ECONOMICS

CH-1(DEFINITIONS)

PREVIOUS YEAR QUESTIONS

Q1) State and explain the different definitions of Economics. Compare welfare
definition with scarcity definition [16]

Ans) 1. General Definition of Economics:

The English word economics is derived from the ancient Greek word oikonomia
—meaning the management of a family or a household.

It is thus clear that the subject economics was first studied in ancient Greece.
What was the study of household management to Greek philosophers like
Aristotle (384-322 BC) was the “study of wealth” to the mercantilists in Europe
between the sixteenth and eighteenth centuries. Economics, as a study of
wealth, received great support from the father of economics, Adam Smith, in
the late eighteenth century. Since then, the subject has travelled a long and this
Greek or Smithian definition serves our purpose no longer. Over the passage of
time, the focus of attention has been changed. As a result, different definitions
have evolved. These definitions can conveniently be grouped into three:

(i) Smith’s Wealth definition;

(ii) Marshall’s Welfare definition; and

(iii) Robbins’ Scarcity definition.

2. Adam Smith’s Wealth Definition:

The formal definition of economics can be traced back to the days of Adam
Smith (1723-90) — the great Scottish economist. Following the mercantilist
tradition, Adam Smith and his followers regarded economics as a science of
wealth which studies the process of production, consumption and accumulation
of wealth. His emphasis on wealth as a subject-matter of economics is implicit
in his great book— ‘An Inquiry into the Nature and Causes of the Wealth of
Nations’ or, more popularly known as ‘Wealth of Nations’— published in
1776.

According to Smith: “The great object of the Political Economy of every

country is to increase the riches and power of that country.” Like the
mercantilists, he did not believe that the wealth of a nation lies in the
accumulation of precious metals like gold and silver.

To him, wealth may be defined as those goods and services which command
value-in- exchange. Economics is concerned with the generation of the wealth
of nations. Economics is not to be concerned only with the production of wealth
but also the distribution of wealth. The manner in which production and
distribution of wealth will take place in a market economy is the Smithian
‘invisible hand’ mechanism or the ‘price system’. Anyway, economics is
regarded by Smith as the ‘science of wealth.’

Other contemporary writers also define economics as that part of knowledge

which relates to wealth. John Stuart Mill (1806-73) argued that economics is a
science of production and distribution of wealth. Another classical economist
Nassau William Senior (1790-1864) argued “The subject-matter of the Political
Economics is not Happiness but Wealth.” Thus, economics is the science of
wealth. However, the last decade of the nineteenth century saw a scathing attack
on the Smithian definition and in its place another school of thought emerged
under the leadership of an English economist, Alfred Marshall (1842- 1924).

Criticisms:

i. This definition is too narrow as it does not consider the major problems
faced by a society or an individual. Smith’s definition is based primarily
 on the assumption of an ‘economic man’ who is concerned with wealth-
hunting. That is why critics condemned economics as ‘the bread-and-
butter science’.
ii. Literary figures and social reformers branded economics as a ‘dismal
science’, ‘the Gospel of Mammon’ since Smithian definition led us to
emphasise on the material aspect of human life, i.e., generation of
wealth. On the other hand, it ignored the non-material aspect of human
life. Above all, as a science of wealth, it taught selfishness and love for
money. John Ruskin (1819-1900) called economics a ‘bastard science.’
Smithian definition is bereft of changing reality.
iii. The central focus of economics should be on scarcity and choice. Since
scarcity is the fundamental economic problem of any society, choice is
unavoidable. Adam Smith ignored this simple but essential aspect of any
economic system.

3. Marshall’s Welfare Definition:

Alfred Marshall in his book ‘Principles of Economics published in 1890 placed

emphasis on human activities or human welfare rather than on wealth. Marshall
defines economics as “a study of men as they live and move and think in the
ordinary business of life.” He argued that economics, on one side, is a study of
wealth and, on the other, is a study of man.

Emphasis on human welfare is evident in Marshall’s own words: “Political

Economy or Economics is a study of mankind in the ordinary business of life; it
examines that part of individual and social action which is most closely
connected with the attainment and with the use of the material requisites of
well-being.”

Thus, “Economics is on the one side a study of wealth; and on the other and
more important side, a part of the study of man.” According to Marshall, wealth
is not an end in itself as was thought by classical authors; it is a means to an end
—the end of human welfare.

This Marshallian definition has the following important features:

i. Economics is a social science since it studies the actions of human

beings.
ii. Economics studies the ‘ordinary business of life’ since it takes into
account the money-earning and money-spending activities of man.
iii. Economics studies only the ‘material’ part of human welfare which is
measurable in terms of the measuring rod of money. It neglects other
activities of human welfare not quantifiable in terms of money. In this
connection A. C. Pigou’s (1877- 1959)—another great neo-classical
economist—definition is worth remembering. Economics is “that part of
social welfare that can be brought directly or indirectly into relation with
the measuring rod of money.”
iv. Economics is not concerned with “the nature and causes of the Wealth of
Nations.” Welfare of mankind, rather than the acquisition of wealth, is the
object of primary importance.

