Adam Smith’s Definition of Economics

Adam Smith was a Scottish philosopher, widely considered as the first modern economist.
Smith defined economics as “an inquiry into the nature and causes of the wealth of nations.”

Criticism of Smith’s Definition

 The wealth-centric definition of economics limited its scope as a subject and was seen
as narrow and inaccurate.
 Smith’s definition forced the subject to ignore all non-wealth aspects of human
existence.
 The Smithian definition over-emphasized the material aspects of well-being and ignored
the non-material aspects.
 It was assumed that human beings acted as rational economic agents who mindlessly
strived to maximize their own well-being.
 The Smithian definition prevents the subject from exploring the concept of resource
scarcity. The allocation and use of scarce resources are seen as a central topic of
analysis in modern economics.

Alfred Marshall’s Definition of Economics

British economist Alfred Marshall defined economics as “the study of man in the ordinary
business of life.” Marshall argued that the subject was both the study of wealth and the study
of mankind. He believed it was not a natural science such as physics or chemistry, but rather a
social science.

Criticism of Marshall’s Definition

 The Marshallian definition, like the Smithian definition, ignored the problem of scarce
resources, which possess unlimited potential uses.
 Marshall’s definition restricted economics as a subject to only analyze the material
aspects of human welfare. Non-material aspects of welfare were ignored.

Lionel Robbin’s Definition of Economics

Lionel Robbin, another British economist, defined economics as the subject that studies the
allocation of scarce resources with countless possible uses. “Economics is the science which
studies human behavior as a relationship between given ends and scarce means which have
alternative uses.”

Criticism of Robbin’s Definition

Robbin’s definition prevented it from analyzing macroeconomic concepts such as national
income and aggregate supply and demand. Instead, economics was merely used to analyze the
action of individuals, using stylized mathematical models.

Modern Definition of Economics

The modern definition, attributed to the 20th-century economist, Paul Samuelson, builds upon
the definitions of the past and defines the subject as a social science. According to Samuelson,
“Economics is the study of how people and society choose, with or without the use of money,
to employ scarce productive resources which could have alternative uses, to produce various
commodities over time and distribute them for consumption now and in the future among
various persons and groups of society.”

Subject Matter of Economics

 Microeconomics
 Macroeconomics
 The subject matter of economics is concerned with wants, efforts and satisfaction.
Economics tells how to utilize limited resources for the satisfaction of unlimited wants. Man
has limited amount of time and money. He should spend time and money in such away that
he derives maximum satisfaction. A man wants food, clothing and shelter. To get these
things he must have money. For getting money he must make an effort. Effort leads to
satisfaction. Thus, wants- efforts- satisfaction sums up the subject mater of economics
initially in a primitive society where the connection between wants efforts and satisfaction
is direct .
 If we take a broad view of the subject matter of economics we may say that, Economics is
the study of all phenomena relating to wealth and value. It is one of the social sciences that
deal with economic goods, the creation of wealth through the satisfaction of human wants,
 the explanation of wealth, value and price, the distribution of income and the mechanism of
exchange and markets of an economy.

Microeconomics বা ব্যষ্টিক অর্থনীতি (বা ক্ষু দ্র অর্থনীতি) অর্থনীতির একটি মৌল শাখা যাতে ব্যক্তি এবং ব্যবসাপ্রতিষ্ঠানের ভোগ ও উপযোগ,
উৎপাদন, মূল্য, মুনাফা ইত্যাদির নিয়ামক নিয়ে আলোচনা করা হয়। বাজার অর্থনীতিতে বাজারে পণ্যের ও সেবার বিনিময় ঘটে। পণ্যের ও সেবা থেকে
ব্যক্তি বা ভোক্তা উপযোগ লাভ করে। বাজরে পণ্য ও সেবা বিনিময়ের প্রধান দুটি নিয়ামক হলো ব্যক্তির (বা পরিবারের) পণ্য বা সেবার চাহিদা ও উৎপাদক
কর্তৃ ক সেসবের যোগান। কোন্‌নিয়ামক (মূল্য বা আয় ইত্যাদি) কী ভাবে ভোগ তথা চাহিদার পরিমাণ নিরূপণ করে এবং উৎপাদকের ক্ষেত্রে কোন্‌কোন্‌
নিয়ামক (উৎপাদন ব্যয়, সরকারি কর, বাজারের শ্রেণী বা প্রকৃ তি) কী ভাবে পণ্য বা সেবার উৎপাদন, মূল্য, বিক্রয় ও মুনাফার পরিমাণ নিরূপণ করে এ
সবই ব্যষ্টিক অর্থনীতি বা ব্যষ্টিক অর্থশাস্ত্রের আলোচ্য বিষয়।

