Unit I

Nature and scope of Business Economics, Demand and Supply: Meaning, law, Individual Vs
Market, Movement Vs Shift, Market equilibrium. Elasticity of Demand: Price, income and
cross elasticity. Measurement of elasticity of demand: outlay and percentage method. Elasticity
of supply: concept and measurement (Percentage method).

INTRODUCTION
What is Economics about?
• Originated from the Greek word ‘Oikonomia’ which means ‘household’.
• Till 19th century Economics was known as ‘Political Economy’.
• First Modern work of Economics by Adam Smith is named as ‘An Enquiry into the Nature
and Causes of the ‘Wealth of Nations’ (1776) abbreviated as ‘The Wealth of Nations’.
• There are two fundamental facts that can be concluded with the concept of Economics:
i. Human beings have unlimited wants; and
ii. The means to satisfy these unlimited wants are relatively scarce forms the subject matter
of Economics.

DEFINITION OF ECONOMICS
• Economics is the study of the processes by which the relatively scarce resources are
allocated to satisfy the competing unlimited wants of human beings in a society.
• This definition of Economics, with the narrow focus on using the relatively scarce
resources to satisfy human wants is domain of modern neo classical micro economic
analysis.

MEANING OF BUSINESS ECONOMICS

• Decision Making refers to the process of selecting an appropriate alternative that will
provide the most efficient means of attaining a desired end, from two or more alternative
courses of action.
• It means evaluation of feasible alternatives, rational judgment on the basis of information
and choice of particular alternative which the decision maker finds as most suitable.
• As we know the question of choice arises because our productive resources such as land,
labour, capital and management are limited and can be employed in alternative uses.
Therefore, more efficient alternatives must be chosen and less efficient alternatives must
be rejected.
• Business Economics also referred as Managerial Economics refers to the integration of
economic theory with business practice.
• Business Economics applies tools of economics to make business decision making.
• It is Applied Economics that fills the gap between economic theory and business practice.
• It has close connection with Economic Theory (Micro and Macro Economics), Operation
Research, Statistics, Mathematics and the Theory of Decision Making.

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• Business Economics is also useful for managers of ‘not-for -profit’ organisations such as
NGO and Voluntary Organisations.

DEFINITION OF BUSINESS ECONOMICS

• Business Economics may be defined as the use of economic analysis to make business
decisions involving the best use of an organisation’s scarce resources.
• Joel Dean defined Business Economics in terms of the use of economic analysis in the
formulation of business policies.
• Business Economics is essentially a component of Applied Economics as it includes
application of selected quantitative techniques such as linear programming, regression
analysis, capital budgeting, break even analysis and cost analysis.

NATURE OF BUSINESS ECONOMICS

Economics has been broadly divided into two parts i.e. Micro Economics and Macro
Economics.

MICRO ECONOMICS
• It is the study of the behavior of different individuals and organisations within an economic
system.
• It examines how the individual units (consumers or firms) make decisions as to how to
efficiently allocate their scarce resources.
• In this the focus is on a small number of or group of units rather than all the units combined
and therefore it does not explain what is happening in the wider economic environment.
• Concepts studied in Micro Economics:
➢ Product Pricing
➢ Consumer Behaviour
➢ Factor Pricing
➢ The Economic Conditions of a section of people
➢ Behaviour of firms
➢ Location of Industry.

MACRO ECONOMICS

• It is the study of the overall economic phenomena or the economy as a whole, rather than
its individual parts.
• In it we study the behavior of the large economic aggregates such as the overall level of
output, total consumption, total saving and total investment and also how these aggregates
shift over time.
• It analyzes the overall economic environment in which the firms, governments and
households make decisions.
• It should be kept in mind that this economic environment represents the overall effect of
the innumerable decisions made by millions of different consumers and producers.

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• Concepts studied under Macro Economics are:
➢ National Income and National Output
➢ The general price level and interest rates
➢ Balance of Trade and balance of payments
➢ External value of currency
➢ The overall level of savings and investment and
➢ The level of employment and rate of economic growth.

NATURE OF BUSINESS ECONOMICS:

The following points will describe the nature of Business Economics:

• Business Economics is a Science - Science is a systematized body of knowledge which
establishes cause and effect relationships. Business Economics integrates the tool of
decision sciences such as Mathematics, Statistics and Econometrics with Economic
Theory to arrive at strategies to achieve business goals.
• Based on Micro Economics – Business Manager is concerned about achievement of the
predetermined objectives of his organization so as to ensure the long-term survival and
profitable functioning of organization. Since Business Economics is concerned more with
the decision-making problems it takes help of micro economics tools.
• Incorporates elements of Macro Analysis – Macro Economics elements like general price
level, income and employment level in the economy and government policies related to
taxation, interest rates, exchange rates, industries, prices, distribution, wages etc. affects
the business. Business Manager must be acquainted with these elements as they influence
business environment.
• Business Economics is an Art – It involves practical application of rules and principles for
attainment of set objectives.
• Use of Theory of Markets and Private Enterprises – Business Economics uses theory of
firm and resource allocation in backdrop of private enterprise economy.
• Pragmatic in Approach – Business Economics is practical in approach as it tackles
practical problems which the firms face in real world.
• Interdisciplinary in Nature – Business Economics uses tools from other subjects like
Mathematics, Operation Research, Management Theory, Accounting, Marketing, Finance,
Statistics and econometrics.
• Normative in Nature – Economic Theory has developed along two lines – positive and
normative.