Criticisms:

i. Marshall’s notion of ‘material welfare’ came in for sharp criticism at the

hands of Lionel Robbins (later Lord) (1898- 1984) in 1932. Robbins
argued that economics should encompass ‘non- material welfare’ also. In
Teal life, it is difficult to segregate material welfare from non-material
welfare. If only the ‘materialist’ definition is accepted, the scope and
subject-matter of economics would be narrower, or a great part of
economic life of man would remain outside the domain of economics.
ii. Robbins argued that Marshall could not establish a link between
economic activities of human beings and human welfare. There are
 various economic activities that are detrimental to human welfare. The
production of war materials, wine, etc., are economic activities but do not
promote welfare of any society. These economic activities are included in
the subject-matter of economics.
iii. Marshall’s definition aimed at measuring human welfare in terms of
money. But ‘welfare’ is not amenable to measurement, since ‘welfare’ is
an abstract, subjective concept. Truly speaking, money can never be a
measure of welfare.
iv. Marshall’s ‘welfare definition’ gives economics a normative character. A
normative science must pass on value judgments. It must pronounce
whether a particular economic activity is good or bad. But economics,
according to Robbins, must be free from making value judgment. Ethics
should make value judgments. Economics is a positive science and not a
normative science.
v. Finally, Marshall’s definition ignores the fundamental problem of
scarcity of any economy. It was Robbins who gave a scarcity definition
of economics. Robbins defined economics in terms of allocation of scarce
resources to satisfy unlimited human wants.

4. Robbins’ Scarcity Definition:

The most accepted definition of economics was given by Lord Robbins in 1932
in his book ‘An Essay on the Nature and Significance of Economic Science.
According to Robbins, neither wealth nor human welfare should be considered
as the subject-matter of economics. His definition runs in terms of scarcity:
“Economics is the science which studies human behaviour as a relationship
between ends and scarce means which have alternative uses.”

From this definition, one can build up the following propositions:

 i. Human wants are unlimited; wants multiply—luxuries
become necessities. There is no end of wants. If food were
plentiful, if there were enough capital in business, if there
were abundant money and time— there would not have been
any scope for studying economics. Had there been no wants
there would not have been any human activity. Prehistoric
people had wants. Modern people also have wants. Only
wants change—and they are limitless.
ii. The means or the resources to satisfy wants are scarce in
relation to their demands. Had resources been plentiful, there
would not have been any economic problems. Thus, scarcity
of resources is the fundamental economic problem to any
society. Even an affluent society experiences resource
scarcity. Scarcity of resources gives rise to many ‘choice’
problems.
iii. Since the prehistoric days one notices constant effort of
satisfying human wants through the scarcest resources which
have alternative uses. Land is scarce in relation to demand.
However, this land may be put to different alternative uses.

A particular plot of land can be either used for jute cultivation or steel
production. If it is used for steel production, the country will have to sacrifice
the production of jute. So, resources are to be allocated in such a manner that
the immediate wants are fulfilled. Thus, the problem of scarcity of resources
gives rise to the problem of choice.

Society will have to decide which wants are to be satisfied immediately and
which wants are to be postponed for the time being. This is the choice problem
of an economy. Scarcity and choice go hand in hand in each and every
economy: “It exists in one-man community of Robinson Crusoe, in the
patriarchal tribe of Central Africa, in medieval and feudalist Europe, in modern
capitalist America and in Communist Russia.”

In view of this, it is said that economics is fundamentally a study of scarcity and

of the problems to which scarcity gives rise. Thus, the central focus of
economics is on opportunity cost and optimisation. This scarcity definition of
economics has widened the scope of the subject. Putting aside the question of
value judgment, Robbins made economics a positive science. By locating the
basic problems of economics — the problems of scarcity and choice — Robbins
brought economics nearer to science. No wonder, this definition has attracted a
large number of people into Robbins’ camp.

The American Nobel Prize winner in Economics in 1970, Paul Samuelson,

observes: “Economics is the study of how men and society choose, with or
without the use of money, to employ scarce productive resources which could
have alternative uses, to produce various commodities over time, and distribute
them for consumption, now and in the near future, among various people and
groups in society.”

Criticisms:

i. In his bid to raise economics to the status of a positive science, Robbins

deliberately downplayed the importance of economics as a social science.
Being a social science, economics must study social relations. His
definition places too much emphasis on ‘individual’ choice. Scarcity
problem, in the ultimate analysis, is the social problem—rather an
individual problem. Social problems give rise to social choice. Robbins
could not explain social problems as well as social choice.
ii. According to Robbins, the root of all economic problems is the scarcity
of resources, without having any human touch. Setting aside the question
of human welfare, Robbins committed a grave error.
iii. Robbins made economics neutral between ends. But economists cannot
remain neutral between ends. They must prescribe policies and make
value judgments as to what is good for the society and what is bad. So,
economics should pronounce both positive and normative statements.
iv. Economics, at the hands of Robbins, turned to be a mere price theory or
microeconomic theory. But other important aspects of economics like
national income and employment, banking system, taxation system, etc.,
had been ignored by Robbins.

Conclusion: The science of political economy is growing and its area can never
be rigid. In other words, the definition must not be inflexible. Because of
modern research, many new areas of economics are being explored.

That is why the controversy relating to the definition of economics remains and
will remain so in the future. It is very difficult to spell out a logically concise
definition. In this connection, Mrs. Barbara Wotton’s remarks may be noted –
‘Whenever there are six economists, there are seven opinions!’

Despite these, Cairncross’ definition of economics may serve our purpose:

“Economics is a social science studying how people attempt to accommodate

scarcity to their wants and how these attempts interact through exchange.” By
linking ‘exchange’ with ‘scarcity’, Prof. A. C. Cairncross has added another cap
to economics.

However, this definition does not claim any originality since scarcity—the root
of all economic problems— had been dealt with elegantly by Robbins.

That is why, Robbinsian definition is more popular:

Economics is the science of making choices. Modern economics is a science of

rational choice or decision-making under conditions of scarcity.
Q2) Critically explain Robin's definition of Economics. Distinguish between
Wealth and Welfare definitions of Economics. [8+8]

Ans) “Economics is a science which studies human behaviour as a relationship

between ends and scarce means which have alternative uses.” – Prof. Lionel
Robbins.

