- Economic Theory is an important component of the subject matter of economic.
- It studies the present and expected behaviour of economic variables like supply, demand, income, consumption and investment.
- It establishes the cause and effect relationship between economic variables.
- For example, it establishes that increase in income is the cause of increase in consumption or that there is a positive relationship between income and consumption.
- Likewise, it establishes that increases in price of commodity (Px) causes decrease in its quantity demanded (Dx).
- Thus, there is negative relationship, between Px, and Dx. popularly known as ‘law of demand’.
Functions of an Economic Theory
Important function of economic theory are as under:
- Simplification: By establishing cause and effect relationship between different economic variables, economic theory simplifies the understanding of economic events
- Prediction: Economic theory underscores the logical relationship between different economic variables that help us to predict the course of economic events.
- Policy Formulation: Establishing logical relationships between economic variables, economic theory facilitates the formulation of plans and policies for the growth and development of the country.
- In other words, Scarcity means that commodities and resources to produce goods and services are less in relation to their demand.
- Mc Connell: “Scarcity is a situation in which there is not enough of resources to meet all human wants.”
Law of Demand
- The law of demand states that, other things being equal, the demand for a good extends with a decrease in prices and contracts with an increase in price.
- In other words, there is and inverse relationship before quantity demanded of a thing and it price, provided other factor influencing demand remain unchanged.
- The term other things being equal implies that income of the consumer, his tastes and preferences and prices of other related goods remain constant.
- Marshall, “The Law of Demand states that other things being equal the amount demanded increases with a fall in price and diminishes when price increases.”
Assumptions of the Law of Demand
- Law of demand holds good when “other things remain the same.”
- It means factors influencing demand other than price are assumed to be constant.
- These constitute the assumptions of the law. It applies to normal goods and not to Giffen goods.
- The main assumptions of the law are as follows:
- Tastes and preferences of the consumers remain constant.
- There is no change in the income of the consumer.
- Prices of the related goods do not change
- Consumers do not expect any change in the price of the commodity in the near future.
Causes of Decrease in Demand
Important causes of decrease in Demand are as under:
- When income of the consumer falls.
- When price of the substitute good decreases.
- When price of the complementary good increases.
- When taste of the consumer shifts against the commodity due to change in fashion or climate.
- When price of the commodity is expected to decrease in the near future.
- Decrease in the number of consumers
- When the income of the consumer is expected to fall in near future.
- Effect of change in income of the buyer on the demand for a commodity is studied with reference to (i) Normal Goods and Inferior Goods.
Degrees of Price Elasticity of Demand
- In Economics five cases of elasticity of demand are studied depending upon their degrees:
- Perfectly Elastic,
- Perfectly Inelastic,
- Unit Elastic,
- More than unit Elastic or Elastic,
- Less than unit Elastic or Inelastic.
- Perfectly Elastic Demand: A perfectly elastic demand refers to the situation when demand is infinite at the prevailing price. It is a situation where the slightest rise in price causes the quantity demanded of the commodity to fall to zero. Fig 4 is a diagrammatic representation of perfectly elastic demand. CD is perfectly elastic demand curve which is parallel to OX-axis. It shows that if price is slightly increased from Rs. 4/- the consumer may buy 10 or 30 units or any quantity that the desires. In this condition, elasticity of demand (Ed) is infinite ∞ or Ed = ∞. It may be noted that under perfect competition demand curve facing a firm is perfectly elastic.
- Perfectly Inelastic Demand: A perfectly inelastic demand is one in which a change in price causes no change in the quantity demanded. It is a situation where even substantial changes in price leave the demand unaffected.
- Unitary Elastic Demand: It is a situation when change in quantity demanded in response to change in price of the commodity is such that total expenditure on the commodity remains constant.
- Greater than Unitary Elastic: Demand is greater than unitary elastic when change in quantity demanded in response to change in price of the commodity is such that total expenditure on the commodity increases when price decreases, and total expenditure decreases when price increases.
- Less than Unitary Elastic: Demand is less than unitary elastic when change in quantity demanded in response to change in price of the commodity is such that total expenditure on the commodity decreases when price decreases, and total expenditure increases when price increases.
Factors Determining Price Elasticity of Demand
- Nature of Commodity: Ordinarily, necessaries like salt, kerosene oil, match boxes, text books, seasonal vegetables etc. have less than unitary elastic (inelastic) demand).
Luxuries, like air-conditioner, costly furniture, fashionable garments etc. have greater than unitary elastic demand. The reason being that change in their price has a great effect on their demand.
Comforts like milk, transistor, cooler, fans etc. have neither very elastic nor very inelastic demand.
Jointly demanded goods, like, car and petrol, pen and ink, camera and film, etc., have ordinarily inelastic demand.
- Availability of Substitutes: Demand for these commodities which have substitutes, (for example, tea has its substitute in coffee, orange juice has its substitute in lime juice) are relatively more elastic.
The reason being that when the price of commodity falls in relation to its substitute the consumers will go in for it and so its demand will increase.
Commodities having no substitutes like cigarettes, liquor etc. have inelastic demand.
- Different Uses of Commodity: Commodities that can be put to variety of uses have elastic demand. For instance, electricity has multiple uses.
It is used for lighting, room-heating, air-conditioning, cooking etc. If the tariffs of electricity increase its use will be restricted to important purpose like lighting. It will be withdrawn from less important uses.
On the other hand, if a commodity such as paper has only a few uses its demand is likely to be inelastic.
- Postponement of the Use: Demand will be elastic for those commodities whose consumption can be postponed. For instance, demand for constructing a house can be postponed. As a result, demand for bricks, cement, sand, gravel etc. will be elastic.
