UNIT 1 INTRODUCTION TO

ECONOMICS AND ECONOMY

Structure

1.0 Objectives

1.1 Introduction

1.2 Concept of Scarcity

1.3 Meaning of Production

1.4 Central Problems of an Economy

1.4.1 What to Produce?
1.4.2 How to Produce?
1.4.3 For Whom to Produce?
1.4.4 The Problem of Growth
1.4.5 Choice between Public and Private Goods
1.4.6 The Problem of ‘Merit Goods’ Production

1.5 Production Possibility Curve

1.6 Allocation of Resources: Solution of Central Problems

1.6.1 Resource Allocation in a Mixed Economy

1.7 Economic Methodology and Economic Laws

1.7.1 Inductive and Deductive Reasoning
1.7.2 Equilibrium

1.8 Positive versus Normative Economics

1.9 Microeconomics and Macroeconomics

1.10 Stocks and Flows

1.11 Statics and Dynamics

1.12 Let Us Sum Up

1.13 References

1.14 Answers or Hints to Check Your Progress Exercises

1.15 Terminal Questions

*Shri I.C. Dhingra, Rtd, Associate Professor, Shaheed Bhagat Singh College (University of Delhi), Delhi.
7
Introduction
1.0 OBJECTIVES
After studying this unit, you will be able to:

 explain the problem of scarcity of resources for satisfying ever-increasing

wants of society;
 state the meaning and nature of an economy;
 describe the concept of economic entities;
 discuss the concept of production possibility curve;
 state the issues relating to allocation of resources between investment and
consumption, and between private and public goods;

 explain the methods of resource allocation in a market economy in a

socialist economy and in a mixed economy;
 clearly describe the basic concepts and methodology of Economics;
 state the nature of economic laws; and
 explain some of the analytical concepts associated with economic
reasoning.

1.1 INTRODUCTION
Let us begin with defining the discipline of Economics.
Definition of Economics
Economics has been variously defined. As summarised by Samuelson, some of
the definitions seek to explain that economics:

 analyses how a society’s institutions and technology affect prices and the
allocation of resources among different uses.

 explores the behaviour of the financial markets, including interest rates

and stock prices.

 examines the distribution of income and suggests ways that the poor can
be helped without harming the performance of the economy.

 studies the business cycle and examines how monetary policy can be
used to moderate the swings in unemployment and inflation.

 studies the patterns of trade among nations and analyses the impact of
trade barriers.

 looks at growth in developing countries and proposes ways to encourage

the efficient use of resources.

 asks how government policies can be used to pursue important goals such
as rapid economic growth, efficient use of resources, full employment,
price stability, and a fair distribution of income.

8
A common theme running through all these definitions is that scarcity is a fact Introduction to
of life and that an efficient use of these scarce resources is to be found. That is Economics and
how we define economics as a science that deals with scarcity. Economy

It explains the behaviour of different economic units, households, firms,

government and the economy as a whole, when they are faced with scarcity.

1.2 CONCEPT OF SCARCITY

“Scarcity” lies at the root of all economic activities. The concept of scarcity
finds an expression in two basic facts of economic life:
A. Unlimited wants or ends, and
B. Scarce resources or means.
A. Unlimited wants or ends
Every person has some wants. Different persons have generally different
wants, and wants of even the same person keep changing with the passage of
time, change of place and status.
Human wants are unlimited and keep on increasing. Different wants differ
in their intensity. Subject to the availability of resources, higher order wants
need be satisfied first and if the resources are still available these may be used
to satisfy lower order wants.
B. Scarce resources or means
Satisfaction of wants requires resources (or the means to satisfy wants).
Availability of resources is limited in relation to requirements.
However, scarce means have alternative uses.
The resources therefore need be allocated among different uses in a systematic
coordinated manner. Every individual and economy has to devise a mechanism
for this.
Different societies try to solve these issues in different ways and in the process
each society creates a set-up called ‘an economy’. The term ‘economy’ or
‘economic system’ is a comprehensive one. It covers the entire set of
institutions and arrangements, (including rules and regulations which facilitate
their interactions) for resolving the basic and permanent problem of an
imbalance between means and wants.
The human society has evolved several sets of such institutional arrangements
each is termed an economic system and they have their own distinguishing
features and nomenclatures. These systems try to adopt their own means and
methodologies for solving the basic problems.
For example, take the case of a capitalist economy. In this case the means of
production are owned and inherited by individuals, and various economic
decisions are guided by prices of goods and services in the market. The income
of an individual is determined by means of production supplied by him to the
market and the price which they are paid for their service. On the other hand, in
a strict socialist economy all the means of production are owned by the state.
The state takes all the decisions regarding the use of available resources.
9
Introduction However, whatever its nature, every economy has to solve the basic problem of
scarcity of means in relation to the ever-increasing and varied wants. The
means and wants can be combined in alternative ways. The problem of scarcity
exists in every society, irrespective of the levels of its development. Hence it
has to address itself to two issues:
1) increasing the availability of means of satisfaction, and
2) laying down the priorities of the wants to be satisfied.
Check Your Progress 1
1) State two important characteristics of wants which make them unlimited
in number.
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2) What is an economy?
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3) Pick up the correct option among the following:
Which of the following can be called scarce:
a) Stock of rotten vegetables
b) Useless plants in a jungle
c) Number of flowers in a nursery
d) Water in a dirty pit.

