burger already produces as many burgers as possible. In this
scenario, the total supply of burgers in the economy is equal to First Burger’s supply. Now a new burger
restaurant opens nearby – Second Burger. This results in an increase in the total supply of burgers in the
economy, which is now equal to the sum First Burger’s and Second Burger’s individual supply.

Technology
The use of advanced technology in the production process increases productivity, which makes the production
of goods or services more profitable. As a result, the supply curve shifts right, i.e. supply increases. Please note
that technology in the context of the production process usually only causes an increase in supply, but not a
decrease. The reason for this is simple: new technology is only adopted if it increases productivity. Otherwise,
sellers can just stick with the technology they already have, which does not affect productivity (and thus
supply).

For example, the highly standardized and technologically advanced processes used in many fast-food burger
restaurants significantly increased productivity and thereby the supply of burgers all over the world. Of course,
the restaurants have no incentive to alter those processes, unless they can be made even more efficient.

Natural and Social Factors

There are always a number of natural and social factors that affect supply. They can either affect how much
output sellers can produce or how much they want to produce. Whenever one of those factors causes supply to
decrease, the supply curve shifts to the left, whereas an increase in supply results in a shift to the right. As a rule
of thumb, natural factors generally affect how much sellers can produce, while social factors have a greater
effect on how much they want to produce.

Examples of natural factors that affect supply include natural disasters, pestilence, diseases, or extreme weather
conditions. Basically, anything that can have an effect on inputs or facilities that are required in the production
process. Meanwhile, examples of social factors include increased demand for organic products, waste disposal
requirements, minimum wage laws, or government taxes. Note that not all of those factors necessarily have an
impact on the cost of production, but all of them affect production decisions.

Expectations
Last but not least, the seller’s expectations of the future have a significant impact on supply. Or more
specifically, their expectations of future prices and/or other factors that affect supply. If they expect prices to
increase in the near future, they will hold some of their output back (i.e. reduce current supply) in order to
increase supply in the future, when it becomes more profitable.

For example, let’s say there’s going to be a huge annual country festival in town next week. During the festival,
demand for burgers spikes significantly every year, which usually increases prices by a few dollars. Therefore,
First Burger restaurant decides to keep some of this weeks ingredients in the storeroom and use them to make
some additional burgers during the festival.
Elasticity and its applications

By definition, elasticity is ‘a measure of the responsiveness of quantity demanded or quantity supplied to one of
its determinants’ ;(Mankiw & Taylor, (2011:94)

 Elasticity allows economists to analyse supply and demand with greater precision.
 Elasticity measures how changes in market conditions can lead to a response in buyers and sellers, i.e.
how much trade is affected by changes in market conditions.
 Price elasticity of demand : ‘a measure of how much the quantity demanded of a good responds to a
change in the price of that good, computed as the percentage change in quantity demanded divided by
the percentage change in price’ ;(Mankiw & Taylor,(2011:94).

The Elasticity of Demand:

 This is how demand responds to changes in determinants.

 We are all familiar with the term ‘I’ll wait to buy it until it goes on sale’ ~ The law of demand illustrates
the concept that a fall in the price of a good increases the quantity that is demanded, and as the definition
states, the price elasticity of demand measures how much a change in the price of a good affects the
quantity that is demanded.
 Goods can be placed in two categories; they are either ‘elastic’ or ‘inelastic’.
 Elastic goods are goods in which demand will vary significantly if the price changes - for example if the
price goes down then the demand will go up. The level of income of a person, the price of the good in
relation to the market price of other similar products and the availability of perfect or close substitutes
are a few things that greatly influence goods which are elastic.
 Inelastic goods are goods that do not have a perfect (if any) substitute. Therefore if there is a vary in the
price of the good (either up – due to an increase in tax per say or down) there will be no real vary in the
demand for the product. Inelastic goods are goods such as lifesaving medicines, tobacco and petrol –
there are no real substitutes for these goods and they are needed, so the demand for these goods will not
change despite an increase or decrease in the price. For this reason, these goods are often taxed very
heavily by the government.