✓ POSITIVE:
➢ Positive and Pure Science analyses cause and effect relationship but does not involve
any judgement.
➢ It states ‘what is ‘of the state of affairs.
➢ It is descriptive in nature and describes the economic behavior of individuals or society
without prescriptions about the desirability of such behavior.

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 ✓ NORMATIVE:
➢ It involves value judgments.
➢ It states ‘what should be’ a particular course of action under given circumstances.
➢ It is prescriptive in nature and in its welfare, considerations are embedded.
➢ Business Economics requires both the concepts positive and Normative in nature. It is
normative as it suggests the application of economic principles for policy formulation
and decision making. However, it also needs to understand the environment thus
involves study of positive theory.
➢ Thus, Business Economics combines the essentials of Normative and Positive
Economic Theory with emphasis more on the former than the latter.

Demand, Supply and Market equilibrium

Demand

An economic principle that describes a consumer’s desire and willingness to pay a price for a
specific good or service. Holding all other factors constant, the price of a good or service
increases as its demand increases and vice versa. Demand means the ability and willingness to
buy a specific quantity of a commodity at the prevailing price in a given period of time.
Therefore, demand for a commodity implies the desire to acquire it, willingness and the ability
to pay for it.
According to Prof. Hibdon, “Demand means the various quantities of goods that would be
purchased per time period at different prices in a given market.” Thus, three things are
necessary for demand to exist; (1) the price of a commodity (2) the amount of the commodity
the consumer or consumers are prepared to buy per unit of time; (3) a given time. Similarly,
Benham wrote down, “The demand for anything at a given price is the amount of it which will
be bought per unit of time at that price.”

Features of Demand
a) Difference between desire and demand. Demand is the amount of a commodity for
which a consumer has the willingness and the ability to buy. There is difference between
need and demand. Demand is not only the need; it also implies that the consumer has the
money to purchase it.
b) Relationship between demand and price. Demand is always at a price. Unless price is
stated, the amount demanded has no meaning. The consumer must know both the price
and the commodity and he will tell his amount demanded.
c) Demand at a point of time. The amount demanded must refer to some period of time
such as 10 quintals of wheat per year or six shirts per year or five kilos of sugar per
month. Not only this, the amount demanded and the price must refer to a particular date.

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Determinants of Demand

The demand for a product is determined by a large number of factors. It would be impossible
to include all possible determinants of demand in any study. Therefore, a few factors which
underlie the demand for most of the products can be easily spotted. These factors are price of
the commodity, incomes of the buyers of the commodity, prices of related goods, advertising
and sales promotion. These factors are found to have a substantial influence on the sales of a
commodity. These are expressed and measured in various ways. In demand studies, these
constitute the controlling variables. The importance of each determinant varies from product
to product. As such the demand for a particular product has to be analysed only after the
importance of each determinant is specified. Some of these factors are within a firm’s control,
others may not be so. For example, a firm can change the price of the commodity, its
promotional expenditure, quality of the product and sales conditions. Let us discuss all these
determinants in brief:
i. Price of the Commodity- The most important factor affecting amount demanded is the
price of the commodity. The amount of a commodity demanded at a particular price is
more properly called price demand. The relation between price and demand is called
the Law of Demand. It is not only the existing price but also the expected changes in
price which affect demand.
ii. Income of the Consumer- The second most important factor influencing demand is
consumer income. In fact, we can establish a relation between the consumer income
and the demand at different levels of income, price and other things remaining the same.
The demand for a normal commodity goes up when income rises and falls down when
income falls. But in case of Giffen goods the relationship is the opposite.
iii. Prices of related goods- The demand for a commodity is also affected by the changes
in prices of the related goods also. Related goods can be of two types: (1) Substitutes
which can replace each other in use; for example, tea and coffee are substitutes. The
change in price of a substitute has effect on a commodity’s demand in the same
direction in which price changes. The rise in price of coffee shall raise the demand for
tea; (2) Complementary goods are those which are jointly demanded, such as pen and
ink. In such cases complementary goods have opposite relationship between price of
one commodity and the amount demanded for the other. If the price of pens goes up,
their demand is less as a result of which the demand for ink is also less. The price and
the demand go in opposite direction. The effect of changes in price of a commodity on
amounts demanded of related commodities is called Cross Demand.
iv. Tastes of the Consumers- The amount demanded also depends on consumer’s taste.
Tastes include fashion, habit, customs, etc. A consumer’” taste is also affected by
advertisement. If the taste for a commodity goes up” its amount demanded is more even
at the same price. This is called increase in demand. The opposite is called decrease in
demand.
v. Wealth- The amount demanded of a commodity is also affected by the amount of
wealth as well as its distribution. The wealthier are the people higher is the demand for
normal commodities. If wealth is more equally distributed, the demand for necessaries

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 and comforts is more. On the other hand, if some people are rich, while the majorities
are poor, the demand for luxuries is generally higher.
vi. Population- Increase in population increases demand for necessaries of life. The
composition of population also affects demand. Composition of population means the
proportion of young and old and children as well as the ratio of men to women. A
change in composition of population has an effect on the nature of demand for different
commodities.
vii. Government Policy- Government policy affects the demands for commodities through
taxation. Taxing a commodity increases its price and the demand goes down. Similarly,
financial help from the government increases the demand for a commodity while
lowering its price.

