The History Of The Business Economics

Published Date: 02 Nov 2017

Q. Explain (using example) the law of Demand. Also, explain the difference between the law of demand and law of supply.

The two most important and the fundamental concepts of economics are Demand & Supply.

Demand:

A consumer’s willingness or desire to pay a price to purchase a product or a service is defined as Demand. In economic sense, it is considered as demand only when there is a wish and also ability, to pay for a product/service. There are various types of demand based on who has the willingness – individuals/ market / company /sector, etc.,

A variety of factors influence the demand. Like,

Market value of the product and its manufacturer

Income of the consumer

Price of the product

Price of related Goods

Income/ Product Prediction

But among all other factors, price of the product plays a vital role in the demand of the product and it forms the basis of Law of Demand.

Law of Demand:

It states that the quantity demanded of a good/service is inversely proportional to its price, provided other factors remaining constant.

If cost of a product increases, not everyone will be able to afford and obviously, the demand of the product decreases and in the same way the demand for a product/service increases when there is a decrease in the price.

Demand Curve:

The graphical representation of the Law of Demand is the Demand Curve, which depicts the price of a product and the amount of customers willing and able to pay for it. It is represented by the direct demand function as (Dx = f(P(x)).

Where, Dx id the quantity demanded of x goods

is the function of independent variables contained within the parenthesis, and

P(x) is the price of x goods.

When P(x) falls, Dx increases and vice-versa.

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Demand Curve

The Demand curve is negatively sloped, ie., the price of the product/service and the quantity demanded from the same product/service is negatively correlated to each other.

There are two effects which explain the negative slope of the Demand Curve. They are explained as follows:

Income Effect:

When the price of a commodity goes down, buyers will have to pay less to purchase the same quantity of the commodity. This indicates the changes in the purchasing power of the given money. This is income effect with respect to fall in the price of a commodity.

Whereas, when the real monetary income increases, one will be able to buy more of the same or the other product. The reverse of this happens when there is increase in the price of the commodity.

Substitution Effect:

A decrease in the price of a commodity leads makes it relatively cheaper to other products in the same category. So many consumers tend to buy the cheaper one because of its lesser price. A consumer who usually buys product A will also buy product B if it’s cheaper than Product A and as a result the demand of the cheaper product increases.

This is called Substitution effect.

There are exceptions to the Law of Demand.

Giffen Paradox Effect:

In case of an inferior good or Giffen good (as price increases the demand for those goods increases). For instance, wheat is considered as the staple food in Maharastra. Even if the price of wheat increases people will keep buying wheat and to adjust the impact on their income will cut down on their other expenses like the buying meat will be given off.

So, in this case even if there is an increase in the price, the demand for the product increased. And as a result the demand curve will be positively sloped.

Veblen goods:

In case of luxury goods (like sedan cars – can be purchased only after the income reaches a certain level), the demand increases when the price increases. For example, people tend to buy products used by celebrities, famous personalities or consider a designer jewelry. This can be purchased only after reaching a specific level and the demand for the product will decrease if the price goes down, because it loses it market value.

Example - Law of Demand:

For instance let us consider our shopping malls. We do have all shops open all through the year. But not all who goes to the mall will purchase a product, even if they like it. That doesn’t mean that the individual is not able to afford for the product. Which means the individual is able to afford and also likes the product but there is no willingness to pay because we may feel that it is overpriced.

But whenever a discount sale goes on in the same mall, we can find huge crowd in the same shop, long billing queues, there are possibilities that we will not find our appropriate size of dress we like (which was available before the sale started), color of our choice may not be available, which all implies that the demand for the same product has increased. The only factor changed here was the price of the product (decreased), which leads to increase in sale (Demand). The total sales of the shop will be increased in several folds during the period of discounted sale ie., increased demand of their product.

This is a simple example which explains the Law of Demand.

Supply:

Now let us discuss the other most important part of economics – Supply.

A seller’s willingness and ability to sell a quantity of any good or service for a particular price is defined as Supply. Price plays a major role even in case of supply. There are two types of supply – market and the individual supply. Market supply is the summation of individual supply.

Law of Supply:

The law of supply which states that, when all other factors remain constant, an increase in price of a good or a service results in an increase in quantity supplied. This means, there is a direct or positive relationship between price and quantity. So when the price decreases, the quantity supplied will also decrease.

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Supply Curve

The Law of Supply when plotted graphically gives the Supply Curve. As the price of a product increases the sellers are willing to supply more quantity as it would yield them more revenue. It interests them because they could earn money by selling less number of costly products than selling large number of cheaper items.