1.3 MEANING OF PRODUCTION

The term ‘Production’ implies the transformation of various inputs into
output thereby increasing the want-satisfying capacity of the inputs. The
process of production transforms the things occurring in nature into goods and
services which are capable of satisfying human wants. The things which are so
transformed are called inputs while output is nothing but the transformed form
of inputs, that is, the goods and services. This involves some human effort,
both physical and intellectual. The transformation may be physical (a different
appearance which enhances want satisfying capacity), spatial (relocate or
transfer the things from one place to another to make them available to the end
users) or inter-temporal (saving/preserving things which arise/grow/made
today for use at a later date-storage and warehousing). A particular
transformation is production if the want-satisfying capacity of the output (also
called ‘product’) is more than that of inputs used. To put it differently
production is nothing but the creation of utility.

10
 Introduction to
1.4 CENTRAL PROBLEMS OF AN ECONOMY Economics and
Economy
Because of the scarcity of resources every economy is faced with certain basic
or fundamental problems which it must try to solve within its socio-economic
framework. These central problems are:

1.4.1 What to Produce?

An economy does not have enough resources to produce everything required
by it. So, it must be selective and decide what to produce and what not to
produce. When some goods are not produced, some wants of the society
remain unsatisfied. The decisions regarding the wants to be satisfied and the
goods and services to be produced are interrelated and are taken in a
coordinated manner. This is called allocation of productive resources. If some
factors of production are employed in the production of product X, to that
extent, these will no longer be available for production of product Y. The
problems can be illustrated by Production Possibility Curve which we will
introduce shortly.

1.4.2 How to Produce?

This is a problem which covers the details of the allocation of productive
resources in the production of various goods and services. More precisely, we
can say that when an economy decides to produce X , it has also to work out
exactly how much of labour, capital, land, etc., would go into its production.
The exact proportion of factor-inputs used in the production of goods needs to
be decided, irrespective of the size and nature of an economy. This is called the
technique of production of that item. For example, we may think of goods
which are produced by using more of labour than capital. In such cases labour
intensive techniques of production are said to be in use. On the other hand, if
more of capital goes into the production of an item, then we say that it is being
produced by a capital-intensive technique.
When an individual producer is to decide about the technique of producing any
particular product, he considers the prices and productivities of alternative
inputs, say labour and capital, since frequently their relative usage can be
varied. He tries to use those inputs in such a combination which costs him the
least and will yields him the maximum output.
His decision is based on consideration of following two factors:
i) the relative price of labour and capital, and
ii) the relative efficiency of the two inputs

1.4.3 For Whom to Produce?

A society comprises a large number of individuals and households. All the
output of consumption goods and services is ultimately meant for their use.
Therefore, all goods and services produced are to be distributed amongst the
individuals and households. The share of each individual and household has to
be determined and also the quantities of specific goods and services which
comprise that share.
We can see that it is possible to propose different principles whereby this
distribution may be carried out. In an economic system organised on market
11
Introduction principles, the income shares of individual members of the society are
determined in the following manner:
In a market economy, productive resources are privately owned. They are sold,
bought and hired like any other goods or services. The price of a productive
resource is determined by the market forces of demand and supply. Whenever
it is to be employed by a producer, he has to pay its market price to its owner.
It is for the owner to supply it to the market or withhold it. The income of each
individual under these conditions, is determined by the amounts of different
productive resources owned and supplied by him to the market and their
respective price.

1.4.4 The Problem of Growth

Every economy seeks to increase its stock of capital to increase its production
capacity and thereby generate more income. The generated income in an
economy has two alternative uses, viz. consumption expenditure (C) and
saving (S). Thus, Y = C + S. Saving is source of finance for investment in an
economy. Investment adds to the capital stock of an economy. And therefore,
there is a need to reduce the share of consumption expenditure (and thereby
increase investment); this helps in capital formation.

1.4.5 Choice between Public and Private Goods

1) Private Goods: There are certain goods (the term goods here includes
services also) whose availability can be restricted to selected individuals
only. For example, a product may be priced in the market and only those
who pay its price may be allowed to have it. This characteristic of a
product by which some people can be prevented from its use is referred
to as the ‘principle of exclusion’. Accordingly, those persons who
cannot pay for it or who are not ready to pay, are not allowed to use it.
The use of the goods is thus divisible between different persons. Any
goods which can be priced and whose use can be restricted to selected
persons is termed as private goods.
2) Public Goods: When it is not possible to restrict the availability of a
product to selected individuals, they are termed as public goods or social
goods. Such goods cannot be so priced as to deprive some persons from
using it. That way, it is indivisible. Defence service is a typical example
of a public service. When a country is protected against foreign
aggression, every citizen is protected.
With its limited resources, an economy cannot have enough of both public and
private goods. It must try to achieve an optimum combination of both.

