Part 1 Lesson - 1 Microeconomics

8/14/2019 Part 1 Lesson - 1 Microeconomics

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PART 1 LESSON - 1MICROECONOMICS

LESSON 1

MICROECONOMICS

Introduction:

Supply and Demand

1. Wants:

Human wants are unlimited. This is the fundamental fact of economic life of the

people. If the wants are limited then no economic problem would have arisen. But in real

life, when one want is satisfied, another one grows up. The important thing is that all

wants are not of equal intensity. Because of the different intensities of the wants, peopleare able to allocate the resources to satisfy some of their wants.

2. Utility:

Since the intensity of want differs, the people are able to allocate the scarce

resources to satisfy their wants. The power of the commodity which satisfies wants is

called utility. The utility means levels of satisfaction which people get form consuming

a commodity. Different persons derive different amounts of utility from a given good. If

a person derives more for that commodity, he expects greater utility from it. People know

utility of goods by their psychological feelings. Finally question of ethics or morality is

not unsolved in the use of word utility in economics.

For example using alcohol may be considered as an activity by society, but no

such meaning is conveyed in economics. So, alcohol possesses utility for some persons

who use it.

Demand

As we have discussed earlier, the greater utility in a commodity attracts the

consumer whose wants they satisfy. The consumers desire for the commodity and they

will go for purchase. To purchase a good, he must have ability to pay. The demand for a

commodity is consumers attitude and reaction towards commodity. It is that mere desire

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for a commodity does not constitute demand for it, if it is not backed by the utility to pay.

The word demand has precise meaning in economics. It refers to

o The willingness and utility to purchase different qualities of a good.

o

At different prices.o During a specific time period ( per day, week and so on )

Demand for a good or service is determined by many different factors other than

price. Some of them are as follows:

a) The taste and desire of the consumer for a commodity.

b) Income of the consumer.

c) Price of substitute goods.

d) Price of complementary goods.

When there is a change in any of these factors demand of the consumer for a good

change. Individual demand for a commodity can be expressed in the following general

function form:

Qd = f (Px, I, Pr, I, T, A)

Where:

PX = Price of the commodity x.

I = income of individual.

Pr = Price of released commodity.

T = Total preference.

A = Advertising expenses made by producer.

Qd = Quantity demanded.

We write the demand function of an individual in the following way, if all

determining factors remain constant expected quantity demanded of a good and its own

price

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Qd = f ( Px ).

This is only general functional form. For the purpose of estimating demand of a

commodity we need a specific form of demand function

Qd = a bPx

The demand function considered to be of a linear form.

Demand curve

A demand schedule is presented in Table 1. In this schedule we see that a

consumer purchase 10 units if the prices at $15, when the price falls @ $ 10 then demand

falls to 15 units. If the price falls at $2 then the demand for unit will be 75 units.

TABLE 1

DEMAND SCHEDULE

PRICE QUALITY DEMANDED

12

10

08

06

04

10

20

30

40

50

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Shifts in demand curve

There will be a shift in the demand curve, when demand changes due to the

factors other than Price. The other factors are income of the consumer, prices of related

goods and his taste and performance.

Illustrations

1. Income increases There will be increases in demand - shift in the demand curve

to the right.

2. Decreases in income There will be decrease in income - demand curve shift to

left.

3. Prices of related commodities There is an increase in price of the product, then

consumer would like to change for another substitute. Therefore the demand for

the substitute rises and the demand curve of substitute shift to right.

4. Preference of the people Two wheeler will be of great demand, when the cost of

car or petrol increases. The demand curve for two wheeler will shift to right.

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Y

12

10

8

6

4

2D

O 10 20 30 40 50 60 70 X

UANTITY

PRICE


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5. The price related commodities substitute and complements can also change the

demand for a commodity.

6. Expectation about future prices if people expect that the price of the good is

likely to go up in future, which will increases the current demand and causes a

shift in the demand curve to the right.

Market demand curve

Individual consumers demand and market demand for a good may be

distinguished. Market demand for a good is the total sum of the demands of individual

consumers, who purchase the good in the market.. We sum up various quantities of a

commodity demanded in the market by the consumers. By adding this, we can obtain the

demand curve for a commodity. Like the individual consumers demand curve will slope

down ward to the right.