Individual Demand
The quantity of a commodity a consumer is willing and able to purchase at every possible price
during a specific time period is known as Individual Demand.

Market Demand
The quantity of a commodity that all consumers are willing and able to purchase at every
possible price during a specific time period is known as Market Demand.

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Fig: Derivation of the market demand curve from consumers’ individual demand curve

As the example above illustrates, the individual consumer's demand for a particular good—call
it good X—will satisfy the law of demand and can therefore be depicted by a downward‐
sloping individual demand curve. The individual consumer, however, is only one of many
participants in the market for good X. The market demand curve for good X includes the
quantities of good X demanded by all participants in the market for good X. The market
demand curve is found by taking the horizontal summation of all individual demand curves.
For example, suppose that there were just two consumers in the market for good X, Consumer
1 and Consumer 2. These two consumers have different individual demand curves
corresponding to their different preferences for good X. The two individual demand curves are
depicted in Figure, along with the market demand curve for good. The market demand curve
for good X is found by summing together the quantities that both consumers demand at each
price. For example, at a price of $1, Consumer 1 demands 2 units while Consumer 2 demands
1 unit; so, the market demand is 2 + 1 = 3 units of good X. In more general settings, where
there are more than two consumers in the market for some good, the same principle continues
to apply; the market demand curve would be the horizontal summation of all the market
participants' individual demand curves.

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 Supply
Supply is a fundamental economic concept. It represents the total amount of certain goods
available to consumers. Supply of a product tends to increase if a price goes up because
companies want to expand their production to meet the increasing demand.
The concept of supply is closely related to the concept of demand, which is how much people
want a particular product or service that suppliers offer consumers at a particular price at a
specific point in time.
There are three key features of supply. These include:
i. Quantity supplied: The amount of a good or service that producers are willing and able
to offer for sale at a specific price.
ii. Time frame: The period over which the supply is measured. In the short term, the supply
may be fixed due to factors such as limited production capacity. In the long term, producers
can adjust their production levels.
iii. Price: The relationship between price and quantity supplied is inverse, meaning that as the
price of a good or service increases, the quantity supplied also increases, and vice versa.
A key part of understanding supply is knowing the law of supply. It states that, as the price of
a good or service increases, suppliers will increase their supply so they can increase their
profits.

Factors Affecting Supply

There are a number of factors which can have an impact on supply. These include, but are not
limited to:
i. Demand. An increase in demand can eventually lead to an increase in supply, while a
reduction in demand can eventually lead to a decrease in supply.
ii. Cost. If a good or service is cheap to produce and/or provide, the likelihood is that there
will be more of it. Likewise, if it is expensive, then the likelihood is that there will be less
of it.
iii. Price. If a product’s market price is comparatively high, that can mean that its maker or
supplier could be motivated to make more of it. On the other hand, if it is not profitable
enough, less of it is likely to be made available. Likewise, if a competitor product’s price
goes up, that could reduce demand, meaning there is less supply and if it goes down that
could increase demand, thus leading to a higher supply.
iv. Technological advancement. Improved production efficiency and lower costs can boost
supply but if new technology makes a product or even a whole industry obsolete, that can
lower supply.
v. Number of sellers in a market. If there are a high number of sellers, that means the supply
will likely rise, but if there is a low number, then the chances are that the supply will be
low.
vi. Government policies. Taxes, subsidies and regulations can have an impact on supply. To
use a couple of extreme examples, a low-tax, low-regulation industry that is heavily
subsidized will probably have a higher level of supply than one which is highly-taxed,
heavily regulated and unsubsidized.

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Individual Supply
Individual Supply is the amount of a commodity that a certain company is willing and able to
sell at a specific price during a specific period.

Individual Supply Curve

It can be defined as the curve that shows various quantities of a commodity that an individual
producer or supplier is willing to supply at different prices during a given time, assuming other
factors affecting supply remain unchanged. In a simple sense, it is the graphical presentation
of the individual supply schedule. Thus, it shows the various quantities of supply of a
commodity by a particular firm at various prices. Its alternative name is a single producer’s
supply curve. The following table and the corresponding graph show the individual supply
schedule and individual supply curve respectively.

Price (Rs. Per Unit) Quantity Supplied (Units)

20 10
40 20
60 30
80 40
100 50

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Market Supply
Market Supply is the amount of a good that all businesses are willing and ready to offer for
sale at a specific price during a specific period.

Market Supply Curve

The market supply curve can be defined as the curve that shows various quantities of a
commodity that all the producers or sellers or suppliers are willing to produce and sell at
different prices during a given time, holding other factors affecting supply constant. It shows
the various quantities of supply of a commodity of the whole market at various prices.
Geometrically it is the horizontal summation of all the individual supply curves. It also slopes
upwards, left to right showing a direct relationship between price and market supply.
It can be derived with the help of a market demand schedule. Let us assume there are only three
suppliers namely supplier A, B, and C of a particular product during given specific time. The
following table shows the market supply schedule
and the corresponding figure shows that the market supply curve or derivation of the market
supply curve.