1.4.6 The Problem of ‘Merit Goods’ Production

Those goods whose consumption is considered highly desirable for the
members of the society are termed as merit goods. The important feature of
the merit goods is that their consumption benefits both the user and non-users.
For example, if a person is educated and healthy, it not only helps him but also
the society as a whole. Health and education, therefore, are called a merit
product/service and it is desirable that every member of the society gets
education. Consumption of merit goods benefits the society as a whole and
raises the level of its efficiency and well-being. Therefore, every society has to
12 decide the extent it can and should produce and consume merit goods.
Check Your Progress 2 Introduction to
Economics and
1) State the central problems of an economy? Economy
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2) What is capital formation?
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3) What is a technique of production?
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4) What are merit goods?
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5) Differentiate between public and private goods.
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1.5 PRODUCTION POSSIBILITY CURVE

The economy has to choose between alternative combinations of various goods
and services. This problem of choice can be illustrated by a simple graph
known as Production Possibility Curve or a Product Transformation
Curve. A typical Production Possibility Curve (PPC) is drawn on the
following assumptions:
i) The country has to choose between alternative combinations of only two
goods, say. LED (L) and computer monitor (M).
ii) All productive resources of the country are taken as given and so is the
state of technology, no changes are made in them.
iii) All productive resources of the economy are fully employed. There is no
wastage or under utilisation.
iv) The productive resources are suitable for the production of both goods
(L) and (M). They can, therefore, be shifted from the production of one to
the other goods. However, such a shift would reduce the production of
the first good and increase that of the other.
v) No factor of production is considered to be specific in the production of
one good alone and inappropriate for the production of the other.
vi) We consider the productive efficiency of the productive resources only in
physical terms, i.e., the units of LED (L) and Computer Monitor which
they can produce. 13
Introduction Based upon these assumptions, we can illustrate the set of production
possibilities available to a country by a hypothetical example. Look at Table
1.1. The figures in the table show that all the productive resources of the
country put together can produce a maximum of either 30 L or 30 M or some
other combinations thereof. The production possibilities illustrated in Table 1.1
are also represented in Fig. 1.1 in the form of a production possibility curve
(PPC).
Quantity of M is measured along X-axis and the numbers of L are measured
along Y-axis. The respective pairs of the quantities of L and M are plotted and
joined with each other to yield a curve which is called the Production
Possibility Curve. Thus, the PPC represents all the possible combinations of L
and M which can be produced by using all the productive resources of the
economy, efficiently. In that sense, each point on the curve represents the
maximum possible output and, for that reason, it is also termed as the
production frontier of the economy.
Table 1.1: Production Possibilities Available to a Country

Combination LED Computer Loss of M for Loss of L for

(Numbers) Monitor each each
(L) (M) Additional Additional
L Produced M Produced
(Tones) (Numbers)
1 30 0 2.8
2 25 14 1.2 0.357
3 20 20 0.8 0.833
4 15 24 0.6 1.250
5 10 27 0.4 1.667
6 5 29 0.2 2.500
7 0 30 5.000

Fig. 1.1

14
The economy can produce any combination of L and M represented by a point Introduction to
either on the PPC or in the shaded area of the diagram. Production Economics and
combinations represented by the shaded area imply that the economy can Economy
produce either L or M or both. For example, combinations represented by
points A, B and C are feasible, as these lie either on the PPC or in the shaded
area. But the combination represented by A is feasible but not efficient.
Combination represented by points B and C are both feasible and efficient. If it
produces at Point A it is not utilising some of its productive resources and let
them go waste. Thus consider point A which represents a combination of 10
tonnes of M and 14 L. The PPC, however, shows that with this much of M, the
economy can produce 27 L (as shown by point C on PPC). Alternatively, with
14 L, the quantity of M can be increased to 25 tonnes (see point B).
Any point beyond the PPC, which is in the non-shaded area of the diagram,
shows a combination of L and M which the economy cannot produce. For
example, point D represents a combination of 30 M and 20 L. However, when
30 M is produced, no resources are left for the production of L. On the other
hand, if 20 L are produced, then the quantity of M has to be reduced to 20.
Characteristics of PPC
A typical PP curve has two characteristics:
1) Downward sloping from left to right
It implies that in order to produce more units of one good, some units of the
other good must be sacrificed (because of limited resources).
2) Concave to the origin
A concave downward sloping curve has an increasing slope. The slope is the
same as MRT. So, concavity implies increasing MRT, an assumption on which
the PP curve is based.
Can PP curve be a straight line?
Yes, if we assume that MRT is constant, i.e. slope is
constant. When the slope is constant the curve must
be a straight line. But when is MRT constant? It is
constant if we assume that all the resources are
equally efficient in production of all goods.
Note that a typical PP curve is taken to be a concave
curve because it is based on a more realistic
assumption that all resources are not equally efficient
in production of all goods. (Fig. 1.2)

Fig. 1.2

Does production take place only on the PP curve?

Yes and no, both. Yes, if the given resources are fully and efficiently utilised.
No, if the resources are under-utilised or inefficiently utilised or both. Refer to
the Fig. 1.3.
On point F, and for that matter on any point on the PP curve AB, the resources
are fully and efficiently employed. On point U, below the curve or any other
15
Introduction point but below the PP curve, the resources are either under-utilised or
inefficiently utilised or both. Any point below the PP curve thus highlights the
problem of unemployment and inefficiency in the economy.

