Economics and Book Keeping

Abhishek Das
Research scholar
Department of Economics
Jadavpur University

Introduction
Human wants :1, 2, 3, 4, 5, .. Unlimited
Resource: used to produce goods / services to
satisfy human wants.
Resources are limited in supply:
inputs or factors of production
time
budgets
information / knowledge / technology
Scarce: i.e. their quantities are insufficient to
satisfy all human wants
Faced with scarcity, people must make choices.

Types of resources
Natural resources: e.g. sunshine, rain, crude
oil, Coal..
Human resources: labour service, human
capitals
Man made resources: e.g. machines,
equipments

Problem and Solution

Resources are insufficient to satisfy ALL
human wants
A relative concept: we want more than we
have
Problem arises: Limited resources vs.
unlimited wants
Solution: Economics and Economist
Economics is the study of the choices
people make to cope with scarcity.

Definitions of Economics
The word economy comes from a Greek
word for one who manages a household.
Mankiws definition:
is the study of how society manages its
scarce resources
Hedricks definition:
is how society chooses to allocate its
scarce resources among competing
demands to improve human welfare
Alternative definitions
what economists do.
is the study of choice.

Fundamental Questions of Economics Scarcity requires all societies to answer the

following questions:
What should be produced?
How many?
How should these goods (and services) be
produced?
When should these goods be produced?
Who gets the goods (and services) that were
produced?

Categories of Basic Principles of

Economics
How do people make decisions?
How do people interact?
How does the economy work overall?

Branches of Economics

Microeconomics
Macroeconomics
International Economics (Trade)
Public Economics
Financial economics

Some Concepts
Positive Economics
Descriptive - what the world is like.
Objective- value judgments need not be
made
Positive statements can theoretically be
tested by appealing to the facts
Normative Economics
Prescriptive - what the world ought to be
like
Subjective value judgments must be made
Normative statements cannot be tested
appealing to facts.

The Modern Economy

Economy - A mechanism that allocates
scarce resources among alternative uses.
This mechanism achieves five things: What,
How, When, Where, Who.
Decision makers - Households, Firms,
Governments.
Household - Any group of people living
together as a decision-making unit. Every
individual in the economy belongs to a
household.
Cont

 Firm - An organization that uses resources to

produce goods and services. All producers are called
firms, no matter how big they are or what they
produce. Car makers, farmers, banks, and insurance
companies are all firms.
Government - A many-layered organization that sets
laws and rules, operates a law-enforcement
mechanism, taxes households and firms, and
provides public goods and services such as national
defense, public health, transportation, and education.
Market - Any arrangement that enables buyers and
sellers to get information and to do business with
each other.

Demand
&
Supply

Demand
Definition: A schedule of the quantities of
a good that buyers are willing and able to
purchase at each possible price during a
period of time, ceteris paribus. [all other
things held constant]
Demand can also be perceived as a schedule
of the maximum prices buyers are willing
and able to pay for each unit of a good.

Demand Function
Is the functional relationship between the
price of the good and the quantity of that
good purchased in a given time period
[UT], income, other prices and preferences
being held constant.
A change in income, prices of other goods
or preferences will alter [shift] the demand
function.

Quantity Demanded
A change in the price of the good under
consideration will change the quantity
demanded.
Q = f (P, holding M, Pr , preferences
constant);
where: M = income ; Pr = prices of related
goods
DP causes a change in X [DQ], this is a
change in quantity demanded

Change in Demand
If M, Pr, or preferences change, the demand
function [relationship between P and Q] will
change.
These are sometimes called demand shifters
Be sure to understand difference between a
change in demand and a change in
quantity demanded.
change in demand --- shift of the function.
change in quantity demanded --- move on the
function

Law of Demand
Theory and empirical evidence suggest that
the relationship between Price and Quantity
is an inverse or negative relationship
At higher prices, quantity purchased is
smaller, or at lower prices the quantity
purchased is greater.
Other things remaining the same, the higher
the price of a good, the smaller is the
quantity demanded.

An example of hot chocolate:

There is a coffee cart in the building that primarily serves the
individuals who work in the building. The market is defined to some
extent by the geography of the building. Individuals who buy the
hot chocolate rarely come from other buildings to purchase a cup.
During the time period [UT]under consideration [8:00-9:00am on
a week day ] the incomes and preferences of buyers are unlikely to
change. The prices of coffee, lattes, etc. can be controlled by the
vendor and the price of soft drinks from the machines remains
constant. The number of workers in the building remain at a
constant level.
Under these circumstances, we observe the number of cups of hot
chocolate [H] sold each morning as the price [P] is changed.
From these observations the demand relationship is estimated.

Cups of Hot Chocolate [H] purchased

eachday between 8-9am
price
per cup

cups
purchased

20 .

$ . 50

15 .

$ . 75

12 . 5

$ 1. 00

$ 1. 25

7 .5

$ 1. 50

5.

$ 1. 75

2 .5

$ 2 . 00

P > 0
[+.75]

10 .

Q < 0
[-7.5]

The demand relationship

can be demonstrated as a
table:
Demand is a schedule of
quantities that will be
purchased at a schedule
of prices during a given
time period, cet. par.
As the price is increased,
the quantity purchased
decreases.

This demand relationship can be expressed as an equation:

P = 2 - .1Q or Q = 20 - 10P: [Q = f (P, . . .) but we graph P on
the Y axis and Q on the X axis.]

