Kamal IIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIII.pdf

Price line and Budget line
 Higher indifference curve shows higher level of
satisfaction than lower one.
 Thus, a rational consumer in his attempt to maximize
satisfaction will try to reach highest possible
indifference curve. But, he has to pay the money for
the goods and he has less or limited money income.
 Thus, price line or budget line shows all those
combinations of two goods which the consumer can
buy spending his given limited money income on two
goods at their given prices.
96
Kamal Regmi, IAAS,Paklihawa

Commodity A
Commodity
B
Price line (Rs. 200)
2

 Let consumer has Rs. 5 to spend on coffee (Rs. 1/ cup) and
biscuit (Rs. 0.05/ packet).
 Possible combination can be:
Combination Cup of tea Biscuit
A 0 100
B 1 80
C 2 60
D 3 40
E 4 20
F 5 00
Cup of tea
Biscuit
1
0 3
2 5
4
20
60
100
40
80
Price line (Rs. 5)
 Budget line depends upon
income of the consumer and
price of the commodity.
3

Change in budget line with change in
price of the commodity
 Change in price of the any one commodities results in
a change in slope of the price line
Commodity A
Commodity
B
L
N
M
4

Change in budget line with change in
consumer’s income
 If price remain at the same level, rise in income leads
to a shift of price line to right hand in parallel position
and vice-versa.
Commodity A
Commodity
B
L
M
L’
M’
• LM and L’M’ are parallel
because the price of two
commodities are maintained
constant.
5

Consumer’s equilibrium
 Consumer’s equilibrium shows a situation in which the
consumer purchases such a combination of commodities that
he gets the maximum satisfaction from his given income and
with given price of commodities.
 The point of equilibrium is such that he does not want a change
from it.
Assumption :
 Price of commodity are given to consumer.
 Consumer’s income is also given.
 Consumer knows the price of commodities and possible
combinations of two commodities which he can choose.
 Consumer is rational and he wants to obtain maximum
satisfaction.
 Consumer knows the combinations among which he is
indifferent. He knows indifference map fully.
 There is perfect competition in market from where he is
purchasing commodities.
6

Price line
Commodity A
Commodity
B
B
A
0
IC 2
A1
B1
MRS=Price ratio
i.e. ∆B/ ∆A= Pa/Pb
IC1
IC 3
IC 4
Consumer’s equilibrium is at the point where IC is tangent
to price line such that slope of IC curve is equal to slope of
price line. 7

Price change and consumer’s equilibrium
Commodity A
Commodity
B
B
A
0
IC 1
A1
B1
IC 2
PCC
E
F
• If we join equilibrium
points E and F with a
smooth curve, the curve is
called Price Consumption
curve.
• The curve shows how
consumption of A varies
with change in price.
8

Income change and consumer’s
equilibrium
Commodity A
Commodity
B
L
M
L’
M’
E
F
B
A
B’
A’
ICC
9

 A change in consumer’s income with price of the goods
remaining unchanged shifts his price line in parallel fashion.
 A rise in income results in parallel shift to right and vice-versa.
 As income rises, price line shifts to right and we get higher and
higher points of equilibrium of consumer.
 If we join these points by a smooth curve, we get a curve that
depicts the relationship between changes in consumer’s income
and his demand.
 It is called Income Consumption Curve (ICC).
 Amount of change in demand due to change in income is called
income effect.
10

 Price effect shows the change in demand of the
consumer to change in price of the commodity, other
things remaining constant.
 It measures the change in amount of the demanded
commodity with change in its price when price of
other commodity with which it is being combined
remains same.
 It measures the change in equilibrium position of
consumer, with change in price of one commodity.
 If price falls, consumer goes over to a higher IC and if
price rises, consumer moves to a lower IC
 Price effect is the result of other two effect:
i) Income effect and ii) Substitution effect
Price Effect (Hicks and Allen)
11

Income effect:
 Change in the amount demanded of the commodity
due to change in real income of the consumer resulting
from change in price.
 When price falls:
 real income of consumer rises
 purchasing power of consumer increases
 Consumer, therefore, demands more of the
commodity than before
 When price rises:
 Real income of the consumer decreases
 Purchasing power of consumer decreases
 Consumer, therefore, demands less of the
commodity than before
12

Substitution effect:
Change in amount demanded of the commodity due to
commodity being cheaper or dearer in relation to other
commodities in consumer’s demand.
If price of a commodity falls:
 It becomes cheaper compared to other
 Cheaper commodity is substituted for the other
 Thus, demand of the commodity increases
 If price of the commodity rises:
 It becomes costlier compared to other
 Costlier commodity is substituted by other
 Thus, demand of the commodity reduces
13

