Economics Notes B-Com free essay sample

ECONOMICS: It is a social science (social science is a science, which studies any aspect of human life) which studies as to how the scarce resources, which have alternative uses should be allocated/utilized so that maximum goods are produced i. e. , maximum wants are satisfied. Basic concept Goods/resources: Anything that provides satisfaction or utility is called goods/resources. Characteristics of resources: †¢ They are scarce †¢ They have alternative uses. Scarcity of resources When demand for a resource exceeds its existing supply that resource is said to be scarce. Note: scarcity and shortage are the two different things. Shortage is a temporary phenomenon i. e. , when supply falls short of the demand temporarily. The problem of scarcity leads to 3 issues (I) What (II) How (III) for whom to produce. Alternative uses When a man can satisfy more that one want with the same resource or can produce more than one product from one resource then the resource is said to have alternative uses. Equilibrium: It is a state when the economy is making full use of resources or when maximum goods are produced. Opportunity cost: The cost of an item measured in term of the alternative forgone is called its opportunity cost. For instance, if government decides to produce more hospitals and fewer schools, the increase in the number of hospitals has an opportunity cost in terms of the number of school forgone. BRANCHES OF ECONOMICS: MICROECONOMICS AND MACROECONOMICS Micro and Macro are the two major subdivisions in the field of economics. Micro examines the economy in miniature, while macro concerns itself with economic aggregates, such as gross domestic product or national Income, unemployment rates etc. Microeconomics Microeconomics studies the economy in miniature, considering specific sectors or industries, and the interactions of households and firms within these markets. Features of Micro 2 The major areas of study in microeconomics include firms optimal production, the impact of public policy on particular markets, and issues related to prices. Significance Because so much of microeconomics examines issues related to prices of goods and services, micro is sometimes referred to as price theory. Macroeconomics Macroeconomics takes a big picture approach to the economy, studying economy wide phenomena and issues affecting the economy as a whole. Features of Macro Major concepts in macroeconomics include unemployment, inflation, productivity, government budget and gross domestic product (GDP). Business Cycles Business cycles, a term for fluctuating periods of economic strength and weakness, are a major topic of study in macroeconomics. Microeconomics detail explanation: Microeconomics is a branch of economics which focuses on the market attitude of the individual customers and organizations which enables the business to understand the market behavior in micro perspective. Micro economics enables the business organizations to take decisions on the smaller and critical aspects; it also takes the factors affecting such decisions into consideration. Macroeconomics detail explanation: Macroeconomics is that branch of economics which studies the economics in a broader sense. Here the behavior of the economy is studied as a whole, such as Gross National Product (GDP) on an economy and how it is affected by changes in unemployment, national income, rate of growth, and price levels and how an increase/decrease in net exports would affect a nations capital account or how GDP would be affected by unemployment rate. Limitation of microeconomics †¢ †¢ †¢ It studies part of the economy and not the whole. It assumes full employment which is rare phenomena; it is therefore, an unrealistic assumption. It assumes laissez faire policy in the economy which is no longer in practice in any country. Limitation of macroeconomics †¢ †¢ †¢ It ignores the welfare of the individual. It looks at the economy as a whole and ignores its internal composition. It is concerned only with the economy-wide decisions and not the individual decisions. Economics is the science of scarcity and choice 3 Economics is a social science which studies as to how the scarce resources, which have alternative uses should be allocated/utilized so that maximum goods are produced i. e. , maximum wants are satisfied. When consumers want exceed the resources available to produce the goods and services, to satisfy consumer wants, there is a scarcity of goods and services. Consumers have to make a choice about which wants they will satisfy. This involves an opportunity cost because some other choice will remain unsatisfied. If there were enough of the goods and services which consumers wanted then they would not need to worry about how they each got a share e. g. air is a free good because there is no restriction on it supply and therefore it is supplied free of charges. However, most