Macroeconomics বা সামষ্টিক অর্থনীতি অন্তর্ভু ক্ত করে “ অর্থনৈতিক কার্যক্রমের সবগুলোর যোগফলকে, প্রবৃদ্ধি, মুদ্রাষ্ফীতি ও বেকার সমস্যা
বিষয়ক তত্বাবধান এবং এইসব বিষয়ে সম্পর্ক যুক্ত জাতীয় অর্থনৈতিক নীতিসমুহ” এবং ইহা সরকারি কার্যক্রম (যেমন, কর স্তর পরিবর্ত ন) কে প্রভাবিত
করে। বিশেষ করে লুকাস সমালোচনায় বলা হয় যে, বেশির ভাগ আধুনিক সামষ্টিক অর্থনীতি তত্ত্বসমুহ ব্যষ্টিক অবকাঠামোর উপর প্রতিষ্ঠিত - ইহা ব্যষ্টিক-
স্তর আচরনের অনুমিত শর্ত সমুহের ভিত্তি।

Econometrics
Econometrics is the application of statistical methods to economic data in order to give
empirical content to economic relationships.

Econometrics is the quantitative application of statistical and mathematical models using data
to develop theories or test existing hypotheses in economics and to forecast future trends from
historical data. It subjects real-world data to statistical trials and then compares and contrasts
the results against the theory or theories being tested.

Econometrics analyzes data using statistical methods in order to test or develop economic
theory. These methods rely on statistical inferences to quantify and analyze economic theories
by leveraging tools such as frequency distributions, probability, and probability distributions,
statistical inference, correlation analysis, simple and multiple regression analysis, simultaneous
equations models, and time series methods.

Basic Concepts of Economics

 Unlimited Want (অসীম অভাব)

 Scarcity and Choice (দুষ্প্রাপ্যতা ও নির্বাচন)
 Oportunity Cost (সুযোগ ব্যয়)
 Supply and Demand
 Time Value of Money
 Scale of Preference
 Purchasing Power

Fundmental Economic Problem

  The fundamental economic problem is the issue of scarcity and how best to produce
and distribute these scare resources.
 Scarcity means there is a finite supply of resources (goods and raw materials).
 Finite resources mean they are limited and can run out.
 Unlimited wants mean that there is no end to the quantity of goods and services people
would like to consume.
 Because of unlimited wants – People would like to consume more than it is possible to
produce (scarcity).

Therefore because of scarcity, economics is concerned with: What to produce? How to

produce? For whom?

Economic systems as a type of social system must confront and solve the three fundamental
economic problems:

1. What kinds and quantities of goods shall be produced, "how much and which of alternative
goods and services shall be produced?"
2. How shall goods be produced? ..by whom and with what resources (using what
technology)...?"
3. For whom are the goods or services produced? Who benefits? Samuelson rephrased this
question as "how is the total of the national product to be distributed among different
individuals and families?"

The economic problem can be divided into three different parts, which are given below.

Problem of allocation of resources

The problem of allocation of resources arises due to the scarcity of resources, and refers to the
question of which wants should be satisfied and which should be left unsatisfied. In other
words, what to produce and how much to produce.

Resources are scarce and it is important to use them as efficiently as possible. Thus, it is
essential to know if the production and distribution of national product made by an economy is
maximally efficient. The production becomes efficient only if the productive resources are
utilized in such a way that any reallocation does not produce more of one good without
reducing the output of any other good.

The problem of full employment of resources

In view of the scarce resources, the question of whether all available resources are fully utilized
is an important one. A community should achieve maximum satisfaction by using the scarce
resources in the best possible manner—not wasting resources or using them inefficiently. There
are two types of employment of resources: Labour-intensive, Capital-intensive

The problem of economic growth

If productive capacity grows, an economy can produce progressively more goods, which raises
the standard of living. The increase in productive capacity of an economy is called economic
growth. There are various factors affecting economic growth. The problems of economic
growth have been discussed by numerous growth models, including the Harrod-Domar model,
the neoclassical growth models of Solow and Swan, and the Cambridge growth models of
Kaldor and Joan Robinson. This part of the economic problem is studied in the economies of
development.

Positive and Normative Economics

Positive and Normative Economics is rightly known as the two arms of Economics. Positive
economics deals with various economic phenomena, while normative economics focuses on
what economics should be, this branch of economics talks about the value of the company’s
fairness. In lucid language, positive economics answers the ‘what’ factor, whereas normative
economics mandates the ‘should be’ or ‘ought to be’ section of economics.