Fig. 1.3

Can the PP curve shift?

Yes, if resources increase. More labour, more capital goods, better technology,
all means more production of both the goods. A PP curve is based on the
assumption that resources remain unchanged. If resources increase, the
assumption breaks down, and the existing PP curve is no longer valid. With
increased resources, there is new PP curve to the right of the existing PP curve.

Fig. 1.4 Fig. 1.5

It can also shift to the left, if the resources decrease. It is a rare possibility but
sometimes it may happen due to fall in population, and due to destruction of
capital stock caused by large scale natural calamities, war, etc.

16
 Introduction to
1.6 ALLOCATION OF RESOURCES: SOLUTION Economics and
OF CENTRAL PROBLEMS Economy

Theoretically, there are two types of economic systems, viz.. Capitalistic

economy and socialistic economy. In practice, all the countries have adopted a
system which is broadly identified as mixed economy.
The problem of resources allocation may be tackled in several ways and each
economy tries to solve it in line with its own chosen objectives.

1.6.1 Resource Allocation in a Mixed Economy

A mixed economy is one in which some decisions are left to the market forces
while others are taken under direct government regulation or even ownership.
Some selected areas of economic activities are reserved for the government
sector. The government acquires the necessary productive resources for these
activities and employ them in conformity with its priorities. The production
pattern of the public sector, the prices of items produced by the public sector
and other measures are used to regulate the allocation of resources in private
sector as well. These other measures include price controls, licensing, taxation,
subsidies and others. Additionally, various labour welfare measures are
implemented and enforced by the government. Similar steps are taken to
encourage the use of productive resources for encouraging the development of
backward areas of the country for removing specific shortages, and for
bringing about a balanced development of the economy as a whole.

1.7 ECONOMIC METHODOLOGY AND

ECONOMIC LAWS
Economic methodology investigates the nature of economics as a science. It
investigates the nature of assumptions, types of reasoning and forms of
explanations used in economic science. Various practices such as
classification, description, explanation, measurement, prediction, prescription
and testing are associated with economic methodology. Economic
methodology examines the basis and groups for the explanations. Economists
give answer why questions about the economy. For example, economists use
the shifting of demand and supply curves to answer the question of why prices
change.
Economics being a social science, economic laws are, therefore, a part of social
laws. In the words of Alfred Marshall, we should separate that part of
behaviour of members of the society where the main motive happens to be an
economic one, where the main motive can be expressed in terms of money
price. The corresponding activities are then economic activities. However, such
a dividing line between economic laws and other social laws is not always
clear. Very often an activity happens to be motivated by a combination of both
economic and non-economic considerations. As a result, it is often quite
difficult to formulate pure economic laws which have full validity also.

1.7.1 Inductive and Deductive Reasoning

Economists have followed two traditions in formulating economic laws.
According to one tradition, the causes (also called conditions or assumptions)
17
Introduction are specified and different economic units are expected to behave in a ‘rational’
manner. The outcome in this case is predictable, provided the assumptions
made are satisfied. The assumptions themselves may be totally unrealistic or
may be very close to reality but they are stated in a precise manner. In any
case, this type of reasoning is called deductive reasoning. In this method, the
generalisation or law is stated and the individual activities are expected to
conform to it. A typical example of deductive reasoning is the law of demand
which states that, other things being equal, the quantity of a product demanded
varies inversely with its price. When price falls, demand expands and when
price rises, demand contracts.
As against this deductive reasoning, some thinkers try to discover economic
laws the other way round. Instead of laying down causes or conditions on a
hypothetical basis, they collect the actual information regarding the behaviour
of economic units under different conditions. In other words, empirical
information is collected and generalisations regarding the behaviour of
economic units under different conditions are worked out. This is called the
method of inductive reasoning. A well-known example of the use of this
method is the Engel’s Law. Through a study of family budgets, Engel
concluded that as the income of a family increases, the proportion of its
expenditure on necessities decreases while that on comforts and luxuries goes
up. Most business firms prefer this line of approach.
In economics, both inductive and deductive methods of reasoning are used to
supplement our understanding of an economy and its working.

1.7.2 Equilibrium
The concept of equilibrium is an important tool of analysis in economics. It is
very frequently used and one should become familiar with it. Usually, an
economic variable (such as the price of a commodity) is subject to various
forces trying to pull it in different directions. When these forces are in balance,
the value of variable stops changing and it is said to be in equilibrium.
Concept of Equilibrium
Equilibrium means a state of rest, the attainment of a position from which there
is no incentive nor opportunity to move.

 A consumer is in equilibrium when his expenditure on different goods

and services yield maximum satisfaction. No move on his part can
increase his satisfaction but, rather, will decrease it.

 A business firm is in equilibrium when its resource purchases and its

output are such that it maximises its profits, if profit maximisation is its
objective, any change on its part will cause profits to decrease.

 A resource owner is in equilibrium when the resources which he owns are

placed in their highest paying employments and the income of the
resource owners is maximised. Any transfer of resource units from one
employment to another will cause his income to decrease.