PRICE SUPPLY A SUPPLY B SUPPLY C MARKET

SUPPLY
(A+B+C)
200 1 2 3 6
400 2 4 6 12
600 3 6 9 18
800 4 8 12 24
1000 5 10 15 30

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Alternative Method
Instead of showing individual supply and market supply in a single graph, we can also show
them by drawing in a separate graph. The following figure shows the alternative representation
of individual and market supply curves.

Figure (a) shows the individual supply curve of supplier ‘A’, figure (b) shows the supply curve
of supplier ‘B’, and figure (c) shows the supply curve of ‘C’. By adding all the individual
supply horizontally at the given level of the price we get market supply curve S which is drawn
in figure (d). For example, at price P, Q M =QA +QB+QC. The upward-sloping market supply
curve conveys that price and market supply are positively related.

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Market Equilibrium

Equilibrium under Perfect Competition is a state where market demand matches the market
supply. When market demand and market supply balance each other, there occurs a situation
of equilibrium in the market. During equilibrium, price and quantity become stable.
Equilibrium is the state of no change. The stable price is known as the Equilibrium Price, and
the stable quantity is known as the Equilibrium Quantity.

Market Supply = Market Demand

What is Equilibrium Price under Perfect Competition?

Equilibrium Price is also known as a market-clearing price. It is the price that is derived by
market forces of demand and supply and occurs when market demand is equal to market supply.
Technically, at an equilibrium price, the price at which the buyers want to purchase the product
is equal to the price at which sellers want to sell the same product.

What is Equilibrium Quantity under Perfect Competition?

Equilibrium Quantity is when there are no shortages or surpluses in a product in the market.
The quantity that customers/consumers want to buy at a particular price at a particular point in
time is equal to the quantity that the suppliers want to sell. When there is excess supply, i.e.
surplus, prices will decline, and when there is more demand, i.e. shortage, prices will rise.

Determination of Equilibrium Price and Equilibrium Quantity under Perfect Competition

Equilibrium Price and Equilibrium Quantity are determined using the demand curve and supply
curve. Demand Curve shows the quantity demanded that the consumers are willing and able to
buy at a particular price during a specified period. The demand curve slopes downward,
showing a negative relationship between quantity demanded and price. Supply curve shows
the quantity supplied that the suppliers are willing to sell at a particular price. The supply curve
slopes upward showing a positive relationship between quantity supplied and price.
The intersection of the demand curve and supply curve decides the equilibrium price and the
equilibrium quantity. There is only one point where equilibrium price and equilibrium quantity
can be achieved; i.e., the intersection of the supply curve and the demand curve.

Example:

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Here, X-axis represents Quantity, and Y-axis represents Price. SS is the supply curve, and DD
is the demand curve. They will interact at point E, causing an equilibrium level. The
corresponding price of ₹6 will be termed the Equilibrium Price (P), and the corresponding
quantity of 50 units will be termed the Equilibrium Quantity (Q).

Equilibrium Price and Equilibrium Quantity in case of Excess Demand (Shortage)

When there is more demand for the product than supply in the market, the occurred situation
is said to be Excess Demand or Shortage. It generally happens when prices are lower than the
equilibrium price. It causes the customers/consumers to buy more products at lower prices.
Expanded demand and constant supply affect the prices and quantity in the market. Sellers and
their selling quantity will be less than the buyers and their buying demands. Sellers will be
willing to sell less at lower prices, and buyers will be willing to buy more. There will be
unfulfilled demand which will lead to an increase in prices. As prices will rise:
• There will be an expansion in quantity supplied (a movement along the supply curve)
• There will be a contraction in quantity demanded (a movement along the demand curve)
Due to these movements, prices will rise, restoring them to the level of equilibrium price. At
the equilibrium price, the equilibrium quantity will be set accordingly, again forming a situation
of equilibrium in the market.

Example:

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Here, X-axis represents Quantity, and Y-axis represents Price. SS is the supply curve, and DD
is the demand curve. E is the Equilibrium Point at which P is the Equilibrium Price (₹6), and
Q is the Equilibrium Quantity (50 units). P1 are the lower prices causing D1 as new demand,
which is more than the equilibrium demand and S1 as the new supply, which is less than the
equilibrium supply. This will lead to a shortage. Due to shortage, demands will remain
unfulfilled, causing an increase in prices from P1 to P. Higher Prices will cause lower demand
(a movement along the demand curve) and higher supply (a movement along the supply curve).
Equilibrium E will be restored at the price of ₹6.