PRICE

The demand relationship can be expressed as a table

(previous slide) or an equation [either P = 2 - .1Q or Q = 20 - 10P]
The data from the table or equation can be graphed:
Rs.

2.25
2.00
1.75
1.50
1.25
1.00
.75

.50

P = Rs.2, Then Q = 0

P = Rs.1.75, then Q = 2.5

. .
. .
..

P = Rs.1.50, then Q = 5

.25
2

P = Rs.1.25, Q = 7.5
P = Rs.1, then Q = 10
P = 0, then Q = 20
Demand

8 10 12 14 16 18 20 22 24

The demand function can be represented as a table,

an equation or a graph.

QUANTITY
{CUPS/UT}

The demand equation P = 2 - .1Q was graphed

PRICE

A change in quantity demanded is a movement on the demand

function caused by a change in the independent variable [ price].

P from Rs.1.50 to Rs.1 causes Q from 5 to 10 units

2.25

2.00
1.75

A change in quantity demanded is a move

from point A to B on the demand function
caused by a change in the price!

1.50
1.25

1.00
.75

Demand [P = 2 - .1Q]

.50
.25

QUANTITY
2

4 6

10 12 14 16 18 20 22 24

{CUPS/ UT}

The demand equation P = 2 - .1Q was graphed

PRICE

A change in any of the parameters (income, price of related goods,

preferences, population of buyers, etc.) will cause a shift of the
demand function.
In this example, the intercepts have changed,
the slope has remained constant
2.50
2.25
2.00
1.75

an increase in demand
D [ P = 2.5 - .1Q]

1.50
1.25
1.00
.75

Demand [P = 2 - .1Q]

.50
.25
2 4

10 12 14 16 18 20 22 24

D`` [P`` = 1.5 - .1Q]

QUANTITY
{CUPS/UT}

PRICE

2.50
2.25
2.00
1.75

buyers are more responsive to P

P` = 2- .048076923Q

1.50
1.25
1.00
.75
.50

buyers
are less
responsive
to P

.25
2

an increase in
the slope
P = 2 - .25Q

a decrease in the
slope

Demand [P = 2 - .1Q]

8 10 12 14 16 18 20 22 24

QUANTITY
{CUPS/UT}

A change in the parameters [income, Pr, preferences, population,

etc.] might alter the relationship by changing the slope
A change in demand refers to a movement or shift of the entire
demand function

PRICE

2.50

An increase in demand

2.25

results in a larger quantity being

purchased at each price

2.00
1.75
increase

1.50
1.25

D2

1.00

[an increase in demand]

.75
.50

Demand [P = 2 - .1Q]

.25

Q = 7.5
2

10 12 14 16 18 20 22 24

QUANTITY

{CUPS/UT}
In this case, an increase in demand results
in an increase in the amount that will be purchased at a price of
Rs.1.25. At this price the Quantity purchased increases from 7.5
to 18. An increase in demand!

PRICE

Effect of a change in the price of a

substitute

2.50
2.25
2.00
1.75
1.50
1.25
1.00
.75
.50
.25

ad
in ecr
fo the eas
rs d e
tea em
k an
d
2

D2

Demand [P = 2 - .1Q]

10 12 14 16 18 20 22 24

If the price of a substitute, like chicken, increases

buyers will buy more steak at each price of steak

QUANTITY
[steak /UT]

If the price of chicken decreases, the buyers will want less steak at
each possible price of steak; the demand for steak decreases!

Complementary goods
Two goods may be complimentary, i.e. the two goods are
used together. [tennis rackets and tennis balls or CDs
and CD Players]
An increase in the price of CDs will tend to reduce the
demand [shift the demand function to the left] for CD Players

PCDs

P2

As people buy fewer

CDs, the demand for
CD players decreases.

Pplayers

As the price of CDs increases

from P1 to P2, the quantity of
CDs decreases from Y1
to Y.

At the same price,

Ppl , the demand
is reduced
from Dto D.

Ppl

Dplayer

Dcd

P1

Y1 CDs/UT

Dplayer

X1 CD Players
per UT

Compliments and Substitutes

Substitutes:
if the price of a substitute increases, the
demand for the good increases.
if the price of a substitute decreases, the
demand for the good decreases.
Compliments:
if the price of a compliment increases, the
demand for the good decreases.
if the price of a compliment decreases,
the demand for the good increases.

Demand Summary
Law of Demand holds that usually as the
price of a good increases, individuals will
buy less of it.
The nature of this relationship is influenced
by a variety of other variables;
income, preferences, prices of related
goods, and other circumstances
as these circumstances change, the
demand relationship changes or shifts.

Demand Summary [cont. . . ]

A change in demand means the
relationship between price and quantity was
altered by a change in some other variable
[a demand shifter] The demand shifts.
A change in quantity demanded is a
change in the quantity bought that was
caused by a change in the price of the good .
There is a movement on the demand function.

Supply
Supply is defined as a schedule of quantities
of a good that will be produced and offered
for sale at a schedule of prices during a
given time [UT], ceteris paribus.
Generally, producers are willing to offer
greater quantities of a good for sale at
higher prices;
a positive relationship
between price and quantity supplied.