Important Characteristics of Robbins’ Definition:

i. Unlimited Wants:
Human wants are unlimited in number. Whenever one want is satisfied,
then automatically several wants grow up.
Hence it is endless. With the progress in civilization and development
science and technology numerous wants are developed. Again several
human wants are reoccurring too. Hence, wants are ‘ever growing and
never ending’.

ii. Limited Means:

Human wants are unlimited but resources or means to satisfy them are
limited. The means refer to goods and services which we use to satisfy
our wants. They are material and non- material goods like time, money,
services, resources etc. These resources are scarce.
Here the term scarcity is used not in the absolute sense but in the relative
sense i.e., in relation to demand. A commodity may be available in small
quantity but if nobody demands, it then it is not scarce. Hence, the scarce
means are the basis of all economic problems. Because, if all these
means or resources are not scarce, then there will be no problem in
economics.

iii. Alternative Use of Resource:

All the scarce means can be used in more than one purpose. In other
words, they can be used in several purposes. For instance, land is very
scarce, but land can be used for construction of buildings, cultivation,
playground etc. Likewise, all these economic resources are used for
various purposes. Thus, in reality goods can be put to alternative uses of
varying importance.
 iv. Economising Resources:
The main problem of economics is how to satisfy the unlimited wants
with limited means which have alternative uses. Robbins describes this
problem as the problem of economising scarce means. In other words, it
is the choice of making of an economic activity. According to Cassel,
“Economics is the science of Scarcity.” Economics is thus a study of
certain kind of economics that is economising the resources.

v. Problem of Choice:
The problem of economising resources leads to the problem of choice.
Since wants are numerous and means are scarce, we have to choose the
most urgent wants from these unlimited wants. Hence, the consumer will
select few wants from the numerous wants according to his preference
pattern. Thus, scarcity of resources makes the choice necessary. Hence,
Economics is termed as a science of choice.

Criticism:

Scarcity definition is more scientific than both wealth and welfare

definitions, but still, it has following criticisms:

 Static:
Prof Samuelson pointed correctly that Robbins’ definition is not
dynamic in nature, because it has only discussed about the
problems of present generation, not anything about future
generation. Hence the definition suffers with the problem of
economic growth.

 Too Vast:
It discussed with the scope of economics to all the activities of
mankind that are related to the problem of choice. The problem of
choice is found in both social and unsocial beings. Thus, it has no
social significance in real world.

 Economic Problems also arise from more supply:

Some economists claimed that economic problem also arises from
the plenty of goods as well. The Great Depression of 1930s in USA
 was due to abundance of goods, but not due to scarcity of
resources.

 Not fit for socialistic economy:

Prof. Maurice has criticized Robbins’ definition that his definition
is not applicable for a socialistic economy, because in this type of
economy, the Government takes all the initiatives for supplying all
the basic necessities of life among the citizens. For the betterment
of whole society, the Government usually launches several
beneficiary activities.

 Not fit for Rich Country:

The economic problem for a rich and sound economy is different
from the underdeveloped or poor economy. Here the resources are
not limited. In fact, resources are plenty in this type of economy.

 Relation with Welfare:

Robbins’ criticised Marshall’s definition on the ground of welfare.
However limited means are used to fulfil unlimited wants. Thus, it
means that maximising satisfaction will lead to more welfare.
Hence, Robbins’ definition is related with welfare also.

Q3) State and explain critically different definitions of Economics. What is the
basic difference between Value and Price? [12+4]

Q4) Microeconomics vs. Macroeconomics (Short Notes) [8]

Q5) Robbin's Scarcity definition of Economics. (Short Notes) [8]

Q6) State and explain critically different definitions of Economics. Explain the
difference between Production and Consumption. [12+4]
CH-2(ECONOMIC SYSTEMS)

PREVIOUS YEAR QUESTIONS

Q1) What is Capitalist Economy? What are the characteristic features of
Capitalist Economy? Distinguish between Capitalistic Economy and Socialistic
Economy? [2+8+6]

Ans) A capitalist economy is an economy where businesses and individuals

own the factors of production. Here, factors of production refer to
entrepreneurship, natural resources, capital goods and labour. In a capitalist
economy, the production of goods and services depends on supply and demand
in the general market. Some of the main characteristics of a capitalist economy
include private property, competitive markets, capital accumulation, wage
labour, price system, and voluntary exchange.

Characteristics of Capitalism:

The following are the basic characteristics of a ‘pure’ capitalism system:

1) Private Property: Every individual has a right to hold property. This

means that every individual is free to consume his private property and
every individual has a right to transfer his property to his successors after
death. Individuals have their property rights protected and are usually free
to use their property as they like as long as they do not infringe on the
legal property rights of others. Private property, however, is protected,
controlled and enforced by law. Private property is necessary because it
supplies the motive underlying economic activity. In a capitalist
economy, the factors of production—land, labour and capital—are
privately owned, and production occurs at private initiative.
2) Free Enterprise: Free enterprise, an essential feature of the capitalist
system, is merely an extension of the concept of property rights. The term
free enterprise implies that private firms are allowed to obtain resources,
to organise production and to sell the resultant product in any way they
choose. In other words, there will not be any government or other
artificial restrictions on the freedom and ability of the private individuals
to carry out any business.

3) Price Mechanism: The price mechanism plays an important role in the

production of goods and services. Under capitalism, the price is
determined by the demand and supply.