goods are economic goods because they are relatively scarce due to the fact that the resources available to produce these goods are scarce. By resources is meant factors of production (land, labor, capital. And enterprise) and these are limited in supply and are said to be scarce. On the other hand consumers’ wants are virtually unlimited because consumers want houses and bigger houses. Clothes and more clothes, foods and better quality food, consumer want are unending. Since the supply of goods and services is not adequate to satisfy all of the consumer wants, consumers must make a choice. Most consumers have a scale of preferences and will therefore choose to satisfy some want but not others. Conclusion: All economic problems arise out of the inadequacy of resources which forces on consumers, producers and the government, the problem of choice. Whatever choice is made, it will involve an opportunity cost. Production possibility frontier (PPF): Production possibility frontier (PPF) graphically represents the possibilities of producing different combination of two goods by employing all the existing resources of an economy most efficiently. Assumptions: †¢ †¢ †¢ The economy is operating at full employment. Factors of production are fixed in supply; Technology remains the same. Illustration: Suppose that a society can spend its resources on two products, guns and food. The society resources are limited. Therefore, there are restrictions on the amount of guns and food that can be produced, which can be shown by PPF. 4 Guns Production Possibilities Curve G G1 Ga P R Technically Infeasible Area G2 Gb Q S Productively Inefficient Area O FbF1 Fa F2 F Food Figure 1 PPC for the Society The curve from point G to F in figure 1 shows the various combinations of guns and food that a society can make, if it uses its limited resources efficiently. a) The society can choose to make †¢ G units of guns and no food; †¢ F units of food and no guns ; †¢ G1 units of guns and F1 units of food point P on the curve †¢ G2 units of guns and F2 units of food point Q on the curve b) The combination of (Gb, Fb) at point S is within the PPF showing inefficient utilization of resources whereas combination (Ga, Fa) at point R is outside the PPF which is not technically feasible or attainable by the economy by employing all its existing resources. The PPF is an important idea in economics which illustrates the need to make a choice about what to produce when it is not possible to have everything i. e. when there is scarcity. Shift in PPF: Production possibility curve may shift due to changes in availability of resources or development in technology. †¢ If the PPF moves outwards to the right, it is refer to as economic growth †¢ If the PPF moves inwards to the left, it means the economy cannot produce as much as before 5 Past Examination Question: Q 1 Distinguish between micro and macro economics (10) [Q1a 2010 (R)] Q 2 â€Å"Economics is a science of scarcity and choice†. Discuss. [Q1b 2010 (R)] Q 3 Write short note on Production Possibility Curve [Q4a 2010 (R)] Q 4 Write short note on micro and macro economics [Q4a 2010 (P)] Q 5 Write short note on micro and macro economics [Q4a 2009 (R)] Q 6 Write short note on micro and macro economics [Q4a 2008 (R)] Q 7 â€Å"Economics is a science of scarcity and choice†. Discuss. [Q1a 2008 (P)] Q 8 Explain micro and macro approaches of Economics Analysis [Q1b 2008 (P)] Q 9 Explain the concept of micro and macro economics and describe their importance in formulation of economics policies. Q1 2007 (R)] Q 10 Write short note on micro and macro economics [Q4d 2007 (P)] Q 11 Write short note on Production Possibility Curve [Q4c 2006 (P)] 6 Law of Demand: Demand: Demand for a good â€Å"X† means different quantities of â€Å"X†, which the potential buyers are able and willing to buy, at different market prices of the good, in the given span of time. Here ability and willingness of the buyer is nec essary to create demand in the market. The demand schedule and the demand curve: Demand is the function of price. It changes with respect to price. The relationship between demand and price can be shown graphically by a demand curve. Table of price and Demand Price (P) 5 4 3 2 1 Quantity demanded (Q) 10 20 30 40 50 The market demand curve: A market demand curve is drawn from a demand schedule, expressing the expected total quantity of the good that would be demanded by all consumers together, at any given price. Market demand schedule Px 800 700 600 500 400 300 A 4 5 7 9 12 15 B 5 6 7 8 11 18 C 3 4 5 6 8 12 D 5 6 7 8 9 11 E 3 3 4 6 8 12 Px 800 700 600 500 400 300 Td 20 24 30 37 48 68 Law of demand: 7 Other things remaining constant as the price of a good â€Å"X† falls its quantity demanded increases, and when its price rises, the quantity demanded of â€Å"X† falls. This law indicates that quantity of â€Å"X† demanded varies inversely with the price. It