Definition of Economics:

How he gets income How he spends it and Study of wealth and Study of man
- Alfred Marshall
Study of Means (resources) And Study of ends (short in supply in relation to demand)
- Lionel Robbins
Study of men as they live and move and think in the ordinary business of life.

study of economic problems of people living in a community.

studies activities of social, real and normal human beings, related to wealth.
deals with what everyone is doing every day in ordinary life (production and distribution of
wealth).
studies human behaviour as a relationship between ends and scarce means.

Two important economic conditions that necessitate the study of economics?

1. Scarcity (limited resources), 2. Unlimited wants
Engineering Economics:
Engineering economy concerned evaluations of Costs and benefits leading to Technical and business for
projects and ventures. Deals with methods that enables one to make economic decisions towards
evaluation of design and engineering alternatives. It helps in examining the relevancy of a project,
estimating its value and justifying it from engineering viewpoint.
ECONOMIC GOALS:
Any science moves with certain goals to be achieved. Economics has become now a crucial branch of
knowledge. Being a social science it keeps on revising its goals from time to time. The list might be quite
large, but we would like to focus only on certain major goals of economics as given under:
1. A low rate of unemployment: People willing to work should be able to find jobs reasonably
quickly. Widespread unemployment is demoralising and it represents an economic waste.
Society forgoes the goods and services that the unemployed could have produced.
2. Price stability: It is desirable to avoid rapid increasesor decreases in the average level of
price.
3. Efficiency: When we work, we want to get as much as we reasonably can take out of our
productive efforts. For this, efficient technology becomes quite useful.
4. An equitable distribution of income: When many live in affluence, no group of citizens should
suffer stark poverty. Given this, developing countries are strategizing goals like participatory
growth and inclusive growth.
5. Growth: Continuing growth, which would make possible an even higher standard of living in the
future, is generally considered an important objective.
6. Economic freedom and choice: Any economy should grow and develop in such a manner that
people should get more choices and there should not be any outside pressure on their choices.
7. Economic welfare: Economic policies should be pursued in such a manner that welfare of the
people or the social benefits get maximised.

8. Sustainable development: It has become a major challenge for economists to carry on the
process of economic growth in such a manner that the resources are optimally utilized not only
for intergenerational equity but also for sustainable development in quite long run.
Scope:
The basic thrust still remains on using the available resources efficiently while giving the maximum
satisfaction or welfare to the people on a sustainable basis.
1.
2.
3.
4.
5.

Demand Analysis and Forecasting

Cost and production Analysis.
Pricing Decisions, policies and practices.
Profit Management.
Capital Management

Scope of Economics :
Economics has two major branches. These are Micro Economic and Marco Economics.
Micro Economics: Micro economics is the study of the study of the economic activity of the individual,
households firms and industries. Micro economics examines how the individual, household, firm or
industry earn and spend their income.
Macro Economics: Macro economics is the study of the economy as a whole. It seeks to explain the
economic functioning of a state, country or the world. It addresses questions pertaining to employment
and economic output of the country.
Importance of economics for engineers

improving or increasing production

reducing human effort and increasing wealth
making world a more comfortable place to live in

- economics - important place in engineering decisions. many decisions have to take costs,
performance, interest, depreciation and profits.
- important role in industrial engineering - from selection of plant site, production planning and
control, replacement analysis, wage structure of workers.
Engineering economy:
Concerned evaluations of Costs and benefits leading to Technical and business for Projects and ventures
Techniques of Engineering Economy:

Principle 1 Choice among alternative

Alternatives to be identified, defined for further analysis. A decision involves making a choice among
two or more alternatives. The quality of the decision made depends on developing and defining the
alternatives for direct evaluation.

Principle 2 Comparison

Among the alternatives only the differences in the expected future outcome to be compared for
making the decision. If all the expected outcomes of the alternatives are same, then there is no basis
or need for a comparison. In such a case one will be indifferent to the alternatives and make
decision on the basis of random selection.

Principle 3 Consistent viewpoint

The different outcomes of the alternatives shall be consistently developed based on a defined
viewpoint. First define the viewpoint for a particular decision. Use it consistently to define, describe
and compare the alternatives.

Principle 4 Common unit of Measurement

For comparing the alternatives use a common unit of measurement of the prospective outcomes.

Principle 5 Consider all the relevant criteria

Selection of a preferred alternative (or decision) requires the use of criteria. The criteria can be in
monetary unit or expressed in some other measurable units.