Supply Schedule
Observation

Price

Quantity
Supplied

Rs.1

Rs.2

10

Rs.3

14

Rs.4

18

The information can be represented

on a graph by plotting each
price quantity combination.

E
F

Rs.5

22

P
Both the graph and the table
represent a supply
relationship: Q = 2 + 4P

A supply schedule can be

displayed as a table.

Rs.5
Rs.4

Rs.2
Rs.1
2

Rs.3

10

12

.
ly
p
p
su

14

Change in Quantity Supplied

A change in the price of the good causes a
change in the quantity supplied.
The change in the price of the good causes a
movement on the supply function, not a
change or shift of the supply function.

Supply Schedule
Observation

Price

Quantity
Supplied

Rs.1
Rs.1

Rs.2

Rs.3
Rs.3

Rs.4

A change in the price causes a

6
change in the quantity supplied.
10
CAUSES
QThis can be represented by a
movement on the supply
14
function in the graph
18

E
F

Rs.5

22

This is a change in quantity

supplied. Not to be
confused with a change in
supply!

P
Rs.5
Rs.4

P causes the quantity supplied

to increase from 6 to 14.

Rs.3
P from Rs.1 to
Rs.3

Rs.2
Rs.1
2

10 12

14

16

Q
/ut

Change in Supply
A change in supply [like a change in
demand] refers to a change in the
relationship between the price and quantity
supplied.
A change in supply is caused by a change
in any variable, other than price, that
influences supply
A change in supply can be represented by a
shift of the supply function on a graph

Change in Supply [cont. . . ]

There are many factors that influence the
willingness of producers to supply a good.
technology
prices of inputs
returns in alternative choices
taxes, expectations, weather, number of
sellers, . . .
Qs = fs (P, Pinputs, technology, . . .)

Change in Supply [cont. . . ]

Qs = fs (P, Pinputs, technology, number of
sellers, taxes, . . .)
A change in the price [P] causes a change
in quantity supplied;
a change in any other variable causes a
change in supply

Supply Schedule

Given the supply schedule,

Observation

An increase in the prices

of inputs would make it
more expensive to produce
each unit of output,
therefore, the supply
decreases

Price

Quantity
Supplied

Rs.1

46

Rs.2

Rs.3

810
1214

Rs.4

16
18

P
Rs.5

Rs.5

20

20

a shift to the left

is a decrease in supply

The decreased quantity

at each price shifts the
supply curve to the left!

Rs.4
Rs.3
Rs.2
Rs.1
2

10

12 14

16

The development of a new

technology that reduces the
cost of production will shift
the supply function to the right

Equilibrium
Equilibrium:
1. A state of rest or balance due to the equal
action of opposing forces.
2. Equal balance between any powers,
influences, [Websters Encyclopedic Unabridged
Dictionary of the English Language]
In a market an equilibrium is said to exist when
the forces of supply [sellers] and demand
[buyers] are in balance: the actions of sellers and
buyers are coordinated. The quantity supplied
equals the quantity demanded!

100

Given a demand
function [which

90
80

represents the
behavior or choices
of buyers,

Rs.70
70
60
50

and a supply function

that represents the
behavior of
sellers,

40
30
20
10
10

20 30 40

50 60

70
60

80 90 100 110 120 130

Qx/ UT

Where the quantity that people want to buy is equal to the quantity
that the producers want to sell, there is an equilibrium quantity.
The price that coordinates the preferences of the buyers and sellers
is the equilibrium price.
At the equilibrium price of Rs.70, the quantity supplied is equal to
the quantity demanded.

When the price is greater than the equilibrium price, the

amount that sellers want to sell at that price [quantity supplied]
exceeds the amount that buyers are willing to purchase [quantity
demanded] at that price. The price is too high.
the quantity demanded is 35

At a Price of Rs.90 the quantity supplied is 80,

surplus = 45

100
90
Rs.90
80

Rs.70
70

At Rs.90 there is a surplus

of 45 units [80-35=45]

equilibrium price
equilibrium quantity

60
50
40
30
20
10
10

303540

50 60 70

60

808090 100 110 120 130

Qx/ UT

surplus = 45

100
90
Rs.90

lower
price

80

Rs.70
70
60

At a price of Rs.90 a surplus

of 45 units exists

50
Quantity
demanded
increases

40
30

Quantity
supplied
decreases

20

Suppliers have more to sell than

buyers will purchase at a price of Rs.90.
To get rid of these unsold
units [inventory], the
sellers lower
the price.

10
10

20

30 3540

50 60 70 808090 100 110 120 130

60

Qx/ UT

As the price of the good is reduced, the quantity supplied decreases.

The quantity demanded increases as the price falls.
As the price moves toward equilibrium, quantity supplied and
quantity demanded are brought into equilibrium.

As a result of market forces

the market moves to

100

equilibrium

90
80

Rs.70
70
60
50

At a price below equilibrium the

the quantity demanded exceeds
the quantity supplied.

price
rises

At a price of Rs.30 the quantity

demanded is 110. The quantity
supplied is 15.