There are a variety of factors that influence the Supply. They are listed below:

Manufacturing cost

Initial cost

Technology to be used

Price of the supplementary or complementary goods

Future price predictions

Number of producers in the market

Generalized Supply Function:

Sx = S(Px , Py , Pc, C, T, E, N, In, Dr)

Where,

Sx = Supply of product x

Px = Price of the product x

Py = Price of the substituent product y

Pc = Price of the complementary product c

C = Cost or input price

T = Technology

E = Expectations of future price

N = Number of sellers

In = Inventory demand

Dr = Reservation demand

Differences between Law of Demand and Law of Supply:

There are certain factors which need to be defined before discussing the differences between the Law of Demand and the Law of Supply.

Elasticity of Demand/ Supply:

Elasticity can be defined as the responsiveness of the quantity demanded of a good or a service with respect to change in other factors like price, income, etc.

In terms of elasticity, a demand or a supply can be elastic or inelastic. There are theoretical situations of Perfect Elasticity and Perfect Inelasticity.

Perfectly Elastic:

A demand is said to be perfectly elastic, when even the slightest increase in the price leads to no demand from the customer and even a marginal decrease in price will make the demand infinite.

A supply is said to be perfectly elastic, when even small changes in price leads to large changes in supply.

Perfectly Inelastic:

A demand is called perfectly inelastic when the change in the price of a product does not affect its demand. Even if there is huge increase in the price, the demand will remain unaffected.

A supply is termed as perfectly inelastic when the supplied quantities remains unaffected by the change in the price.

Movement along the Demand and Supply Curve:

Change in the price of a good or a service leads to movement along the Demand and/or supply curve.

As we move from lower price to higher price, we move upwards on the demand curve which is termed as Contraction of Demand and the downward movement on the demand curve as a result of decrease in the price is termed as Expansion or Extension of Demand.

demand contractions and expansions http://www.i-study.co.uk/Economics/images/supply-contraction.jpg

Movement along Demand Curve Movement along Supply Curve

Shift in the Demand and Supply Curve:

When the price of a good or a service remains constant, the changes in the other parameters like the income of the consumer, advertising cost in case of Demand and change in factors like number of market suppliers, etc from the Supply perspective leads to shift in the Demand and the Supply curve respectively.

demand curve shiftssupply curve shifts

Fig 1.Shift in the Demand Curve Fig 2.Shift in the Supply Curve

As shown in the above figure Fig 1, a rightward shift of the Demand Curve from Demand D to Demand D1, leads to increase in the Demand and similarly a leftward shift indicates a decrease in demand. This change in demand is not due to the change in the product’s own price but change in the price of its related goods (substitution or complementary good).

Also from Fig 2, it is clear that the rightward shift in the Supply curve indicates increase in the supply and leftward shift indicates decrease in the supply.

The differences between Law of Demand and Law of Supply are summarized below:

Parameters

Law of Demand

Law of Supply

Perspective

It is stated from the consumer point of view

Law of Supply is stated from Supplier’s Point of view

Price vs Qd

As Price increases, the quantity demanded decreases

As price increases, the quantity supplied also increases

Relationship between P & Qd

Quantity demanded has a indirect or negative relationship with the price

Quantity demanded has a direct or positive relationship with the price

Curve sloping

The demand curve is negatively sloped

The supply curve is positively sloped

Curve Expansion

There is an expansion of demand due to fall in price

There is a expansion in the supply due to increase in price

Movement along the curve:

A: Expansion of Demand

Expansion of demand, ie., increase in demand occurs when there is downward movement in the demand curve (price reduction)

Expansion in supply occurs when there is a upward movement along the supply curve, ie., increase in the price

B: Contraction of Demand

Contraction of demand occurs when there is an upward movement in the demand curve (price increases)

Contraction in supply takes place when there is a downward movement in the supply curve (price reduces)

Shift along the curve

Rightward shift in the demand curve shows increase in the demand and left shift shows decrease in demand

Rightward shift in the supply curve shows increase in the supply and vice – versa

Perfectly Elastic

Even marginal changes in the price leads to dramatic increase in the demand (theoretically infinite demand)

Small changes in price leads to larger changes in the supply

Perfectly Inelastic

Change in the price of the commodity does not affect the demand of the product (unresponsive to the price)

Supply remains the same through all price levels (increase or decrease in price does not affect supply)

Influencing factors

Income of the consumers, price of related goods, Price/Income expectation, Advertising Expenditure

Input price, Technology, expectation of future prices, number of sellers in the market, price of related goods.

Examples of Law of Demand and Law of Supply:

Example 1:

From a research it was found that the car sales in December 2012 saw a huge decline in the YoY growth rate. A statistics shows that India’s leading car manufacturer Tata Motors recorded a decline of 20% in its total sales.

One of the possible causes for this is the constant increase in the petrol and diesel prices these days. Earlier when the diesel prices where comparatively lesser than the petrol price more number of people started buying diesel cars. This led to decrease in the number of people buying petrol cars and an increase in the demand of diesel cars. This is an example of Law of Demand in case of Supplementary goods. This also serves as an example for Law of Supply because, as the price of the petrol cars have increased and the taxation for SUVs and premium petrol cars have increased, the suppliers are willing to provide more of those cars. This is because it would yield them more profit than diesel cars.