COMMODITY A
COMMODITY
B
SE
P1
Q
B
A
14

Price effect, income effect and
substitution effect for a fall in price
COMMODITY A
COMMODITY
B
0 N1 N3 N2 M T M'
L
L'
IC1
P1 P2
IC2
Q
SE IE
Price effect = income effect +substitution effect
N1N2 = N3N2 + N1N3
15

Price effect, income effect and
substitution effect for a rise in price
COMMODITY A
COMMODITY
B
0 N2 N3 N1 M’ T M
L’
L
P1
IC1
IC2
P2
Q
SE
IE
Price effect = income effect +substitution effect
N1N2 = N3N2 + N1N3
16

Demand and Law of Demand
The various quantities of goods that would be purchased
per unit of time at different prices in a given market is
known as demand.
 Three main characteristics of demand:
Willingness and ability to pay.
Willingness towards any commodity but does not
have ability to pay is just a wish.
Demand is always at a price.
Demand is always per unit of time.
Demand curve: Curve showing demand and price
relation.
17

Types of Demand
1. Individual and Market Demand:
 It refers to the classification of demand of a product based
on the number of consumers in the market.
 Individual demand can be defined as a quantity demanded
by an individual for a product at a particular price and
within the specific period of time.
 Market demand is the aggregate of individual demands of
all the consumers of a product over a period of time at a
specific price, while other factors are constant.
Kamal Regmi, IAAS,Paklihawa 18

2. Organization and Industry Demand:
 This refers to the classification of demand on the basis of
market.
 The demand for the products of an organization at given
price over a point of time is known as organization
demand.
 The sum total of demand for products of all organizations
in a particular industry is known as industry demand.

3. Autonomous and Derived Demand:
dependency on other products.
 The demand for a product that is not associated with the
demand of other products is known as autonomous or
direct demand.
 It arises due to the natural desire of an individual to
consume the product.
 On the other hand, derived demand refers to the demand
for a product that arises due to the demand for other
products.
 Moreover, the demand for substitutes and complementary
goods is also derived demand.

4. Demand for Perishable and Durable Goods:
usage of goods. The goods are divided into two categories,
perishable goods and durable goods.
 Perishable or non-durable goods refer to the goods that
have a single use.
 On the other hand, durable goods refer to goods that can be
used repeatedly.

5. Short-term and Long-term Demand:
time period.
 Short-term demand refers to the demand for products that
are used for a shorter duration of time or for current period.
This demand depends on the current tastes and preferences
of consumers.
 On the other hand, long-term demand refers to the
demand for products over a longer period of time.
 Generally, durable goods have long-term demand.

6. Joint Demand
 When two or more goods are demanded to satisfy
the same want, it is called joint demand.
 Example: Demand for car and petrol
7. Composite Demand
 When a particular product is demanded to be put
to multiple uses, it is called composite demand.
 Example: Demand for milk as it is used to make
tea, ice-cream, butter, etc

Determinants of demand
1. Price of the good.
2. Price of related good i.e. substitute good and complementary
good (petrol and cars)
3. Income
4. Individual taste and preference.
5. Expectations about future prices and income.
6. Number of consumers.
7. Climate and weather.
8. State of business:
Boom…………. high
Depression…. Low
9. Consumer’s innovativeness
10. Advertisement and sales promotion
11. Government policy
24

Law of demand
Statement:
According to Bilas, “ The law of demand states that other
things being equal, the quantity demanded per unit of time
will be greater when price is lower and smaller when price
is higher.”
Prof. Somuelson, “ Law of demand states that people will
buy more at lower prices and buy less at higher prices,
other things remaining the same.”
25

Assumption of law of demand
No change in taste and preference of the consumer.
Consumer’s income remains the same.
 Marshall assumed money income should not be
changed.
 Friedmou thinks real income should remain
constant.
 The prices of the commodities related to commodity
in demand should not be changed.
No new substitutes for goods have been discovered.
People do not think or feel that present fall in price is
prelude to further decline in price.
26

 It can be shown through demand curve in two ways:
I. Movement along demand curve
If income and other determinant such as taste and
preference, price of related goods, etc are kept constant
and there is a change only in only price of the commodity,
then we move along the same demand curve.
It is technically also known as extension and contraction of
demand curve.
Changes in Demand for a Commodity
Commodity A
Price
P2
P1
Q1 Q2 27

2. Shift of demand curve
 A shift of the demand curve is referred to as a change in a
demand due to any factor other than price like change in
price of other goods, change in income level, change in
consumer taste and preference, etc.
Commodity A
Price
Q1 Q2
P
28

Exception of law of demand
1. Commodities which are regarded as status symbol.
2. Expectation of rise and fall in price in future.
3. Ignorance on part of consumers on quality.
4. Giffen goods:
 Those goods whose demand increases with increase in price are
called giffen goods.
 The concept of Giffen goods focuses on a low income, non-luxury
products that have very few close substitutes.
 These goods have negative price effect.
 For example: Rice which is a staple food grain in a region occupies
majority of food consumption that cannot be substituted. Thus,
even if the price of the rice increases, there is no substitute of rice
in food basket, so it’s demand does not fall.
 SE: +ve and small whereas IE: -ve and large
 Thus, PE: negative, i.e. demand decreases with fall in price
29