40
30
Rs.30
20
10

quantity
supplied
increases
10 15
20

30

40

quantity
demanded
decreases
shortage = 95
50

60
60

70

80

90 100 110
110 120 130

Qx/ UT

At a price of Rs.30 the quantity demanded exceeds the quantity

supplied by 95 units [110 - 15 = 95]. This is a shortage.
Since the buyers cannot obtain all they want at a price of Rs.30, some buyers will
offer to pay more. Some buyers will not pay the higher price, they buy less so the
quantity demanded decreases.At the higher price the quantity supplied increases

100

demand
increases

90
Rs.89

The market for good X is

price
rises

80

Rs.70
70

in equilibrium at Px = Rs.70

60
50
40

D2

equilibrium
quantity
increases

30
20
10
10

20 30 40 50 60
60

70 80
80 90 100 110 120 130

An increase in the price of a substitute

[good Y] causes the demand for good X
to increase.
As a result of the increased demand,
market forces push Px up.

Qx/ UT

The increase in the demand for

good X results in an increase in
both the equilibrium price and
quantity.
Identify other factors that could
increase demand!

100
90

Given a demand function,

80

an equilibrium is defined.

70
$70
60

Rs.50.89
50
40

A decrease in demand,
establishes a new equilibrium
at a lower price and
quantity.

30
20
10
10 20 30 40
60 70 80 90 100 110 120 130
39.2 50 60

Demand might be reduced by:

a decrease in the price of a substitute,
an increase in the price of a compliment,
a change in income,
a change in the number of buyers
or their preferences, or, . . .
.

Qx/ UT

A change in the
price of the good
does not change
demand! It changes
the quantity
demanded.

100

S2

90
80

supply
increases

Rs.70
70
price
60 falls
Rs.5050
40
30
20
10
10 20 30 40

Given an equilibrium
condition in a market,

an increase in supply will

increase the equilibrium
quantity and decrease
equilibrium P.

50 60
60 70

8086 9 100 110 120 130

Quantity
increases

Qx/ UT

Identify factors that increase supply:

1.
fall in price of inputs
2.
improved technology
3.
increase in number of sellers
4.
fall in return in alternative
uses of inputs
5.
or, . . .

A decrease in supply

causes the equilibrium price to increase

and equilibrium quantity to decrease.

S1
100

decrease in supply

Rs.90
90
80

70
$70

price rises

What forces might cause the

supply to decrease?
1. an increase in the prices
of inputs
2. increase in returns from
alternative actions
3. problems in technology
[regulations, . . . ]
4. decrease in number of
sellers or producers

60
50

quantity
decreases

40
30
20
10
10 20 3035
40

50 60
60 70 80 90 100 110 120 130

Qx/ UT

100
90
80

70
$70
60

demand
increases
price might
go up or down
or stay the same

50
40
30
20
10

supply
increases

and decrease
price

+P
-P

increase

S2 If both supply and

and
increase
price

results in
a marketincrease
force to
results
in
increase
a market Q

demand decrease,
the P will be
indeterminate and
the equilibrium Q
will decrease.

D2

force to
increase Q
10 20 30 40 50 60
6070

80 90 100
100 110 120 130

Qx/ UT

When demand and supply both shift, the resultant effect on either
equilibrium price or quantity will be indeterminate.
Both the increase in demand and supply increase quantity;
The increase in demand pushes price up.

equilibrium Q increases.

The increase in supply pushes price down.

The change in price may be positive or negative, it depends on the magnitude

of the shifts in and slopes of demand and supply.

A decrease in supply
An increase in demand

tends to increase P and reduce Q.

tends to increase both P and Q.

Result is that Price will rise, Quantity may increase, decrease or stay the same
depending on the magnitudes of the shifts and slopes of supply and demand.
In this example,
Price
the price
Rs.105
increases to
100
Rs.105.
90

When supply
80
increases and Rs.70
70
demand
60
decreases,
the price will
50
fall but the
40
change in Q
30
will be
20
indeterminate!

S1
to push
price up

decrease in supply

pushes
price up

reduces and
quantity increase
Q

an increase in
demand tends

D2

10
10 20 303540 49
50 60
60

70 80 90 100 110 120

the quantity decreases to 49

Qx/ UT

Supply and Demand Analysis

Supply and demand is a simplistic model
that provides insights into the effects of
events that are related to a specific market.
Whether an event will tend to cause the
price of a good to increase or decrease is of
importance to decision makers.
To estimate the magnitude of price and
quantity changes more sophisticated models
are needed.

Elasticity

Elasticity
Elasticity is a concept borrowed from physics
Elasticity is a measure of how responsive a
dependent variable is to a small change in an
independent variable(s)
Elasticity is defined as a ratio of the
percentage change in the dependent variable
to the percentage change in the independent
variable
Elasticity can be computed for any two
related variables

Elasticity [cont. . . ]
Elasticity can be computed to show the effects of:
a change in price on the quantity demanded [ a
change in quantity demanded is a movement
on a demand function]
a change in income on the demand function for
a good
a change in the price of a related good on the
demand function for a good
a change in the price on the quantity supplied
a change of any independent variable on a
dependent variable

Own Price Elasticity

Sometimes called price elasticity
can be computed at a point on a demand
function or as an average [arc] between
two points on a demand function
ep, are common symbols used to
represent price elasticity
Price elasticity [ep] is related to revenue
How will a change in price effect the
total revenue? is an important question.

Elasticity as a measure of responsiveness

The law of demand tells us that as the
price of a good increases the quantity that
will be bought decreases but does not tell us
by how much.
ep [own price elasticity] is a measure of
that information]
If you change price by 5%, by what
percent will the quantity purchased change?