http://flagpedia.net/currency/euro
‘Necessities’ versus ‘Luxuries’ :

 A factor which greatly affects the elasticity of a good is income levels, and therefore the concept of
‘necessities’ versus ‘luxuries’. People need ‘necessities’ to live – such as food but can choose not to buy,
and do without ‘luxuries’.
 John Stuart Mill essentially described the demand for necessities like bread as inelastic: "There are many
articles for which it requires a very considerable rise of price materially to reduce the demand; in
particular, articles of necessity, such as the habitual food of the people in England, wheaten bread: of
which there is probably almost as much consumed, at the present cost price, as there would be with the
present population at a price considerably lower." ;(Mill,1909, first pub.1848).
 Generally speaking, specific markets tend to be more elastic then broad markets. For an example; take
shoes. There is no substitute for shoes in general; they are needed to protect our feet. In this sense, they
are an inelastic good. However from the ‘specific market’ perspective, they are a more elastic demand
because there are so many different types of shoes, and therefore there are many substitutes – the only
real difference is the price.

The Effects of Time on the Elasticity of a Good:

 When viewing the supply and demand if goods in terms of elasticity, it is important to keep in mind the
concept of time. Goods which may be seen as inelastic may transition to being elastic over a period of
time if the price of the good rises substantially.
 For example, if there is a rise in the price of tobacco, there will be no change initially in the demand of
tobacco as it is an inelastic good, and there are no perfect substitutes for smokers. Nonetheless, over a
few years, some people may not be able to afford the high prices and decide to cut back and smoke less
frequently or quit altogether, or encourage some to not take up smoking at all, and the demand for
tobacco may gradually decrease. Thus making tobacco an elastic demand.

The Importance of Elasticity to Firms and Governments:

 The concept of elasticity is important to firms and governments because it allows them to calculate how
much an increase or decrease in the price of a good will affect the total revenue of the company – i.e.
how much they will profit.
 For example, an increase in the price of an elastic good due to an increase in the tax, will affect the
quantity of the good which will be demanded by consumers. In this case it is up to them to decide
whether they can justify an increase in the tax and risk the decrease in demand for the good.
 An increase in the tax of an inelastic good would increase the total revenue because there would be no
real change in the demand for the good despite the tax increase.
 As David Ricardo, a British economist in the 19th century said, ‘Taxes on luxuries have some advantage
over taxes on necessaries. They are generally paid from income, and therefore do not diminish the
productive capital of the country. If wine were much raised in price in consequence of taxation, it is
probable that a man would rather forego the enjoyments of wine, than make any important
encroachments on his capital, to be enabled to purchase it. They are so identified with price, that the
contributor is hardly aware that he is paying a tax. But they have also their disadvantages. First, they
never reach capital, and on some extraordinary occasions it may be expedient that even capital should
contribute towards the public exigencies; and secondly, there is no certainty as to the amount of the tax,
for it may not reach even income. A man intent on saving, will exempt himself from a tax on wine, by
giving up the use of it. The income of the country may be undiminished, and yet the State may be unable
to raise a shilling by the tax.’ ;( Ricardo,1817)

Government Intervention in the Market:

  Some governments believe that some things (basic necessities such as petrol) should be affordable to all,
as income is unevenly distributed, so people should be able to afford these basic goods at a reasonable
price.
 As such, they may intervene in the free market and set a maximum price that a good could be valued at (
this is known as a price ceiling ) and a minimum price that a good could be valued at (this is known as a
price floor).