0 N2 N1 N3
L
L’
P1
P2
Q
IC2
IC1
COMMODITY A
COMMODITY
B
M’
M2
30

Elasticity of demand- Meaning, type
and measurement
 It measures the responsiveness of quantity demanded
to change in any one of the determinants of demand
keeping other factors constant.
 Types of elasticity of demand:
1. Price Elasticity of demand
2. Income Elasticity of demand
3. Cross Elasticity of demand
31

A. Price Elasticity of Demand
 It is the degree of responsiveness of quantity
demanded of good to a change in its price.
 It is defined as ratio of proportionate change in
quantity demanded of goods caused by given
proportionate change in price.
 Mathematically,
Price elasticity = proportionate change in quantity
demanded/proportionate change in price
= ∆Q/Q1
∆P/P1
= ∆Q*P1
∆P*Q1
32

Degree of price elasticity of demand
1) Perfectly inelastic demand
When the quantity demanded of good does not
change at all to whatever change in price, demand is
said to be perfectly inelastic or elasticity of demand is
zero (Ep = 0) Price
Quantity
33

2) Perfectly elastic demand
 It is horizontal line parallel to x-axis (quantity)
 It indicates that quantity demanded is extremely (
infinetily) responsive to price
Slight rise in price drops quantity demanded to zero.
Infinite demand at particular price which may fall to
zero as slight change in price.
Elasticity of demand is equal to infinity (Ep = ∞)
Price
Quantity 34

3) Unitary elastic demand
 When quantity demanded of good changes by
exactly same percentage as price, demand is said to
be unitary elastic.
 In this case Ep = 1.
 Graph of this type is rectangular hyperbola.
 Rectangular hyperbola is a curve under which total
area at all point will be same.
Price
Quantity 35

4) Relatively elastic demand
 When proportionate change in price causes relatively
a greater proportionate change in quantity
demanded of goods, then demand is said to be
relatively elastic.
 In this case, Ep>1
Price
Quantity
36

5) Relatively inelastic demand
 When proportionate change in price causes relatively
a less proportionate change in quantity demanded of
goods, then demand is said to be relatively inelastic.
 Example: Agriculture goods
 In this case, Ep<1
Price
Quantity
37

Factors determining price elasticity
of demand
I. Degree of necessity
 Essential or necessary goods --relatively inelastic
 Luxury goods – relatively elastic as their consumption
can be postponed.
II. Availability of substitutes
 Greater number of close substitute -- greater elastic
 Eg. Coca-cola
III. Number of uses of goods
 Greater number of use of commodity, higher the
elasticity of demand.
 Coal: as price falls, it can be used in households,
industries, railways, etc.
38

IV. Level of income of consumer
 High earning consumer has less elastic demand than
low earning consumer.
 Elasticity of demand is less for high quality mango
for high earning consumer and vice-versa.
V. Habitual necessities
 Commodity whose consumption is a habit with
consumers has low price elasticity.
 Eg. Cigarettes and liquors
VI. Time period under consideration
 Price elastic in short period is low.
 Price elastic in long period is high as consumers have
options to consume varieties of goods.
39

VII.Place of commodity in consumer’s budget
 Lesser the proportion of expenditure on commodity
by consumer, the less elastic is demand. Eg.
Toothpaste, newspaper, shoe polish
 Demand for durable good is quite elastic. Eg. TV,
steel, etc.
VIII.Joint demand
 Elasticity of demand for ink depends directly on
elasticity of demand for pens.
40

Importance of price elasticity of
demand
I. Importance in taxation policy
 When a finance minister enforce a tax on a certain
commodity, he has to see whether demand is elastic
or inelastic.
 If demand is inelastic for rich people, he can
increase tax and thus can collect larger revenue.
II. Price discrimination by monopolist
 If monopolist finds that demand for his commodity
is inelastic, he will at once fix the price at a higher
level in order to maximize his net profit and vice-
versa.
41

III. Importance to businessman
 When demand of good is elastic, they increase sales
by lowering its price.
 In case of inelastic demand, they charge higher
price.
IV. Help to trade union
 Trade unions can raise wages of labour in an
industry where demand of product is relatively
inelastic.
 If demand for product is relatively elastic, trade
unions cannot press for higher wages.
42

V. Use in international trade
 Elasticity of demand concept has importance in many
aspects of international trade.
 For example:
Country benefits from such exports which have inelastic
demand for rise in price and elastic demand for fall in
price.
Country benefits from such imports which have
inelastic demand for a fall in price and elastic demand
for rise in price.
VI. Guidelines to the producers
 Concept of elasticity provides guidelines for producers
for amount to be spent on advertisement.
 If demand is elastic, producers shall have to spend large
sum of money on advertisement for increasing sales.
43