Principle 6 Make uncertainty explicit

In the future outcomes of an alternative, uncertainty is inherent. This shall be recognized in the
analysis and comparison.

Principle 7 Compare projected outcomes with actual results

The outcome of the selected alternative shall be compared with the actual results achieved.
Improved decision making shall be made from this adoptive process.
Application of Engineering Economy:

Functional activity

Types of Decision

Functional activity

Planning

Production

Material Management

Plant Engineering

Transport

Action management

Types of Decision
o

Capital budget

Make or buy decisions

Replacement

Project Evaluation

Basic economic concepts:

1) Utility
2) Goods
3) Wealth
4) Classification of wealth
5) Services
6) Income

Utility:

Utility of a commodity is its value in use.

Utility of a commodity is the capacity to satisfy human wants.
Is the amount of satisfaction that can be derived from a commodity.

Wealth

desirable things - that satisfy human wants directly or indirectly

desirable things - represented by goods
all goods that satisfy human wants may not be wealth - available in plenty, not tranferable - air,
rain - water stored in a dam is wealth.
has exchange value.
shall have following qualities
o utility - satisfy human wants
o scarcity - scarce wrt demand
o transferability - from one man to another
classification as under
Wealth
Individually
Owned

Personal
Possessions

Clothings

Private
Capital
Textile
Machinery

Collectively
Owned
Collective
Possessions

Coal Mines

Public
Capital
Public
Library

National

International

o
o
o
o

Personal or private wealth - wealth that belongs to a certain person

Collectively owned wealth - owned by municipal boards, provincial and central government
(coal mines, harbours, public buildings)
National wealth - collective wealth of the nation (coal mines)
International wealth - wealth belonging to all the nations (oceans, inventoins)

Goods:
o

o
o
o

defined as anything (material or non-material) that can satisfy human wants

o material goods - useful material things (all rights to hold, use, drive benefits, to receive
them at a future time)
gifts of nature, land, water, air, climate
products of agriculture, mining, fishing
buildings, machinery, implements
mortgages, bonds, shares of companies
patents, copyrights
o non-material goods, following 2 categories
One's own qualities or faculties for action and enjoyment. eg. muscular
strength, business ability, professional skills. These goods lie within an individual
and hence called internal.
External - consists of relation with other people. eg. .good will, business
connections
Transferable - land, building of an individual that can be transferred to others.
non-transferable - person's qualities
free goods
o given by nature without requiring the effort of man. eg. air. They do not have a price in
comparison with economic goods that are scarce and hence bear a price.

Services:

Income:

Personal income - Payment directly or indirectly in terms of money. Income which are in the
form of money. Includes payment in kind or remunerations - free use of a house, gas, water,
electricity.
National income

Demand:
The demand for any commodity, at a given price, is the quantity of it, which will be bought per unit of
time at that price.
1. Demand always refers to demand at a price. Demand without price has no sense. eg. Demand for
mangoes is 100 kg is meaningless without price.
2. Demand means demand per unit of time - day, week, month...
demand implies:
1. desire to possess a thing
2. means of purchasing it
3. willingness to use the means for purchasing it.
Effective Demand = willingness to buy + ability to pay

Law of demand:
Other things remaining the same, when the price of a commodity falls, its demand will go up. Likewise
when the price of a commodity rises, its demand will fall. Price and demand move in opposite directions.

Higher the price

Lower the demand

Lower the price

Higher the demand

If

Other things remaining constant

income
consumers taste
consumers preference
substitutes price
advertising expenditure

Assumptions of the law:

The income of the buyer remains the same.

The taste of the buyer remains the same.
The prices of other goods - substitutes and complements - remains the same.
No close substitute is discovered.
Consumer preference is same.
Advertising expenditure is same.

Characteristics of Law of Demand:

1) Inverse relationship Price & Quantity demanded opposite

2a) Price

an independent variable

2b) Demand a dependent variable

Limitations or Exceptions of Law of demand:

1. Change in habits, customs and income:
2. Necessities of life: not applicable in case of necessities of life. eg. flour. Increase in price of flour
will not bring down the price. A fall in price also will not increase the demand very much.
3. Fear of shortage in future:
4. Fear of a rise in price in the future:
5. Articles of distinction: eg. diamond. if the price increases demand increases.
6. Giffen goods: Sometimes people buy less of a good at a lower price and more at a higher price.
eg. low paid workers. If the price of bread rises demand falls.
7. Ignorance: A consumer may not be aware of the previous price. In such cases he will purchase
more when the price has actually gone up.
Types of Demands:
1. Individual Demand & Market Demand
2. Autonomous Demand & Derived Demand
3. Demand for Durable & Perishable Goods
4. Industry Demand & Company Demand
5. Total Market & Market Segment
Individual Demand & Market Demand