Equilibrium Price and Equilibrium Quantity in Case of Excess Supply (Surplus)

Excess supply is a market condition when the quantity supplied is greater than the demand for
the commodity. It occurs at prices greater than the equilibrium price. There occur some
conditions when prices in the market are higher than the equilibrium price. One common
example of such a condition is Price Floor. The higher prices will lead to expansion in quantity
supplied as the suppliers will want to sell more and more when prices are high. So, in the
market, the quantity supplied will be more than the quantity demanded, creating a situation of
Excess Supply or Surplus. Sellers and their selling quantity will be more than the buyers and
their buying demands. Supplies will remain idle in the market as there will not be enough
buying activities. In order to sell idle supplies, suppliers will decrease the selling price until
they will be able to sell all their products. In this case, every seller will have the option to
decrease their prices, since the consumers/customers will be willing to buy the supplies at lower
prices. As prices will fall:
• There will be a contraction in quantity supplied (a movement along the supply curve),
wiping the excess supply out of the market.
• There will be an expansion in quantity demanded (a movement along the demand
curve).

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Due to these movements, prices will fall, restoring them to the level of equilibrium price. At
the equilibrium price, the equilibrium quantity will be set accordingly, again forming a situation
of equilibrium in the market.

Example:

Here, X-axis represents Quantity, and Y-axis represents Price. SS is the supply curve, and DD
is the demand curve. E is the Equilibrium Point at which P is the Equilibrium Price (₹6), and
Q is the Equilibrium Quantity (50 units). P1 are the high prices causing d1 as new demand,
which is less than the equilibrium demand, and s1 as the new supply, which is more than the
equilibrium supply. This will lead to a surplus. Due to surplus, supplies will remain idle,
causing a decline in prices from P1 to P. Lower Prices will cause higher demand (a movement
along the demand curve) and lower supply (a movement along the supply curve). Equilibrium
E will be restored at a price of ₹6.

Divergence from Equilibrium Price

A change in one of the variables (shifters) held constant in any model of demand and supply
will create a change in demand or supply. A shift in a demand or supply curve changes the
equilibrium price and equilibrium quantity for a good or service. Figure given below highlights
“Changes in Demand and Supply” combines the information about changes in the demand and
supply of coffee.

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In the above figure, Panel A represent “An Increase in Demand” Panel B represent “A
Reduction in Demand” Panel represent “An Increase in Supply” and Panel D represent “A
Reduction in Supply” In each case, the original equilibrium price is $6 per pound, and the
corresponding equilibrium quantity is 25 million pounds of coffee per month. Figure 3.17
“Changes in Demand and Supply” shows what happens with an increase in demand, a reduction
in demand, an increase in supply, and a reduction in supply.

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An Increase in Demand
An increase in demand for coffee shifts the demand curve to the right, as shown in Panel (a) of
Figure “Changes in Demand and Supply”. The equilibrium price rises to $7 per pound. As the
price rises to the new equilibrium level, the quantity supplied increases to 30 million pounds
of coffee per month. Notice that the supply curve does not shift; rather, there is a movement
along the supply curve.
Demand shifters that could cause an increase in demand include a shift in preferences that leads
to greater coffee consumption; a lower price for a complement to coffee, such as doughnuts; a
higher price for a substitute for coffee, such as tea; an increase in income; and an increase in
population

A Decrease in Demand
Panel (b) of Figure “Changes in Demand and Supply” shows that a decrease in demand shifts
the demand curve to the left. The equilibrium price falls to $5 per pound. As the price falls to
the new equilibrium level, the quantity supplied decreases to 20 million pounds of coffee per
month.
Demand shifters that could reduce the demand for coffee include a shift in preferences that
makes people want to consume less coffee; an increase in the price of a complement, such as
doughnuts; a reduction in the price of a substitute, such as tea; a reduction in income; a
reduction in population; and a change in buyer expectations that leads people to expect lower
prices for coffee in the future.

An Increase in Supply
An increase in the supply of coffee shifts the supply curve to the right, as shown in Panel (c)
of Figure “Changes in Demand and Supply”. The equilibrium price falls to $5 per pound. As
the price falls to the new equilibrium level, the quantity of coffee demanded increases to 30
million pounds of coffee per month. Notice that the demand curve does not shift; rather, there
is movement along the demand curve.
Possible supply shifters that could increase supply include a reduction in the price of an input
such as labor, a decline in the returns available from alternative uses of the inputs that produce
coffee, an improvement in the technology of coffee production, good weather, and an increase
in the number of coffee-producing firms.

A Decrease in Supply
Panel (d) of Figure “Changes in Demand and Supply” shows that a decrease in supply shifts
the supply curve to the left. The equilibrium price rises to $7 per pound. As the price rises to
the new equilibrium level, the quantity demanded decreases to 20 million pounds of coffee per
month.
Possible supply shifters that could reduce supply include an increase in the prices of inputs
used in the production of coffee, an increase in the returns available from alternative uses of
these inputs, a decline in production because of problems in technology (perhaps caused by a
restriction on pesticides used to protect coffee beans), a reduction in the number of coffee-
producing firms, or a natural event, such as excessive rain.