VII.Use of concept in factor pricing
 Price elasticity concept is helpful in explaining relative
shares of factors of production in production process.
 The factors having price inelastic demand for goods they
produce can obtain higher price than those with elastic
demand.
 Workers producing petro-products having inelastic
demand can easily get their wages raised.
VIII.Price determination in case of joint supply
 Eg. wool and mutton
 If demand for wool is inelastic as compared to demand
for mutton, a higher price for wool is charged and a lower
price for mutton.
44

Measurement of price elasticity of
demand
Generally price elasticity of demand is measured by four
methods:
1. Total expenditure method
2. Point elasticity of demand/ Graphic method
3. Percentage/ proportionate/ mathematical method
4. Arc elasticity of demand
45

Total expenditure method
 This method was given by Marshall
 Elasticity of demand can be measure from the change in
expenditure of consumer on commodity as its price
changes.
 Also known as Total Outlay Method.
 It has three cases:
i. If with a fall in price (demand increase) , the total
expenditure increases or with rise in price (demand
decrease) the total expenditure falls, in that case
elasticity of demand is greater than one i.e. Ed>1.
ii. If with a rise or fall in price, the total expenditure
remains the same, demand will be unitary elastic
i.e. Ed = 1.
46

iii. If with a fall in price, the total expenditure also falls and
with rise in price, the total expenditure also rises, the
demand is said to be less elastic or the elasticity of
demand is less than one i.e. Ed<1.
Price (P) Quantity
demanded (Qd)
Total
expenditure
Elasticity of
demand
1 10 10
Ed<1
2 9 18
3 8 24
4 7 28
5 6 30
Ed = 1
6 5 30
7 4 28
Ed>1
8 3 24
9 2 18
10 1 10 47

The above table shows three possibilities:
I. More elastic demand
II. Unitary elastic demand
III. Less elastic demand
Price
Total Expenditure
Ed<1
Ed=1
Ed>1
P1
P2
P3
P4
Q1
Q2
Q3
A
B
C
D
48

Point Method/Graphic Method
This method is also given by Marshall.
In this methods, we can calculate price elasticity of
demand at a point on a linear demand curve.
Ep = lower segment of demand curve/upper segment of
demand curve
Price
Quantity
A
B
E
C
D
49

 From the figure we can see that,
At point E, Ep = ED/EA = 1
At point C, Ep = CD/AC < 1
At point B, Ep = BD/AB > 1
At point D, Ep = 0/AD = 0
At point A, Ep = AD/0 = ∞
50

Derivation of point elasticity of
demand in graphic method
 Price Elasticity of Demand= Proportionate change in
demand/Proportionate change in price
= Change in demand/original demand  Change in
price/original price
= ΔQ/q  ΔP/p = ΔQ/ ΔP  p/q
 We can proof the formula for point elasticity of demand
with the help of a graph.
51

R
B
A
C
Q Q1 T
P1
0
P
QUANTITY DEMAND
PRICE
 Ep = QQ1/PP1  OP/OQ
 Ep = BC/AB  QA/PA…….......1
 Since ΔABC and ΔAQT are
similar, ratios of corresponding
sides are same
 Thus, BC/AB = QT/QA
 Substituting this at relation 1
 Ep = QT/QA  QA/PA
 Thus, Ep = QT/PA
Again, ΔAPR and ΔAQT are
similar
Thus, QT/PA = AT/AR
Therefore, Ep = AT/AR
52

Percentage/Proportionate/Mathematical
method
 In this method, price elasticity is estimated by dividing
percentage change in amount demanded by percentage change
in price of commodity.
 If proportionate change in amount demanded is higher than
proportionate (percentage) change in price, elasticity will be
greater than one and vice-versa.
Ep = price elasticity of demand
= proportionate change in demand/proportionate change in
price
= ∆Q/Q1
∆P/P1
= ∆Q*P1
∆P*Q1
53

 ∆Q/∆P shows slope of demand curve which has to be
multiplied with ratio of price to quantity to get estimate
of price elasticity.
 Thus, it should be clear that we cannot judge elasticity
from slope of demand curve alone.
 This method is designed to measure elasticity at a point
of demand curve (for a small change in price)
54

Arc Elasticity of Demand
 The arc price elasticity of demand measures the
responsiveness of quantity demanded to a price.
 It takes the elasticity of demand at a particular point on
the demand curve, or between two points on the curve.
 Used when price and demand changes are larger than what is
assumed in point elasticity method
 Mathematically,
Arc elasticity of demand = Q2-Q1/Midpoint of Quantity
P2-P1/Mid point of Price
55