Price of the product

Rs

Demand
A

Demand
B

Demand
C

TOTAL
(A+B+C)

12

18

10

21

24

Autonomous Demand & Derived Demand:

Autonomous Demand

Does not depend on demand on the product eg sugar , milk

Derived Demand

Arises because of the other commodity

eg cotton, bricks, cement, petrol, battery

Complementary commodities

Power regulator for refrigerator, TV set

Demand for Durable & Perishable Goods:

Demand for Durable Goods demand changes over a long period
1) Consumer durable
Clothes, shoes, furniture, TV, scooters
2) Producer durable
Like fixed assets building, plant, machinery, office furniture
Perishable Goods demand depends on current prices
1)Consumer goods
All food items, drinks, soaps, fruits
2)Producer goods
Raw materials, fuel, power, packing items
Industry Demand & Company Demand:
Company Demand
1) Maruti
2) Hidustan Motors
3) Standard Motors
4) Hyundai
5) BMW
6) Premier Automobiles
Industry Demand Total of all automobile industries

Total Market & Market Segment:

Market segments
Geographical area

Distribution channels
Customer sizes
Domestic
Foreign
Total market sum of all the market segments

Demand Determinants or Factors of Demand:

1) Price of the product &its demands
2) Price of the substitutes & complementary goods
3) Consumers Income
4) Consumers Tastes & Preferences
5) Number of Consumers & their Distribution
6) Amount spent on Advertisement
7) Consumer expectations
8)

Demonstration effect

9) Consumer Credit facility

10) Population of the country

Price of the substitutes & complementary goods

Substitutes
Tea and coffee
Complementary goods
Petrol

car & scotter

Butter &jam bread

Consumers Income
By demand analysis
1)Essential consumer goods
Feed grains, salt, cooking fuel, housing

2)Inferior goods
Bajra ( wheat & rice )
Kerosene stove ( gas stove )
3)Ordinary normal goods
Cloth
4)Luxury goods
Precious materials , TV sets

Consumers Tastes & Preferences

1)Consumers Tastes
Depends on social customs, habits, life style , age ,sex
2)Consumers Preferences
producers advertisement to change preferences

Number of Consumers & their Distribution

The larger the number of customers, the greater the demand & vice versa

Amount spent on Advertisement

Incurred in addition to manufacturing cost for promoting sales

Consumer expectations
On account of
1) Increase in DA, Bonus, Pay scales
2) Fall in Production stock, Demand increases.

Demonstration effect
When new models appear in the market, rich people buy first color TV

Consumer Credit facility

1) Bank loans
2) Credit cards
3) Availability of credit from the sellers

Population of the country

The larger the population, the larger the demand

Demand function:
Demand function for a product relates to quantity of a product which consumers demand during a
specific period to the factors that influence the demand. Demand function is a relationship between
demand for a product (dependent variable) and its determinants (independent variable).

Linear demand function

Non-linear demand function

Linear demand function

Price Vs Quantity demanded
When the slope of the demand curve remains constant throughout its length.

Non-linear demand function

Price Vs Quantity demanded
Slope of the demand curve changes all along the demand curve demand function yields a demand curve
instead of a demand line.

Demand forecasting:
Demand forecasting is the activity of estimating the quantity of a product or service that consumers will
purchase. Demand forecasting involves techniques including both informal methods, such as educated
guesses, and quantitative methods, such as the use of historical sales data or current data from test
markets. Demand forecasting may be used in making pricing decisions, in assessing future capacity
requirements, or in making decisions on whether to enter a new market. (-wikipedia)
This is used for arranging
1) Raw materials
2) Equipments
3) Machine accessories
4) Labour
5) Buildings

forecasting may be classified into two, viz.,:

(i) Short term demand forecasting and
(ii) long term demand forecasting.
In a short term forecast, seasonal patterns are of much importance. It may cover a period of three
months, six months or one year. It is one which provides information for tactical decisions.
Which period is chosen depends upon the nature of business. Such a forecast helps in preparing suitable
sales policy. for example

Evolving suitable production policy to avoid over production & under production. Hence
production schedules have to be geared to expected sales.
Reducing purchase of raw materials & controlling inventory.
To determine pricing policy to avoid price increase when the market is weak and price reductin
when the market is strong.