Positive Economics: The term positive economics refers to the objective analysis in the study of
economics. Most economists look at what has happened and what is currently happening in a
given economy to form their basis of predictions for the future. This investigative process is
positive economics.

Normative Economics: Normative economics is a perspective on economics that reflects

normative, or ideologically prescriptive judgments toward economic development, investment
projects, statements, and scenarios.

Key Takeaways

 Positive economics is an objective stream of economics that relies on facts or what is

happening.
 Conclusions drawn from positive economics analyses can be tested and backed up by data.
 Positive economic theory does not provide advice or instruction.
 Statements based on normative economics include value judgments or what should be in
the future.
 Normative economics aims to determine what should happen or what ought to be.
 While positive economics describe economic programs, situations, and conditions as they
exist, normative economics aims to prescribe solutions.
 Normative economics expresses ideological judgments about what may result in economic
activity if public policy changes are made.
 Behavioral economics tends to be a normative project.
 Normative economics cannot be verified or tested.
 Positive economics and normative economics can work hand in hand when developing
policy.

Scarcity
Scarcity refers to the tension between limited resources and unlimited wants. This situation
requires people to make decisions about how to allocate resources efficiently, in order to
satisfy basic needs and as many additional wants as possible.

Opportunity Cost
Opportunity costs represent the potential benefits that an individual, investor, or business
misses out on when choosing one alternative over another. (Accounting - Opportunity cost is
the profit lost when one alternative is selected over another.) The concept works such that the
highest valued alternative must be left when a choive is poissible.

In microeconomic theory, the opportunity cost of a particular activity option is the loss of value
or benefit that would be incurred (the cost) by engaging in that activity, relative to engaging in
an alternative activity offering a higher return in value or benefit.

In basic equation form, opportunity cost can be defined as:

Opportunity Cost = (returns on best Forgone Option) - (returns on Chosen Option)

Directly or indirectly, opportunity cost underpins the majority of day-to-day economic decisions
that are made in society. For example, the opportunity cost of mowing one’s own lawn for a
doctor or a lawyer (who might otherwise make $100 an hour if they elected to work overtime
during that time instead) would be higher than for a minimum-wage employee (who in the
United States might earn $7.25 an hour), which would make the former more likely to hire
someone else to mow their lawn for them.

As a representation of the relationship between scarcity and choice, the objective of

opportunity cost is to ensure efficient use of scarce resources. It incorporates all associated
costs of a decision, both explicit and implicit.
Microeconomics
Microeconomics is the study of decisions made by people and businesses regarding the
allocation of resources, and prices at which they trade goods and services. It considers taxes,
regulations, and government legislation.

Microeconomics focuses on supply and demand and other forces that determine price levels in
the economy. It takes a bottom-up approach to analyzing the economy. In other words,
microeconomics tries to understand human choices, decisions, and the allocation of resources.

Having said that, microeconomics does not try to answer or explain what forces should take
place in a market. Rather, it tries to explain what happens when there are changes in certain
conditions.

For example, microeconomics examines how a company could maximize its production and
capacity so that it could lower prices and better compete.

A lot of microeconomic information can be gleaned from company financial statements.

Microeconomics involves several key principles, including (but not limited to):

 Demand, Supply and Equilibrium: Prices are determined by the law of supply and demand.
In a perfectly competitive market, suppliers offer the same price demanded by consumers.
This creates economic equilibrium.
 Production Theory: This principle is the study of how goods and services are created or
manufactured.
 Costs of Production: According to this theory, the price of goods or services is determined
by the cost of the resources used during production.
 Labor Economics: This principle looks at workers and employers, and tries to understand
patterns of wages, employment, and income.

The rules in microeconomics flow from a set of compatible laws and theorems, rather than
beginning with empirical study.

Macroeconomics
(Source: Investopedia)

Macroeconomics, on the other hand, studies the behavior of a country and how its policies
impact the economy as a whole. It analyzes entire industries and economies, rather than
individuals or specific companies, which is why it is a top-down approach. It tries to answer
questions such as “What should the rate of inflation be?” or “What stimulates economic
growth?”