% change in quantity demanded

% change in price

or, ep

% Q
% P

At a point on a demand function this can be

calculated by:

QQ22-- Q
Q11 = Q

ep =

Q1
P2 -PP
=1P
2 -1 P
P1

Q
Q1

=
P
P1

+2
Q

ep =

[2/3 = .66667]

Q31

% Q = 67%

P
-2

P
71

[-2/7=-.28571]

% P = -28.5%

= -2.3

[rounded]

The own price elasticity of demand

at a price of Rs.7 is -2.3

Price decreases from Rs.7 to Rs.5

This is point price elasticity. It is calculated at a point
on a demand function. It is not influenced by the direction
or magnitude of the price change.

Px
P1= Rs.7

P2- P1 = 5 - 7 = P = -2

P = -2

P2 = Rs.5

Q2 - Q1 = 5 - 3 = Q = +2

D
Q = +2

Q1 = 3

Q2 = 5

Qx/ut

There is a problem! If the

price changes from Rs.5 to
Rs.7 the coefficient of
elasticity is different!

Q
-2

ep =

5Q1
+2
P

[-2/5 = -.4]

% Q = -40%
% P = 40%

= -1

[+2/5 = .4]
P51
When the price increases from Rs.5 to Rs.7,

[this is called unitary elasticity]

the ep = -1 [unitary]

In the previous slide, when the price decreased from Rs.7 to Rs.5, ep

The point price elasticity is

different at every point!

Px
P2= Rs.7

There is an
easier way!

= -2.3

P1= Rs.5

ep = -2.3

P = +2

ep = -1

D
Q = -2

Q2 = 3

Q1= 5

Qx/ut

By rearranging terms

An easier way!
Q
Q1
Q1
P

ep =

Q1

P1

* P =

P1

ep

Q2= 5

P2- P1 = 5 - 7 = P = -2

+2
-2

Q1

= -1

P71

P1 = Rs.7,

Q2 - Q1 = 5 - 3 = Q = +2

Then,

this is the
slope of the
demand function

Given that when:

P1 = Rs.7, Q1 = 3
P2 = Rs.5,

P1

this is a point on
the demand
function

= -1

Q
31

= -2.33

Q1 = 3

On linear demand functions the

slope remains constant so you
just put in P and Q

This is the slope of the demand Q = f(P)

The following information was

given

P1 = Rs.7, Q1 = 3
P2 = Rs.5, Q2= 5
Q2 - Q1 = 5 - 3 = Q = +2
P2- P1 = 5 - 7 = P = -2

Rs.7

A
B

Rs.5

+2
-2

The equation for the demand

function we have been using is
Q = 10 - 1P. A table can be
constructed.

What is the Q
intercept?

Px must decrease
by 5.

The slope of the demand function

[Q = f(P)] is

Q = f (P)

Px

Q increases by 5

= -1

Q = 10
Qx ut

The slope [-1] indicates that for every

1 unit increase in Q, Px will decrease by 1.
Since Px must decrease by 5, Q must
increase by 5

Q = 10 when Px = 0

The slope-intercept form

Q = a 10+ m- 1P

The slope is -1

The intercept is 10

For a simple demand function: Q = 10 - 1P

price

quantity

ep

Rs.0

10

Rs.1

0
-.11

Rs.2

-.25

Rs.3

Rs.4

Rs.5

-.43
-.67
-1.

Rs.6

-1.5

Rs.7

Rs.8

-2.3
-4.

Rs.9

Rs.10

-9
undefined

Total
Revenue

using our formula,

ep =

P
the slope is -1,

P1

* Q1

price is 7

P71

Q31

ep = (-1) *

= -2.3

at a price of Rs.7, Q = 3
Calculate ep at P = Rs.9
Q=1
9

ep = (-1)

Calculate ep for all other

price and quantity
combinations.

= -9

For a simple demand function: Q = 10 - 1P

price

quantity

ep

Total
Revenue

Rs.0

10

Rs.1

0
-.11

Rs.2

-.25

9
16

Rs.3

Rs.4

-.43
-.67

21
24

Rs.5

Rs.6

-1.
-1.5

25
24

Rs.7

Rs.8

-2.3
-4.

Rs.9

Rs.10

21
16
9
0

-9
undefined

Notice that at higher prices

the absolute value of the price
elasticity of demand, ep is
greater.
Total revenue is price times
quantity; TR = PQ.
Where the total revenue [TR]
is a maximum, ep is equal
to 1
In the range where ep < 1, [less
than 1 or inelastic], TR increases as
price increases, TR decreases as P
decreases.
In the range where ep > 1,
[greater than 1 or elastic], TR
decreases as price increases, TR
increases as P decreases.

To solve the problem of a point elasticity that is different for every price quantity
combination on a demand function, an arc price elasticity can be used. This arc price
elasticity is an average or midpoint elasticity between any two prices. Typically,
the two points selected would be representative of the usual range of prices in the
time frame under consideration.