Calculating the Price Elasticity of Demand:

 Economists calculate the price elasticity of demand by dividing the percentage change in the quantity
demanded by the percentage change in the price.
Formula for the Price Elasticity of Demand = The Percentage Change in The Quantity Demanded (QD)
The Percentage Change in Price (P)

 It is important to remember that there is a negative relationship between the quantity demanded and the
change in price, therefore they will always have opposite signs.
 Price elasticity’s of are often times recorded as negative numbers, it is a common practice to remove the
negative sign in the answer and take the absolute value of the number.
 Greater price elasticity implies a greater response of quantity demand to price.
 When calculating the price elasticity of demand between two points on a demand curve, you may realise
that the slope of the line is not a useful measure of the responsiveness of the good to increases or
decreases in its price.
 For example you could come across two demand curves with very different numerical values for their
slopes but they represent the same behavior.
 To solve this problem, some use the ‘midpoint formula’ which is calculating a percentage change and
dividing it by the initial and final values.
 In other words, calculate the price elasticity of demand by converting the changes in price and demand
to percentages. This gives us a common unit of comparison that is not affected by the unit of
measurement which is being used.
 Price elasticity of demand is described as being the ‘The ratio of the percentage of change in quantity
demanded to the percentage of change in price; measures the responsiveness of quantity demanded to
changes in price’ ;(Case, Fair & Oster, 2009:123)
 Below is an example of a normal, straight line demand curve.
http://www.tutor2u.net/economics/gcse/revision_notes/demand_supply_demand_intro.htm
A ‘Perfectly Inelastic’ Good:

 If from your calculations, you find that there is a price elasticity of demand of zero, this means that the
good is inelastic, i.e. that the quantity demanded is not affected by a change in the price of the good. If
the elasticity is zero then the good is known as ‘perfectly inelastic’ and it can be concluded that the
quantity demanded is fixed.
 Below is an example of a demand curve representing a ‘perfectly inelastic’ good.

http://wps.pearsoncustom.com/pcp_90734_uop_casefair/109/27997/7167315.cw/index.html
A ‘Perfectly Elastic’ Good:

 If there is a demand curve in which even the smallest increase in the price of a good reduces the quantity
demanded to zero, then this good can be classified as being a ‘perfectly elastic’ good.
 For this type of good, firms can sell as much of the good that they want to for the market value, but even
the smallest increase in its price will reduce the quantity demanded to zero. This is due to competition
and the presence of perfect substitutes.
http://wps.pearsoncustom.com/pcp_90734_uop_casefair/109/27997/7167315.cw/index.html
Case Study of a ‘Perfectly Elastic’ Good:

 Two vendors – vendor A and vendor B are selling water and are set up at the finish line of a marathon.
Say that both vendors are selling the exact same water for the same price – so they are receiving equal
amounts of customers. If vendor A decides to raise the price of his water, his demand will instantly
decrease to zero because everyone will start to buy from vendor B – who sells the water at market value.
Therefore for the vendors, the smallest increase above market value will decrease the quantity demanded
to zero, making this good a ‘perfectly elastic’ good.
 As we can see from the graphs, when the elasticity value is less than one, the demand can be described
as being inelastic and the quantity changes more than the price.
 On the other hand, when the elasticity value is greater than one, the demand can be described as being
elastic, and quantity therefore changes less than the price.
 When viewing demand curves therefore it can be concluded that; because the price elasticity of demand
measures how much a change in the price of a good affects the quantity demanded, the flatter the
demand curve, the greater the elasticity of the good represented on the curve (just as on the graph above
we can see that the horizontal straight line through a given point represents perfect elasticity
 Furthermore, the steeper the demand curve, through a given point on the graph, the smaller the price
elasticity of the good ( just as we can see from the examples above, the vertical line represents perfect
in-elasticity)
http://vector-magz.com/search/free-vector-clipart-water-bottle/
Total Revenue of Price Elasticity of Demand:

 One of the most important factors that governments and firms examine with regard to price elasticity of
demand is the total revenue. This is the amount which is paid by buyers and received by sellers for the
good.
 This can be calculated by multiplying P x Q – the price of the good multiplied by the quantity of the
good (which is sold for that price).
 Graphically, the total revenue can be calculated by multiplying the height of the box along the demand
curve (P), by the width of the box under the demand curve (Q).

http://ingrimayne.com/econ/elasticity/RevEtDemand.html
 There are three general rules to remember when dealing with the total revenue of the price elasticity of
demand.