P2
P1
QUANTITY DEMAND
PRICE
D
D
M1 M2
0
56

B. Income elasticity of demand
 Ratio of percentage change in amount demanded as a result of
given percentage change in income of consumers is called
income elasticity of demand.
 According to Watson, “ Income elasticity of demand means
ratio of percentage change in quantity demanded to percentage
change in income. ”
 It means responsiveness of demand to change in income.
Ey = income elasticity of demand
= proportionate change in demand/proportionate change in
income
= ∆Q/Q1
∆Y/Y1
= ∆Q*Y1
∆Y*Q1
57

Types of income elasticity of demand
1. Positive income elasticity of demand
When amount demanded of a commodity increases with
increase in income and vice-versa, the income-demand
curve will be shown as positively sloping from left
upward to right.
Income
Quantity
Ex: Normal Goods
58

2. Negatively income elasticity of demand
When amount demanded of a commodity diminishes
with an increase in income of consumer, the commodity
is said to be an inferior one.
Income
Quantity
Ex: Inferior Goods
59

3. Zero income elasticity of demand
 When demand of commodity does not respond to
change in income, it is said to be completely income
inelastic.
 Example: salt, etc.
Income
Quantity 60

Inferior goods:
 Goods whose demand decreases with increase in
consumer’s income and vice-versa.
 Follow law of demand.
 S.E = large and +ve where as I.E = small and -ve
 For example,
Second hand cars are cheaper. So, I will buy a second
hand car if my income is low. On the other hand, as my
income rises I would prefer a brand new car that I can
afford.
61

0 N1 N2 N3
L
L’
P1
P2
Q
IC2
IC1
COMMODITY A
COMMODITY
B
M1 M’
M2
62

 The law of demand is also applies to inferior goods
 i.e. there is positive price effect for a fall in price even
though the income effect is negative due to the
commodity A being inferior
• SE (N1N3)+ve, but IE (N3N2)–ve
• However, SE outweigh IE
• Therefore, PE (N1N2)+ve
• i.e. law of demand established
63

C. Cross elasticity of demand
It measures the responsiveness of demand for a
commodity, say tea, when price of other related
commodity, say coffee, changes by small amount.
According to Fuguson, “ Cross elasticity of demand is
proportionate change in quantity of X demanded resulting
from given relative change in price of related good Y. ”
Cross elasticity of demand = proportionate change in
demand of X / Proportionate change in price of Y
64

Types of cross elasticity of demand
1. Positive:
 Increase in price of Y leads in increase demand in X.
 Example: Substitution good
2. Negative:
 A proportionate increase in price of one commodity leads
to proportionate fall in demand of another.
 Example: Complementary good
3. Zero:
 Change in price of one good does not affect the demand
of another.
 Example: Independent good
65

Reasons for downward sloping of
demand curve
Substitution effect
Income effect
Law of diminishing marginal utility
66

Supply and Law of Supply
It is the amount of a commodity that sellers are able and
willing to offer for sale at different price per unit of time.
Meyer, “ Supply is a schedule of the amount of a good that
would be offer for sale at all possible prices at any period
of time. ”
Supply: Quantity of the commodity which is actually
brought into market for sale at given price per unit of
time.
Stock: The total quantity of a commodity that exists in a
market and can be offered for sale at short notice.
67

Determinant of supply
I. Price of product
II. Technologies change
 Advanced technologies can yield more quantity and at a lower
cost.
 This may result in producer to be willing to supply more
amount of goods.
III. Resource supply and production cost
 Change in production costs like wages cost, material cost and
energy cost might impact in producer production and supply.
IV. Tax or subsidy
 Increase in tax increase total cost, thereby decreasing supply.
 Subsidies decrease the total cost, thereby increasing supply,
in order to maximize profit.
 Thus, tax and subsidies are two important tools used by
central government which control supply of goods. 68

V. Expectation of prices in future
VI. Price of other goods
 If producer is currently producing good A and price of
good B increases, then he might switch to producing
good B, which would give better result.
VII. Number of producers in market
VIII.Climate change in case of agricultural crops.
IX. Goals of firm
 If firms expect higher profit in future, they will take risk
and produce goods on large scale resulting in larger
supply of commodities.
69

Types of Supply
1. Market Supply:
 Market supply is also called very short period supply.
 Another name of market supply is ‘day-to-day supply or
‘daily supply’.
 Under these goods like—fish, vegetables, milk etc., are
included.
 Supply for perishable goods.
 In this supply is not made according to the demand of
purchasers but as per availability of the goods.

2. Short-term Supply:
 Supply can be adjusted to the limited extent by varying the
variable factor alone.
 In short period supply also, the demand cannot be met as
per requirements of the purchaser. The demand is met as
according to the goods available.
3. Long-term Supply:
 It is the time period during which the supply conditions are
fully able to meet the new demand conditions.
 If demand has been changed the supply can also be
changed because there is sufficient time to meet the
demand by making manufacturing goods and supplying
them in the market.