 An economy is in equilibrium at the level of income (and employment)

where aggregate demand equals aggregate supply.
Equilibrium concepts are important, not because equilibrium is ever in fact
18 attained but because they show us the directions in which economic changes
proceed. Economic units in disequilibrium usually move toward equilibrium Introduction to
positions. Economics and
Economy
Equilibrium can be analysed in two forms:
1) Partial: In partial equilibrium analysis we concentrate on a single
market in isolation from the rest of the economy.
2) General: In general equilibrium analysis, we analyse simultaneously all
the markets in the economy on the basic premise that everything depends
on everything else.

1.8 POSITIVE VERSUS NORMATIVE

ECONOMICS
The term positive economics is concerned with only formulating economic
laws and describing reality. The economic laws may be derived from
theoretical assumptions or from recorded facts. Either way, they only tell us
what exists. They do not pass any judgement as to whether the findings of
economic analysis are desirable or need a modification.
As against this, normative economics realises the fact that an economy is
never perfect. The outcome of its working can always be improved upon. It
is quite normal to find an economy faced with many problems requiring
immediate attention. Such problems can be related to price changes,
employment, scarcity of certain inputs, inequalities of Income and wealth, and
so on. In normative economics, the knowledge gained is put to use for
improving the working of the economy. Targets of improvement are laid down
and policy measures are formulated by which the targets are to be achieved.
Thus, normative economics is concerned with what ought to be.

A positive statement:

“An increase in price of petrol leads to a fall in its quantity demanded.”

A normative statement:

Government should take steps to cut the consumption of Petrol.

More generally, normative statement uses the verb “should”.

1.9 MICROECONOMICS AND

MACROECONOMICS
The terms microeconomics and macroeconomics are used in connection with
the level of aggregation, that is the extent to which economic units and
variables are covered in economic analysis. At one end, the analysis may cover
the behaviour and responses of a single economic unit and at the other extreme
it may cover the entire economy. These two terms (micro and macro) are
derived from Greece words mikros and makros which mean small and large
respectively.

19
Introduction Microeconomics deals with the behaviour of individual elements in an
economy such as the determination of the price of a single product or the
behaviour of a single consumer or business firm.
As against this, macroeconomics covers large aggregates or collection of
economic units which may extend to the entire economy. In the words of
Kenneth Boulding, macroeconomics covers the great aggregates and
averages of the economic system rather than individual items. Here we
study collections of variables and economic units (i.e., macro variables) such
as national income, employment, level of prices in general, intersectoral flows
of goods and services, total savings and investment, and the like. While the
study of an individual firm or an industry lies within the scope of
microeconomics, an entire sector falls within the scope of macroeconomics.
To use a metaphor, macroeconomics studies elephant as one object;
microeconomics (like five blind men in a flok tale) studies individual parts of a
whole body. Each study leads to different results. Or, to use another metaphor,
one enjoys the macro-view of a cricket test match while one enjoys a ball-by-
ball description when sitting in before a TV.

1.10 STOCKS AND FLOWS

Economic variables are of two kinds: 1) stocks and 2) flows. A stock variable
is the one which can be measured only with reference to a point of time
and not over a period of time. As against this, a flow variable is the one
which can be measured only with reference to a period of time and not a
point of time. We come across numerous economic variables which belong to
one category or the other. Take the examples of the supply of money and
magnitude of wealth. They have reference to point of time. They are, therefore,
‘stock’ concepts. Correspondingly, examples of flow variables are production,
saving, expenditure, income, sales, purchases, etc. All these variables can be
measured only over a period of time. A factory can produce so much during,
say, a month and not at a given moment of time. A person does not have an
income at a point of time. But he has it only for a period of time. A flow
concept can assume some value only with the passage of time, not otherwise.
One should observe that stock and flow variables are often used together in
economic analysis.

1.11 STATICS AND DYNAMICS

Economic analysis can be conducted either by using a static framework or a
dynamic setting. Static and dynamic modes of analysis can be differentiated in
more than one ways. According to one definition, in a static model (theory)
the variables (cause effect) are not dated. The demand-supply model of market
behaviour is a static model. The model that demand depends on own price,
supply depends on own price, with an equilibrium condition that demand must
equal supply, time does not enter into the picture at all and the variables are all
undated. According to this definition, a dynamic model would be one where
the relevant variables are dated. If the demand-supply model is restructured as
follows, then the model would become dynamic according to this criterion.
Dt = f(Pt)
St = g(Pt)
20 Dt = St
Economic variables can further be classified into stocks and flows. A stock Introduction to
variable is the one which can be measured only with reference to a point of Economics and
time. A flow variable, on the other hand, is measurable only over a period of Economy
time.
Static economic or comparative statics is a technique of analysis in which the
parameters of the economy are taken to be given. The assumption of ceteris
paribus is made and the initial and final equilibrium positions arc compared. In
dynamic-economics or dynamic analysis, parameters of the economy are
allowed to change.

1.13 REFERENCES
1) Case, Karl E. and Ray C. Fair, Principles of Economics, Pearson
Education, New Delhi, 2015.
2) Stiglitz, J.E. and Carl E. Walsh, Economics, viva Books, New Delhi,
2014.
3) Hal R. Varian, Intermediate Microeconomics: a Modern Approach, 8th
edition, W.W.Norton and Company/ Affiliated East-West Press (India),
2010.