Macroeconomics examines economy-wide phenomena such as gross domestic product (GDP)

and how it is affected by changes in unemployment, national income, rates of growth, and price
levels. Macroeconomics analyzes how an increase or decrease in net exports impacts a nation’s
capital account, or how gross domestic product (GDP) is impacted by the unemployment rate.
Macroeconomics focuses on aggregates and econometric correlations, which is why
governments and their agencies rely on macroeconomics to formulate economic and fiscal
policy. Investors who buy interest-rate-sensitive securities should keep a close eye on monetary
and fiscal policy.

(Source: Byjus)

Macroeconomics studies the association between various countries regarding how the policies
of one nation have an upshot on the other. It circumscribes within its scope, analysing the
success and failure of the government strategies.

In macroeconomics, we normally survey the association of the nation’s total manufacture and
the degree of employment with certain features like cost prices, wage rates, rates of interest,
profits, etc., by concentrating on a single imaginary good and what happens to it.

The important concepts covered under macroeconomics are as follows:

 Capitalist nation
 Investment expenditure
 Revenue

Examples: Aggregate demand, and national income.

(Source: TheInvestorsbook.com)

Definition: Macroeconomics is that specialized field of economics which focuses on the overall
economy. It works on the aggregate value of the various individual units, to determine its more
substantial impact on the whole nation. All the prominent reforms and policies are based on
this concept.

For instance; the nation’s income is computed as the per capita income, which is nothing but
the average of the total earning of all the citizens in that country.
Content: Macroeconomics

1. Scope
 Theories
 Policies
2. Importance
3. Issues
4. Limitations
5. Conclusion

Scope of Macroeconomics

Macroeconomics is a vital field of study for the economists, government, financial bodies and
researchers to analyze the general national issues and economic well-being of a country.

Macroeconomics widely cover two major fundamentals which are further sub-parted into
multiple topics, as explained below-

Macroeconomics Theories

Government, as we know, is the regulatory body of a nation, it considers the various aspects
which are crucial and impacts the lives of the citizens.

There are six significant theories under macroeconomics:

Economic Growth and Development: The status of a country’s economy can be evaluated in
terms of the per capita real income, as studied under macroeconomics.

Theory of National Income: It covers the various topics related to the evaluation of national
income, including the income, expenditure and budgeting.

Theory of Money: Macroeconomics analyzes the functions of the reserve bank in the economy,
the inflow and outflow of money, along with its impact on the employment level.

Theory of International Trade: It is a field of study that enlightens upon the export and import
of goods or services. In brief, it determines the impact of cross-border trade and duty charged,
on the economy.

Theory of Employment: This stream of macroeconomics helps to figures out the level of
unemployment and prevailing employment conditions in the country. Also, to know how it
affects the supply, demand, savings, consumption, expenditure behaviour.

Theory of General Price Level: The most important of all is the analysis of product pricing and
how these price levels fluctuate because of inflation or deflation.

Macroeconomics Policies

The government & the reserve bank functions together while determining the macroeconomic
policies, for the nation’s welfare and development.

The two segments of this section are as follows:

Fiscal Policy: As we know, fiscal policy is a means of meeting the deficit of income over the
expenditure; it is a form of budgetary decision under macroeconomics.

Monetary Policy: Monetary policy is framed by the reserve bank in collaboration with the
government. These policies are the measures taken to maintain economic stability and growth
in the country by regulating the various interest rates.

Importance of Macroeconomics

The answer is macroeconomics is a vital concept that considers the whole nation and works for
the welfare of the economy.
Trade Cycle Analysis- It is beneficial for timing the economic fluctuations to avoid or be
prepared for any financial crises or adverse situations.

Economic Policies Formulation- Framing of the monetary and fiscal policies majorly depends

upon the study of prevailing macroeconomic conditions in the country.

Downsizes the Effect of Inflation and Deflation- Macroeconomics also helps the government
and the financial bodies to be prepared for the situations of economic instability.

Facilitates Material Welfare- This stream of economics gives a broader perspective of social or
national issues. Therefore, the ones who look forward to contributing to the welfare of society
needs to study macroeconomics.

Regulates Economic System- It ensures or keeps a check over the proper functioning of the
country’s economy and actual position.

Resolves Economic Issues- The analysis of macroeconomics theories and issues helps the
economists and the government to figure out the causes and possible solutions of such macro-
level problems.

Economic Development- Dealing with different economic conditions by making use of

macroeconomics research, opens up the way towards the country’s growth.
Limitations of Macroeconomics

 Considers Aggregates as Homogenous: The individual data may not be similar in

structure or composition. Thus, when such single figures are compiled to get an
aggregate value, it may not seem to be that useful.

 Misleading: The extensive application of the macroeconomics measures seems to be

irrelevant when aimed at 100% results.