Conversely, goods whose demand cannot be postponed, their demand will be inelastic.
- Income of Consumer: People whose income are very high or very low, their demand will ordinarily be inelastic.
Because rise or fall in price will have little effect on their demand. Conversely, middle income groups will have elastic demand.
- Habit of Consumer: Goods to which a person becomes accustomed will have inelastic demand like cigarette, coffee, tobacco etc.
It is so, because a person cannot do without them.
- Proportion of Income spent on a Commodity: Goods on which a consumer spends a very small proportion of his income, i.e., toothpaste, boot-polish, newspaper, needles etc. will have an inelastic demand.
On the other hand, goods on which the consumer spends a large proportion of his income, i.e., cloth, scooter etc. their demand will be elastic.
- Price-level: Elasticity of demand also depends upon the level of price of the concerned commodity.
Elasticity of demand will be high at higher level of the price of the commodity and low at the lower level of the price.
- Time Period: Demand in inelastic in short-period but elastic in long period.
It is so because in the long-run a consumer can change his habits.
So rise in price in the long-run is followed by relatively more fall in demand.
- Supply function studies the functional relationship between supply of a commodity and its various determinants.
- The supply of a commodity mainly depends on the goal of the firm, price of the commodity, price of other goods, prices of factors of production used in the production of the commodity and state of technology.
- Price of the Commodity: There is a direct relationship between price of a commodity and its quantity supplied. Generally higher the price, higher the quantity supplied,and lower the price lower the quantity supplied.
- Prices of other Goods: The supply of a goods depends upon the prices of other good. As increase in the prices of other goods makes them more profitable for the firms.
They will increase their supply. On the other hand, the supply of the good, the price of which has not charged, will become relatively profitable.
The supply of such a good may decrease.
- Number of Firms: Market supply of a commodity also depends upon number of firms in the market. Increase in the number of firms implies increase in market supply and conversely decrease in the number of firms implies decrease in market supply of a commodity.
- Goal of the Firm: If the Goal of the firm is to maximize profits, more quantity of the commodity will be offered at high price.
- On the other hand, if the goal of the firm is to maximize sales or maximize output or employment more will be supplied even at the same price.
- Price of Factor of Production: Supply of commodity is also affected by the price of factors used for the production of the commodity.
If the factor price decreases, cost of production also reduces, accordingly supply increases. Conversely, if the factor price increases cost of production also increase and supply tends to decrease.
- Change in Technology: Chang in Technology also effects supply of the commodity. Improvement in the technique of production reduces cost of production. Consequently, profits tend to increase inducing an increase in supply.
- Expected Future Price: If the producer expects price of the commodity to rise in the near future, current supply of the commodity should reduce.
If on the other hand, fall in the price is expected, current supply should increase.
- Government Policy: Taxation and subsidy policy of the Government also effect market supply of the commodity. Increase in taxation tends to reduce the supply, while subsidies tend to induce greater supply of the commodity.
Causes of Increase in Supply
- Improvement in technology
- Reduction in the price of factors of production causing fall in cost of production.
- Increase in price of related goods.
- Increase in number of firms in the market.
- When the firm expects a fall in the price of the commodity in near future.
- When goal of the firm shifts from maximisation to sales maximisation. (a) Same price More Quantity
Causes of Decrease in Supply
- When the technique become obsolete resulting in high cost of production
- When factor increase causing increase in cost of production.
- When prices of related goods fall.
- Decrease in number of firms in the market.
- When the firm expects a rise in commodity price in the near future.
- Objective of the firm shifts from sales maximisation to profit maximisation.
Degrees of Elasticity of Supply
Perfectly Elastic Supply: Perfectly elastic supply results in an infinite change in quantity due to a very small change in price.
Factors Affection Elasticity of Supply
- Nature of the Inputs used: The elasticity of supply depends on the nature of inputs used for the production of commodity. If the production of a product utilizes factors of production that are commonly used to produce other products, it will tend to have a more elastic supply.
On the other hand, if it uses specialised factors of production suited only for its production, its supply will be relatively inelastic.
- Natural Constraints: The elasticity of supply is also influenced by the natural constraints in the production of a commodity.
The nature places restrictions upon supply.
If we wish to produce more teak wood, it will take years of plantation before it becomes usable.
- Risk Taking: The elasticity of supply depends on the willingness of entrepreneurs to take risk.
If entrepreneurs are willing to take risk, the supply will be more elastic. On the other hand if entrepreneurs hesitate to take risk, the supply will be inelastic
- Nature of the Commodity: Perishable commodities have inelastic supply, because their supply cannot be increased or decreased, even when price changes.
On the contrary, supply of durable goods is elastic, because their supply can be increased or decreased as a result of increase or decrease in price.
- Cost of Production: Elasticity of supply is also influenced by cost of production.
If production is subject to law of increasing costs, then supply of such goods will be inelastic.
- Time Factor: Elasticity of supplies also influenced by time factor. Longer the time period greater will be the elasticity of supply.
On the other hand, shorter the time-period, smaller will be the elasticity of supply, because it is not possible to change the supply of the goods in short period. In analysing the impact of time upon the elasticity of supply, economists find it useful to distinguish between
- Very Short Period: In very short period, there is insufficient time to change output so supply is perfectly inelastic
- Short Period: In short period the plant capacity is fixed but output can be altered by changing the intensity of its use, supply is therefore more elastic;
- Long Period: In the long period, all desired adjustments including changes in plant capacity can be made, and supply becomes still more elastic.
- Technique of Production: If the production technique of a commodity is quite complex and needs large stock of capital ,then the supply of that commodity will be inelastic, because supply will not be amenable to change easily due to change in price.
On the other hand, goods involving simple technique of production will have elastic supply.