1. If you have a price elasticity which is less than one, the demand curve is inelastic, an increase in the price
will raise the total revenue and a decrease will reduce the total revenue because the demand never changes, but
the price goes down so the seller is losing money.

2. If you have a price elasticity which is greater than one, the demand curve is elastic. An increase in the
price will reduce the total revenue and a decrease in price will increase total revenue e.g. in a sale. The demand
is easily changeable due to the availability of substitutes.

3. In a unique case of unitary elasticity, a percentage change in the price will cause an equal percentage
change in the quantity demanded. In this case the price elasticity is equal to one, and a change in the price will
not affect the total revenue.
Elasticity and Total Revenue Along a Linear Demand Curve:

o When dealing with demand curves you may find that some will have an elasticity that is constant
along the entire curve, for a linear demand curve, the elasticity will change along the line.
o It is important to remember that even is the slope of a linear demand curve is constant, the
elasticity is not.
 o This can be explained by the fact that the slope is the ratio of the changes between the variables
of price and quantity. Elasticity is the ratio of the percentage changes in the variables of price
and quantity.
Recall that the price elasticity of demand is = % change in QD
% change in P

o This is a Linear Demand Curve:

http://www.tutorsglobe.com/homework-help/microeconomics/example-for-demand-function-73653.aspx
Case Study:

 The concept of price elasticity of demand is often used by companies such as museums of cinemas - for
example when they are pricing admissions.

Say that for instance,you are the owner of a small cinema and you are running short of funds, the logical action
to take would be to change the price of the admissions. The question is: do you raise or lower the prices?

If you lower the prices of admissions, you might have higher attendances, but for less money, whereas if you
higher the prices, you may have lower attendances but for a higher price per ticket. The key thing to examine
would be whether the demand for cinema tickets is elastic or inelastic.

If it was inelastic, you would raise your revenue because you would have a constant, fixed number of people
paying for the tickets at a higher price.

If the demand was elastic, your number of admissions would fall if you raised the prices due to the competition
of other cinemas that might charge less or offer a better deal.

In this case the clear solution would be to lower the prices for admissions, because your demand for tickets
would increase and subsequently the increase in demand would override the loss in money for the cut in the
price for the tickets.

It is also important in these circumstances to consider statistics – prices vs. admissions in other cinemas and
prices vs. admissions in your cinema for previous years.

http://www.riverbendfilmfest.org/?page_id=9
Income Elasticity of Demand:

 Income elasticity of demand is when economists measure how the quantity demanded of a good
changes if peoples incomes change.
 This can be defined as 'a measure of how much the quantity demanded of a good responds to a change in
consumers’ income,computed as the percentage change in quantity demanded divided by the percentage
change in income'; (Mankiw & Taylor, 2011:103).
 Again this is examining the concept of ‘luxury’ versus ‘necessity’
 It is usually luxuries that are cut if people have a decrease in their level of income and they are short of
money i.e. for any necessities that may be elastic, they may find perfect substitutes for them for less
money.
 The concept of 'Normal' versus 'Inferior' goods is also important when examining the effects that a
persons income may have on their demand for certain products.
For instance, if a persons income increases, their demand for certain 'lower quality' products might decrease
such as food, if their incomes are higher, they will be able to afford better quality and perhaps more wholesome
food.
Likewise, if a persons income decreases, then their demand for 'normal' goods might decrease and they may
resort to buying the ' inferior' goods in order to save money.