4) The Market System: The market mechanism is the key factor that
regulates the capitalist economy. A market economy is one in which
buyers and sellers express their opinions about how much they are willing
to pay for or how much they demand of goods and services. Prices guide
the purchase decisions of the consumers. At the same time, while they
decide to buy or not to buy a product, consumers vote for or against the
product by using their money. Thus, market prices, which reflect the
desires of millions of consumers, provide guidance to investors and other
business persons. The market system, also called the price system, may,
therefore, be regarded as the organising force in a capitalist economy.

5) Economic Freedom: Another feature of capitalism is economic freedom.

This freedom implies three things:

(1) Freedom of enterprise,

(2) Freedom of contrast,
(3) Freedom to use one’s property.
 Under the capitalism, everybody is free to take up any occupation that he
likes, and to enter into agreements with fellow citizens in a manner most
profitable to him.
In a capitalist economy, the individual is free to choose any occupation he
is qualified for. This freedom of choice enables the worker to make the
best possible bargain for his labour. This implies that the employers have
to competitively bid for labour. Freedom of occupational choice,
however, does not mean guarantee of the job a worker opts for; the choice
is practically limited by the extent of availability of the jobs.

6) Consumers’ Sovereignty: Consumers’ sovereignty is at its best in the

capitalist system where consumers have complete freedom of choice of
consumption. Under capitalism, the consumer is the king. Consumers’
sovereignty means freedom of choice on the part of every consumer. The
consumer buys whatever he likes and as much as he likes. The money
price which the consumer offers expresses his wish. The production
decisions in the free-market economy are based on the consumer desires
which are reflected in the demand pattern. Frederic Benham remarks-
“Under capitalism, the consumer is the king.”

7) Unplanned Economy: As is clear from the features mentioned above,

the capitalist system is essentially characterised by the absence of a
central plan. No central economic planning is done in a capitalist
economy. There are no rules and regulations framed by the central
agency. The productive function is the result of decision taken by a large
number of entrepreneurs. Freedom of enterprise, occupation and property
rights rule out the possibility of a central plan. Resource allocation and
investment decisions in a free market economy are influenced by market
forces rather than by the State.
8) Freedom to Save and Invest: The freedom to save is implied in the
freedom of consumption, for savings depend on income and
consumption. The term saving implies the sacrifice of consumption. As
George Halm observes- “The right to save is supported by the right to
transmit wealth, so that the choice between present and future
consumption is not limited to the adult life of one person. The freedom to
save, inherit, and accumulate wealth is, therefore, a right which is perhaps
more typical for the private enterprise system than is free choice of
consumption and occupation.”

9) Economic Inequalities: Another feature of capitalism is the existence of

glaring inequalities in income, wealth and economic power. The
existence of big monopolies results in the concentration of not only
income and wealth but also of economic power in the hands of a few
people.

10) Motive of Profit: Profit is an important element of capitalism

Investment tends to take the direction in which there is more possibility
of profit. If the producers feel that they can obtain greater profit by the
production of comfortable goods they will be inclined to do so without
caring what people actually need.

11) Competition: Competition among sellers and buyers is an

essential feature of an ideal capitalist system. Competition reduces market
imperfections and associated problems. Therefore, in a free market
economy, a sufficient amount of competition is considered necessary if
the whole production and distribution process is to be regulated by
market forces. Competition is necessary in a private enterprise economy
 to keep initiative constantly on alert, to protect the consumer, and to
maintain a sufficiently flexible price system.

12) Limited Role of Government: The absence of a central plan does

not mean that the government does not play any role in a private
enterprise economy. Indeed, government intervention is necessary to
ensure some of the essential features and smooth functioning of the
capitalist system. For example- government interference is necessary to
define and protect property rights, ensure freedom of entry and exit,
enforce contractual agreements among private entrepreneurs, ensure the
satisfaction of certain community wants, etc. However, government
interference in the system is comparatively very limited. The pure
capitalist system described above is highly idealised system. There is
hardly any pure capitalist or free enterprise system in the real world
today. The capitalist economies of today are characterised by state
regulation in varying degrees. As a matter of fact, the modern capitalist
economies are mixed or regulated systems.

The difference between Capitalist and Socialist Economy is as follows:

1) Factors of Production: A capitalist economy is an economic system

where businesses and individuals own the factors of production while a
socialist economy is an economy where each person in society has equal
ownership od the factors of production.
2) Private and Public Sectors: In a capitalist economy there is a
predominance of private sectors, whereas, in a socialist economy there is
a predominance of public sectors.
3) Motive: The main motive of a capitalist economy is profit while the main
motive of socialism is social welfare.
 4) Role of Government: The government has a limited role in pure
capitalism while the government has a high involvement in socialism.
5) Labour: There can be exploitation od labour in a capitalist economy, but
a socialist economy attempts to prevent labour exploitation.
6) Income Distribution: Income distribution in a capitalist economy is
unequal, while the income distribution in a socialist economy is equal,
and the income distribution in a socialist economy is equal.

Q2) What is Mixed Economy? Discuss the characteristic features of Mixed

Economy. Distinguish between Capitalist and Socialist Economy? [4+6+6]

Ans) A mixed economy is an economic system that has elements of both

capitalism and socialism. It lies on a continuum somewhere between pure
socialism and pure capitalism. Mixed economic systems usually allow private
ownership and control of most of the means of production but under
government regulation.
But unlike in socialist economies, the government does not own all of the means
of production.  The government intervenes through the regulation of the
economy only if it’s necessary.