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Elasticities of Demand
Till now we were concerned with the direction of the changes in prices and quantities
demanded. From the point of view of a business firm, it is more important to know the extent
of the relationship or the degree of responsiveness of demand to changes in its determinants.
Often, we would want to know how sensitive is the demand for a product to its price; for
example, if price increases by 5 percent, how much will the quantities demanded change? Also,
how much change in demand will be there if the average income rises by 5 percent? What
effect will an advertising campaign have on sales? Economists use a number of different types
of elasticities to answer questions like these so as to make demand predictions and to
recommend changes in strategies.
Consider the following situations:
1. As a result of a fall in the price of headphones from Rs 500 to Rs 400, the quantity
demanded increases from 100 headphones to 150 headphones.
2. As a result of fall in the price of wheat from Rs 20 per kilogram to Rs 18 per kilogram,
the quantity demanded increases from 500 kilograms to 520 kilograms.
3. As a result of fall in the price of salt from Rs 9 per kilogram to Rs 7.50, the quantity
demanded increases from 1000 kilogram to 1005 kilograms.

What do you notice?

You notice that the demand for headphones, wheat and salt responds in the same direction to
price changes. The difference lies in the degree of response of demand. The differences in
responsiveness of demand can be found out by comparing the percentage changes in prices and
quantities demanded. Here lies the concept of elasticity.
The amount of a commodity purchased is a function of many variables such as price of the
commodity, prices of the related commodities, income of the consumers and other factors on
which demand depends. A change in one of these independent variables will cause a change in
the dependent variable, namely, the amount purchased per unit of time. The elasticity of
demand measures the relative responsiveness of the amount purchased per unit of time to a
change in any one of these independent variables while keeping others constant. In general, the
coefficient of elasticity is defined as the proportionate change in the dependent variable divided
by the proportionate change in the independent variable.
Elasticity of demand is defined as the responsiveness of the quantity demanded of a good to
changes in one of the variables on which demand depends. More precisely, elasticity of
demand is the percentage change in quantity demanded divided by the percentage change in
one of the variables on which demand depends.
We may find different measures of elasticity such as price elasticity, cross elasticity, income
elasticity, advertisement elasticity and elasticity of substitution. It is to be noted that when we
talk of elasticity of demand, unless and until otherwise mentioned, we talk of price elasticity
of demand. In other words, it is price elasticity of demand which is usually referred to as
elasticity of demand.

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Price Elasticity of Demand
Perhaps, the most important measure of elasticity of demand is the price elasticity of demand
which measures the sensitivity of quantity demanded to ‘own price’ or the price of the good
itself. The concept of price elasticity of demand is important for a firm for two reasons.
• Knowledge of the nature and degree of price elasticity allows firms to predict the impact
of price changes on its sales.
• Price elasticity guides the firm’s profit-maximizing pricing decisions.

Price elasticity of demand expresses the responsiveness of quantity demanded of a good to a

change in its price, given the consumer’s income, his tastes and prices of all other goods. In
other words, it is measured as the percentage change in quantity demanded divided by the
percentage change in price, other things remaining equal.
The price elasticity of demand (also referred to as PED) tells us the percentage change in
quantity demanded for each one percent (1%) change in price. That is,

The percentage change in a variable is just the absolute change in the variable divided by the
original level of the variable.
Therefore,

A negative sign on the elasticity of demand illustrates the law of demand: less quantity is
demanded as the price rises. Notice that the change in quantity was due solely to the price

ANUJ JATAV 19
change. The other factors that potentially could affect sales (income and the competitor’s price)
did not change.
The greater the value of elasticity, the more sensitive quantity demanded is to price. Strictly
speaking, the value of price elasticity varies from minus infinity to approach zero. This is
because Δq/Δp has a negative sign. In other words, since price and quantity are inversely related
(with a few exceptions) price elasticity is negative. While interpreting the coefficient of price
elasticity, we consider only the magnitude of the price elasticity- i.e. its absolute size. For
example, if Ep = -1.22, we say that the elasticity is 1.22 in magnitude. That is, we ignore the
negative sign and consider only the numerical value of the elasticity. Thus, if a 1% change in
price leads to 2% change in quantity demanded of good A and 4% change in quantity demanded
of good B, then we get elasticity of A and B as 2 and 4 respectively, showing that demand for
B is more elastic or responsive to price changes than that of A. Had we considered minus signs,
we would have concluded that the demand for A is more elastic than that for B, which is not
correct. Hence, by convention, we take the absolute value of price elasticity and draw
conclusions.

Interpretation of the Numerical Values of Elasticity of Demand

Economists have found it useful to divide the demand behaviour into different categories, based
on values of price elasticity. Since we draw demand curves with price on the vertical axis and
quantity on the horizontal axis, ΔQ/ΔP = (1/slope of curve). As a result, for any price and
quantity combination, the steeper the slope of the curve, the less elastic is demand.

The numerical value of elasticity of demand can assume any value between zero and infinity.

Elasticity is zero, (Ep= 0) if there is no change at all

in the quantity demanded when price changes i.e. when
the quantity demanded does not respond at all to a price
change. In other words, any change in price leaves the
quantity demanded unchanged and consumers will buy
a fixed quantity of a good regardless of its price.
Perfectly inelastic demand is as an extreme case of
price insensitivity and is therefore only a theoretical
category with less practical significance. The vertical
demand curve represents perfectly or completely
inelastic demand.

ANUJ JATAV 20
Elasticity is one, or unitary, (Ep= 1) if the percentage
change in quantity demanded is equal to the percentage
change in price. It shows special case of unit-elastic demand,
where the demand curve is a rectangular hyperbola.