Cross Price Elasticity of Supply:

 The 'Cross Price Elasticity of Demand' is a measure of how much the change in the price of one good
can affect the quantity that is demanded of another good.
 This is defined as 'a measure of how much the quantity demanded of one good responds to a change in
the price of another good, computed as the percentage change in quantity demanded of the first good
divided by the percentage change in the price of the second good' ;( Mankiw & Taylor, 2011:104).
 To calculate the cross price elasticity of demand:
Cross price Elasticity of Demand = Percentage in Quantity Demanded of Good 1
Percentage in Quantity Demanded of Good 2

 Whether your answer will turn out to be positive or negative depends on whether the good is a substitute
or a complement to another good.
 If the good is a substitute for another good, the cross price elasticity of demand will be positive because
the goods will move in the same direction. For example, if the price of cinema tickets increases, people
may decide to wait until it comes out on DVD to watch it instead. Therefore the demand for DVD
players and DVD's will increase.
 On the other hand, if the goods are compliments to one another, then the cross price elasticity of demand
will be negative, because a decrease in the demand for one will cause a decrease in the demand of the
other. For example, the relationship between DVD's and DVD players - they are complements to one
another.

Price Elasticity of Supply:

 There are many factors that can cause a company top increase the amount of the good that they supply:
such as when the technology of the industry improves, when the price of the good rises, when the
demand rises, or when their input prices of the goods that they need to produce the product fall.
 The definition of the price elasticity of supply states that: ‘price elasticity of supply is a measure of how
much the quantity supplied of a good responds to a change in the price of that good, computed as the
percentage change in quantity supplied divided by the percentage change in price.’ ;(Mankiw & Taylor,
(2011:104)
· Supply of a good is elastic if changes in the price cause a response in the quantity supplied.

· Supply is inelastic if a change in price causes only a small change in the quantity supplied.

· The price elasticity of supply is affected by the ability of producers to vary the amount of the
manufactured good which is being produced.

 Similar to price elasticity of demand, goods become more elastic over long periods of time e.g. it takes a
few years for a company to downscale the quantity of its supply being produced.

To Calculate the Price Elasticity of Supply:

 Formula Needed:

Price Elasticity of Supply = Percentage Change in Quantity Supplied (QS)

Percentage Change in the Price (P)

 Quantity responds to price in the supply curve.

 Similar to the demand curve, a vertical straight line represents a perfectly inelastic supply and a
horizontal line represents a perfectly elastic supply.

‘Perfectly Elastic’ and ‘Perfectly Inelastic’ Supply Curves:

http://thismatter.com/economics/supply-elasticity.htm
 For ‘perfect in-elasticity’ supply, the elasticity = 0, and the quantity will be the same regardless of any
changes in the price.
 For a ‘perfect elastic’ supply, elasticity = infinity, and very small changes in price lead to very large
changes in the quantity supplied.
The costs and economics of production, Economies of scale

Fixed and variable costs

Fixed costs are those that do not vary with output and typically include rents, insurance, depreciation, set-up
costs, and normal profit. They are also called overheads.
Variable costs are costs that do vary with output, and they are also called direct costs. Examples of typical
variable costs include fuel, raw materials, and some labour costs.
An example
Consider the following hypothetical example of a boat building firm. The total fixed costs, TFC, include
premises, machinery and equipment needed to construct boats, and are £100,000, irrespective of how many
boats are produced. Total variable costs (TVC) will increase as output increases.

OUTPUT TOTAL FIXED COST TOTAL VARIABLE COST TOTAL COST

1 100 50 150
2 100 80 180
3 100 100 200
4 100 110 210
5 100 150 250
6 100 220 320
7 100 350 450
8 100 640 740
Plotting this gives us Total Cost, Total Variable Cost, and Total Fixed Cost.