But now, when the diesel prices are almost on par with the petrol prices, we see a large number of people shifting to two wheelers, so that they will be able to get more mileage when compared to cars. Also the price of the bike is very much lesser than that of the car. This also explains the Law of Demand.

Example 2:

Consider the case of real estate these days. From the builders perspective even though there are a lot of unsold flats, they are not willing to sell them for lower price. Instead they are ready to hold back as selling them now for lesser price will not erode his profit.

Example 3:

Let us discuss an example of party wear clothing for infants and toddlers.

Party wear clothing are for occasional use and their prices are bit on the costlier side. Infants and toddlers will outgrow before they outwear it. It is even doubtful whether they will wear it twice or thrice before they outgrow them. The price for these kinds of expensive party wear infant clothes is higher and obviously the quantity demanded is less.

On the other hand there are a lot of shops, dealers and brands that provide these clothing. There is a lot of choice from ethnic clothing to western outfits, which implies the supply is high. This is because they can make huge profit in selling fewer numbers of clothes when compared to normal casual clothing.

Q. Explain (with the help of diagram & examples) different types of short run and log run costs. Also, explain (with the help of examples for each) the different type of economies and diseconomies scale.

Production is defined as the process of converting the input resources into output of goods and services. Production can be carried out in long or short run.

Short run Costs:

Short run is defined as the period of time in which the firm cannot change its plant, equipment and the scale of the organization in short run production, at least one of the input factors remains completely fixed and other factors may vary.

In the short run, as at least one factor of production is fixed, output can be increased only by adjusting the variable factors. So we have to consider both fixed and variable costs to compute the short run cost. To be precise, in short run, the total cost is the aggregate of total fixed costs, variable costs and the average costs is the aggregate of average fixed cost and average variable costs.

Types of Short run costs:

1 .Total Fixed Costs (TFC):

This can be defined as the total amount of money spent on the fixed input factors. These cost of production that do not change with the output. They are very much independent of the output. This cost has to be incurred even if the production stops as they contribute to the fixed components of the Production in the short run.

Tota

Total Fixed Costs

Examples of TFC: land cost, interest, insurance charges, maintenance, wages and salaries of the permanent staffs.

For instance let us consider a shop in the market. The shopkeeper will have to pay the rent for the shop, pay his employees regardless of the revenue he makes. Even if the shop is closed for his personal reasons he is supposed to pay all of these. Building space in this example is considered as fixed input and the rent is termed as Total Fixed Costs.

2. Total Variable Costs (TVC):

The cost of the variable factors of input, which is said to vary with the output quantity, is termed as Total Variable costs. This cost rises when the output rises and declines when the output reduces. Unlike fixed input factors these input factors can be varied based on the changes in the level of output.

Total Variable Costs

3. Total Cost (TC):

Total expenses incurred by a company or a firm in producing the final product, which includes raw materials, salary, land cost, machinery, etc.

Total Cost is the aggregate of Total Fixed Cost (TFC) and Total Variable Cost (TVC).

TC = TFC+ TVC

Total Cost

4. Average costs of Production:

Average cost is the cost per unit of output produced. Can be defined as the sum of Average Fixed cost (AFC) and Average Variable cost (AVC).

AC = AVC + AFC

Average Fixed cost is the fixed cost per unit which is determined by the following formula,

AFC = TFC / Q

Here TFC remains constant in the course of production ie. even if the output level changes there would be no change in the TFC but Q can change in short run.

Average Variable cost is the variable cost per unit which is derived from the following formula.

AVC = TVC /Q

Average Cost

5. Marginal Costs of Production (MC):

Marginal cost is defined as the cost of producing an additional level of output. It refers to the change in the costs, obviously the change in the total variable cost.

MC is the addition to the total cost of production (TC). It is expressed as follows:

Marginal Cost

Example for Types of Short run costs:

Consider a factory manufacturing leather shoes. For this process, the basic requirement would be land, insurance, machinery, labor, leather, and other raw materials. The land, factory space, etc account to the fixed inputs components whereas the cost of the raw materials, salary to the laborers forms the variable input components. Let us consider that they have bagged an order of 50000 in a month which is 5 folds higher than their usual production, in that case, the production can be increased by increasing the number of employees. Because increasing the machinery for one order would be meaningless. So the increase in the number of employees would lead to an increase in TVC and so obviously TC increases.

Total Fixed cost would be the cost of Land, machinery, insurance, etc.

Total Variable cost is the cost of the labor, raw materials, etc.

The Total Cost is the expense of manufacturing includes the cost of all these components. Even if there are any defective products it would contribute to the Total Cost.