 Fallacy of Deductive Inferences: Macroeconomics function on aggregate values. But,

the interpretation of the individual activities may not be the same as compared to the
conclusion drawn on a mass level.

 Conceptual and Statistical Complexities: When the individual data have different units,
its aggregation becomes arduous and holds no significance.

 Unnecessary Aggregate Variables: When the individual elements need to be examined

separately, the aggregate values cannot be used for the purpose.

 Neglects Individual Consumers: The concept of macroeconomics overlooks the

importance of the individual unit or consumer since the fundamental is to make use of
the aggregates.
  Too Much Generalization: The conclusion derived from the aggregation of the data, is
generally taken to be true for all the individuals.

Differences Between Microeconomics And Macroeconomics

Microeconomics Macroeconomics

Meaning

Microeconomics is the branch of Economics Macroeconomics is the branch of Economics

that is related to the study of individual, that deals with the study of the behaviour and
household and firm’s behaviour in decision performance of the economy in total. The most
making and allocation of the resources. It important factors studied in macroeconomics
comprises markets of goods and services and involve gross domestic product (GDP),
deals with economic issues. unemployment, inflation and growth rate etc.

Area of study

Microeconomics studies the particular Macroeconomics studies the whole economy,

market segment of the economy that covers several market segments

Deals with

Microeconomics deals with various issues Macroeconomics deals with various issues
like demand, supply, factor pricing, product like national income, distribution,
pricing, economic welfare, production, employment, general price level, money,
consumption, and more. and more.

Business Application

It is applied to environment-al and external

It is applied to internal issues.
issues.
 
 

Scope
It covers several issues like demand, supply,
It covers several issues like distribution,
factor pricing, product pricing, economic
national income, employment, money, general
welfare, production, consumption, and
price level, and more.
more.

Significance

It is useful in regulating the prices of a It perpetuates firmness in the broad price

product alongside the prices of factors level, and solves the major issues of the
of production (labour, land, entreprene- economy like deflation, inflation, rising
ur, capital, and more) within the prices (reflation), unemployment, and
economy. poverty as a whole.

Limitations

It has been scrutinised that the

It is based on impractical misconception of composition’
presuppositions, i.e., in microeconomics, incorporates, which sometimes fails to
it is presumed that there is full prove accurate because it is feasible that
employment in the community, which is what is true for aggregate
not at all feasible. (comprehensive) may not be true for
individuals as well.
Demand (P-55)
Demand is an economic principle referring to a consumer's desire to purchase goods or services
and willingness and ability to pay a price for a specific good or service.

Demand is always quoted with price & time e.g. Demand for whole milk for middle income
household is 1 liter per day at price of Rs. 28 per liter. Thus demand may be defined as ‘The
demand for a product is the amount of it which will be bought per unit of time at a particular
price.

Characteristics:
1. Willingness, desire and ability to pay.
2. Demand is always at a price
3. Demand is always per unit of time.

Types of Demand:
1. Market demand is the total quantity demanded across all consumers in a market for a
given good.
2. Aggregate demand is the total demand for all goods and services in an economy.
3. Direct demand is the demand for a final good. Food, clothing and cell phones are an
example of this. Also called autonomous demand, it is independent of the demand for
other products.
4. Derived demand is the demand for a product that comes from the usage of others. For
example, the demand for pencils will result in the demand for wood, graphite, paint and
eraser materials. In this example, the demand for wood is dependent on the demand for
its uses.
5. Price demand relates to the amount a consumer is willing to spend on a product at a
given price. Businesses use this information to determine at what price point a new
product should enter the market. Consumers will buy items based on their perception of
that product's value.
6. Income demand means the eagerness of a person to buy a definite quantity at a given
income level. As consumers make more income, quantity demand increases. This means
people will buy more overall when they earn more income. Tastes and expectations also
change with an increase in income, reducing the size of one market and increasing the
size of another. Consumers will often buy a product or service because it is what they can
afford but may deem it lower quality. The demand for those lower-quality products will
decrease as income increases.
7. Cross demand is one of the important types of demand where the demand of a product is
not subjected to its own price but the price of other similar products is known as the cross
demand.
 8. Competitive demand occurs when there are alternative services or products a customer
can choose from. From a business's perspective, they can use fluctuations in the price of
their competitors to determine how their own will sell. An example of this is between
name-brand and store-brand medicine. If a consumer prefers a name brand but it is out of
stock or the price increases significantly, the store brand will see a rise in sales.