Setting sales targets. If targets are set very high, it will discourage salesmen who fail to achieve
them. If set too low, targets will be easily achieved and hence incentives will have no meaning.

Long term forecasts are helpful in suitable capital planning. It is one which provides information for
major strategic decisions. It helps in saving the wastages in material, man hours, machine time and
capacity. Planning of a new unit must start with an analysis of the long term demand potential of the
products of the firm. for example

Planning a new unit or expansion of existing unit. For example if it requires 5 years to build,
equip and bring into operation, a new factory, then the forecast of demand shall be made five
years ahead and projected for a further 5 years.
Planning for replacement of a plant or to buy new or improved machinery. The period shall
depend upon the expected life of the plant or machinery, the time required to purchase and
bring it into use and the time required for recovering the capital expenditure.
Long term financial requirements
Planning manpower - training and personnel development takes considerable time to complete.
Hence they can be started well in advance only based on the basis of man power requirement
estimates according to long term sales forecast.

Methods of Demand or Sale Forecasting:

1) Survey of buyers intentions
Ask customers what they are planning to buy, also called as opinion surveys. to be cautious
against biased opinion. If shortages are expected, customers may exaggerate the requirement.
Some times customers will misjudge, mislead or uncertain about the quantity required. This method
is not suitable for household customers - when multiple alternatives are there, which to buy.
2) Collective opinion
Also called sales-force polling. Sales man expected sales in their respective territory. Estimates
of individual salesmen is consolidated to find the total estimated sales. Revised estimates by
Production manager, Sales manager, department heads & Top executives are made taking into
account bias of the salesman (pessimistic, optimistic), change in competition, advertisement,
product design, purchasing power, population etc.
3) Trend projections
A firm in existence for some time, will have accumulated considerable data on sales over
different time periods. Such data when arranged chronologically yield "time series". This can be
done either in tabular form or graphical form. Apply statistical techniques like method of least
squares to plot a line. The trend can be extrapolated for the future.
4) Economic Indicators
a) Agricultural income, to find the demand for agricultural inputs, machineries, fertilizers.
b) Personal income, for the demand of consumer goods.

c) Construction contracts sanctioned to determine the demand for, say cement.

d) Automobile registration, for demand of car accessories, petrol.

5) Historic Estimate
This technique makes use of the assumption that what has happened in the past will happen in
the future. For example, if a concern has sold 200,000 refrigerators last summer, it will sell the
same or more quantity this summer. This is useful if the pattern is seasonal.
6) Market survey or Market Research Techniques
This technique is useful when a company introduces a new product. For a new product no past
data will be available. The survey can be done by the sales personnel on an informal way or by
conducting a systematical survey using mathematical tools.
7) Delphi method
Method was introduced by Rand Corporation in late 1940s by Olaf Helmer, Dalkey & Gordon. A
panel of experts were interrogated by a sequence of questionnaire. The response in one
questionnaire is used to prepare the next questionnaire.
8) Judgmental Techniques
o

o
o

Opinions of consumers and customers: Questionnaire may be sent to consumers and

customers who have already purchased the product. An estimate of the performance
and future demand can be made.
Retailers and Wholesalers can give some insight into current and future sales.
Opinion of area sales manager is useful.

9) Prior knowledge
Used by ancillary units which are part of a bigger organization. The bigger organization informs
about the demand.
10) Forecasting by past average
In this method the forecast sales for the next period is the average sales for the previous period.
E.g Period
Sales

Forecasted sale for the period = (7+5+9+8+5+8)/6 = 7

11. Correlation analysis:

Elasticities of Demand

Elasticity of demand is the relationship or degree of responsiveness of demand to the changes in its
determinants. Therefore there are as many demand elasticities as there are number of determinants.
Kinds of demand elasticities
1.
2.
3.
4.