Average cost of production in this case would be the cost of manufacturing a pair of shoes.

Marginal Cost of Production is the additional cost that is incurred by the company for the manufacturing of extra 40000 shoes.

Long Run Costs:

Long run is defined as the period of time in which all the factors of productions varies. There are no fixed input components of production and so the Total Cost of Production for a long period is zero when the output is zero. The Total Cost varies with the output, increases if the output increases and decreases if the output quantity decreases.

From the above definition it is clear that, the land, factory and machinery which were considered as fixed factors in short run, are considered as a variable factors in long run. This means,

Entry / Exit into an industry is possible

Increase/ Decrease in the number of plants is also possible.

Types of Long-run Costs:

Long-run Average Cost (LAC):

The cost of producing one unit of a good or service in the long run by varying all input factors. In other words, it is obtained by long-run total cost divided by the quantity of output produced.

The Long-run average cost curve shows the average cost of production, produced by different sized plants at different levels of output.

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Long-run Average Cost Curve

Long-run Total Cost (LTC):

The cost incurred by a firm/industry for all the input factors of productions to produce a good or a service is termed as Long-run Total Cost. As all the input components in long-run are varied, all costs are varied. There is no fixed cost.

Long-run Total Cost

Long-run Marginal Cost (LMC):

The change in the long-run total cost of producing a good or service resulting from a change in the quantity of output produced.

LMC = d(LTC) / dQ

Long-run Marginal Cost

Economies and Diseconomies of Scale:

The terms economies refers to cost advantages. Such advantages arise whenever there is an expansion of firm or extending the scale of production or exploring the scope of production. Also at the same time, when such economies are over exploited then it gives rise to disadvantages for the firm which is called Diseconomy. In simple terms, cost disadvantages that a firm faces are termed as Diseconomies.

Economies and Diseconomies of Scale can be divided into internal and external.

Internal Economies of Scale:

Whenever a firm plans to expand by increasing its scale of production, certain cost advantages can be expected within the firm and this is called as Internal Economies. It can be of various types as discussed below:

Technical Economies:

When a firm decides to expand by increasing the scale of production, the management would employ high tech machineries which would increase the production and decrease the time of production. All these are technical economies.

Commercial Economies:

As the size of the firm grows, they will be able to handle larger volumes of raw materials and also larger volumes of the end-product can be stored in their warehouse, if required. This would help them to buy the materials in bulk and also sell the product in bulk, resulting in lesser transportation costs and distribution costs. These are termed as commercial economies.

Financial Economies:

A growing firm can easily float funds from internal and external sources as they can establish good security systems.

Managerial Economies:

This is considered as the most important internal economies. As the firm increases in size, not always there will be a need to employ new or additional managers if the existing manager can handle efficiently. An efficient manager can manage the increase in the volumes of production and growing business.

Internal Diseconomies of Scale:

If the firm continues to increase in size beyond a limit, several problems may be encountered and leads to internal diseconomies of scale. Cost disadvantages arise when the firm increases beyond a point and so long-run average cost (LAC) also increases, leading to diseconomies of scale. But diseconomies arise mainly due to poor management.

Sometimes diseconomies arise due to managerial inefficiency. Internal diseconomies can be explained by comparing the small firms with large firms in the same industry. Small industry does not require specialists to handle issues, making them differ from large companies in their techniques of management; the production techniques used are different in large and small companies based on cost considerations; to run a large firm huge capital amount is required which is the not case in small industries.

External Economies of Scale:

When cost advantages are obtained due to factors external to an organization but within the industry. This is called as external economies. When a number of companies are located in an area, al of them get mutual advantage. The external economies occur when there are physical and cost advantages resulting from general development of the industry. Example: - Equipment manufactures to build plants, ITI institutes for training skilled laborers.

External Diseconomies of Scale:

Factors which are beyond the control of the company, increases the total cost of the company leading to external diseconomy. External diseconomies happen as a result of internal diseconomies occurs. Environmental pollution is one of best examples for the external diseconomies leading to increase in both private and social cost of production.

Example:

Let us consider an example of hypermarket such as Tata’s Star Bazaar. They maximize their profits by bulk buying as they purchase huge volumes of products from suppliers. They are major customer for many leading brands. They make better profits as the customers feel their prices are comparatively lesser. Thus they exploit economies of scale. When they increase the area of their hypermarket by a floor or so, then it is considered as Internal Economies of Scale. There are times when certain stock becomes unavailable and there are instances when their sales personnel are not aware of it until someone questions them about it. This is because of the increase in size of the store. This is Internal Diseconomies of scale as immediate attention is not possible.

Staff with experience in other small shops would be interested in joining their hypermarket, due to their brand value. This would result in saving time and money in training them. This can be considered as External Economies of Scale.