Law of diminishing marginal utility

The utility means levels of satisfaction which people get from consuming a

commodity but the marginal utility is an additional satisfaction a consumer gets from

consuming are more unit of a commodity or service.

For example. A is hungry and want food. He ate the first plate of food and he gets

a certain amount of satisfaction. He took second plate and he will get lesser satisfaction

with the second plate. The additional amount of satisfaction desired by the consumers

while consuming each additional plate is known as marginal utility. Marshall-- Who was

famous exponent of the marginal utility analysis has started the law of diminishing

marginal utility as: the additional benefit which a person derives from a given increases

of his stock of a thing diminished with every increase in the stock that he already has

The law is based on the following factor

1. Total wants of man is unlimited and each single want is satisfiable. The individual

consumes more and more units of goods, the intensity of wants falls. At a

particular point, he has reached saturation point. The individual wants no more

units to consume. At this point the marginal utility is zero.

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2. The fact, on which the law of diminishing utility is based, is that the different

goods are not perfect substitute for each other in the satisfaction of various

particular wants. The marginal utility of the good would not have diminished.

Elasticity of demand

The law of demand expresses the relationship between the price and the

commodity demanded. That is, If the price of the commodity falls, the quality demanded

will rise and if the price of the commodity rises, the quantity demanded will fall. Thus

there is an inverse relationship between prices and quantity demanded as per law of

demand. All other things which are assumed to be constant are taste and preference of

consumer, the income of the consumer and the prices of related goods.

The law of demand indicates the only the direction of change in quantity demanded

in response to a change in price but not the exact quantity or to what extreme the quantity

demanded of a good will change. Elasticity is the percentage change in one variable

divided by the percentage change in another. Thus it is a measure of relative changes. It is

useful to know how the quantity demanded will change when price change. This is

known as price elasticity of demand.

Price elasticity of demand

Price elasticity of demand is defined as the ratio of percentage in quantity to a

percentage in price.

i.e. ep = Percentage in quantity demand

Percentage change in price

When percentage of change in quantity demanded a commodity is greater

than the percentage change in price, the price elasticity of demand (ep) will be greater

than one and in this case the demand said to be elastic.

When a percentage in quantity demanded of a commodity is less than the

percentage change in price that the price elasticity of demand is less than one and it is

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known as inelastic. The percentage change in quantity demanded of a commodity is equal

to percentage change in price. The price elasticity is equal to one.

The above two figures (1, 2) represents two demand curves (elastic and inelastic)

for a given fall from op to op1, increase in quantity demanded is much greater in fig1

than fig2.

Figure1 is generally said to be elastic and the demand for the good in figure 2 to

be inelastic.

As per Marshalls theory the elasticity or responsiveness of demand in a market

is great or small according to the amount demanded increases much or little for a given

fall in price and diminishes much or little for a given rise in price. Elastic is a matter of

degree and used in the relative sense. When we say that demand for good is elastic we

mean only that the demand for it is relatively more elastic. Alternatively, when we say

that demand for a good is inelastic, we do not mean that its demand is absolutely

inelastic but only that it is relatively less elastic.

Then,

Elastic demand = ep > 1

Inelastic demand = ep < 1

Unitary elastic demand = ep = 1.

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Y D Y D

PP

P1

P1D D

O M M1 X O M1 N

Fig 1 Fig 2


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There are extreme cases in price elasticity of demand. One is perfectly inelastic

demand ( i.e. ep = 0 ). And the other is perfectly in elastic demand. ( ep = )

See fig no 3 in the Q to D is straight vertical line represent demand curve. It is

vertical because it is perfectly inelastic. That means, what ever the price, quantity demand

of a commodity remain unchanged @ 0 Q example medicine required for a patient.

What- ever the price he will buy the quantity demanded.

See fig no 4. This is perfectly elastic demand i.e. ( ep = ). In this case the

demand curve is in a horizontal line. A small change in price of a good will charge the

buyer to change completely away from the good, so that, the quantity demanded falls

zero. This means that if any perfectly competitive firms raise the price of its good, it will

loose all its customers to buy good from it.

Determinants of price elasticity

The following are some of the main factors which determine the elasticity of

demand for a good.