The formula to calculate the average or arc price

elasticity is:
Q
P1 + P2
ep =
*

P1 + P 2 =
12

P1 = Rs.7,

Q1 = 3

P2 = Rs.5,

Q2 = 5

Q1 + Q 2 =
8

Q2 - Q1 = 5 - 3 = Q = +2
P2- P1 = 5 - 7 = P = -2

Px
Rs.7

The average or arc ep between

Rs.5 and Rs.7 is calculated,

ep =

-1
P

The average

P1 12
+ P2
Q1 +8 Q2

Slope of demand

Rs.5
Q

Q1 + Q2

=-1

= - 1.5

ep between Rs.5 and Rs.7 is -1.5

Qx/ut

Calculate the point ep at each

price on the table.

Given: Q = 120 - 4 P

Price

Quantity

ep

TR

Rs. 10
Rs. 20
Rs. 25
Rs. 28

Calculate the TR at each price

on the table.
Calculate arc ep at between
Rs.10 and Rs.20.
Calculate arc ep at between
Rs.25 and Rs.28.

Calculate arc ep at between Rs.20 and Rs.28.

Graph the demand function [labeling all axis and functions], identify
which ranges on the demand function are price elastic and which are
price inelastic.

Calculate the point ep at each

price on the table.

Given: Q = 120 - 4 P
Quantity

ep

TR

Rs. 10

80

-.5

Rs.800

Rs. 20

40

-2

Rs.800

Rs. 25

20

-5

Rs.500

Rs. 28

-14

Rs.224

Price

Calculate the TR at each price

on the table. TR = PQ
Calculate arc ep at between
Rs.10 and Rs.20.
ep = -1
Calculate arc ep at between
Rs.25 and Rs.28.
ep = -7.6

ep = -4
Calculate arc ep at between Rs.20 and Rs.28.
Graph the demand function [labeling all axis and functions], identify
which ranges on the demand function are price elastic and which are
price inelastic. At what price will TR by maximized?
P = Rs.15

Graphing Q = 120 - 4 P,
When ep is -1 TR is a maximum.
When |ep | > 1 [elastic], TR and P
move in opposite directions. (P has
a negative slope, TR a positive slope.)
When |ep | < 1 [inelastic], TR and P
move in the same direction. (P and TR
both have a negative slope.)
Arc or average ep is the average
elasticity between two point [or prices]

TR is a maximum
where ep is -1 or TRs
slope = 0

Price

pointep is the elasticity at a point or price.

The top half of the demand

function is elastic.

30

|ep | > 1 [elastic]

TR

ep = -1
|ep | < 1

15

inelastic
60

120 Q/ut

The bottom half of the demand

function is inelastic.

Price elasticity of demand describes

how responsive buyers are to change
in the price of the good. The more elastic, the more responsive to P.

Use of Price Elasticity

Ruffin and Gregory [Principles of Economics,
Addison-Wesley, 1997, p 101] report that:
short run |ep| of gasoline is = .15 (inelastic)
long run |ep| of gasoline is = .78 (inelastic)
short run |ep| of electricity is = . 13
(inelastic)
long run |ep| of electricity is = 1.89 (elastic)
Why is the long run elasticity greater than
short run?
What are the determinants of elasticity?

Determinants of Price Elasticity

Availability of substitutes [greater availability of
substitutes makes a good relatively more elastic]
Portion of the expenditures on the good to the
total budget [lower portion tends to increase
relative elasticity]
Time to adjust to the price changes [longer time
period means there are more adjustment possible
and increases relative elasticity
Price elasticity for brands is tends to be more
elastic than for the category of goods

An application of price elasticity.

The price elasticity of demand for milk is estimated between -.35 and -.5.
Using -.5 as a reasonable figure, there are several important observations that
can be made.
What effect does a
10% increase in the Pmilk
have on the quantity that
individuals are willing to buy ?

ep

Since p = -.5

To solve for % Q
Multiply both sides by +10%

-5%( =
(+10%)x
-.5p
=

A 10% increase in the price of milk would

reduce the quantity demanded by about
5%.
If price were decreased by 5%, what
would be the effect on quantity
A 10% increase
demanded?
in P reduces Q
by 5%

% Q
% P

% Q
% Q x (+10%)
% +10%
P

Pmilk
P2
P1

+10%
-5%
Q2 Q1

Dmilk
Qmilk

ep

% Q
% P

The price elasticity of demand is a measure of

the % Q that will be caused by a % P.

If the price elasticity of demand for air travel was estimated at -2.5, what
effect would a 5% decrease in price have on quantity demanded ?

-2.5 =

% Q

%
P
- 5%

=> +12.5% change in quantity demanded

If the price elasticity of demand for wine was estimated at -.8, what
effect would a 6% increase in price have on quantity demanded ?

-.8 =

% Q

%+6%
P

= -4.8% decrease in quantity demanded

If the price elasticity of demand for milk were -.5, the effects
of a price change on total revenue [TR] can also be estimated.
Since ,

ep

% Q
% P

When ep < 1, demand is inelastic. This means that

the % Q < % P . Since the % price
decrease is greater than the % increase in Q,
TR [TR = PQ] will decrease.

When ep < 1, a price decrease will decrease TR; a price increase will

increase TR, Price and TR move in the same direction. [inelastic demand
with respect to price]

When ep > 1, demand is elastic. This means that the % Q > % P .

When the % price decrease is less than the % increase in Q,

TR [TR = PQ] will increase.