Elasticity is greater than one (Ep > 1) when the percentage

change in quantity demanded is greater than the percentage
change in price. In such a case, demand is said to be elastic.
In other words, the quantity demanded is relatively sensitive
to price changes. When drawn, the elastic demand line is
fairly flat.

Elasticity is less than one (Ep < 1) when the percentage change
in quantity demanded is less than the percentage change in
price. In such a case, demand is said to be inelastic. In this
situation, when price falls the buyers are unable or unwilling to
significantly contract demand. In other words, the quantity
demanded is relatively insensitive to price changes. When
drawn, the inelastic demand line is fairly steep.

Elasticity is infinite, (Ep= ∞) when a ‘small price reduction raises

the demand from zero to infinity. The demand curve is horizontal
at the price level (where the demand curve touches the vertical
axis). As long as the price stays at one particular level any
quantity might be demanded. Moving back and forth along this
line, we find that there is a change in the quantity demanded but
no change in the price. If there is a slight increase in price, they
would not buy anything from the particular seller. That is, even
the smallest price rise would cause quantity demanded to fall to
zero. Roughly speaking, when you divide a number by zero, you
get infinity, denoted by the symbol∞. So, a horizontal demand curve implies an infinite price
elasticity of demand. This type of demand curve is found in a perfectly competitive market.
The horizontal demand curve represents perfectly or infinitely elastic demand.

ANUJ JATAV 21
 Elasticity Measures, Meaning and Nomenclature

Numerical measure Verbal description Terminology

of elasticity
Zero Quantity demanded does not change as price Perfectly (or completely)
changes inelastic
Greater than zero, but Quantity demanded changes by a smaller Inelastic
less than one percentage than does price
One Quantity demanded changes by exactly the Unit elasticity
same percentage as does price
Greater than one, but Quantity demanded changes by a larger Elastic
less than infinity percentage than does price
Infinity Purchasers are prepared to buy all they can Perfectly (or infinitely)
obtain at some price and none at all at an even elastic
slightly higher price

Now that we are able to classify goods according to their price elasticity, let us see whether the
goods mentioned below are price elastic or inelastic.

What do we note in the above hypothetical example? We note that the demand for headphones
is quite elastic, while demand for wheat is quite inelastic and the demand for salt is almost the
same even after a reduction in price.

Elasticities of demand and supply; Price elasticity of demand and supply, income
elasticity and cross price elasticity; taxes in demand-supply framework, government
intervention in the market: The welfare loss.

ANUJ JATAV 22
Income Elasticity of Demand
The income elasticity of demand is a measure of how much the demand for a good is affected
by changes in consumers’ incomes. Estimates of income elasticity of demand are useful for
businesses to predict the possible growth in sales as the average incomes of consumers grow
over time. Income elasticity of demand is the degree of responsiveness of the quantity
demanded of a good to changes in the income of consumers. In symbolic form,

Ei = Percentage change in demand/Percentage change in income

There is a useful relationship between income elasticity for a good and the proportion of income
spent on it. The relationship between the two is described in the following three propositions:
1. If the proportion of income spent on a good remains the same as income increases, then
income elasticity for that good is equal to one.
2. If the proportion of income spent on a good increase as income increases, then the income
elasticity for that good is greater than one. The demand for such goods increase faster than
the rate of increase in income.
3. If the proportion of income spent on a good decrease as income rises, then income elasticity
for the good is positive but less than one. The demand for income-inelastic goods rises,
but substantially slowly compared to the rate of increase in income. Necessities such as
food and medicines tend to be income- inelastic

Income elasticity of goods reveals a few very important features of demand for the goods in
question.
If income elasticity is zero, it signifies that the demand for the good is quite unresponsive
to changes in income. When income elasticity is greater than zero or positive, then an
increase in income leads to an increase in the demand for the good. This happens in the
case of most of the goods and such goods are called normal goods. For all normal goods,
income elasticity is positive. However, the degree of elasticity varies according to the nature
of commodities.

ANUJ JATAV 23
When the income elasticity of demand is negative, the good is an inferior good. In this
case, the quantity demanded at any given price decreases as income increases. The reason
is that when income increases, consumers choose to consume superior substitutes.

Another significant value of income elasticity is that of unity. When income elasticity of
demand is equal to one, the proportion of income spent on goods remains the same as
consumer’s income increases. This represents a useful dividing line. If the income elasticity
for a good is greater than one, it shows that the good bulks larger in consumer’s expenditure as
he becomes richer. Such goods are called luxury goods. On the other hand, if the income
elasticity is less than one, it shows that the good is either relatively less important in the
consumer’s eye or, it is a good which is a necessity.
The following examples will make the above concepts clear:
(a) The income of a household rises by 10%, the demand for wheat rises by 5%.
(b) The income of a household rises by 10%, the demand for T.V. rises by 20%.
(c) The incomes of a household rises by 5%, the demand for bajra falls by 2%.
(d) The income of a household rises by 7%, the demand for commodity X rises by 7%.
(e) The income of a household rises by 5%, the demand for buttons does not change at all.