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PERFECTLY PERFECTLYY INELASTIC Y ELASTIC

Dep =

ep = 0P

O Q X O X

QUANTITY QUANTITYFig 3Fig 4

PRICE P

RICE


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1. The proportion of consumers income spent on a commodity

This is the most important factor; the elasticity of demand of a commodity

can be influenced by the proportion of income spent on a particular commodity. That

means, the proportion of consumers income spent on a specific commodity will have

the effect on the elasticity of demand. The greater proportion of income spent on the

product, and greater will be the elasticity of demand and vice versa.

For example: A common salt: The demand for a common salt will be highly

inelastic because household spent only a fraction of their income on it.

2. The uses of a commodity

If the commodity have greater number of uses, the elasticity of demand of the

commodity will be greater. The price of a commodity will be very high; if the same has

several uses and it will be put to the most important use.

3. Time period considered

The time factor is very important inelasticity of demand which influences

the elasticity of demand for a product. If time involved is long, the demand tends to be

more elastic. The consumer may shift to substitute goods in the long run. In the short run,

it is too difficult to switch over to substitute product.

4. The availability of substitute

This substitutes availability is one of the most important factors, which

determine the price elasticity of demand. If substitute available, its demands tends to be

elastic. If the price of such commodity goes up, there will be a shift to close substitute by

the consumers and the demand for the commodity will greatly decline. If the substitute is

not available, the consumers will have to buy it even at the higher prices and therefore its

demand would tend to be inelastic.

5. Joint demand for goods

This will also affect the elasticity of demand.

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6. Degree of luxury or necessity

Luxury products tend to have greater elasticity than necessities. The products

that initially have a law of degree of necessity which forms habits. The same can be a

necessity to some consumers, due to formation habits.

7. Permanent or temporary price change

The response in a one day sale will be different from the response for a

permanent price decrease of the same magnitude.

Cross elasticity of demand:( substitute and complements)

There are two goods which are related to each other and their price remains the

same. If there is any change in price of one product, the demand of the product will

change and demand of other good, also changes when its own price remains the same.

The percentage of changes in the demand for one good in response to a

percentage change in price of another good represents the cross elasticity of demand of

one good for the other.

The cross price elasticity of demand measures the responsiveness of the demandof a good to a change in the price of another good.

The formula used to calculate the coefficient cross elasticity of demand is

EA, B = Percentage change with quantity demanded of A

Percentage change in the price of good B

E A,B = (qA * 100 ) / qA = qA / qA

(pB * 100) /pB pB / pB

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Where:

E, stands for cross elasticity of demand of A for B.

qA, stands for the original quantity demanded of A.

qA, stands for change in quantity demandedof good A.pB, stands for original price of good B.

pB, stands for a small change in the price of good B.

In the case of substitute, the cross elasticity of demand is positive. If the price of

one goes up, the price of another also increases. In case of perfect substitute, the

cross elasticity of demand is equal to infinity,

In the case of two complementary goods the cross elasticity of demand is

negative. This means the prices of one good goes up, and the price of another willdecrease.

Where two goods are independent the cross elasticity of demand will be zero.

Income elasticity of demand

The income elasticity of demand may be defined as the ratio of the percentage

change in purchase of a good to the change in income. The income elasticity of demand

measures the responsiveness of demand of a good to the change in income of the people

demanding the good.

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Y D`x Dx Y Dy

P1

P P P2

Dx Dy

D`xO O

M2 M1 Q1 Q2

QUANTITY QUANTITY

PRICE

PRICE


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This can be calculated as follows:

Income elasticity = % change in purchase of a good

% change in incomeq = I

I Q

Where:

Q, change in quantity purchased.

I, change in income.

I, initial income.

Q, stands for initial quantity.

o A zero income demand occurs when an income is not associated with a change in

demand of a good.

o A positive income elasticity of demand is associated with normal goods. An

income in demand will lead to rise in demand. If the elasticity of demand is less

than 1, then it is a necessity good. If it is more than one then it is luxury good or

superior good.

o A negative income elasticity of demand is associated with inferior goods. An

increase in income may lead to fall in demand.

Consumers Behavior

Marginal utility theory

Cardinal or marginal utility analysis is an important theory of Consumer behaviors,

which provides an explanation for consumers demand for a product. This establishes an

inverse relationship between price and quantity demanded of a product.

The utility means the satisfaction derived by the consumer from the consumption of

a commodity. If he expects greater utility from a commodity, he must have greater desire

for that commodity. Total utility of a commodity to person is the sum of utilities which

he obtains from consuming a certain number of units of a commodity per period.