When ep > 1, a price decrease will increase TR; a price increase will

decrease TR, price and TR move in opposite directions. [elastic demand

wrt price]

TR
Graphically this can be shown
TR = PQ, so the maximum TR is the
rectangle 0Q1 EP1

TR is a maximum

TR

elastic

P2

price rises

at the midpoint, ep = -1

+TR

P1

(P2 Q2) is less

As price rises into the elastic range

the TR will decrease. Notice that
in this range the slope of demand
is negative, the slope of TR is
positive

Price and
TR move in
opposite
directions

E
than
Loss in
(P
1 Qwhen
1)
TR
P

Q2

D
Q1

Q/ut

TR
When price elasticity of demand is
inelastic
A price decrease
will result in
a decrease in TR [PQ]. notice that
both TR and Demand have a
negative slope in the inelastic
range of the demand function.
Price and TR move in the same
direction.

A price decrease will reduce

TR; a price increase will
increase TR. Note that
this information is useful
but does not provide
information about profits!

TR is a maximum

TR

at the midpoint, ep = -1

P1
P0

inelastic

TR = P1 Q1
[Maximum]
results
in a smaller PQ

[TR]

Q1

Q0

Q/ut

Own Price Elasticity of Demand

ep is a measure of the responsiveness of
buyers to changes in the price of the good.
ep will be negative because the demand
function is negatively sloped.
A linear demand function will have unitary
elasticity at its midpoint. AT THIS POINT
TR IS A MAXIMUM!
A linear demand function will be more
elastic at higher prices and tends to be
more inelastic in the lower price ranges

Inelastic ep
When |ep| < 1 [less than 1] the demand is
inelastic
The |%Q| < |%P|, buyers are not very
responsive to changes in price.
An increase in the price of the good results
in an increase in total revenue [TR], a
decrease in the price decreases TR. Price
and TR move in the same direction

D1 is a perfectly elastic

D2

perfectly
inelastic

demand function.
For an infinitely small
change in price, Q changes
by infinity.
Buyers are very
responsive to price changes. An
infinitely small change in price
changes Q by infinity.

e p

0
%
Q
% P

ep = 0
perfectly elastic
ep = undefined
As the dema
nd function
becomes mo
horizontal, [
re
buyers are m
o
r
e
r
esponsive
to price chan
ges],ep app
roaches infin
ity.

==undefined
0

D2 is a perfectly inelastic demand function, no matter how

much the price changes the same amount is bought. Buyers
are not responsive to price changes! ep = 0, perfectly inelastic.

D1
De

Q/ut

Examples
Goods that are relatively price elastic
restaurant
meals,
china/glassware,
jewelry, air travel [LR], new cars,
in the long run, |ep| tends to be greater
Goods that are relatively price inelastic
electricity, gasoline, eggs, medical care,
shoes, milk
in the short run, |ep| tends to be less

Income Elasticity
[normal goods]

ey

% Qx

Income elasticity is a measure of the change in

demand [a shift of the demand function] that is
caused by a change in income.

% Y

[Where Y = income]

The increase in income, Y, increases demand

to D2. The increase in demand results in a
larger quantity being purchased at the
same Price [P1]..

At a price of P1 , the quantity demanded

given the demand D is Q
D1 . is the

demand function when the income is Y1 .

For a normal good an increase
in income to Y2 will shift the
demand to the right. This is an
increase in demand to D2.

Due to increase
in income,
demand
increases

P1

D2
D

% Y > 0; % Q> 0; therefore,

ey >0

[it is positive]

Q1
.

Q2 Q/ut

Income Elasticity [continued. . .]

[normal goods]

ey

% Qx
% Y

A decrease in income is associated with a decrease in

the demand for a normal good.

At income Y1, the demand D1 represents

the relationship between P and Q. At
a price [P1] the quantity [Q1] is
demanded.
% Y < 0 [negative];

For a decrease in income [-Y],

the demand decreases; i.e. shifts
to the left, at the price [P1 ], a
smaller Q2 will be purchased.

A decrease in income,

% Q < 0 [negative];

decreases
demand

so, ep > 0 [ positive]

P1
For either an increase or decrease in income
the ep is positive. A positive relationship
[positive correlation] between Y and Q
is evidence of a normal good.

D2
Q2

Q1

D1
Q/ut

When income elasticity is positive, the good is considered a normal

good. An increase in income is correlated with an increase in the
demand function. A decrease in income is associated with a
decrease in the demand function.
For both increases

The greater the value of y,

the more responsive buyers
are to a change in their incomes.

+ eeyy

Q
+-%%%Q
Q
x xx

and decreases in
income, ey is positive

% Y
+- %
% Y
Y

When the value of y is greater than 1, it is called a superior good.

The |% Qx| is greater than the |% Y|.
Buyers are very responsive to changes in
income. Sometimes superior goods are
called luxury goods.

ey

% Qx
% Y

Income Elasticity
[inferior goods]

There is another classification of goods where changes in income

shift the demand function in the opposite direction.
An increase in income [+Y] reduces demand.
An increase in income reduces
the amount that individuals
are willing to buy at each price
of the good. Income elasticity
is negative: - ey

-e
eyy =

-%%Q
Q

xx

%+Y
Y

decreases
demand

P1
The greater the absolute value
of - ey, the more responsive buyers
are to changes in income

- %Qx
Q2

D2
Q1

D1
Q/ut

Income Elasticity
[inferior goods]
Decreases in income increase the demand for inferior goods.
A decrease in income [-Y] increases demand.
A decrease in income [-Y]
results in an increase in demand,
the income elasticity of demand
is negative
For both increases and decreases in
income the income elasticity is negative
for inferior goods. The greater the
absolute value of ey, the more responsive
buyers are to changes in income

- eyey

% Y
-Y

P1

D2

+%Q
Q1

. .