1.14 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Unlimited, ever increasing
2) Economy refers to the setup created for meeting the basic and permanent
problem of an imbalance between means and wants.
3) c)
Check Your Progress 2
1) The central problems of an economy are (i) what to produce, (ii) how to
produce, (iii) for whom to produce, (iv) the problems of growth, (v)
choice between public and private goods (vi) the problem of merit goods
production.
2) Addition in its stock of capital is capital formation.
3) Technique of production refers to exact proportion of factor inputs used
in the production of goods.
4) The goods whose consumption benefits both user and non-users are merit
goods.
5) Private goods are the goods whose availability is restricted to selected
individuals whereas in case of public goods nobody is excluded in the
availability of such goods.

23
 UNIT 2 DEMAND AND SUPPLY
ANALYSIS
Structure
2.0 Objectives
2.1 Introduction
2.2 The Nature of Demand
2.3 Determinants of Demand
2.3.1 Determinants of Demand by a Consumer
2.3.2 Determinants of Market Demand

2.4 The Law of Demand

2.4.1 The Demand Schedule
2.4.2 The Demand Curve
2.4.3 Why does a Demand Curve Slope Downwards?

2.5 Change in Quantity Demanded versus Change in Demand

2.6 The Concept of Supply
2.6.1 Determinants of Supply

2.7 The Law of Supply

2.7.1 The Supply Schedule
2.7.2 The Supply Curve
2.7.3 Exceptions to the Law of Supply

2.8 Changes in Supply versus Changes in Quantity Supplied

2.8.1 Changes in Quantity Supplied
2.8.2 Change in Supply
2.8.3 Why the Supply Curve Shifts?

2.9 The Idea of Elasticity

2.9.1 Elasticity of Demand
2.9.2 Elasticity of Supply

2.10 Measurement of Price Elasticity of Demand

2.11 Determinants of Price Elasticity of Demand
2.12 Determinants of Elasticity of Supply
2.13 Let Us Sum Up
2.14 References
2.15 Answers or Hints to Check Your Progress Exercises
2.16 Terminal Questions

*Shri I.C. Dhingra, Rtd, Associate Professor, Shaheed Bhagat Singh College
26 (University of Delhi), Delhi.
 Demand and
2.0 OBJECTIVES Supply Analysis
After studying this unit, you will be able to:
 distinguish between want and demand;
 explain the law of demand with the help of a demand schedule and a
demand curve;
 identify the movement along a demand curve and a shift of the demand
curve;
 state the concept of supply and its determinants;
 discuss the concept of elasticity of demand and supply and various
methods of their measurement; and
 explain the importance and determinants of elasticity of demand and
supply.

2.1 INTRODUCTION
Satisfaction of human needs is the basic end and goal of all production
activities in an economy. As we have learnt in Unit 1, human wants are
unlimited and recurring in nature, whereas means available to satisfy them are
limited. Therefore, a rational consumer has to make an optimal use of available
resources. The demand and supply analysis provides a framework within which
these decisions have to be made. Hence, in this unit we shall discuss the
various issues related to the theory of demand and supply analysis.

2.2 THE NATURE OF DEMAND

At first, let us understand the meaning of the terms like desire, want, and
demand. Desire is just a wish on the part of the consumer to possess a
commodity. If the desire to possess a commodity is backed by the purchasing
power and the consumer is also willing to buy that commodity, it becomes
want. The demand, on the other hand is the wish of the consumer to get a
definite quantity of a commodity at a given price in the market backed by a
sufficient purchasing power. There are three important points to remember
about the quantity demanded:
First, the quantity demanded is the quantity desired to be purchased. It is the
desired purchase. The quantity actually bought is referred to as actual purchase.
Secondly, quantity demanded is always considered as a flow measured over a
period of time, like if the quantity demanded of oranges is 10, it must be per
day or per week, etc.
Thirdly, the quantity demanded will have an economic meaning only at a
given price. For example, the demand for oranges equal to 10 units per week at
a price of Rs. 100 per dozen is a full and meaningful statement, as used in
micro-economic theory.

2.3 DETERMINANTS OF DEMAND

The demand of a product is determined by a number of factors. Let us discuss
them in detail.