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Marginal utility of a commodity is the additional utility which he gets when he

consumes one more unit of a commodity.

Consider the following table. Which explain diminishing marginal utility?

No of coffee cups

Consumer per day

Total utility

( utils )

Marginal utility

( utils )

1

2

3

4

5

6

7

8

15

27

37

45

50

51

48

43

15

12

10

8

5

1

-2

-5

The number of units of a commodity consumed at which consumer is fully

satisfied is known as satiation quantity. Total utility declines when the consumer

consumes more than 6cups of coffee for per day. Marginal utility can be expressed in

the following.

M Un = TUn - TUn 1

Where n is any given number

In graphical analysis marginal utility of a commodity can be known by measuring

the slope of the utility curve.

Law of diminishing marginal utility and law of equal marginal utility, explain

consumer behavior and have general uses.

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1. Law of diminishing marginal utility

According to the law, the marginal utility of a good diminishes when a

consumer consumes more units of good.

Marshal has stated the law as follows.

The additional benefit which a person derives from a given increase of his stock of a

thing diminishes with every increase in the stock that he already has.

This law describes the fundamental tendency of human nature. The law can be arrived at

by observing how people behave.

Application of law of diminishing marginal utility

a) This law helps in deriving law of demand. The concept of consumersupply is based on principal of diminishing marginal utility.

b) Redistribution of income will increase social welfare. For example.

Improving progressive income tax on such section of the society and

spending the tax on social services of the poor people is based on the

diminishing marginal utility.

c) This law of diminishing marginal utility has helped to explain the paradox

or contradiction of value this is knows as diamond water paradox. Water

is essential to live and has value for human being. But they are less priced

or no price at all. But diamond has high price, but no value for consumer.

The water is available in large quantities so that its marginal utility is very low or

even zero. That is why, its price is low or zero.

The modern economists explain the total utility of a commodity does not

determine the price of a commodity and if the marginal utility which is crucially

important determinant of price.

2. Law of equal marginal utility

Law of equal marginal utility is that the consumer will distribute his money

income between the goods in such a way that the utility derived from the last dollar spent

on each good is equal. This is that the consumer is in equilibrium position when

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marginal utility of money expenditure on each good is the same. Therefore, the marginal

utility of money expenditure on a good is equal to the marginal utility of a good divided

by the price of a good.

i.e = MUm = MUa

Pa

Where: MUa = marginal utility of a good a.

Pa = price of good a.

MUm = marginal utility of money expenditure.

Consumer surplus

Consumer surplus = what a purchaser is willing to pay what he actually

pays.

Consumers surplus can be defined as the difference between price that one is

willing to pay and the price one actually pays for a particular product. The net effect is

the consumer derives extra satisfaction from the purchase he daily makes over the price

of goods than the price they actually pay for them. The extra satisfaction the consumer

gets from buying a good has been called consumer surplus. If the consumer derivesgreater utility from a good, he is willing to pay greater amount of money. That means the

marginal utility of a unit determine the price, a consumer will be prepared to pay for the

unit.

Therefore consumer surplus = marginal utility ( price * number of unit

purchased ).

Where Mu is is the sum of marginal utilities of units of a good purchased.

o We can also derive the concept of consumer surplus from the law of diminishing

utility. The marginal utility goes on diminishing when a consumer purchase more

units of good and the consumers willingness to pay for additional units, declines

as he has more units.

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o When the marginal utility from a product becomes equal to its given price, that

means that at the margin what a consumer will be willing to pay is greater than

the price he actually pays for them.

The uses of the concept of consumer surplus

o The consumer surplus is useful in showing benefit which a consumer obtains

from a fall in price of a good.

o Consumer surplus is used to evaluate gain from a subsidy.

o Consumer surplus is used to measure loss of benefit from imposition of a tax.

o The concept of consumer surplus is used to resolve water diamond paradox.

o In modern welfare economics the concept of a consumer surplus is used to

cost benefit analysis of public investment projects.

