Managerial Economics

A close interrelationship between management and economics had led to the

development of managerial economics. Economic analysis is required for various
concepts such as demand, profit, cost, and competition. In this way, managerial
economics is considered as economics applied to “problems of choice’’ or alternatives
and allocation of scarce resources by the firms.

Managerial economics is a discipline that combines economic theory with managerial

practice. It helps in covering the gap between the problems of logic and the problems
of policy. The subject offers powerful tools and techniques for managerial policy
making.

Definition

To quote Mansfield, “Managerial economics is concerned with the application of

economic concepts and economic analysis to the problems of formulating rational
managerial decisions.

Spencer and Siegelman have defined the subject as “the integration of economic
theory with business practice for the purpose of facilitating decision making and
forward planning by management.”

Nature and Scope of Managerial Economics

The most important function in managerial economics is decision-making. It involves

the complete course of selecting the most suitable action from two or more
alternatives. The primary function is to make the most profitable use of resources
which are limited such as labor, capital, land etc. A manager is very careful while
taking decisions as the future is uncertain; he ensures that the best possible plans
are made in the most effective manner to achieve the desired objective which is
profit maximization.
 Economic theory and economic analysis are used to solve the problems of
managerial economics.
 Economics basically comprises of two main divisions namely Micro economics
and Macro economics.
 Managerial economics covers both macroeconomics as well as
microeconomics, as both are equally important for decision making and
business analysis.
 Macroeconomics deals with the study of entire economy. It considers all the
factors such as government policies, business cycles, national income, etc.
 Microeconomics includes the analysis of small individual units of economy
such as individual firms, individual industry, or a single individual consumer.

All the economic theories, tools, and concepts are covered under the scope of
managerial economics to analyze the business environment. The scope of
managerial economics is a continual process, as it is a developing science. Demand
analysis and forecasting, profit management, and capital management are also
considered under the scope of managerial economics.
Demand for Managerial Economics

The demand for this subject has increased post liberalization and globalization
period primarily because of increasing use of economic logic, concepts, tools and
theories in the decision making process of large multinationals.

Also, this can be attributed to increasing demand for professionally trained

management personnel, who can leverage limited resources available to them and
maximize returns with efficiency and effectiveness.

Role in Managerial Decision Making

Managerial economics leverages economic concepts and decision science

techniques to solve managerial problems. It provides optimal solutions to
managerial decision making issues.

Business firms are a combination of manpower, financial, and physical resources

which help in making managerial decisions. Societies can be classified into two main
categories − production and consumption. Firms are the economic entities and are
on the production side, whereas consumers are on the consumption side.

The performances of firms get analyzed in the framework of an economic model.

The economic model of a firm is called the theory of the firm. Business decisions
include many vital decisions like whether a firm should undertake research and
development program, should a company launch a new product, etc.

Business decisions made by the managers are very important for the success and
failure of a firm. Complexity in the business world continuously grows making the
role of a manager or a decision maker of an organisation more challenging! The
impact of goods production, marketing, and technological changes highly contribute
to the complexity of the business environment.
Steps for Decision-Making

The steps for decision making like problem description, objective determination,
discovering alternatives, forecasting consequences are described below –

Economic analysis is the most crucial phase in managerial economics. A manager

has to collect and study the economic data of the environment in which a firm
operates. He has to conduct a detailed statistical analysis in order to do research
on industrial markets. The research may comprise of information regarding tax
rates, products, competitor’s pricing strategies, etc., which may be useful for
managerial decision-making.

The Economic Systems

Economic market system is a set of institutions for allocating resources and making
choices to satisfy human wants. In a market system, the forces and interaction of
supply and demand for each commodity determines what and how much to
produce.

In price system, the combination is based on least combination method. This

method maximizes the profit and reduces the cost. Thus firms using least
combination method can lower the cost and make profit. Resources are allocated
 by planning. In a market economy, goods are allocated according to the decisions
of producers and consumers.

 Pure Capitalism − Pure capitalism market economic system is a system in

which individuals own productive resources and as it is the private ownership;
they can be used in any manner subject to the productive legal restrictions.
 Communism − Communism is an economy in which workers are motivated to
contribute to the economy. Government has most of the control in this system.
The government decides what to produce, how much, and how to produce. This is
an economic decision making through planned economy.
 Mixed Economy − Mixed economy is a system where most of the wealth is
generated by businesses and the government also plays an important role.

The Concept of Utility: It’s Meaning, Total Utility and Marginal Utility

Although the concept of ‘taste’ and ‘satisfaction’ are familiar for all of us, it is much
more difficult to express these concepts in concrete terms. For example, suppose you
have just eaten an ice-cream and a chocolate.

Can you tell how much are you satisfied from each of these items? Probably you can
tell which item you liked more. But, it is very difficult to express “how much” you
liked one over the other. It is evident, that we need a more quantitative measure of
satisfaction. Due to this reason, economists developed the concept of utility.