+%Q
%
Qxx

D1
x

Q2 Q/ut

Income Elasticity
Income elasticity [ey] is a measure of the
effect of an income change on demand. [Can
be calculated as point or arc.]
ey > 0, [positive] is a normal or superior
good an increase in income increases
demand, a decrease in income decreases
demand.
0 < ey < 1 is a normal good
1 < ey is a superior good
ey < 0, [negative] is an inferior good

Examples of y
normal goods, [0 < ey < 1 ], (between 0
and 1)
coffee, Coca-Cola, food, Physicians
services, hamburgers, . . .
Superior goods, [ ey > 1], (greater than 1)
movie tickets, foreign travel, wine, new
cars, . . .
Inferior goods, [ey < 0], (negative)
Country wine, beans, . . .

Cross-Price Elasticity
Cross-price elasticity [exy] is a measure of how responsive
the demand for a good is to changes in the prices of related
goods.
Given a change in the price of good Y [Py ], what is the
effect on the demand for good X [Qy ]?

exy is defined as:

exy

%Q
%

Cross-price elasticity of demand , [exy]

[substitutes]

Pp
2

When pork is Rs.1.50, Qp pork

is purchased.
price of pork increases
The quantity demanded
of pork decreases.

for an increase

1.50

in Ppork,

-Qp

Qp
.

[price of beef]

[price of pork]

When the price of pork increases, it will tend to increase the demand
for beef. People will substitute beef, which is relatively cheaper, for
pork, which is relatively more expensive.

Qp

Dp

pork/ut

When beef is Rs.2, Qb beef

is purchased.
Pb
at Pb = Rs.2 more
increase
beef will be bought
demand
to substitute for
the smaller
2
quantity of
pork.
demand for
Db
beef increases
Db

Qb

Qb

beef/ut

Cross-price elasticity
In the case of beef and pork
the ebp is not the same as epb
ebp is the % change in the demand for beef with respect
to a % change in the price of pork

epb is the % change in the demand for pork with respect

to a % change in the price of beef
beef may not be a good substitute for pork
pork may not be a good substitute for beef

Cross-price elasticity of demand , [exy]

[substitutes]

The cross elasticity of the demand for beef with respect to the
price of pork, ebeef-pork or ebp can be calculated:

+ebp
ebp =
positive

+Q
Q
%
ofb beef
%P+ofP
pork
p

An increase in the price of pork,

causes an increase in the demand
for beef.

cross elasticity is positive

+eebpbp =
positive

- Qb
% Q of beef
%P of pork
- Pp

A decrease in the price of pork,

causes a decrease in the demand
for beef.

If goods are substitutes, exy will be positive. The greater the

coefficient, the more likely they are good substitutes.

Cross-price elasticity of demand , [exy]

[compliments]

Pc

a decrease in the price

of crayons,

P1
Po

Pc

as more crayons are

purchased, the
demand for colour
books increases.

increase
demand

At the same
price a larger
quantity will
be bought

Rs.3

-Pc

Dp

Dc
Q2

Q1

crayons

increases the quantity demanded

of crayons

- ebc

bc
negative

Q
%+ Q
ofbb
%P of c

- Pc

2000

2500

+ Qb

Dc
colour books

for compliments, the cross

elasticity is negative for price
increase or decrease.

Cross-Price Elasticity
exy > 0 [positive], suggests substitutes, the
higher the coefficient the better the
substitute
exy < 0 [negative], suggests the goods are
compliments, the greater the absolute value
the more complimentary the goods are
exy = 0, suggests the goods are not related
exy can be used to define markets in legal
proceedings

Elasticity of Supply
Elasticity of supply is a measure of how
responsive sellers are to changes in the
price of the good.
Elasticity of supply [ep] is defined:

% Quantity Supplied

% price

Elasticity of supply

es =
Given a supply function,

P1

%P

at a price [P1], Q1 is produced and offered

for sale.

P2

%Qsupplied

a larger
At a higher price [P
2],
quantity, Q2, will be produced
and offered for sale.
The increase in price [ P ], induces
a larger quantity goods [ Q]for
sale.

+P

The more responsive sellers are to

P, the greater the absolute value of s.

+Q
Q1

Q2

Q /ut

[The supply function is flatteror

more elastic]

The supply function is a

model of sellers behavior.

Si a perfectly inelastic
supply, es = 0

Sellers behavior is influenced by:

1. technology
2. prices of inputs
3. time for adjustment
market period
short run
long run
very long run

4. expectations
5. anything that influences costs of production
taxes
regulations, . . .

Se
a perfectly
elastic supply
[es is undefined.]

Q /ut

Elasticity
Price elasticity of demand [measures a move on a demand
function caused by change in price/arc or point]
elastic, inelastic or unitary elasticity
income elasticity [measures a shift of a demand function
associated with a change in income]
superior, normal, and inferior
cross elasticity
measure the shift of a demand function for a good
associated with the change in the price of a related good
[compliment/substitute]
price elasticity of supply [measures move on a supply
curve]