Law of Demand
The law of demand states that the quantity demanded of a good or service shows an inverse
relationship with the price of a good or service when other factors are held constant (cetris
peribus).

Holding all other factors constant, an increase in the price of a commodity (good or service) will
decrease the quantity demanded, and vice versa.

The law of demand is a fundamental principle in macroeconomics. It is used together with

the law of supply to determine the efficient allocation of resources in an economy and find the
optimal price and quantity of goods.

Qdx = f (Px, I, Py, T)

Which is a functional relationship where:

 Qdx: Quantity demanded by the consumer in a period of time

 f = symbol that indicates the dependency relationship that exists between the variables of
both sides of equality.
 Px = Prices of good x
 I = Monetary income of the consumer
 Py = Prices of other goods, or price of the good y.
 T = Taste of consumer
 

Limititation of Law of Demand

This law will be applicable only if the below mentioned points are fulfilled.

1. No change in price of related commodities.

2. No change in income of the consumer.
3. No change in taste and preferences, customs, habit and fashion of the consumer.
4. No change in size of population
5. No expectation regarding future change in price.

Exceptions of Law of Demand

Giffen Goods: A ‘Giffen goods’ is a special variety of inferior goods. Sir Robert of Scotland
observed in the 19th century that poor people spend the major proportion of their income on a
staple food, viz., and potato. If the price of this good rises they will become so poor that they will
be found to spend loss on other items and buy more potatoes in order to get a minimum diet and
keep themselves alive. In such goods the demand curve will be upward sloping.

Basic necessities of life: In case of basic necessities of life such as salt, rice, medicine, etc. the
law of demand is not applicable as the demand for such necessary goods does not change with
the rise or fall in price.

Snob Appeal: People sometimes buy certain commodities like diamonds at high prices not due
to their intrinsic worth but for a different reason. The basic object is to display their riches to the
other members of the community to which they themselves belong. This is known as snob
appeal, which includes people to purchase items of conspicuous consumption. This is a genuine
exception to the law of demand. The demand curve for such an item will be upward sloping.
Fear of shortage: When people feel that a commodity is going to be scarce in the near future,
they buy more of it even if there is a current rise in price. For example: If the people feel that
there will be shortage of L.P.G. gas in the near future, they will buy more of it, even if the price
is high.

Price expectation: When the consumer expects that the price of the commodity is going to fall
in the near future, they do not buy more even if the price is lower. On the other hand, when they
expect further rise in price of the commodity, they will buy more even if the price is higher. Both
of these conditions are against the law of demand.

Speculative Demand: In a speculative market (such as the stock market) a rise in the price of a
commodity (such as a share) creates the impression among the buyers that its price will rise
further. So people start buying more of the commodity when its price rises. This is not truly an
exception to the law of demand in the sense that the demand curve here is not upward sloping.

Demand Curve
In economics, demand curve is a graphic representation of the relationship between product
price and the quantity of the product demanded. It is drawn with price on the vertical axis of
the graph and quantity demanded on the horizontal axis.

The Elasticity of Demand

The elasticity of demand refers to the degree to which demand responds to a change in an
economic factor. The elasticity of demand, or demand elasticity, measures how demand
responds to a change in price or income.
Price is the most common economic factor used when determining elasticity. Other factors
include income level and substitute availability.

It is commonly referred to as price elasticity of demand because the price of a good or service is
the most common economic factor used to measure it.

Price Elasticity of Demand

A good's price elasticity of demand (PED) is a measure of how sensitive the quantity demand-
ed is to its price. Price elasticity of demand is the ratio of the percentage change in quantity
demanded of a product to the percentage change in price. Economists employ it to understand
how supply and demand change when a product’s price changes.Price elasticity of demand is a
measurement of the change in quantity demanded of a product in-relation-to/due-to change in its
price. Expressed mathematically, it is:

Percentage Change∈Quantity Demanded

Price Elasticity of Demand ¿
Percentage Change∈Price

Change∈Quantity Demanded
× 100
Initial Quantity Demanded
¿
Change∈Price
×100
Initial price

Q−Q1 ∆Q
× 100 ×100
Q Q
¿ ¿
P−P 1 ∆P
× 100 ×100
P P

∆Q P
¿ ×
∆P Q

Economists use price elasticity to understand how supply and demand for a product change when
its price changes.