27
Introduction 2.3.1 Determinants of Demand by a Consumer
The demand for commodity or the quantity demanded of a commodity on the
part of the consumer is dependent on a number of factors. These are mentioned
as follows:
i) Price of the commodity in question
ii) Prices of other related commodities
iii) Income of the consumers, and
iv) Taste of the consumers.
Demand function refers to the rule that shows how the quantity demanded
depends upon above factors. A demand function can be shown as:
Dx = f (Px, Py,Pz, M, T)
where, Dx is quantity demanded of X commodity, Px is the price of X
commodity, Py is the price of substitute commodity, Pz is price of a complement
good, M stands for income, T is the taste of the consumer.
If all the factors influencing the demand for a commodity X vary
simultaneously, the picture would be highly complicated. Therefore, normally
we allow only one of the factors to change, assuming that all other factors
remain unchanged (‘ceteris paribus’ other things remaining equal).
Demand Relationship: Relationship of quantity demanded of a commodity to
its various determinants can be stated as follows:
1) Price of the commodity: Normally, higher the price of the commodity,
the lower the demand of the commodity. This is the law of demand.
2) Size of the consumer’s income: When the increase in income leads to an
increase in the quantity demanded, the commodity is called a ‘normal
good’. If an increase in income leads to a fall in the quantity demanded,
we call that commodity an ‘inferior good’.
3) Prices of other commodities: A consumer’s demand for a commodity
may also be influenced by the prices of some other commodities. Some
are complementary goods, which are consumed along with the
commodity in question while others may be used in place of this
commodity. This category is called substitutes.
Demand bears inverse relationship with prices of complements and
direct relationship with prices of substitutes.
Tea and coffee are substitutes and a car and petrol are example of a pair
of complementary goods.
4) Tastes of consumer: If a consumer has developed a taste for a particular
commodity, he/she will demand more of that commodity. Similarly, if a
consumer has changed his taste against a particular commodity, less of it
will be demanded at any particular price. This development of tastes may
be related to seasons of the year as well. In summer months, you may
consume more cold drinks and ice creams, whereas in winters, the
preference may shift towards hot or warm drinks like tea and coffee etc.

28
2.3.2 Determinants of Market Demand Demand and
Supply Analysis
The factors determining the demand for a commodity in a market are the same
as those which determine the demand for the commodity on the part of a
consumer. Besides that two additional factors are also to be included. These
two factors are:
1) Size of the population: All other factors remaining unchanged, the
greater is the size of the population, more of a commodity will be
demanded.
2) Income distribution: People in different income groups show marked
differences in their preferences. So if larger share out of national income
goes to the rich, demand for the luxury goods may rise and a rise in
income share of the poor will increase demand for the wage goods.
A correct specification of the demand equation is a must for the estimated
function to predict demand accurately.
Check Your Progress 1
1) Distinguish between want and demand of a commodity.
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) What are the determinants of demand of a commodity by an individual
consumer?
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) Explain the factors influencing the market demand of a commodity.
......................................................................................................................
......................................................................................................................
......................................................................................................................

2.4 THE LAW OF DEMAND

The inverse ralationship between the quantity of a commodity and its price,
given all other factors that influence the demand is called ‘law of demand’. It
gives us a demand curve that slopes downwards to the right. We can explain
this idea with help of a demand schedule, a table that records quantities
demanded at different prices. This schedule, on being recorded on a two
dimensional axes system, gives us a demand curve.

2.4.1 The Demand Schedule

Let us use imaginary figures to show the application of the law of demand.
Table 2.1 given below, showing the application of the law of demand, is called
the ‘Demand Schedule’.
29
Introduction Table 2.1 : The Demand Schedule of a Consumer for Apples

Quantity Demanded of
Price of Apple per Kg. Apples
(in Rs.)
(in Kg. per week)
100 15
200 12
300 8
400 3

Four combinations of price and quantity demanded are shown in the Table 2.1.
We can easily infer that as price of an apple rises quantity demanded by the
consumer is falling.
2.4.2 The Demand Curve
The demand curve graphically shows the relationship between the quantity of a
good that consumers are willing to buy and the price of the good. Let us
understand the demand curve with the help of the Fig. 2.1. In this figure, on the
Y-axis, price of an apple in rupees in measured and on the X-axis the quantity
demanded of apples per week is measured. The first combination of Table 2.1
is shown by point a where at Rs. 100 per kg 15 units of apples are demanded.
Similarly points b, c, d represent combinations of Rs. 200 price – 12 quantity
demanded, Rs. 300 price – 8 quantity demanded and Rs. 400 price – 3 quantity
demanded, respectively. The joining together of points a, b, c, and d give us the
demand curve, DD.

Fig. 2.1

The most important feature of a demand curve is that it slopes downward from
left to right. In Fig. 2.1 the demand curve is a straight line. But it can also be in
the form of a curve as shown in Fig. 2.2.
Whether a demand curve is a straight line or a curve depends on how much
quantity demanded rises with the fall of its price or how much quantity
demanded falls with the rise in the price of the commodity. Whether we take
Fig. 2.1 or 2.2, in both the cases the law of demand is applicable.
30
 Demand and
Supply Analysis

Fig. 2.2

If we record demand schedules of two or more consumers of a commodity on

the same axes, we can get a number of demand curves. Horizontal summation
of those curves gives us the market demand curve. We are illustrating a two
consumer market demand curve for ice cream with help of the following
schedule and diagram:
Table 2.2

Price (Rs) Quantity Demanded by Market

Demand
Household A Household
B
3 4 + 5 =9
4 3 + 4 =7
5 2 + 3 =5
6 1 + 2 =3

Market demand curve is a horizontal summation of individual demand curves,

as illustrated below.