Q3) Define Socialism. What are the merits and demerits of a Socialist
Economy? Discuss how the basic problems of socialist economy differs from
those of a Capitalist Economy? [2+6+8]

Q4) Short Notes [8]

a) Features of a Socialist Economy
b) Features of a Capitalist Economy
Q5) Distinguish between Mixed and Capitalist Economy? [6]

CH-3(DEMAND)

PREVIOUS YEAR QUESTIONS

Q1) State and explain the Law of Demand. What is Price Elasticity of
Demand? Discuss the factors affecting Price Elasticity of Demand. [4+4+8]

Ans) The law of demand states that other factors being constant (ceteris
paribus), price and quantity demand of any good are inversely related to each
other. When the price of a product increases, the demand for the same product
will fall.
Law of demand explains consumer choice behaviour when the price changes. In
the market, assuming other factors affecting demand being constant, when the
price of a good rises, it leads to a fall in the demand of that good. This is the
natural consumer choice behaviour. This happens because a consumer hesitates
to spend more for the good with the fear of going out of cash.

The above diagram shows the demand curve which is downward sloping.
Clearly when the price of the commodity increases from price p3 to p2, then its
quantity demand comes down from Q3 to Q2 and then to Q3 and vice versa.

Price elasticity of demand is a measurement of the change in the consumption

of a product in relation to a change in its price. Expressed mathematically, it is:
Price Elasticity of Demand = Percentage Change in Quantity
Demanded ÷ Percentage Change in Price
Since changes in price and quantity usually move in opposite directions, usually
we do not bother to put in the minus sign. We are more concerned with the co-
efficient of elasticity of demand rather than the sign!

Economists use price elasticity to understand how supply and demand for a
product change when its price changes.
As a rule of thumb, if the quantity of a product demanded or purchased changes
more than the price changes, then the product is considered to be elastic (for
example, the price goes up by 5%, but the demand falls by 10%)
.
If the change in quantity purchased is the same as the price change (say, 10% ÷
10% = 1), then the product is said to have unit (or unitary) price elasticity.

Finally, if the quantity purchased changes less than the price (say, -5%
demanded for a +10% change in price), then the product is deemed inelastic.

Example of Price Elasticity of Demand

To calculate the elasticity of demand, consider this example: Suppose that the
price of apples falls by 6% from $1.99 a bushel to $1.87 a bushel. In response,
grocery shoppers increase their apple purchases by 20%. The elasticity of apples
is thus: 0.20 ÷ 0.06 = 3.33. The demand for apples is quite elastic.

Factors That Affect Price Elasticity of Demand

 Availability of Substitutes: The more easily a shopper can

substitute one product for another, the more the demand will fall.
For example, in a world in which people like coffee and tea
equally, if the price of coffee goes up, people will have no problem
switching to tea, and the demand for coffee will fall. This is
because coffee and tea are considered good substitutes for each
other.
 Urgency: The more discretionary a purchase is, the more its
quantity of demand will fall in response to price increases. That is,
the product demand has greater elasticity.
 Say you are considering buying a new washing machine, but the
current one still works; it’s just old and outdated. If the price of a
new washing machine goes up, you’re likely to forgo that
immediate purchase and wait until prices go down or the current
machine breaks down.
*The less discretionary a product is, the less its quantity
demanded will fall. Inelastic examples include luxury items that
people buy for their brand names. Addictive products are quite
inelastic, as are required add-on products, such as inkjet printer
cartridges.
One thing all these products have in common is that they lack good
substitutes. If you really want an Apple iPad, then a Kindle Fire
won’t do. Addicts are not dissuaded by higher prices, and only HP
ink will work in HP printers (unless you disable HP cartridge
protection). *
 Duration of Price Change: The length of time that the price
change lasts also matters. Demand response to price fluctuations is
different for a one-day sale than for a price change that lasts for a
season or a year.
Clarity of time sensitivity is vital to understanding the price
elasticity of demand and for comparing it with different
products. Consumers may accept a seasonal price fluctuation rather
than change their habits.
 Extent of uses: Commodities which can be used for a variety of
purposes, (e.g., electricity) have elastic demand. If price per unit of
electricity falls, people will increase the consumption of electricity.
On the other hand, when a commodity is used only for one or two
select purposes, a price change in the market will have a less effect
on its market demand, therefore their demand will be inelastic.
 Nature or type of Good: The Price Elasticity of Demand for a
good is affected by its nature. Different goods can be a necessity
good, a comfort good, or a luxury good for a person. 
There is one more thing that is a single good can be a necessity for
one person, a comfort for the second person, and a luxury for a
third person. So, we can say that a good’s nature is relative.

 Time Period: The price elasticity of demand varies directly with

the time period. The given time period can be as shorts as a day
and as long as several years. 
The price elasticity of demand is directly proportional to the time
period. This means the elasticity for a shorter time period is always
low or it can be even inelastic.
The reason stated for this is the redundant human nature to change
habits. We generally stick to a commodity and respond very late to
the price changes. However, the elasticity of demand is high in a
longer time period as our habit changes over time. We can
substitute the original product if its price changes in the long run.

 Income Levels: Our Society is divided into different classes based

on incomes and lifestyle. Upper-class people generally have a
higher income and live a lavish life whereas the lower-class people
can’t afford luxury items because they have a low income.
Income levels have a considerable effect on the elasticity of
demand. The Elasticity of Demand for a commodity is generally
very low for higher income level groups. The change in prices does
not bother people from such groups.
 Whereas the Price Elasticity of Demand of a commodity is very
high for people belonging to low-income level groups. Poor people
are highly affected by the change in the prices of commodities.