Price elasticity of demand

Income elasticity
Cross elasticity
Advertising (promotional) elasticity

Price Elasticity of demand

The degree of responsiveness of quantity demanded to a change in price.
eP = Proportionate change in quantity demanded
proportionate change in price
=

where

Q = original quantity demanded

P = original price
Q = change in quantity demanded
P = change in price
A minus sign is introduced to make the elasticity coefficient a non-negative value.
ARC Elasticity
The measure of elasticity of demand between two finite points on a demand curve is known as arc
elasticity.
Sum1:
Assume the figure below is the demand curve for lattes and you have to determine the elasticity of
demand if prices increased from $4/latte to $5/latte. Since you do not have the exact formula you have
to use the Arc Elasticity of Demand method.
P = 5-4 = 1
Q = 10 - 20 = -10
eP =
= -5

Problem : Yesterday, the price of envelopes was $3 a box, and Julie was willing to buy 10 boxes. Today,
the price has gone up to $3.75 a box, and Julie is now willing to buy 8 boxes. Is Julie's demand for
envelopes elastic or inelastic? What is Julie's elasticity of demand?
To find Julie's elasticity of demand, we need to divide the percent change in quantity by the percent
change in price.
Change in Quantity = (8 - 10)/(10) = -0.20
Change in Price = (3.75 - 3.00)/(3.00) = 0.25
Elasticity = |(-0.20)/(0.25)| = |-0.8| = 0.8
Her elasticity of demand is the absolute value of -0.8, or 0.8. Julie's elasticity of demand is inelastic,
since it is less than 1.
Problem : If Neil's elasticity of demand for hot dogs is constantly 0.9, and he buys 4 hot dogs when the
price is $1.50 per hot dog, how many will he buy when the price is $1.00 per hot dog?
This time, we are using elasticity to find quantity, instead of the other way around. We will use the same
formula, plug in what we know, and solve from there.
in the case of John, Change in Quantity = (X 4)/4
Therefore :
Elasticity = 0.9 = |((X 4)/4)/( Change in Price)|
Change in Price = (1.00 - 1.50)/(1.50) = -0.33
0.9 = |(X 4)/4)/(-0.33)|
|((X - 4)/4)| = 0.3
0.3 = (X - 4)/4
X = 5.2
Since Neil probably can't buy fractions of hot dogs, it looks like he will buy 5 hot dogs when the price
drops to $1.00 per hot dog.
Problem : Which of the following goods are likely to have elastic demand, and which are likely to have
inelastic demand?
Home heating oil
Pepsi
Chocolate

Water
Heart medication
Oriental rugs
Elastic demand: Pepsi, chocolate, and Oriental rugs
Inelastic demand: Home heating oil, water, and heart medication
Problem : If supply is unit elastic and demand is inelastic, a shift in which curve would affect quantity
more? Price more?
Shifting the demand curve would affect quantity more, and shifting the supply curve would affect price
more.
Problem : Katherine advertises to sell cookies for $4 a dozen. She sells 50 dozen, and decides that she
can charge more. She raises the price to $6 a dozen and sells 40 dozen. What is the elasticity of
demand? Assuming that the elasticity of demand is constant, how many would she sell if the price were
$10 a box?
To find the elasticity of demand, we need to divide the percent change in quantity by the percent
change in price.
% Change in Quantity = (40 - 50)/(50) = -0.20 = -20%
% Change in Price = (6.00 - 4.00)/(4.00) = 0.50 = 50%
Elasticity = |(-20%)/(50%)| = |-0.4| = 0.4
The elasticity of demand is 0.4 (elastic).
To find the quantity when the price is $10 a box, we use the same formula:
Elasticity = 0.4 = |(% Change in Quantity)/(% Change in Price)|
% Change in Price = (10.00 - 4.00)/(4.00) = 1.5 = 150%
Remember that before taking the absolute value, elasticity was -0.4, so use -0.4 to calculate the
changes in quantity, or you will end up with a big increase in consumption, instead of a decrease!
-0.4 = |(% Change in Quantity)/(150%)|
|(%Change in Quantity)| = -60% = -0.6
-0.6 = (X - 50)/50
X = 20

The new demand at $10 a dozen will be 20 dozen cookies.

Point elasticity of demand

Price elasticity of demand at any point on a linear demand curve is
equal to the ratio of the right and left segments of the linear demand
curve.

Types of Elasticity of Demand or Types of price Elasticity of Demand: Price elasticity of demand is
classified under the following five sub heads:
1. Perfectly elastic demand
2. Perfectly inelastic demand
3. Relatively elastic demand
4. Relatively Inelastic demand
5. Unitary elastic demand
1. Perfectly elastic demand: It refers to the situation where the
slightest rise
in price causes the quantity demanded of a commodity to fall to zero
and at the present level of price people demand infinitely large
quantity of the commodity.
The coefficient of elasticity of demand is infinite.

2. Perfectly inelastic demand: It refers to the situation where even

substantial changes in price do not make any change in the quantity
demanded, i.e., for any change in the price, the demand remains
constant.
The coefficient of elasticity of demand is zero.