is the relationship of cause (change in price) and effect (change in quantity demanded). Demand curve is negatively sloped indicating that quantity of â₠¬Å"X† demanded varies inversely with the price. Assumption of the law: The following factors should remain constant. †¢ Prices of related goods; †¢ Consumer’s income; †¢ Consumer’s preferences; †¢ Weather conditions; †¢ Population; and †¢ Future expectations. Change in demand: When there is a change in other factors that affect demand, the relationship between quantity demanded and price will also change, and there will a shift in the demand curve either upward or downward and the relationship between price and quantity demanded will also change. The diagram shows change in demand (shift in demand curve) due to change in other factors that affect price rather than the price itself. Change in quantity demanded: If price of a good change (goes up or down), given no change in other factors that affect price, then there will be a change in the quantity demanded. The change in quantity demanded is graphically represented as movement along demand curve. The diagram shows the change in quantity demanded due to the change in price. Supply: The different quantities of a good say â€Å"X†, which the potential producers (firms) are willing and able to sell at different prices of the good in the market. Law of supply: Other things remaining constant, as the price of the good â€Å"X† rises in the market its quantity supplied also increases and when the price falls the quantity of the good supplied also falls. 8 Market Supply Schedule Px 500 400 300 200 A B C D E Px Sd 50 40 20 30 60 500 200 45 38 17 25 55 400 180 40 30 12 20 48 300 150 30 20 10 15 25 200 100 Supply curve: It is positively sloped i. e. it moves upward from left to right, indicating that as the price rise quantity supplied also rises. Assumption of the law: †¢ Price of the input should not change; †¢ Government policy should not change; †¢ Demand condition should not change; †¢ Technology should remain the same; and †¢ Production environment should not change. Change in quantity supplied: It is caused by change in price of the good. When the supply for a good changes because of change in its price while other things remaining constant there will be a movement along the supply curve. Graphically it can be represented as: Shift in supply curve: It is caused by other factors other than price (price remains unchanged). It is graphically said shift in the supply curve. It can be represented as: How price is determined? The price of a good say ‘x’ is determined in the market through the free interaction of twin market forces of demand and supply. As a result of free interaction of demand and supply of ‘x’ a price say ‘P’ is set in the market. It is the price at which quantity of ‘x’ demanded equal to its quantity supplied. Demand and Supply schedule: Demand 70 100 150 200 320 Px 500 400 300 200 150 Supply 200 180 150 100 70 9 4) Elasticity: Elasticity can be defined as ratio of change in dependant variable with respect to independent variable Types of elasticity of demand 1. price elasticity 2. income elasticity 3. cross elasticity 1) Price Elasticity of demand: The responsiveness of quantity of a good say ‘x’ demanded to the change in its price. The rate at which quantity of ‘x’ demanded increases or decreases in response to a given decrease or increase in price. E/d = %change in quantity demanded of ‘x’ % change in the price of the ‘x’ With respect to elasticity the goods can be: I) Price elastic II) Price inelastic I) Price elastic: When small change in price of a good causes a relatively large change in its quantity demanded, the demand is price elastic. E. g. a 10% fall in the price of T. V set results in 20% increase in the demand for it. Price elastic demand = % change in demand gt; % change in price II) Price inelastic: When large change in the price of a goods results in relatively a small change in its quantity demanded, the demand is price inelastic. E. g. 20% change in the price of salt results in only 0. 5% change in its demand. Price inelastic demand = % change in demand lt; % change in price 2) Income elasticity of demand: Responsiveness of demand too the change in consumer’s income is called income elasticity. It measures at what rate the demand increase in reference to a given rise or fall in c onsumer’s income. (y = Income) Ey = %change in the quantity demanded of a good %change in consumer’s income I) Income elastic demand: When relatively small change in income causes large change in demand for a good, then the demand for the good is income elastic. change in demand gt; %change in income i. e. (Ey gt; 1) II) Income inelastic demand: When relatively large change in income causes a small change in demand for a good, then the demand for the good is income inelastic. %change in demand lt; %change in income i. e. (Ey lt; 1) Ey may be =1, when % change in demand = % change in income. 