4. Joint Supply:
 Joint supply refers to the goods produced or supplied
jointly e.g., cotton and seed; mutton and wool.
 In joint supplied products one is the main product and the
other is the by-product of its subsidiary.
 By-product is mostly the automatic outcome when the
main product is produced.

5. Composite Supply:
 In this, the supply of a commodity is made from various
sources and is called the composite supply.
 When there are different sources of supply of a
commodity or services, we say that its supply is composed
of all these resources.
 We normally get light from electricity, gas, kerosene and
candles.
 All these resources go to make the supply of light.
 Thus, the way of supplying the light is called composite
supply.

Law of supply
Law of supply states that the quantity of good offered or
willing to offer by producers or owners for sale increases
with increase in market price of goods and fall if market
price decreases, all other things remaining same.
Supply curve slope upward from left to right.
Price
Quantity Supply
74

Changes in Supply for a Commodity
Increase and Decrease in Supply:
Increase and decrease along supply curve happens
due to change in price of good and resulting change in
quantity supplied at that price.
Price
Q1
P1
P2
Q2
S
S
Quantity
75

Shift in Supply:
Shift in supply curve happens due to change
determinant of supply other than price i.e. Income,
climate, tax, subsidies, etc.
Price
Q1 Q2
P
S
S
S1
S2
Quantity
76

Elasticity of supply and its types
 Responsiveness of supply to change in any of the
determinant of supply.
 Price elasticity of supply is defined as responsiveness of
supply to change in price of good.
 There are five degrees of elasticity of supply. They are:
I. Perfectly elastic supply (Es= ∞)
II. Perfectly inelastic supply: seller put fixed quantity of
good for sale no matter what price is. (Es= 0)
III. Unit elastic supply (Es = 1)
IV. Relatively elastic supply (Es >1)
V. Relatively inelastic supply (Es <1)
77

1. Perfectly elastic supply
2. Perfectly inelastic supply
Price
Price
Quantity
Quantity 78

3. Unitary elastic supply
4. Relatively inelastic supply
Price
Price
Quantity
Quantity 79

5. Relatively elastic supply
Price Quantity
80

Measurement of Elasticity of Supply:
 To measure the elasticity of supply at a particular point on
the curve SS’, we have drawn a straight line NT in such a
way that it touches the SS’ curve at points A and C.
81

 As these two points lie very close to each other, the slope
of the supply curve as well as the slope of the NT line is
the same.
 Following is the formula:
ES = ∆Q/∆P.P/Q =QR/PP1. OP/OQ = AB/BC. QA/OQ
 Since, Triangles ABC and NQA are similar triangles.
 Thus we can write NQ/QA instead of AB/BC
 Therefore,
ES = NQ/QA. QA/OQ =NQ/OQ
 As above figure suggests NQ < OQ, the coefficient of
elasticity of supply is less than one i.e., inelastic.
82

 If the NT straight line passes through the origin, the
elasticity of supply becomes unity and if it passes through
the price or vertical axis, the coefficient will be greater than
one, i.e., elastic.
Elasticity >1 Elasticity =1 Elasticity <1
O Q
A O Q O A Q
P P
P
Supply
Price
S
S
S
S
S
S
83

Equilibrium price
Quantity
Price
S
S
D
D
P
Q
P1
Qd
Qs
Fig. Market Equilibrium
84

Shift in demand and Supply
 Shift in Demand
Quantity
Price
D’
Q
P
D’
D
D
D”
D”
P’
Q’ Q”
P”
S
S
85

 Shift in Supply
Quantity
Price
Q
P
D
D
S
S
S’
S’
S”
S”
P’
P”
Q” Q’
86

Cost curve and their relationship
 Cost is the value of money that has been used up to
produce commodity or deliver a service and hence is
not available for use anymore.
 In business cost is usually a monetary valuation of:
1. effort
2. material
3. resources
4. time and utilities consumed
5. risks incurred
6. opportunity forgone in production and
delivery of goods and services.
87

 It is an amount that has to be paid or given up in order to
get something.
 Production:
It refers to the creation of goods and services which has
exchange value i.e. creation of utility.
Factors of productions are:
land
labour
Capital and
management
 Cost of production means that it is aggregation of price
paid for factor of production used in producing a
commodity.
88

Types of cost
Types of cost
Real cost
Opportunity
cost
Implicit cost Explicit cost Money cost Social Cost
89

1. Real cost
 Overall actual expenses involved in creating a good or services
for sale to consumers.
 In addition to cash, it also includes time, labour, lost
opportunity, etc.
 Real cost of owing an automobile is price paid to automobile
plus maintenance, petrol, insurance, etc.
2. Opportunity cost
 According to Leftwitch, “ opportunity cost of a particular
product is the value of a forgone alternative product that
resources used in its production could have produced. ”
3. Implicit cost
 Costs that are incurred but not explicitly recognized in
account/record books.
 Family labour costs and cost of management by owner.
90