3. Relatively elastic demand: Here, a small proportionate change in the price of a commodity results in a
larger proportionate change in its quantity demanded.
The coefficient of elasticity of demand is greater than unity.
4. Relatively Inelastic demand: A larger proportionate change in the price of
a
commodity results in a smaller proportionate change in its quantity
demanded.
The coefficient of elasticity of demand is greater than zero, but less than
unity.

Petrol petrol has few alternatives because people with a car, need to
buy petrol. For many driving is a necessity. There are weak substitutes,
such as train, walking and the bus. But, generally, if the price of petrol goes up, demand proves very
inelastic.

Salt. If the price of salt increased, demand would largely be unchanged. It is only a small % of
income and people tend to buy infrequently. It is a good with no real substitutes at all.

A good produced by a monopoly. Any good produced by a monopoly is likely to be inelastic

demand. For example, if Sky increase the cost of premiership pay per view, many football fans will
pay the extra price. Though because it isnt a necessity, demand may be less inelastic than say
petrol.

Tap water. For householders, tap water is a necessity, with no alternatives. If the water company
increase the cost of water bills, people would keep buying the service. It would have to rise to a
very high price before people disconnected their water supply. This is why tap water is regulated.

Diamonds. Bought very infrequently, diamonds are the ultimate luxury with few exact alternatives.
You could buy other precious gems, but others may not have the same allure as diamonds. A cut in
price wouldnt increase demand very much.

Peak rail tickets. For commuters who rely on the train to get to work in London, demand will be
very inelastic. If price of fares from Surbiton to London increase, demand will only fall by a small
amount. The alternatives for commuting into London, such as driving are limited.

Cigarettes. If cigarette tax increases and the price of all tobacco increases, demand will be inelastic
because many smokers are addicted and dont have any alternatives to keep buying.

Apple iPhones, iPads. The Apple brand is so strong that many consumers will pay a premium for
apple products. If the price rises for apple iPhone, many will continue to buy. If it was a less well
known brand like Dell computers, you would expect demand to be price
elastic.

5. Unitary elastic demand: It refers to a situation where a given proportionate

change in price is accompanied by an equally proportionate change in the
quantity demanded. In other words, a given proportionate fall in the price is
followed by an equally proportionate increase in demand and vice versa.
The co efficient of elasticity of demand is unity.

Heinz soup. These days there are many alternatives to Heinz soup. If price rises, people will switch
to less expensive varieties.

Shell petrol. We say that petrol is overall inelastic. But, if an individual petrol station increases
price, people will buy from other petrol stations. The only exception is if a petrol station has a local
monopoly e.g. at service station on the motorway there is a captive audience. But, in a city centre
with many alternatives, people will have an elastic demand.

Tesco bread. Tesco bread will be highly price elastic because there are many better alternatives. If
the price of Tesco bread rises, consumers will switch to alternatives.

Daily Express. If the Daily express increases in price, there are similar newspapers people will
switch to. For example, the Daily Mail or Daily Mirror. If it was a newspaper like the Financial Times
of the Economist, demand would be more inelastic, as there is no close substitute to the Financial
Times.

Aero chocolate bar. If Aeros increase, people will switch to alternative types of chocolate bar.

Porsche sports car. If a Porsche increases, demand will probably be elastic because it is a high % of
income, and so the higher price will put people off. Also, there are other alternatives, such as
Jaguar or Aston Martin. However, this is a little less clear cut. Some car enthusiasts may want to
buy a Porsche whatever the price.

Type

Numerical expression

Description

Shape of the curve

Perfectly elastic demand

e=

infinite

horizontal

Perfectly inelastic demand

e = 0

zero

vertical

Unit elasticity

e = 1

one

Rectangular hyperbola

Relatively elastic demand

e =>1

Greater than one

Flat

Relatively inelastic demand

e=<1

Less than one

Steep

Factors determining price elasticity of demand:

1. Nature of the product
2. Extent of usage

3.
4.
5.
6.
7.