3) Cross Elasticity: It means the responsiveness of demand of one good to the change in the price of another good i. e. it is the ratio of change in demand for a good say ‘x’ to the given change in the price of another good say ‘y’. Through the concept of cross elasticity of 10 demand the relationship between two goods is determined I. e. whether two goods complementary, substitute or neutral. †¢ If the change in price of one good say ‘y’ causes inverse change in the demand for the other good say ‘x’ then these goods are called complementary goods. †¢ If a change in price of one good say ‘y’ causes direct change in the demand for the other good say ‘x’ then these goods are called substitute goods. Measurement approaches. There are three methods to measure the elasticity of demand 1. otal revenue method; 2. proportional or percentage method; 3. geometrical method 1) Total revenue method: In this method we compare the total outlay of the consumer before and after variation in price. Here elasticity of demand is expressed in three ways. (a) unity (b) greater than unity and (c) less than unity. I. e. E=1, Egt;1 Elt;1. E = 1: When one percent change in th e price of a good cause exactly one percent change in its quantity demanded or firm’s total revenue remains constant after the change in the price of good, the elasticity of demand is equal to 1. P Total revenue 10 10 100 5 20 100 In the above example revenue before the change in price = revenue after the change in price. Q Egt;1 (price elastic demand) If the percent change in demand is greater than the percent change in price or firm’s total revenue varies inversely with the price of good i. e. as the price of the good fall firm total revenue increases and it decreases as the price of the good rises, elasticity is greater than 1 or demand is known as Price Elastic. P Q Total revenue 10 10 100 8 20 160 In the above example revenue before the fall in price lt; (is less than) revenue after the fall in price. 1 Elt;1: (price inelastic demand) Elasticity is less than one or demand is price inelastic when percent change in demand is less than percent change in price or total revenue of the firm varies directly with the price of good. P Q Total revenue 10 10 100 6 12 72 In the above example revenue before the fall in price gt; (is greater than) revenue after the fall in pric e. 2) Proportional or percentage method: Point elasticity of demand: When there is a small change in the quantity demanded of a product in response to a small change in its price, there will appear just a point on the demand curve. The measurement of demand at that point can be done with the help of following formula. Ed = %change in quantity demanded %change in price Ed = Q ? P Q P ( refers to the change or frictional change) This point elasticity is measured geometrically in case demand curve is a downwards sloping straight line. Elasticity of demand at any point of this demand curve equal to the demand curve below the point divided by the part above the point. For instance in DD’ demand curve at point M the elasticity is given by: Ed = MD’ MD To measure elasticity of demand at curve first draw a tangent to that curve DD’. The elasticity of demand will be part of the tangent above the point divided by the part below. 3) Geometrical method: Arc elasticity of demand: Mathematically Arc elasticity of demand is the measure of elasticity of demand between 2 distinct point on a given demand curve e. g. on the given demand curve Dx arc elasticity is measure between A B. Arc elasticity is measured by dividing the average of the change in the quantities demanded by the average of price. 12 Two hypothetical cases of elasticity of demand are assumed and they are as follows. Case 1: Perfectly or infinitely elastic demand: It means that any quantity can be sold or purchase only at the prevailing price. Graphically, perfect elastic demand is represented by horizontal demand curve. Therefore, it means that elasticity of demand is infinite at given price. Case II: Perfectly inelastic demand: It is another extreme case of elasticity which is just opposite to the 1st case (perfectly elastic demand). It means regardless of the change in price the demand remains the same. There is no change in quantity demanded even if price is changed to a large extent. Graphically it can be represented as vertical demand curve. 5) Determinants of Elasticity Many factors influence elasticity, some of which include: 1. Necessities versus Luxuries It is harder to find substitutes for necessities so quantity demanded will change less. 2. Availability of Close Substitutes If there are close substitutes, buyers will move away from more expensive items and demand will be elastic. 3. Definition of the Market The more broadly we define an item, the more possible substitutes and the more elastic the demand. 