Using formula for income elasticity,

i.e. Ei = Percentage change in demand/Percentage change in income
We will find income-elasticity for various goods. The results are as follows:

It is to be noted that the words ‘luxury’, ‘necessity’, ‘inferior good’ do not signify the strict
dictionary meanings here. In economic theory, we distinguish them in the manner shown
above.
An important feature of income elasticity is that income elasticities differ in the short run and
long run. For nearly all goods and services the income elasticity of demand is larger in the long
run than in the short run. Knowledge of income elasticity of demand is very useful for a
business firm in estimating the future demand for its products. Knowledge of income elasticity
of demand helps firms measure the sensitivity of sales for a given product to incomes in the
ANUJ JATAV 24
economy and to predict the outcome of a business cycle on its market demand. For instance, if
EY = 1, sales move exactly in step with changes in income. If EY >1, sales are highly cyclical,
that is, sales are sensitive to changes in income. For an inferior good, sales are countercyclical,
that is, sales move in the opposite direction of income and EY < 0. This knowledge enables the
firm to carry out appropriate production planning and management

CROSS - PRICE ELASTICITY OF DEMAND

Price of Related Goods and Demand

The demand for a particular commodity may change due to changes in the prices of related goods. These
related goods may be either complementary goods or substitute goods. This type of relationship is
studied under ‘Cross Demand’. Cross demand refers to the quantities of a commodity or service which
will be purchased with reference to changes in price, not of that particular commodity, but of other
inter-related commodities, other things remaining the same. It may be defined as the quantities of a
commodity that consumers buy per unit of time, at different prices of a ‘related article’, ‘other things
remaining the same’. The assumption ‘other things remaining the same’ means that the income of the
consumer and also the price of the commodity in question will remain constant.

(a) Substitute Products and Demand

In the case of substitute commodities, the cross demand curve slopes upwards (i.e. positively) showing
that more quantities of a commodity, will be demanded whenever there is a rise in the price of a
substitute commodity. In figure , the quantity demanded of tea is given on the X axis. Y axis represents
the price of coffee which is a substitute for tea. When the price of coffee increases, due to the operation
of the law of demand, the demand for coffee falls. The consumers will substitute tea in the place of
coffee. The price of tea is assumed to be constant. Therefore, whenever there is an increase in the price
of one commodity, the demand for the substitute commodity will increase.

(b) Complementary Goods

In the case of complementary goods, as shown in the figure below, a change in the price of a
good will have an opposite reaction on the demand for the other commodity which is closely
related or complementary. For instance, an increase in demand for solar panels will necessarily
ANUJ JATAV 25
increase the demand for batteries. The same is the case with complementary goods such as
bread and butter; car and petrol, electricity and electrical gadgets etc. Whenever there is a fall
in the demand for solar panels due to a rise in their prices, the demand for batteries will fall,
not because the price of batteries has gone up, but because the price of solar panels has gone
up. So, we find that there is an inverse relationship between price of a commodity and the
demand for its complementary good (other things remaining the same).

We shall now look into the cross - price elasticity of demand.

The cross-price elasticity of demand between two goods measures the effect of the change in
one good’s price on the quantity demanded of the other good. Here, we consider the effect of
changes in relative prices within a market on the pattern of demand. A change in the demand
for one good in response to a change in the price of another good represents cross elasticity of
demand of the former good for the latter good. It is equal to the percentage change in the
quantity demanded of one good divided by the percentage change in the other good’s price.

ANUJ JATAV 26
In the case of the cross-price elasticity of demand, the sign (plus or minus) is very important:
it tells us whether the two goods are complements or substitutes.
When two goods X and Y are substitutes, the cross-price elasticity of demand is positive: a rise
in the price of Y increases the demand for X and causes a rightward shift of the demand curve.
When the cross-price elasticity of demand is positive, its size is a measure of how closely
substitutable the two goods are. Greater the cross elasticity, the closer is the substitute. Higher
the value of cross elasticity, greater will be the substitutability.
• If two goods are perfect substitutes for each other, the cross elasticity between them is infinite.
• If two goods are close substitutes, the cross-price elasticity will be positive and large.
• If two goods are not close substitutes, the cross-price elasticity will be positive and small.
• If two goods are totally unrelated, the cross-price elasticity between them is zero.
When two goods are complementary (tea and sugar) to each other, the cross elasticity between
them is negative so that a rise in the price of one lead to a fall in the quantity demanded of the
other causing a leftward shift of the demand curve. The size of the cross-price elasticity of
demand between two complements tells us how strongly complementary they are: if the cross-
price elasticity is only slightly below zero, they are weak complements; if it is negative and
very high, they are strong complements.
However, one need not base the classification of goods on the basis of the above definitions.
While the goods between which cross elasticity is positive can be called substitutes, the goods
between which cross elasticity is negative are not always complementary. This is because
negative cross elasticity is also found when the income effect of the price change is very strong.
The concept of cross elasticity of demand is useful for a manager while making decisions
regarding changing the prices of his products which have substitutes and complements. If cross
elasticity to change in the price of substitutes is greater than one, the firm may lose by
increasing the prices and gain by reducing the prices of his products. With proper knowledge
of cross elasticity, the firm can plan policies to safeguard against fluctuating prices of
substitutes and complements.

ANUJ JATAV 27