Q2) Explain the different kinds of price elasticity of demand with the help of
figures. [5]

Ans) Let us discuss the different types of price elasticity of demand:

1. Perfectly Elastic Demand:
When a small change in price of a product causes a major change in its demand,
it is said to be perfectly elastic demand. In perfectly elastic demand, a small rise
in price results in fall in demand to zero, while a small fall in price causes
increase in demand to infinity. In such a case, the demand is perfectly elastic or
ep = infinity.
The degree of elasticity of demand helps in defining the shape and slope of a
demand curve. Therefore, the elasticity of demand can be determined by the
slope of the demand curve. Flatter the slope of the demand curve, higher the
elasticity of demand.
In perfectly elastic demand, the demand curve is represented as a
horizontal straight line, which is shown in Figure-2:
From Figure-2 it can be interpreted that at price OP, demand is infinite;
however, a slight rise in price would result in fall in demand to zero. It can also
be interpreted from Figure-2 that at price P consumers are ready to buy as much
quantity of the product as they want. However, a small rise in price would resist
consumers to buy the product.

Though, perfectly elastic demand is a theoretical concept and cannot be applied

in the real situation. However, it can be applied in cases, such as perfectly
competitive market and homogeneity products. In such cases, the demand for a
product of an organization is assumed to be perfectly elastic.

From an organization’s point of view, in a perfectly elastic demand situation,

the organization can sell as much as much as it wants as consumers are ready to
purchase a large quantity of product. However, a slight increase in price would
stop the demand.

2. Perfectly Inelastic Demand:

A perfectly inelastic demand is one when there is no change produced in the
demand of a product with change in its price. The numerical value for perfectly
inelastic demand is zero (ep=0).
In case of perfectly inelastic demand, demand curve is represented as a
straight vertical line, which is shown in Figure-3:
It can be interpreted from Figure-3 that the movement in price from OP1 to OP2
and OP2 to OP3 does not show any change in the demand of a product (OQ).
The demand remains constant for any value of price. Perfectly inelastic demand
is a theoretical concept and cannot be applied in a practical situation. However,
in case of essential goods, such as salt, the demand does not change with change
in price. Therefore, the demand for essential goods is perfectly inelastic.

3. Relatively Elastic Demand:

Relatively elastic demand refers to the demand when the proportionate change
produced in demand is greater than the proportionate change in price of a
product. The numerical value of relatively elastic demand ranges between one
to infinity.

Mathematically, relatively elastic demand is known as more than unit elastic

demand (ep>1). For example, if the price of a product increases by 20% and the
demand of the product decreases by 25%, then the demand would be relatively
elastic.
The demand curve of relatively elastic demand is gradually sloping, as
shown in Figure-4:
It can be interpreted from Figure-4 that the proportionate change in demand
from OQ1 to OQ2 is relatively larger than the proportionate change in price
from OP1 to OP2. Relatively elastic demand has a practical application as
demand for many of products respond in the same manner with respect to
change in their prices.

For example, the price of a particular brand of cold drink increases from Rs. 15
to Rs. 20. In such a case, consumers may switch to another brand of cold drink.
However, some of the consumers still consume the same brand. Therefore, a
small change in price produces a larger change in demand of the product.

4. Relatively Inelastic Demand:

Relatively inelastic demand is one when the percentage change produced in
demand is less than the percentage change in the price of a product. For
example, if the price of a product increases by 30% and the demand for the
product decreases only by 10%, then the demand would be called relatively
inelastic. The numerical value of relatively elastic demand ranges between zero
to one (ep<1). Marshall has termed relatively inelastic demand as elasticity
being less than unity.
The demand curve of relatively inelastic demand is rapidly sloping, as
shown in Figure-5:
ADVERTISEMENTS:
It can be interpreted from Figure-5 that the proportionate change in demand
from OQ1 to OQ2 is relatively smaller than the proportionate change in price
from OP1 to OP2. Relatively inelastic demand has a practical application as
demand for many of products respond in the same manner with respect to
change in their prices. Let us understand the implication of relatively inelastic
demand with the help of an example.

5. Unitary Elastic Demand:

When the proportionate change in demand produces the same change in the
price of the product, the demand is referred as unitary elastic demand. The
numerical value for unitary

elastic demand is equal to one (ep=1).

The demand curve for unitary elastic demand is represented as a
rectangular hyperbola, as shown in Figure-6:
From Figure-6, it can be interpreted that change in price OP1 to OP2 produces
the same change in demand from OQ1 to OQ2. Therefore, the demand is
unitary elastic.

Q3) Differentiate between Change in Demand and Change in Quantity

Demanded. (Ask Ma’am) Show that the value of Price Elasticity varies
from zero to infinity on a straight-line demand curve. [4+6]

Ans) Change in quantity demanded (or movement along the demand curve) is
associated with a change in the demand curve by a rise/fall in the price of the
commodity. It is expressed in the form of an expansion of demand or
contraction in demand. When the demand of a good rise due to a fall in the price
of the good alone, it is termed as expansion of demand. When the demand of a
good falls due to rise in its price, it is called as contraction in demand.
Graphically, it means movement along the demand curve. At price OP, the
demand is OQ. When price falls to OP2, demand rises to OQ2. In this case the
consumer moves from A to B downwards but remains on the same demand
curve. When price rises to OP1, demand falls to OQ1. Once again, the
consumer moves along the same demand curve from A to C.
Change in demand (or shift in demand curve) is associated with the change in
demand for a commodity caused by factors other than the price of a commodity
such as price of related goods, income of the consumer etc. It is expressed in the
form of an increase or decrease in demand. When at the given price, the demand
of a good increases, it is called increase in demand. When at the given price, the
demand decreases, it is called decrease in demand. Graphically, it means, shift
of the demand curve. At price OP, the demand is OQ. When there is an increase
in demand at a given price, the demand curve shifts to the right. If there is a
decrease in demand at the given price, the demand curve shifts to the left. Thus,
change in quantity demanded is due to a fall/rise in price while the change in

demand is due to other factors than price.