4. Time Horizon The longer the time available, the easier to find substitutes and the more elastic the demand. 5. Relative Size of Purchase Purchases which are a very small portion of total expenditure tend to be more inelastic, because consumers are not worried about the extra expenditure. 13 Past Examination Questions: Q 1 Define price Elasticity of demand? Q 2 Differentiate between: i. Price elasticity of demand ii. Cross elasticity of demand iii. Income elasticity of demand [Q2a 2b 2010 (R)] Q 3 Define price Elasticity of demand? [Q2a 2010 (P)] Q 4 How the Price elasticity of demand is measured? Explain. Q2b 2010 (P)] Q 5 Write short note on change in demand and change in quantity demanded. [Q4c 2010 (P)] Q 6 Define price Elasticity of demand? [Q3a 2009 (P)] Q 7 Distinguish among Price, Income and cross Elasticity of demand. [Q3b 2009 (P)] Q 8 Define price Elasticity of demand and compare it with Cross elasticity of demand. [Q2a 2008 (R)] [Q2b 2008 (R)] Q 9 How the Price elastici ty of demand is measured? Explain. Q 10 Write short note on Point and Arc elasticity of demand [Q4a 2008 (P)] Q 11 Write short note on Point elasticity of demand and Arc elasticity of demand [Q4c 2007 (R)] Q 12 Define price Elasticity of demand? And Differentiate between: i. Price elasticity of demand ii. Cross elasticity of demand iii. Income elasticity of demand [Q1a 1b 2007 (P)] Q 13 Write short note on change in demand and change in quantity demanded. [Q4b 2007 (P)] Q 14 What is the different between Law of Demand and Elasticity of Demand. [Q1a 2006 (R)] Q 15 Differentiate between: i. Price elasticity of demand ii. Cross elasticity of demand iii. Income elasticity of demand [Q1a 2006 (R)] Q 16 What is meant by Elasticity of demand? Explain its various kinds. Q1a 2006 (P)] Q 17 Describe the concept of Point and Arc elasticity of demand [Q1b 2006 (R)] 14 Consumer’s equilibrium: â€Å"A consumer is said to be equilibrium when he gets maximum level of satisfaction by spending his limited income on purchase of any two goods†. A rational consumer will therefore attempt to reach the highest possible indifferent curve and try to obtain maximum level of satisfaction by spending his limited income. Consumer’ s equilibrium with the help of indifference curve: In order to get the consumer’s equilibrium through indifference curve analysis following assumptions are made: 1. A consumer has a scale or preference for different combination of any two goods and it remain constant throughout the analysis. 2. A consumer has a fixed amount of income to be spend on any two goods and he is spent his entire income on the purchase of the two goods and does not save any part of his income. 3. Prices per unit of two goods X and Y are given and remain constant throughout the analysis. 4. The two goods are perfectly divisible and substitutable to some extent. 5. All the units of goods are homogeneous. 6. Consumer is a rational person attempts to get maximum level of satisfaction. According to indifference curve analysis a consumer is in equilibrium at a point on his price line where it is tangent to an indifference curve, which is convex at that point. In other words, he is in equilibrium, when diminishing marginal rate of substitution i. e. , the rate at which he is willing to substitutes â€Å"x† for â€Å"y† equal to the price ratio of â€Å"x† for â€Å"y† i. e. , the rate at which he can substitute â€Å"x† for â€Å"y†. Price line AC is tangent to ICii at point B which is the equilibrium point and the perpendicular from point B to x and y-axis represents quantities of goods ‘X’ and ‘Y’ respectively. Indifference curve (IC): An indifference curve is a curve which shows various combinations of two or more goods where each combination gives equal level of satisfaction, because of which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one combination over another. In other words, they are all equally preferred. Properties of IC: †¢ The indifference curves has negative slope. †¢ The shape of the curve is always convex to the origin. †¢ Two indifference curves never intersect. ) The indifference curves has negative slope: It has negative slope i. e. it moves downward from left to right. 15 X 4 5 6 8 12 Y 14 10 8 6 5 Combinations A B C D E It has negative slope because when the consumer increase consumption of one of the goods say X he will have to reduce Y to keep his level of satisfaction constant. In other words Indifference curves slopes downwards from left to right indicating that as the quantity of commodity X incre ases, the amount of commodity Y should fall in order that the level of satisfaction from every combination should remain the same. ) The shape of the curve is always convex to the origin: The convexity of an Indifference curve is explained by the law of diminishing marginal rate of substitution. Marginal rate of substitution between goods X and Y is the quantity of good Y which the consumer is willing to give