4. Explicit cost
 Costs that are incurred and explicitly recognized in
account/record books.
 Inputs on which cash outlays and recorded in accounts.
 Cost incurred in variable inputs like seeds, fertilizer, etc.
6. Money cost
 Cost incurred by producer in employing various factors
of production in production process is called money cost.
 Hanson, “ Money cost of producing a certain output of a
commodity is sum of all payment to factors of production
engaged in production of that commodity. ”
5. Social cost
 Social cost is the total cost of production of commodity
which includes the direct and indirect costs which
society has to pay for output of the commodity.
91

Short run cost/ Cost in short run
 Short run is the period of time in which certain inputs cannot
be increased or decreased , regardless of amount of output
produced.
 Similarly, there are other inputs known as variable inputs
whose amount can be increased or decreased.
 A firm’s short run total costs are split up into groups viz total
fixed cost and total variable cost.
TC = TFC + TVC
TFC = expenditure incurred which is not variable in production
process.
Eg salaries, wages, depreciation, rent, interest, etc.
TVC= expenditure incurred which is variable in production
process. It changes in response to a change in rate of output.
92

Output TFC (Rs.) TVC (Rs.) TC (Rs.)
0 60 0 60
1 60 100 160
2 60 180 240
3 60 240 300
4 60 340 400
5 60 500 560
6 60 720 780
93

0
100
200
300
400
500
600
700
800
900
0 2 4 6 8
Cost
Output
TFC
TVC
TC
T
94

 In above figure, up to point T, TVC is increasing at
decreasing rate (law of diminishing return yet not exist)
because company is employing less of variable resources.
 After point T, TVC is increasing at increasing rate ( law of
diminishing return exist) as more and more resources are
used as output increased.
95

Short run per unit cost curves
I. Average fixed cost
 Computed by dividing TFC by total output
 AFC = TFC/ total output
 AFC curve is negatively sloped throughout because
as output increases it gets spread over greater
number of units.
Quantity TFC (Rs.) AFC (Rs.)
1 70 70
2 70 35
3 70 23.3333
4 70 17.5
5 70 14
6 70 11.6667 96

0
10
20
30
40
50
60
70
80
0 1 2 3 4 5 6 7
Average
Fixed
Cost
Output
AFC
Fig. Average Fixed Cost
97

II. Average variable cost (AVC)
 Computed by dividing TVC by total output.
 AVC = TVC/total output
 AVC declines at first, reaches a minimum point and
then rises.
Quantity TVC (Rs.) AVC (Rs.)
1 100 100
2 180 90
3 240 80
4 340 85
5 500 100
6 720 120
98

0
20
40
60
80
100
120
140
0 1 2 3 4 5 6 7
Average
variable
Cost
Output
AVC
99

III. Average cost
 Overall cost per unit of output.
 Obtained by dividing total cost by output or by adding average
fixed cost and average variable cost.
AC = TC/Q
AC = AFC + AVC
 Starting where both AFC and AVC decline, AC musts decline as
well.
 But even after AVC turns up, the continuous decline in AFC
causes AC to continue decline.
 However, increase in AVC outweighs decline in AFC, AC
reaches to its minimum point and starts increasing thereafter.
 Thus, minimum point of AVC lies to left of minimum point of
AC curve.
100

0
20
40
60
80
100
120
140
160
180
0 1 2 3 4 5 6 7
Cost
Output
AFC
AVC
AC
101

IV. Marginal cost
 Change in total cost resulting from a unit change in
output.
 It can also be defined as change in total variable cost
resulting from a unit change in output.
MC2 = TC2 – TC1
MC3 = TC3 – TC2 ......
MCn = TCn – TCn-1
MCn = (TVCn +TFC)– (TVCn-1 +TFC)
= (TVCn +TFC)– (TVCn-1 +TFC)
= TVCn - TVCn-1
 Marginal cost does not depend upon fixed costs.
102

Quantit
y
TFC TVC TC MC AC
1 70 100 170 - 170
2 70 180 250 80 125
3 70 240 310 60 103.33
4 70 340 410 100 100.25
5 70 500 570 160 114
6 70 720 790 220 131.67
103

 Marginal cost decreases at first, reaches minimum and
then rises as output is increased.
0
50
100
150
200
250
0 1 2 3 4 5 6 7
Cost
Output
AC
MC
104

Relation between AC and MC
Unit of
output
Total
cost(TC)
Rs.
Average
cost(AC) Rs.
Marginal
cost(MC)Rs.
1 150 150.0
2 190 96.0 40
3 220 73.3 30
4 236 59.0 16
5 270 54.0 34
6 324 54.0 54
7 415 69.3 91
8 600 75 185
105

0
20
40
60
80
100
120
140
160
180
200
0 1 2 3 4 5 6 7 8 9
Cost
Unit of output
AC
MC
106