Under change in quantity demanded, there is a movement along the same

demand curve, whereas under change in demand, there is a shift of the demand
curve.
Price elasticity of demand measures the responsiveness of quantity demanded
to a change in price. It is calculated as the percentage change in quantity
demanded divided by the percentage change in price.

On a straight-line demand curve, the slope (or the change in quantity demanded
per unit change in price) is constant. As we move along the demand curve from
left to right, the absolute value of the slope decreases, and the price elasticity
becomes less and less elastic. At the midpoint of the demand curve, the price
elasticity is equal to one, which means that the percentage change in quantity
demanded is equal to the percentage change in price. As we move further to the
right along the demand curve, the absolute value of the slope becomes smaller
and smaller, and the price elasticity becomes more and more inelastic,
approaching zero. At the same time, as we move further to the left along the
demand curve, the slope becomes steeper, and the price elasticity becomes more
and more elastic, approaching infinity.
Thus, we can conclude that on a straight-line demand curve, the price elasticity
varies from zero to infinity as we move along the curve from right to left.
Q4) Change in quantity demanded and change in demand. (Short Notes) [8]
Good or service

Q5) Explain the reasons for downward slope of Demand curve. Also explain
the exception to the Law of Demand. [6+8]

Ans) A demand curve is the graphical representation of the demand schedule

for a commodity. It is the graphic statement of an individual buyer's reaction on
amount demanded at a given price in the given point of time. A demand curve
has got a negative slope. It slopes downwards from left to right. A demand
curve shows the maximum quantities per unit of time that consumers will buy at
various prices.

In the words of Richard Lipsey "The curve which shows the relation between
the price of a commodity and the amount of that commodity the consumer
wishes to purchase is called Demand Curve. The following are the reasons for
downward sloping demand curve-:

(1) Law of diminishing marginal utility: A consumer always equalises

marginal utility with price. The law states that a consumer derives less
and less satisfaction (utility) from every additional increase in the stock
of a commodity. When price of a commodity falls the consumer's price
utility equilibrium is disturbed i.e., price becomes smaller than utility.

The consumer in order to restore the new equilibrium between price and
utility buys more of it so that the marginal utility falls with the rise in the
amount demanded. So, long the price of a commodity falls, the consumer
will go on buying more amount of it so as to reduce the marginal utility
and make it equal with new price.

Thus, the shape and slope of a demand curve is derived from the slope of
marginal utility curve.
(2) Income effect: Another cause behind the operation of law of demand is
income effect. As the price of a commodity falls, the consumer has to
buy the same amount of the commodity at less amount of money. After
buying his required quantity he is left with some amount of money.

This constitutes his rise in his real income. This rise in real income is
known as income effect. This increase in real income induces the
consumer to buy more of that commodity. Thus, income effect is one of
the reasons why a consumer buys more at falling prices.

(3) Substitution effect: The substitution effect is another reason for the
downward sloping demand curve. With a fall in the price of the
commodity, and the price of its substitutes remaining the same, the
consumer will buy more units of that commodity. As a result, demand
will increase. On the other hand, with a rise in the price of the
commodity, and the price of its substitutes remaining the same, the
consumer will buy fewer units of that commodity. As a result, demand
will decrease. For example, as the price of tea declines, and the price of
coffee being unaffected, the demand for tea will rise, and conversely with
an increase in the price of the tea in the market, its demand will fall.

(4) New consumers: When the price of a commodity falls many other
consumers who were deprived of that commodity at the previous price
become able to buy it now as the price comes within their reach.

(5) Multiple use of commodity: There are some commodities which have
multiple uses. Their uses depend upon their respective, prices. When
 their prices rise, they are used only for certain selected purposes. That is
why their demand goes down.

For example, electricity can be put to different uses like heating, lighting,
cooling, cooking etc. If its price falls people use it for other uses other
than that. A rise in price of electricity will force the consumer to
minimise its use. Thus, with a fall and rise in price of electricity its
demand rises and falls accordingly.

7 essential exceptions to the Law of Demand

The law of demand does not apply in every case and situation. The
circumstances when the law of demand becomes ineffective are known as
exceptions of the law. Some of these important exceptions are as under.

(1) Giffen goods: Some special varieties of inferior goods are termed as
Giffen goods. Cheaper varieties of this category like bajra, cheaper
vegetable like potato come under this category. Sir Robert Giffen of
Ireland first observed that people used to spend most of their income on
inferior goods like potato and less of their income on meat. But potatoes
constitute their staple food. When the price of potato increased, after
purchasing potato they did not have so many surpluses to buy meat. So,
the rise in price of potato compelled people to buy more potato and thus
raised the demand for potato. This is against the law of demand. This is
also known as Giffen paradox.

(2) Conspicuous Consumption: This exception to the law of demand is

associated with the doctrine propounded by Thorsten Veblen. A few
goods like diamonds etc are purchased by the rich and wealthy sections of
the society. The prices of these goods are so high that they are beyond the
reach of the common man. The higher the price of the diamond the higher
 the prestige value of it. So, when price of these goods falls, the consumers
think that the prestige value of these goods comes down. So, quantity
demanded of these goods falls with fall in their price. So, the law of
demand does not hold good here.

(3) Conspicuous necessities: Certain things become the necessities of

modern life. So, we have to purchase them despite their high price. The
demand for T.V. sets, automobiles and refrigerators etc. has not gone
down in spite of the increase in their price. These things have become the
symbol of status. So, they are purchased despite their rising price. These
can be termed as “U” sector goods.