1. PED =0, Demand is perfectly Inelastic. Demand doesn’t change at all when the price
changes.
2. 0 < PED < 1, Demand is (Relatively) Inelastic.
3. PED =1, Demand is Unitary Elastic
4. 1< PED < ∞, Demand is (Relatively) Elastic
5. PED = ∞, Demand is Perfectly Elastic
Types of Price Elasticity of Demand

If the percentage change in quantity demanded It is known

Which means:
divided by the percentage change in price equals: as:

Perfectly Changes in price result in demand

Infinity
elastic declining to zero

Changes in price yield a significant

Greater than 1 Elastic
change in demand

Changes in price yield equivalent

1 Unitary
(percentage) changes in demand

Changes in price yield an

Less than 1 Inelastic
insignificant change in demand

Perfectly Changes in price yield no change in

0
inelastic demand
Inelastic Demand

Inelastic demand is where the price elasticity of demand is less than 1, which means that
customers are largely unreactive to changes in price. For example, there may be 100 customers
who want to buy Ferrari for $200,000. If Ferrari was to increase its prices to $250,000 and 99
customers buy it, then the product is very inelastic. This is because customers do not care too
much about the price.

Inelastic demand may occur because of limited substitute goods. For example, the local
supermarket may only offer one type of bread. The only other place to go is miles away, so there
may also be an element of opportunity cost. To get a similar product, the consumer will have to
spend time and money on fuel to get there. As a result, the supermarket may be able to raise
prices substantially before consumers start going elsewhere.

As we can see from the chart above – demand hardly reacts to a change in price. At $0.25, 3
bagels are demanded at that price. However, the price rises to $1.50, with demand falling to only
2. So although the price has risen by 600 percent, demand has only fallen by 33 percent.
Therefore, demand is inelastic because it does not respond significantly to the price.

Factors affecting Inelastic Price Elasticity of Demand

1. Infrequent purchases: It might be the song from your favourite artist or a new mobile phone
– consumers are willing to spend more because it is a one off purchase. Paying a little extra for a
one off purchase has a different psychological impact when compared to paying extra for a good
that the consumer purchases every day.

2. No substitutes: Consumers have little choice but to fill their cars up with petrol. So even if the
price of petrol doubled, they still need to buy it to get around. There is simply a lack of
substitutes, so they are forced to buy the good no matter the price. The only alternative is just not
to drive, which is not really an option for many.

3. Geographical location: Some products/services are able to achieve a ‘geographical

monopoly’, whereby consumers have little choice. For instance, we only need to look at football
or baseball games as examples – customers can only buy food and drink available in the stadium.
The consumer’s willingness to pay is much greater because there is no alternative, with an
element of convenience.

4. Necessities: Some products are necessary to live, so consumers have to pay however much it
costs. For example, consumers have to pay for their medication no matter what it costs. Without
it, they may fall gravely ill and need hospital treatment. There are also other necessities such as
utilities, food, and water that are all necessary to live and which may in some cases be more
prone to inelastic demand.
5. Seasonal: Products such as mince pies, turkey, and ice cream are generally seasonal.
Consumers eat more ice cream in the summer and more mince pies near Christmas. As a result,
consumers are willing to spend more because they receive a greater utility during the seasons —
perhaps because of the seasonal supply, or, the greater satisfaction received during different
times of year, for example, ice cream during the summer.

Examples of Inelastic Demand Petrol, Salt, Monopoly, Diamonds, Rail tickets, Cigarettes,
Apple iPhone

Elastic Demand

When a product or service has elastic demand, it means that customers are very responsive to
price. So if the local Pretzel store starts charge an extra 5 cents and it loses half its customers, we
can conclude that demand is very elastic. Consumers are unwilling to spend more and therefore
go elsewhere instead.

In short, products/services with elastic demand have more emphasis placed on price than any
other factor. Issues such as quality are largely negated in favour of the lowest price.

We can consider insurance as a prime example; at least specific types such as car and home
insurance. There is little difference between offerings, and comparison websites have become
popular for this very reason. Consumers are extremely price-sensitive and are happy to shop
around to find a good deal.

As we can see from the chart above, demand is significantly sensitive to price. At $1.00, 2
doughnuts are demanded at that price. However, when the price falls to $0.80, demand increases
significantly to 6 doughnuts. So although the price has fallen by 20 percent, demand has
increased by over 300 percent. Demand is, therefore, elastic because demand responds
significantly to the price.

Factors affecting Elastic Price Elasticity of Demand

1. Homogenous product: If a product/service is relatively similar, customers are more likely to

shop around and be reactive to price changes. Insurance is a good example. As prices go up,
some consumers will look to change to a cheaper provider. Even a few dollars increase can lead
to consumers going on the web to look up comparative prices for a similar policy.