Indifference curves

We have explained Marshals cardinal utility analysis of demand. Two English

economists J.R hicks and R.G.D.Allen severely criticized Marshals consumer demand

analysis, based up on cardinal measurement of utility and presented the indifference

curve approach based up on the notion of ordinal utility. The ordinal utility is that the

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Y

D

Consumer Surplus

P S

D`

MU

O M X

QUANTITY

PRICE

AND

MARG

INA

LUTILITY


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utility of a particular good and service cannot be measured using an objective scale, since

the utility is a psychological feeling which cannot be quantifiable. The assumption of

ordinal utility is quite reasonable and realistic, according to them. A consumer is capable

of ranking different alternatives available that is comparing different levels of

satisfaction. According to ordinal utility, the consumer may not be able to give the exact

amount of utilities that he derives from commodities, but he is capable of judging

whether the satisfaction is equal to, lower than or higher than another.

If the consumer is presented with a number of various combinations of goods, he

can rank them.. He can indicate his preference or indifference between any other pair of

combination. This concept of ordinal utility implies the consumer cannot go beyond

stating his preference or indifference and he can not tell by how much he prefers.

The indifference curve represents all those combinations of two goods which

give same satisfaction to consumers. This is the basic tool of Hicks Allen cardinal

analysis of demand.

An indifference curve map consists of a set up indifference curves. This

represents complete description consumers (individual) preference

SUPPLY

Supply curve and law of supply

Supply can be defined as the quantity that produces are willing and able to offer

for sale at a given price over a given period of time

Supply can also be defined as the total amount of good or service available for

purchase; along with demand.

There is a vast difference between stock and supply. Stock is the total volume of

commodity which is available at a particular moment of time and can therefore be

brought into market for sale at a short notice and supply means the quantity which is

actually brought in the market at a price during a period.

The supply schedule is the relationship between the quantity of goods by the

producer of a good and the current market price.

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It is graphically represented by the supply curve. The supply schedule or supply

curve of a commodity means how quantity of a commodity which the seller (or produces)

are willing and able to make available in the market, varies with changes in the price.

The supply schedule giving various prices of rice and quantities of Rice supplied

at those prices is shown in the table

Supply schedule

PRICE $

QUANTITY

SUPPLIED

225

275

325

375

425

100

200

300

400

500

This schedule shows that the whole schedule or curve depicting the relationship

between price and quantity which the sellers produce as offer for scale in the market

during a period of time.

Law of supply

The law of supply can be defined as when the price of commodity rises, the

quantity supplied of it in the market increases and when the price of a commodity falls ,

its quantity supplied decreases , other factors determining supply remaining the same.

When the price of Rice raises $225 to $425 per quintal the quantity supplied of

rice in the market increases from 100 quintals to 500 quintals per period.

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YS

425

375

325

275

225 S

O 100 200 300 400 500


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According to law of supply the quantity supplied of a commodity is directly or

positively related to price.

The law of supply curve implies that only at a higher price of good, more quantity

if it will be produced and made available in the market during a given period. We have to

understand why more quantity of a good is supplied, when the price is high. The producer

expects generally maximum gain from producing and supplying it in the market. While

the sellers sell at a higher price, they make greater potential gain. Here there are twoassumptions, one producer aims at maximum profit from production and sale of a

commodity and two is , output of a commodity expanded, the addition cost of producing

extra units goes up due to diminishing returns to the variable factors.

The supply curve of the commodity slopes upward to the right is due to the direct

relationship between price of the goods and its quantity supplied.

Supply price is the term used for the price at which a given quantity of the

commodity is supplied by the sellers is called supply price.

The term supply is used as the whole schedule or curve depicting the relationship

between price and quantity supplied in a period.

The term quantity supplied refers to the quantity of a commodity which produces

would make it available at a particular point.

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Extension of supply

The term extension of supply is used when the rise in price of a commodity

brings about increase in quantity supplied of the commodity, other factors determining

supply remaining constant.

This is entirely different from increase in supply. While extension in supply of a

commodity occurs as a result of rise in price of the commodity, increases in supply mean

that due to the reduction of price of resources, improvement in technology, etc.

This is contraction in supply of a commodity when the price falls, then a smaller

quantity of it is supplied at a lower price.

The decrease in supply implies that because of rise in prices of resources,

example: imposition of excise duty.