(4) Ignorance: A consumer’s ignorance is another factor that at times

induces him to purchase more of the commodity at a higher price. This is
especially so when the consumer is haunted by the phobia that a high-
priced commodity is better in quality than a low-priced one.

(5) Emergencies: Emergencies like war, famine etc. negate the operation of
the law of demand. At such times, households behave in an abnormal
way. Households accentuate scarcities and induce further price rises by
making increased purchases even at higher prices during such periods.
During depression, on the other hand, no fall in price is a sufficient
inducement for consumers to demand more.

(6) Future changes in prices: Households also act speculators. When the
prices are rising households tend to purchase large quantities of the
commodity out of the apprehension that prices may still go up. When
 prices are expected to fall further, they wait to buy goods in future at still
lower prices. So, quantity demanded falls when prices are falling.

(7) Change in fashion: A change in fashion and tastes affects the market for
a commodity. When a broad toe shoe replaces a narrow toe, no amount of
reduction in the price of the latter is sufficient to clear the stocks. Broad
toe on the other hand, will have more customers even though its price
may be going up. The law of demand becomes ineffective.
CH-4 (PERFECT COMPETITION AND MONOPOLY)

Q1) Explain the short run equilibrium of a perfect competitive market? [10]

Ans) Under perfect competition, an individual firm is a price taker, that is, it
has to accept the prevailing price as a given datum. It cannot influence the price
by its individual action. As a result, demand curve or average revenue curve of
the firm is a horizontal straight line (i.e., perfectly elastic) at the level of the
prevailing price. Since perfectly competitive firm sells additional units of output
at the same price, marginal revenue curve coincides with average revenue
curve. Marginal cost curve, as usual, is U-shaped.

Now, in order to decide about its equilibrium output, the firm will compare
marginal cost with marginal revenue. It will be in equilibrium at the level of
output at which marginal cost equals marginal revenue and marginal cost curve
is cutting marginal revenue curve from below.

At this level it will be maximising its profits. Since marginal revenue is the
same as price (or average revenue) under perfect competition, the firm will
equalise marginal cost with price to attain equilibrium output.

Consider Fig. 23.2 in which price OP is prevailing in the market. PL would then
be the demand curve or the average and marginal revenue curve of the firm. It
will be seen from Fig. 23.2 that marginal cost curve cuts average and marginal
revenue curve at two different points, F and E.
F cannot be the position of equilibrium, since at F second order condition of
firm’s equilibrium, namely, that marginal cost curve must cut marginal revenue
curve from below at the point of equilibrium, is not satisfied. The firm will be
increasing its profits by increasing production beyond F because marginal
revenue is greater than marginal cost.

The firm will be in equilibrium at point E or output OM since at E marginal cost

equals marginal revenue (or price) as well as marginal cost curve is cutting
marginal revenue curve from below. As under perfect competition marginal
revenue curve is a horizontal straight line, the marginal cost curve must be
rising so as to cut the marginal revenue curve from below.Therefore, in case of
perfect competition the second order condition of firm’s equilibrium requires
that marginal cost curve must be rising at the point of equilibrium.

Hence the twin conditions of firm’s equilibrium under perfect competition are:

(1) MC=MR = Price

(2) MC curve must be rising at the point of equilibrium.

But the fulfilment of the above two conditions does not guarantee that the
profits will be earned by the firm. In order to know whether the firm is making
profits or losses and how much of them, average cost curve must be introduced
in the figure. This has been done in Fig. 23.3 where SAC and SMC curves are
short-run average cost and short-run marginal cost curves respectively.

Profit per unit of output is the difference between average revenue (price) and
average cost. In Fig. 23.3, at the equilibrium output OM, average revenue is
equal to ME, and average cost is equal to MF. Therefore, the profit per unit of
output is EF the difference between ME and MF.

The total profits earned by the firm will be equal to EF (profit per unit)
multiplied by OM or HF (total output). Thus, the total profits will be equal to
the area HFEP. Because normal profits are included in average cost, the area
HFEP indicates super-normal profits.
Since we are assuming that all firms in the industry are working under same
cost conditions and also for all of them price is OP, all will be earning super-
normal profits equal to the area HFEP. Thus, while all firms in the industry will
be in short-run equilibrium, but the industry will not be in equilibrium since
there will be a tendency for the new firms to enter the industry to complete
away the super-normal profits. But the short run is not a period long enough for
the new firms to enter the industry.

The existing firms will therefore continue earning super-normal profits equal to
HEFP in the short period. It is evident that in the situation depicted in Fig. 23.3
all firms will be in equilibrium at E and each will be producing OM output, but
the tendency for the new firms to enter the industry will be present, though they
cannot enter during the short period.

Now suppose that the prevailing market price of the product is such that the
price line or average and marginal revenue curve lies below average cost curve
throughout. This case is illustrated in Fig. 23.4 where the ruling price is OP’
which is taken as given by the firm.
P’ L’ is the price line which lies below AC curve at all levels of output. The
firm will be in equilibrium at point E at which marginal cost is equal to price (or
marginal revenue) and marginal cost curve is rising. Firm would be producing
OM’ output but would be making losses, since average revenue (or price) which
is equal to ME’ is less than average cost which is equal to MF.

The loss per unit of output is equal to E’F’ and total loss will be equal to P’E’F
‘FT which is the minimum loss that a firm can make under the given price-cost
situation. Since all the firms are working under the same cost conditions, all
would be in equilibrium at point E’ or output OM’ and every one will be
making losses equal to P’E’F’H.

As a result, the firms will have a tendency to quit the industry in order to search
for earning at least normal profits elsewhere. We thus see that at price OP’ the
firms will be in equilibrium at E’ but there will be a tendency for firms to leave
it through they cannot do so in the short period.