Availability of substitutes
Income level of people
Proportion of the income spent on the product
Urgency of demand
Durability of a product

1. Nature of the product

The demand for products that fall in the range of necessity is inelastic (e.g. rice, salt, wheat).
This is because their demand does not change even when there is a change in price. On the
other hand, the demand for luxury items like TVs, washing machines, is elastic. Here even a
small change in price has a huge change in demand.
2. Extent of usage
If a product has varied usage, like steel, aluminium, wood, it has comparatively an elastic
demand. If the price of teak wood falls its demand increases, as it can be put to various uses. On
the other hand, if its price rises, its use in some areas will reduce, and in some other areas there
will not be any change in demand.
3. Availability of substitutes
When a product has many substitutes, then its demand will be relatively elastic. This is because,
if the price of one substitute goes down, then customers switch over to it and vice versa.
Products without substitutes or with weak substitutes have relatively inelastic demand.
4. Income level of people
Individuals with high income is less affected by price changes. Whereas individuals with low
income are more affected by price changes.
5. Proportion of the income spent on the product
When a person spends only a very small part of his income on certain products (e.g. match
boxes, salt) the price change in these products does not affect his demand for them
6. Urgency of demand
If a person wants to buy a product immediately
no matter what its price is,
or has no other way to buy the product at that point of time
or no substitutes are available
the demand for such products are inelastic.
For example, if one is building a house and has to urgently finish it, then any price change in
cement, bricks or steel will have little impact on the demand.
7. Durability of a product
If a commodity is durable or repairable, like shoes, then its demand is elastic.
Uses of Elasticity of Demand
1. The business firms take into account the elasticity of demand when they take decisions
regarding pricing of goods.
2. The elasticity of demand concept is used by the government in economic policy regarding
regulation of prices of farm products.
Income Elasticity of Demand

It is defined as the degree of responsiveness of quantities demanded to change in income.

It may be defined as the ratio of proportionate change in the quantity demanded of commodity to a
given proportionate change in income of the consumer.
Income Elasticity, Ei = Percentage Change in Quantity Demanded
Percentage Change In Income

Where, Q = Quantity demanded; Y-income

A consumers income rises from Rs. 1000 to Rs. 1200, his purchase of the good X (say, rice) increases
from 25 kgs per month to 28 kgs, then calculate his income elasticity of demand for rice.
Ei =

= 0.6

From this, we conclude that, the quantity demanded of rice rises by 0.60 per cent, if the income of the
consumer rises by one per cent.
Types of Income Elasticity of Demand
1. Zero income elasticity: A given increase in the consumers money income
does not result in any increase in the quantity demanded of a commodity (Ei=0).
e.g. ink, salt etc
2. Negative income elasticity: A given increase in the consumers money
income is followed by an actual fall in the quantity demanded of a commodity.
This happens in the case of economically inferior goods (Ei < 0).
e.g. An increase in income might lead one to shift his demand from bidis to cigaretes.
3. Unitary income elasticity: A given proportionate rise in the consumers
money income is accompanied by an equally proportionate rise in the quantity
demanded of a commodity and vice versa (Ei=1).
4. Income elasticity of demand greater than unity: For a given
proportionate rise in the consumers money income, there is a greater
proportionate rise in the quantity demanded of a commodity. Ei is greater than
unity. This is in case of luxuriy items.
5. Income elasticity of demand less than unity: For a given proportionate
rise in the consumers money income, there is a smaller proportionate rise in the
quantity demanded of a commodity. The income elasticity of demand is less than unity in case
of necessaries like wheat, rice. The percentage expenditure on necessaries increases in a smaller
proportion when the consumers money income goes up (Ei < 1).

PRODUCTION ANALYSIS
PRODUCTION
Production is concerned with the way in which resources or inputs such as land, labor, and
machinery are employed to produce a firms product or output. Production may be either services or
goods. To produce the goods we use inputs. Basically inputs are divided into two types. those are fixed
inputs and variable inputs. Fixed inputs are the inputs that remain constant in short-term. Variable
inputs are inputs, which are variable in both short-term and long-term.
Production Function
Production function expresses the relationship between inputs and outputs. Production
function is an equation, a table, a graph, which express the relationship between inputs and
outputs. Production function explains that the maximum output of goods or services that can be
produced by a firm in a specific time with a given amount of inputs or factors of production.
Production Function: Q = f (K, L)
We are producing Q quantities of goods by employing K capital and L labor.
Here
Q
Represents quantity of goods
K
Represents Capital employed
L
Represents Labor employed
Production analysis - short term Law of diminishing returns

Short-Term production function is a function, which we are producing goods in the short-term by
employing two inputs that are :
Capital (K) : It is fixed input which is constant in the short-term.
Labor (L) : It is variable input in the short-term.
In the short-term we are producing only one product by employing two inputs
The two inputs are K capital and L is labor.
In the short term we will increase L input and we will keep K as constant.

