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Elasticity of demand refers to the degree to which demand for a good or service varies with its price.
It is when price or other factors have a big effect on the quantity consumers want to buy. As a general
rule, reduction in price leads to increase in sales and vice versa. This holds true for all luxury or non-
essential items such as cars. Exception to this rule applies to necessities like food, medicine, basic
clothing as the demand for them does not change with price, hence is called inelasticity of demand.
Formula:
The formula for elastic demand is the percentage change in quantity demanded divided by the
percentage change in price.
Elasticity of demand = % change in quantity
% change in price
Types of Elasticity: There are 4 types of elasticity –

Types of
elasticity of
demand

Price Elasticity
Elasticity Elasticity Elasticity

## Perfectly Perfectly Relatively Relatively Unitary

Elastic Inelastic Elastic Inelastic Elastic

## 1) Price elasticity of demand relates to the responsiveness of quantity demanded of a good to

the change in the price. Price elasticity can be precisely defined as
‘the proportionate change in quantity demanded in response to a
small change in price, divided by the proportionate change in
price’. Because the price elasticity of demand measures how much
quantity demanded responds to the price, it is closely related to the
slope of the demand curve. But instead of looking at unit change,
elasticity looks at percentage change.
Example: If the price of apples falls from \$100 per unit to \$90 per
unit. With the decline in the price the demand of the apples rises from 100 units to 150 units.
2) Income elasticity of demand: The income is the other factor that influences the demand for
a product. The income elasticity of demand is similar to the price
elasticity, but instead of the product’s demand being changed by the
price it is changed by the change in income of the people who
generally purchase the product. For example, if the income of a group
of people increased by 20% and the demand for the product increased
by 40%, then the income elasticity of the product would equal 2, this
will make the product elastic.
More the income, more purchasing power leading to increased demand. The formula to compute the
income elasticity of demand is:
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For most of the goods, the income elasticity of demand is greater than one indicating that with the
change in income the demand will also change and that too in the same direction, i.e. more income
means more demand and vice-versa.

3) Cross elasticity of demand: The cross elasticity of demand refers to the change in quantity
demanded for one commodity as a result of the change
in the price of another commodity. This type of
elasticity usually arises in the case of the interrelated
goods such as substitutes and complementary goods.

## The two commodities are said to be complementary, if

the price of one commodity falls, then the demand for
other increases, on the contrary, if the price of one
commodity rises the demand for another commodity
decreases. For example, petrol and car are complementary goods.
While the two commodities are said to be substitutes for each other if the price of one
commodity falls, the demand for another commodity also decreases, on the other hand, if the
price of one commodity rises the demand for the other commodity also increases. For
example, tea and coffee are substitute goods.

The cross elasticity of demand for goods X and Y can be expressed as:

Example: Price of the Coca Cola soft drink were to increase by 10%, but in response the
demand of Pepsi soft drinks were to increase as well by 20%. This would be a form of cross
elasticity.

Many companies use cross elasticity to sell products together as a bundle, such as reducing
the cost of cereal, but in turn increasing the demand for milk. Using cross elasticity can be
advantageous to companies working together and those that are in direct competition of each
other.
4) Advertisement elasticity of demand: The responsiveness of the change in demand to the
change in advertising or rather promotional expenses, is
known as advertising elasticity of demand. In other words, the
change in the demand as a result of the change in
advertising elasticity of demand. It can be expressed as:

## It is used to help determine the change in demand of a product

The most important thing that Elasticity of Demand does is help a business determine how much a
product should cost and how much of a supply they should have for it. This helps the business
maximize their profits.

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The elasticity of demand for a product is the basis of its price determination. The ratio in which the
demand for a product will fall with the rise in its price and vice versa can be known with the
knowledge of elasticity of demand. The business firms take into account the price elasticity of
demand when they take decisions regarding pricing of the goods. This is because change in the price
of a product will bring about a change in the quantity demanded depending upon the coefficient of
price elasticity. This change in quantity demanded as a result of, say a rise in price by a firm, will
affect the total consumer’s expenditure and will therefore, affect the revenue of the firm. If the
demand for a product of the firm happens to be elastic, then any attempt on the part of the firm to
raise the price of its product will bring about a fall in its total revenue. Thus, instead of gaining from
the increase in price, it will lose if the demand for its product happens to be elastic. On the other
hand, if the demand for the product of a firm happens to be inelastic, then the increase in price by it
will raise its total revenue. Therefore, for fixing a profit-maximizing price, the firm cannot ignore
the price elasticity of demand for its product.