 Both AC and MC are calculated from total cost of
production. Therefore, AC = TC/q
MC = ∆TC/ ∆q
 When average cost is falling, the marginal cost is
always lower than average cost.
 When AC is rising, MC lies above AC and rises faster
than AC.
 MC curve cuts AC at AC’s minimum point.
 This relationship between MC/SMC and AC/SAC is
purely geometric relationship with no technological
reason behind it but it is of interest to us.
107

Long run cost/cost in long run
 Long run is a condition in which no factors of
production are fixed i.e. almost all factors of
production are variable factors.
 The land, labor, capital goods, and entrepreneurship
all vary to reach the long run cost of producing a good
or service.
 Long run cost curves are derived from short run cost
curves.
 Long run cost curves represent short run cost curves of
a firm suitable for making adjustment of long run
production.
108

Derivation of Long Run Cost (LAC)
 Long run cost curves can be drawn by making tangent
to SAC curves of different firms of different capacity.
Cost
Output
LAC
SAC1 SAC2
SAC3
Q
0 A B D
C 109

Relationship between LAC and SAC
1. LAC can only be tangential to SAC.
 The reason is that for any given level of output, the
average cost cannot be higher in long run than in short
run.
 On the other hand it is not always possible in short run
to produce given output in cheaper way possible.
110

2. LAC does not touches the lowest point of any short run
cost curve except for one which is tangent to SAC at
lowest point of LAC.
 When LAC is falling, it is tangential to falling portion of SAC
curve and when it is rising it is tangential to rising portion of
SAC curve and minimum at minimum portion of SAC curve.
 Thus to produce an output less than OQ at the least cost, the
firm operates the plant at less than its full capacity or less
than its minimum cost of average production.
 To produce an output larger than OQ at the least cost, the
firm operates the plant beyond its optimum capacity.
 OQ is the optimum point because the output OQ is produced
at the minimum point of the long run average cost curve and
the corresponding SAC .
111

Concept of Revenue
 The amount of money which the firms receive by sale of its
output in the market is known as revenue.
 Total revenue: It refers to the total amount of money that a firm
receives from the sales of its products. Mathematically,
TR = price * output
 Average revenue: It is the revenue per unit of commodity sold.
It is calculated by dividing the total revenue by total output.
Mathematically,
AR = total revenue/ total output = price
Thus, average revenue is the price of the product.
 Marginal revenue: Addition made to total revenue by sales of
an additional unit of products in market is marginal revenue.
MRn = TRn – TRn-1
112

Relationship between AR and MR
curves
When AR (price) remains constant, MR will also remain
constant and will coincide with AR.
 Eg: suppose price is Rs. 10
No of unit
sold
TR AR MR
0 0 -- --
1 10 10 10
2 20 10 10
3 30 10 10
4 40 10 10
5 50 10 10
6 60 10 10 113

114
0
10
20
30
40
50
60
70
0 1 2 3 4 5 6 7
Revenue
No. of unit sold
TR
AR
MR

 MR curve never touches Y-axis
 It implies at zero quantity, MR is undefined.
 AR curves should be asymptotic to Y-axis. However, since
AR curve also depicts/shows demand curve, we simply say
that at a high price, there will be zero demand. Thus, AR
can touch Y-axis.
115

AR/Price
Demand

 Suppose price varies than,
No of unit
sold
TR AR MR
0 0 - -
1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 30 5 0
117

0
2
4
6
8
10
12
0 1 2 3 4 5 6 7
Revenue
Output
AR
MR
118

Usefulness/significance of cost
concept
1. Measurement of profit
 Profit = TR-TC
 Aim of firm is to maximize profit i.e. to increase positive
difference between TR and TC.
 Producer will be at equilibrium when TR=TC.
 Also if we consider MR and MC, firm tries to maximize
MR and gap between MR and MC. Thus, the firm is in
equilibrium when,
 MR = MC
 MC cuts MR from below
119

0
200
400
600
800
1000
1200
1400
1600
0 1 2 3 4 5 6 7 8 9
Revenue/Cost
Output
TR
TC
120

MC
MR
Revenue/Cost
Output
121

2. Determine breakeven point
Point at which firms revenue just covers cost of production
in which firm is neither in loss nor in profit.
0
200
400
600
800
1000
1200
1400
1600
0 1 2 3 4 5 6 7 8 9
Revenue/Cost
Output
TR
TC
breakeven point
123

3. Determine shut down point
 Point at which firm AR only covers AVC.
 Firm is in loss to average fixed cost.
 Firm should stop production.
AR
AVC
AC
MC
Revenue/Cost
Output 124

4. To know economics of scale of production.
 If LAC decrease as level of production increases upto
normal capacity, it is known as economics of scale of
production.
Cost
Output
a
b
c
LAC
125

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