2. Many Substitutes: When there are many other products available, a higher price for one
makes the others more appealing. For example, there are hundreds of types of chocolates and
chocolate bars. Any price differentiation beyond the norm can lead to consumers choosing an
alternative.
3. Low Switching Costs: If there is no cost associated with switching, it makes the decision to
purchase a substitute good more likely; allowing demand to fluctuate more. If prices go up for
KitKats, there is no cost applied if you no longer buy one. So there is no financial penalty for
buying a substitute. By contrast, phone contracts do the exact opposite and lock consumers in for
up to 2 years.

4. Luxury / Non-necessary: Goods or services that are luxury do not need to be brought, so
consumers can be more sensitive to price.

Examples of Elastic Demand Soup, Bread, Newspaper, Chocolate, Airline tickets

Unitary Demand

Unitary Demand is the theory that as price increases by X%, demand falls by an equal X%. Let
us take an example. A television manufacturer sells 100 televisions for $50,000. That works out
as $500 per unit. It decides to raise its price by 10% to $550. At the same time, demand falls by
an equal 10%; meaning it only sells 90 televisions.

In reality, there are no examples of unitary demand. The reason being is that human demand is
non-linear. That is to say that there is not a direct relationship between price and demand.

There are other factors at play such as quality and availability of substitute goods. Therefore,
although a good may become 10 percent cheaper, many will still prefer product X because it is
their favorite. For example, Coca-Cola may increase its price by 10%. Demand will not
necessarily fall by 10% because many consumers will still prefer it to Pepsi and are willing to
pay the extra price.

 Real life application of Demand Elasticity

 Income Elasticity of Demand
 Commodities – Necessities, Comfort, luxuries
 Cross Elasticity of Demand
 Laws of Supply
 Law of supply vs. Law of Demand
 Supply, Supply Schedule, Supply Curve
Change in Quantity Demanded vs Change in Demand
Or
Shifting of Demand vs Change in Demand
Change in quantity demanded or shifting of demand refers to the change in the amount of
quantity demanded of a commodity as a result of change in the price of it.

Change in demand refers to the change in demand of a commodity as a result of change in

factors other than price. Such factors can be – income, test, preference, population, future
expectations etc.

Methods of Demand Forecasting

1. Survey Method or Qualitative Method
a. Consumer Interview Method
I. Questionnaires
II. Complete Enumeration Method
III. Sample Survey Method
b. Opinion Polls
I. Expert Opinion Method / Delphi Method
II. End User Method
2. Statistical Method or Quantitative Method
a. Trend Projection Method / Time Series Analysis
b. Economic Indicators
I. Barometric Method
II. Regression Analysis

In the Delphi method, a group of experts generate a demand forecast based on their expertise &
knowledge. This forecast is presented to a different group within the company for interpretation.
After multiple rounds of interpretation, the forecast passes on to the decision-makers of the
organization.

Under the End Use Method, also called as the User Expectation Method, the list of several
users of the product under forecasting is prepared first, who are then asked about their individual
purchasing patterns and then from such information the complete product demand forecast is
ascertained.

Barometric Method: This method is based on the past demands of the product and tries to
project the past into the future. The economic indicators are used to predict the future trends of
the business. Based on future trends, the demand for the product is forecasted. An index of
economic indicators is formed. There are three types of economic indicators, viz. leading
indicators, lagging indicators, and coincidental indicators.
The leading indicators are those that move up or down ahead of some other series. The lagging
indicators are those that follow a change after some time lag. The coincidental indicators are
those that move up and down simultaneously with the level of economic activities

Trend Projection Method: This method is useful where the organization has a sufficient
amount of accumulated past data of the sales. This date is arranged chronologically to obtain a
time series. Thus, the time series depicts the past trend and on the basis of it, the future market
trend can be predicted. It is assumed that the past trend will continue in the future. Thus, on the
basis of the predicted future trend, the demand for a product or service is forecasted.

Regression Analysis: This method establishes a relationship between the dependent variable
and the independent variables. In our case, the quantity demanded is the dependent variable and
income, the price of goods, the price of related goods, the price of substitute goods, etc. are
independent variables. The regression equation is derived assuming the relationship to be linear.
Regression Equation: Y = a + bX. Where Y is the forecasted demand for a product or service.

What Is an Inferior Good?

An inferior good is an economic term that describes a good whose demand drops when people's
incomes rise. These goods fall out of favor as incomes and the economy improve as consumers
begin buying more costly substitutes instead.

Price Elasticity of Demand vs Income Elasticity of Demand – P77