In the short run, at least one factor of production is fixed. This means that output can be increased
by adding more variable factors such as employing more workers and buying in more raw materials

Fixed costs are those that do not vary with output and typically include rents, insurance, depreciation,
set-up costs, and normal profit. They are also called overheads. When output is zero, cost is positive
because fixed cost has to be incurred regardless of output. In this case the fixed cost is 1000.

Variable costs are costs that do vary with output, and they are also called direct costs. They
increase as output increases. Examples of typical variable costs include fuel, raw materials, and some
labour costs.

Total cost of any output is the value of all the inputs used in its production. Cost will rise or fall as
the ratio of outputs to input changes. These changes are a result of change in efficiencies orc changes
in prices of the inputs. In the below case total cost have been given based on the output.

## Total Cost (TC)Total cost = fixed costs + variable costs

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In the below figure the total cost (OC) of producing Q units of output is total fixed cost OF plus total
variable cost (FC).

Given that total fixed costs (TFC) are constant as output increases,
the curve is a horizontal line on the cost graph.

## The total variable cost (TVC) curve slopes up at an accelerating

rate, reflecting the law of diminishing marginal returns.
The total cost (TC) curve is found by adding total fixed and total
variable costs. Its position reflects the amount of fixed costs, and
Average fixed costs
Average fixed costs are found by dividing total fixed costs by
output. As fixed cost is divided by an increasing output, average
fixed costs will continue to fall.
The average fixed cost (AFC) curve will slope down continuously,
from left to right.

## Average variable costs are found by dividing total fixed variable

costs by output.

The average variable cost (AVC) curve will at first slope down from left to right, then reach a
minimum point, and rise again.

## AVC is ‘U’ shaped because of the principle of variable

Proportions, which explains the three phases of the curve:

## 1. Increasing returns to the variable factors, which cause

average costs to fall, followed by:
2. Constant returns, followed by:
3. Diminishing returns, which cause costs to rise.

## Average variable cost

(AVC) = total variable costs (TVC) /output (Q)

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Average total cost
Average total cost (ATC) is also called average cost or unit cost. Average total costs are a key cost
in the theory of the firm because they indicate how efficiently scarce resources are being used.
Average variable costs are found by dividing total fixed variable costs by output.
Average total cost (ATC) can be found by adding average fixed costs (AFC) and average variable
costs (AVC). The ATC curve is also ‘U’ shaped because it takes its shape from the AVC curve, with
the upturn reflecting the onset of diminishing returns to the variable factor.

## Average total cost (ATC) = total cost (TC) / output (Q)

Marginal cost is the cost of producing one extra unit of output. It can be found by calculating the
change in total cost when output is increased by one unit.

It is important to note that marginal cost is derived solely from variable costs, and not fixed costs.

The marginal cost curve falls briefly at first, then rises. Marginal costs are derived from variable
costs and are subject to the principle of variable proportions.

reasons:

## 1. It is the leading cost curve, because changes in total

and average costs are derived from changes in marginal cost.
2. The lowest price a firm is prepared to supply at is the
price that just covers marginal cost.

## Average total cost and marginal cost are connected because

they are derived from the same basic numerical cost data. The general rules governing the
relationship are:

1. Marginal cost will always cut average total cost from below.
2. When marginal cost is below average total cost, average total cost will be falling, and when
marginal cost is above average total cost, average total cost will be rising.
3. A firm is most productively efficient at the lowest average total cost, which is also where
average total cost (ATC) = marginal cost (MC).

Marginal costs are derived exclusively from variable costs, and are unaffected by changes in fixed
costs. The MC curve is the gradient of the TC curve, and the positive gradient of the total cost curve
only exists because of a positive variable cost.

In the above case average cost per unit is minimized at a range of output - 300 and 500 units.

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Thereafter, because the marginal cost of production exceeds the previous average, so average cost
rises in this case the marginal cost of each extra unit between 500 and 1000 is 14 and this increase
in output has the effect of raising the cost per unit from 9 to 13 in the short run.

Economies of Scale refer to the cost advantage experienced by a firm when it increases its level of
output. The advantage arises due to the inverse relationship between per-unit fixed cost and the
quantity produced. The greater the quantity of output produced, the lower the per-unit fixed
cost. Economies of scale also result in a fall in average variable costs with an increase in output.
This is brought about by operational
efficiencies and synergies as a result
of an increase in the scale of
production.