Total fixed costs

Given that total fixed costs (TFC) are constant as output increases, the curve is a horizontal line on the cost
graph.
Total variable costs
The total variable cost (TVC) curve slopes up at an accelerating rate, reflecting the law of diminishing
marginal returns.
Total costs
The total cost (TC) curve is found by adding total fixed and total variable costs. Its position reflects the amount
of fixed costs, and its gradient reflects variable costs.
Average fixed costs
Average fixed costs are found by dividing total fixed costs by output. As fixed cost is divided by an increasing
output, average fixed costs will continue to fall.
OUTPUT TOTAL FIXED COST (£000) AVERAGE FIXED COST (£000)
1 100 100
2 100 50
3 100 33.3
4 100 25
5 100 20
6 100 16.6
7 100 14.3
8 100 12.5
The average fixed cost (AFC) curve will slope down continuously, from left to right.
Average variable costs
Average variable costs are found by dividing total fixed variable costs by output.
OUTPUT TOTAL VARIABLE COST (£000) AVERAGE VARIABLE COST (£000)
1 50 50
2 80 40
3 100 33.3
4 110 27.5
5 150 30
6 220 36.7
7 350 50
8 640 80
The average variable cost (AVC) curve will at first slope down from left to right, then reach a minimum point,
and rise again.
AVC is ‘U’ shaped because of the principle of variable Proportions, which explains the three phases of the
curve:
1. Increasing returns to the variable factors, which cause average costs to fall, followed by:
2. Constant returns, followed by:
3. Diminishing returns, which cause costs to rise.
Average total cost
Average total cost (ATC) is also called average cost or unit cost. Average total costs are a key cost in the theory
of the firm because they indicate how efficiently scarce resources are being used. Average variable costs are
found by dividing total fixed variable costs by output.
AVERAGE FIXED COST AVERAGE VARIABLE COST AVERAGE TOTAL COSTS
OUTPUT
(£000) (£000) (£000)
1 100 50 150
2 50 40 90
3 33.3 33.3 67
4 25 27.5 52.5
5 20 30 50
6 16.6 36.7 53.3
7 14.3 50 64.3
8 12.5 80 92.5

12.5 80 92.5

Average total cost (ATC) can be found by adding average fixed costs (AFC) and average variable costs (AVC).
The ATC curve is also ‘U’ shaped because it takes its shape from the AVC curve, with the upturn reflecting the
onset of diminishing returns to the variable factor.
Areas for total costs
Total Fixed costs and Total Variable costs are the respective areas under the Average Fixed and Average
Variable cost curves.
Marginal costs
Marginal cost is the cost of producing one extra unit of output. It can be found by calculating the change in
total cost when output is increased by one unit.
OUTPUT TOTAL COST MARGINAL COST
1 150
2 180 30
3 200 20
4 210 10
5 250 40
6 320 70
7 450 130
8 740 290
It is important to note that marginal cost is derived solely from variable costs, and not fixed costs.
The marginal cost curve falls briefly at first, then rises. Marginal costs are derived from variable costs and are
subject to the principle of variable proportions.

The significance of marginal cost

The marginal cost curve is significant in the theory of the firm for two reasons:
1. It is the leading cost curve, because changes in total and average costs are derived from changes in
marginal cost.
2. The lowest price a firm is prepared to supply at is the price that just covers marginal cost.
ATC and MC
Average total cost and marginal cost are connected because they are derived from the same basic numerical cost
data. The general rules governing the relationship are:
1. Marginal cost will always cut average total cost from below.
2. When marginal cost is below average total cost, average total cost will be falling, and when marginal
cost is above average total cost, average total cost will be rising.
3. A firm is most productively efficient at the lowest average total cost, which is also where average total
cost (ATC) = marginal cost (MC).
Total costs and marginal costs
Marginal costs are derived exclusively from variable costs, and are unaffected by changes in fixed costs. The
MC curve is the gradient of the TC curve, and the positive gradient of the total cost curve only exists because of
a positive variable cost. This is shown below:

Sunk costs
Sunk costs are those that cannot be recovered if a firm goes out of business. Examples of sunk costs include
spending on advertising and marketing, specialist machines that have no scrap value, and stocks which cannot
be sold off.
Sunk costs are a considerable barrier to entry and exit.