Units of K
Employed

Output Quantity

37

60

83

96

107

117

127

128

42

64

78

90

101

110

119

120

37

52

64

73

82

90

97

104

31

47

58

67

75

82

89

95

24

39

52

60

67

73

79

85

17

29

41

52

58

64

69

73

(8)

(18)

(29)

(39)

(47)

(52)

(56)

(52)

14

20

27

24

21

17

Units of L employed

You can observe in the table we are producing 8 quantities of goods by employing 2 capital and
1 labor.

Here when we increased labor 1 to 2, output is 18. When we increased labor from 2 to 7 the
total output reached to 56 quantities with constant K=2 CAPITAL.

After certain point of time (L=8) the output is starts to decease i.e. 52.

In this case we have to understand, in the short-term by increasing labor without

increasing capital, after certain level, the output starts to decrease. The reason to decrease the output
is The Law of Diminishing Returns.
The Law of Diminishing Returns

This law states:

As additional units of variable input are combined with a fixed input, at some point the
additional output (i.e. marginal product) starts to diminish.
or
with a fixed amount of any one factor of production, successive increase in other (variable) factors (of
production) will after a point, will yield a diminishing increment in output.
eg. In the case of multi story building construction, the higher the building, the larger will be the
expenditure on constructing upper stories. This is because more labour and capital are required to take
the material from ground floor to upper storeys.
A Farmer Example of Diminishing Returns
Consider a corn farmer with one acre of land. In addition to land, other factors include quantity of seeds,
fertilizer, water, and labor. Assume the farmer has already decided how much seed, water, and labor he
will be using this season. He is still deciding on how much fertilizer to use. As he increases the amount of
fertilizer, the output of corn will increase. It may also reach a point where the output actually begins to
decrease since too much fertilizer can become poisonous.
The law of diminishing returns states that there will be a point where the additional output of corn
gained from one additional unit of fertilizer will be smaller than the additional output of corn from the
previous increase in fertilizer. This table shows the output of corn per unit of fertilizer.

As the farmer increases from one to two units of fertilizer, total

output increases from 100 to 250 ears of corn. Therefore the
marginal, or additional, ears of corn gained from one more unit
of fertilizer is 150 (250 - 100). From two to three units of
fertilizer, the total output increases from 250 to 425 ears of
corn, a 175 marginal increase.
At what point does the law of diminishing returns set in? Look for the point at which the marginal
increase is at the highest point and the next marginal increase is less. In this example, that occurs after
the farmer adds the third unit of fertilizer. At three units, the marginal output in ears of corn is 175, but
when the fourth unit is added, the marginal output drops to 125.
Again, this does not mean the total production starts to decrease. In fact, the total production is still
increasing, as shown in the total ears of corn column. Also note that at the sixth unit of fertilizer, the
farmer starts to experience negative returns, where the increase in fertilizer actually decreases the total
output and the marginal output becomes negative.
A Caf Example of Diminishing Returns
We have all been to a caf where they consistently seem
slammed with customers in the mornings and wonder why
they don't schedule more employees for that shift.
Assuming the caf cannot increase in size to serve the
customers, it has to rely on operating at an efficient point
given the input factors that can be easily adjusted. In this

case, the input factor that can change in the short run is labor.
This chart shows the total cups of coffee served and marginal coffees served as they increase the
number of workers. At what point does the law of diminishing returns set in? Does this situation also
experience a decrease in returns? If so, at what point and why do you think that occurs?

After the fourth employee is added, the law of diminishing returns sets in. With four employees, they
serve 350 coffees; with five, 425. Even though the output still increases, the marginal increase from four
to five employees is only 75 cups of coffee; from three to four employees, the marginal increase is 125.

Discuss your understanding on the table of data given below:

i) with a rough sketch on demand curve;
ii) with a rough sketch on supply curve;
iii) calculate the price elasticity of demand and supply for the first two price data; and
iv) discuss the significance of the price Rs.35
Price of a lunch

Supply offered by restaurants

Demand from consumers

30
60

140
60

Rs 25
Rs 35

Rs 45
90
50
i) demand curve is shown as - - - ref fig
ii) supply curve is shown as ------- ref fig
iii) price elasticity of demand = [(60 - 140)/ 140] / [(35 -25)/25] = -1.43 and
price elasticity supply = [(60 - 30)/ 30] / [(35 -25)/25] = 2.5
iv) significance of the price Rs.35 is that it is the market prices where the seller and
the buyer agree to trade the goods for that quantity at that time.

Comparison of demand, and supply curves.