Factors determining supply

a. Prices of factors

Here the factors refer to resources. Change in prices of resources will

cause a change in cost of production and because of the cost increases; there will

be decreases in supply. This implies that supply curve would shift to the left.b. Prices of other products

We assume that the prices of all other produces remain unchanged, when

we draw a supply curve. Any change in prices of other products would influence

the supply product by creating substitution of one product for another.

c. Production technology

While making a supply curve, we assume that other factors remain the

same when other factor changes, they cause a shift in the entire supply curve. Achange in technology affects the supply function by altering cost of production.

If the cost of production declines, the firm would supply more than before at the

given price. Supply curve would shift to the right if the supply increases.

d. Number of producers

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If the number of producers of a product increases, the supply will increase

causing a right ward shift in the supply curve.

e. Taxes and subsidies

The supply of a product will also be influenced by the taxes and subsidies.

The imposition of a sales tax or excise duty will increase the price of the

product. The firms will supply the same quantity of it at a higher price or less

quantity of it at the same price. This facto causes a left ward shift in supply

curve.

f. Future price

The sellers expectations of future price also influence the supply of a

product in the market. During the period of inflation, Sellers expects the prices

to rise in future, they will reduce the supply of production. The hoarding huge

quantities also an important factor is reducing supplies and causing further rise

in their prices.

g. Objective of the firm

The objective of the firm is also another important factor which

determines the supply of good produced by it. A firm aims at maximum sales or

revenue and profit is not the aim of the firm at present. Large quantity of

products made available by the company in the market. Therefore at this point,

supply will be more in the market.

Elasticity of supply

We have already discussed about the elasticity. The elasticity is the percentage

change in one variable divided by the percentage in another variable. It is a measure of

relative changes. When a small fall in price of a commodity leads to contraction of

supply, the supply is elastic and when a big fall in price leads to a very small contraction

in supply is said to be inelastic. On the other hand, a small rise in price leading to big

extension in supply, the supply is said to be elastic and when a big rise in price leads to

small extension to supply indicates inelastic supply.

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In Precise terms, the elasticity of demand can be defined as a percentage in the

quantity supplied of a product divided by the percentage change in price that caused the

change in quantity supplied.

Elasticity of supply = % change in quantity supplied

% change in price

= Q x P

P Q

For example, the price of a motor cycle rises from 5000$ per unit to 5500$. Due

to change in price, the supply of motor cycle increases 3000 units from 2000units. The

elasticity of supply will be

= 1000 * 5000 = 2 * 5 = 3.33.

500 3000 3

Two supply curves have been drawing in two graphs below. At price P (1) the

quantity supplied in figure A is OQ1 with a rise in price of the product the quantity

supplied increases to OQ2 from OQ1 in figure A and from ON1 to ON2 in figure B.

Now compare, both the figure (A and B) regarding the quantity supplied. Quantity

supplied in A is larger than the quantity supplied figure B (i.e N1 and N2 ). Therefore

supply in A is said to be elastic and in figure B the supply is said to inelastic.

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Elasticity of supply depends upon various key factors. These factors play important role

in determining prices of products.

1. Availability of the production facilities

If the producers want to expand their production, they must have

infrastructural facilities for expanding output. For example, in industrial field

if there is shortage of power and fuel, the expansion in supply would not be

possible in responsible to the rise in price of individual products.

2. The length of time

The elasticity of supply of a product depends upon the time duration in which

the products get to make adjustments for changing the level of output in

response to the change in price.

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Y Y

S S

P2P2

P1 P1

S S

O Q1 Q2 X O N1 N2 X

QUANTITY

QUANTITY

PRICE

PRICE

FIGURE A FIGURE B


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The time period may be divided into three following types:

a. Very short time

If the market period is very short it is not possible to make any production. The

supply curve is vertical and therefore perfectly inelastic.

b. Short run

In the short period of time the firm can change the output in response to change

in price. Short run supply curve is elastic.

c. Long run

In the long run also the firm can change the output after adjusting all

factors of production. There is a possibility of entry for new firms or leave the

industry. The long run supply curve is more elastic.

3. Substitution of one product for another

The change in quantity supplied depends on the possibilities of substitution, the

greater the extent of possibilities of shifting resources from the B products

production to product A, the greater the elasticity of supply of the A product. For

example the market price of wheat rises. The farmers shift their resources to

develop wheat production, due to rise in price, the greater the extent of shifting

resource from other products to wheat, the greater the elasticity of supply of wheat.

Part 1 Lesson - 1 Microeconomics

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