up for every additional unit of X, so that the level of satisfaction remains the same, from all the successive combinations. X 14 10 8 6 5 Y 4 5 6 8 12 Combinations A B C D E 3) Two indifference curves never intersect: No two Indifference curve intercept with each other. In order to prove that two indifference curve do not intercept with each other. Let us draw two Indifference curve (IC1 IC2) intercepting with each other at point B, As shown in the diagram. If two indifference curves intercepts (as shown in the diagram) then satisfaction at point A= satisfaction at point B and satisfaction at point B = satisfaction at point C because 1 indifference curve shows equal level of satisfaction at all level and therefore satisfaction at point A = C. But logically it is meaning less and unacceptable because each indifferent curve represents a particular level of satisfaction to the consumer, which is different from other Indifference Curve. Income Effect on Consumer Equilibrium Income Effect is the effect on the consumer equilibrium exclusively as a result of change in money income, while all the other things including prices of related goods remaining constant. 16 †¢ A rise in the income of a consumer shifts the Budget line to the right upward on higher IC and it makes possible for a consumer to buy more units of both commodities resulting in higher level of satisfaction and equilibrium point go upward. A fall in the income shifts the Budget line to the left side on lower IC and so there will be a fall in the buying of both the commodities which results in lower level of satisfaction and equilibrium point move downward. †¢ †¢ If we draw a line which touches all the consumer equilibrium points, we will get Income Consumption Curve (ICC). ICC shows how the consumption of two goods is affected by change in income when prices are constant. NORMAL GOODS AND INCOME EFFECT When demand for a good varies directly with consumer’s income i. e. onsumer buys more of good than before when income rises and vice versa. The income effect on such goods is positive and such goods are called Normal goods. INFERIOR GOODS AND INCOME EFFECT †¢ The good which is purchased less with the increase in income is called Inferior Good, or a good the demand for which falls as income rises is called Inferior good. Where one of the goods is inferior then: †¢ If good on Vertical Axis is bou ght more as income rises so good on Horizontal Axis is Inferior good. †¢ If good on Horizontal Axis is bought more as income rises so good on Vertical Axis is Inferior good. 7 Substitution effect: Substitution effect explain the effect of change in the relative price of a good say â€Å"x† on consumer’s demand for â€Å"x† while his real income and other things remains constant. Let’s suppose a consumer is in equilibrium at point E buying OK and OM quantities of goods X and Y respectively. Here it is presumed that price of good Y and consumer’s nominal income remains unchanged while the price of X falls indicated by the new price line AB’. If nothing happens consumer will move on to the higher equilibrium point E’ on IC2 and will become better off. Lets assume that the gain in consumer’s real income caused by the fall in the price of ‘x’ is with drawn by reducing his nominal income to the same extent as the fall in the price of ‘x’ i. e. there is compensating variation in income. The movement from original equilibrium point E to another equilibrium point on fictitious price line (Q) is called substitution effect. So the substitution effect is that when the price of x falls, the consumer buys more of x than before because he substitute x (which is now relatively cheaper) for Y (which is now relatively dearer). But due to compensating variation in ncome he remains on the original indifference curve i. e. he neither become better off nor worse off than before. Price effect: Price effect explains the effect of change in the price of a good say â€Å"x† on consumer’s demand for â€Å"x† while price of â€Å"y† and consumer’s nominal income remain constant. As the pr ice of â€Å"x† falls while other things (price of good â€Å"y† and consumer’s nominal income) remains constant, consumer demand for â€Å"x† increases and by virtue of that he becomes better off than before and conversely as the price of ‘x’ rises his demand for ‘x’ decreases and he becomes worse off than before. This change is because of the change in consumer’s real income. Actually the price effect is the total effect of change in the price of ‘x’ on his demand for ‘x’, which is sum of the two effects i. e. †¢ Income effect †¢ Substitution effect 18 P. E = I. E + S. E As such it can be calculated that when the price of ‘x’ falls consumer’s demand for ‘x’ increases because of income effect and substitution effect which combine together are known as price effect. B) Differentiate between indifference curve and Iso-quant? Indifference curve †¢ Iso-quant †¢