## It also means reduced costs per unit

that arise from increased total output
of a product. For example, a large
family buys a big pack of detergent.
Each box of detergent costs less per
wash because you can buy it in bulk.
The manufacturer saves on
packaging and distribution, so it
passes the savings onto you. Bulk is
also cheaper for you because you
make fewer trips to the store.

Economies of scale is also described as competitive advantage that large entities have over smaller
entities. It means that the larger the business, non-profit or government, the lower its costs. For
example, the cost of producing one unit is less when many units are produced at once.

## EOS has 2 major impact on production cost:

1. It reduces the per unit fixed cost. As a result of increased production, the fixed cost gets
spread over more output than before.

2. It reduces the per unit variable costs. Economies of scale bring down the per unit variable
costs. This occurs as the expanded scale of production increases the efficiency of the
production process.

## The graph above explains the long run average costs

faced by a firm against its level of output. When the
firm expands its output from Q to Q2, its average cost
falls from C to C1. Thus, the firm can be said to
experience economies of scale up to output level Q2.
For a firm, key result that emerges from the analysis of
the production process is that a profit-maximizing firm
always produces that level of output which results in the
least average cost per unit of output.

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There are 2 types of Economies of Scale

## 1. Internal Economies of Scale

They refer to economies that are unique to a firm. For instance, a firm may hold a patent over a mass
production machine, which allows it to lower its average cost of production more than other firms in
the industry.

## 2. External Economies of Scale

They refer to economies of scale faced by an entire industry. For instance, suppose the government
wants to increase steel production. In order to do so, the government announces that all steel
producers who employ more than 10,000 workers will be given a 20% tax break. Thus, firms
employing less than 10,000 workers can potentially lower their average cost of production by
employing more workers. This is an example of an external economy of scale – one that affects an
entire industry or sector of the economy.

##  Please find below the answer to question number 3 (b)

Costs and revenues of a firm determine its nature and the levels of profit. Cost refers to the expenses
incurred by a producer for the production of a commodity. Revenue denotes the amount of income,
which a firm receives by the sale of its output.

Total revenue refers to the total sale proceeds of a firm by selling its total output at a given price.

## TR = PQ, where TR = Total Revenue, P = Price, Q = Quantity sold.

Suppose a firm sells 100 units of a product at the price of \$5 each, the total revenue will be 100 × \$5
= \$500.

## Average revenue is the revenue per unit of the commodity sold.

AR = TR/Q; where AR = Average revenue, TR = Total revenue and Q = Quantity sold. In our
example, average revenue is = 500/100 = \$5. Thus, average revenue means price.

Marginal revenue is the addition to total revenue by selling one more unit of the commodity.
Suppose 5 units of a product are sold at a revenue of \$100 and 6 units are sold at a total revenue of
\$120. The marginal revenue will be \$120 - \$100 = \$20. It implies that the 6th unit earns an additional
income of \$20.

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The equality between average revenue and marginal revenue occurs for a firm selling an output in
a perfectly competitive market. This diagram
contains the average revenue curve and marginal
revenue curve for tomatoes sold by Ram the tomato
grower in Amby Valley. Ram is one of thousands of
Tomato growers in the market, selling identical
products. As such, Ram receives the going price for
tomato.

## This single horizontal line, labeled MR = AR, is

actually two curves, the marginal revenue curve and
the average revenue curve. They appear to be one
curve because each overlays the other.

They coincide because marginal revenue is equal to average revenue at every output quantity. The
equality between marginal revenue and average revenue is the result of perfect competition. Because
Ram receives the same per unit price for every tomato, incremental revenue is equal to the per unit
revenue.

Under perfect competition the number of firms selling an identical product is very large. The market
forces supply demand so that only one price tends to prevail for the whole industry determines the
price. Thus the demand for the firm’s product becomes infinitely elastic. Since the demand curve is
the firm’s average revenue curve, the shape of the AR curve is horizontal to the X-axis at price OP
as shown in panel of fig and the MR curve coincide with it. This is also shown in the table where
AR and MR remain constant at Rs. 20 at every level of output. Any change in the demand and supply
conditions will change the Market price of the product and consequently the horizontal AR curve of
the firm.

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