Fig. 2.3

31
Introduction 2.4.3 Why does a Demand Curve Slope Downwards?
Law of demand states that there is an inverse relationship between the price of
a commodity and its quantity demanded.
1) Substitution Effect
Substitution effect results from a change in the relative price of a commodity.
Suppose a Pepsi Can and a Coke Can both are priced at Rs. 90 and Rs. 20 each.
If the price of Coke is raised to Rs. 25, and the price of Pepsi is not changed,
Pepsi will become relatively cheaper to Coke, i.e. although the absolute price
of Pepsi has not changed, the relative price of Pepsi has gone down. The
change in the relative price of commodity causes substitution effect.
Similarly, if price of mango falls, the rest of the fruits will appear costlier, in
comparison with mango.
So in both the cases above, the quantity demanded of relatively costlier items
will register a decline.
2) Income Effect
This is the effect of a change in total purchasing power of the money income of
the consumer. As price of mango falls the purchasing power of the given
money income rises, or his real income rises. Thus, he can buy more of the
mangoes with the same money income. His demand for any other commodities
may also rise. This is called the ‘income effect’. A commodity with positive
income effect is called a ‘normal good’. It shows a positive or direct
relationship between the income and the quantity demanded.
When rise in income leads to a fall in the quantity demanded, we have a case of
negative income effect. Such goods are called the ‘inferior goods’.
3) Price Effect
Price Effect is the sum total of the substitution effect and income effect, i.e.
PE = SE + IE
Where PE = Price Effect.
SE = Substitution Effect
IE = Income Effect
It is important to note that substitution effect and income effect operate
simultaneously with the change in the price of the commodity. ‘Substitution
effect’, and ‘income effect’ taken together give ‘price effect.’ We can identify
three cases.
1) Substitution effect always operates in a manner such that as price falls,
quantity demanded of this commodity increases. If along with
substitution effect, we take income effect and if that happens to be
positive (a case of normal commodity) the law of demand will
necessarily apply.
2) Given substitution effect, if income effect is negative (a case of an
‘inferior commodity’) the law of demand can still apply provided the
substitution effect outweighs or is more powerful than the negative
income effect, and

32
3) Given substitution effect, if income effect is negative and it outweighs or Demand and
is more powerful than the substitution effect, the law of demand will not Supply Analysis
hold good.
GIFFEN GOOD
A case where negative income effect outweighs substitution effect is possible
when we have ‘Giffen good’ named after the Robert Giffen who first talked of
such paradox. Here a fall in the price of a commodity does not lead to a rise in
its demand, it may result in a fall in demand for this commodity.

2.5 CHANGE IN QUANTITY DEMANDED Vs.

CHANGE IN DEMAND
When the demand for a commodity changes because of the change in its price,
it is called ‘change in quantity demanded’. On the other hand, when the change
in demand is due to the factors other than its price cause a change it is called
‘change in demand’.
Expansion and Contraction in Demand
The change in quantity demanded of a commodity is called the expansion in
demand if a fall in the price causes the quantity demanded to rises. Conversely,
if with a rise in the price of a commodity, its quantity demand falls, we call it
contraction in demand. These can be represented in the form of a movement on
a demand curve, as shown in Fig. 2.4.

Fig. 2.4

DD is the demand curve. At point ‘a’ on the demand curve we find that at price
OPa, OQa of a commodity is demanded. As price falls to OPc, demand becomes
OQc. This movement from point a to point c on the demand curve DD is
referred to as ‘extension in demand’. Similarly when price of a commodity
rises to OPb, demand falls to OQb. Thus, the movement from a to b on the
demand curve DD is known as ‘contraction in demand’.
Change in Demand
Change in demand takes place when the whole demand scenario undergoes a
change. This change occurs due to a change in any determinant of demand
33
Introduction other than the price of that commodity.
Change in demand may take two forms:
i) Increase in demand, and (ii) Decrease in demand
Increase in demand takes place when;
a) at a given price, higher quantity is demanded, or
b) at a higher price, the same quantity is demanded
Decrease in demand takes place when:
a) at a given price, lower quantity is demanded, or
b) at a lower price, the same quantity is demanded
Graphically, increase in demand results in rightward shift of the whole demand
curve. Likewise, decrease in demand results in leftward shift of the demand
curve. This is shown in the Fig. 2.5.

Fig. 2.5

At price Pa, at point ‘a’ on DD, quantity demanded is OQa. At the same price,
quantity demanded rises to OQb at point b on the demand curve D'D'. This is
called ‘increase in demand’. Similarly, at price OPa the quantity demanded
comes down to OQc on point ‘c’ of demand curve D"D". This change in
quantity demanded is ‘decrease in demand’. The shift of the demand curve to
the right shows ‘increase in demand’ and a movement of the demand curve to
the left of the initial demand curve is a ‘decrease in demand’.
Many factors can shift a demand curve. Some of them are:
1) A rise in income of the consumer can enables him to demand more of a
commodity at a given price and a fall in income will generally force him
to curtail his demand.
2) A rightward shift in the demand curve can also take place because of
increase in price of a substitute. Similarly, a leftward shift in the demand
curve can be because of decrease in price of a substitute.
3) If the consumer develops a taste for a commodity, he may demand more
of it even if the price remains unchanged, shifting the demand curve to
the right. On the other hand, a leftward shift in the demand curve can
34 indicate that our consumer has started disliking the commodity.