Utility refers to want satisfying power of a commodity. It is the satisfaction, actual or

expected, derived from the consumption of a commodity. Utility differs from person-
to-person, place-to-place and time-to-time. In the words of Prof. Hobson, “Utility is
the ability of a good to satisfy a want”. In short, when a commodity is capable of
satisfying human wants, we can conclude that the commodity has utility.
After understanding the meaning of utility, the next big question is: How to measure
utility? According to classical economists, utility can be measured, in the same way, as
weight or height is measured. For this, economists assumed that utility can be
measured in cardinal (numerical) terms. By using cardinal measure of utility, it is
possible to numerically estimate utility, which a person derives from consumption of
goods and services. But, there was no standard unit for measuring utility. So, the
economists derived an imaginary measure, known as ‘Util’.

Utils are imaginary and psychological units which are used to measure satisfaction
(utility) obtained from consumption of a certain quantity of a commodity.

Suppose you have just eaten an ice-cream and a chocolate. You agree to assign 20
utils as utility derived from the ice-cream. Now the question is: how many utils be
assigned to the chocolate? If you liked the chocolate less, then you may assign utils
less than 20.

However, if you liked it more, you would give it a number greater than 20. Suppose,
you assign 10 utils to the chocolate, then it can be concluded that you liked the ice-
cream twice as much as you liked the chocolate.

Utils cannot be taken as a standard unit for measurement as it will vary from
individual to individual. Hence, several economists including Marshall, suggested the
measurement of utility in monetary terms. It means, utility can be measured in terms
of money or price, which the consumer is willing to pay.

In the above example, suppose 1 util is assumed to be equal to Rs. 1. Now, an ice--
cream will yield utility worth Rs. 20 (as 1 util = Rs. 1) and chocolate will give utility of
Rs. 10. This utility of Rs. 20 from the ice-cream or f I0 from the chocolate is termed as
value of utility in terms of money.
It must be noted that it is impossible to measure satisfaction of a person as it is
inherent to the individual and differs greatly from person-to-person. Still, the concept
of utility is very useful in explaining and understanding the behaviour of consumer.

Total Utility (TU):

Total utility refers to the total satisfaction obtained from the consumption of all
possible units of a commodity. It measures the total satisfaction obtained from
consumption of all the units of that good. For example, if the 1st ice-cream gives you
a satisfaction of 20 utils and 2nd one gives 16 utils, then TU from 2 ice-creams is 20 +
16 = 36 utils. If the 3rd ice-cream generates satisfaction of 10 utils, then TU from 3
ice-creams will be 20+ 16 + 10 = 46 utils.

TU can be calculated as:

TUn = U1 + U2 + U3 +……………………. + Un

Where:

TUn = Total utility from n units of a given commodity

U1, U2, U3,……………. Un = Utility from the 1st, 2nd, 3rd nth unit

n = Number of units consumed

Marginal Utility (MU):

Marginal utility is the additional utility derived from the consumption of one more
unit of the given commodity. It is the utility derived from the last unit of a commodity
purchased. As per given example, when 3rd ice-cream is consumed, TU increases
from 36 utils to 46 utils. The additional 10 utils from the 3rd ice-cream is the MU.

In the words of Chapman, “Marginal utility is addition made to total utility by

consuming one more unit of a commodity”.
MU can be calculated as: MUn = TUn – TUn-1

Where: MUn = Marginal utility from nth unit; TUn = Total utility from n units;

TUn-1 = Total utility from n – 1 units; n = Number of units of consumption

MU of 3rd ice-cream will be: MU3 = TU3 – TU2 = 46 – 36 = 10 utils One More way to
Calculate MU

MU is the change in TU when one more unit is consumed.

MU = Change in Total Utility/ Change in number of units = ∆TU/∆Q

Total Utility is Summation of Marginal Utilities

The concepts of TU and MU can be better understood from the following schedule

Ice-creams Consumed Marginal Utility (MU) Total Utility (TU)

1 20 20

2 16 36

3 10 46

4 4 50

5 0 50

6 -6 44

MU is positive and TU is increasing till the 4th ice-cream. After consuming the 5th ice-
cream, MU is zero and TU is maximum.

This point is known as the point of satiety or the stage of maximum satisfaction. After
consuming the 6th ice-cream, MU is negative (known as disutility) and total utility
starts diminishing. Disutility is the opposite of utility. It refers to loss of satisfaction due
to consumption of too much of a thing.

The Law of Diminishing Marginal Utility

The law of diminishing marginal utility states that “During the course of consumption,
as more and more units of a commodity are used, every successive unit gives utility
with a diminishing rate, provided other things remaining the same; although, the total
utility increases.”

Assumptions in the Law of Diminishing Marginal Utility:

For the law of diminishing marginal utility to be true, we need to make certain
assumptions. Each assumption is quite logical and understandable. If any of the
assumptions are not true in the case, the law of diminishing marginal utility will not be
true.

Following are the assumptions in the law of diminishing marginal utility:

The quality of successive units of goods should remain the same. If the quality of the
goods increase or decrease, the law of diminishing marginal utility may not be proven
true.

 Consumption of goods should be continuous. If there comes a substantial

break in the consumption of goods, the actual concept of diminishing marginal
utility will be altered.
 Consumer’s mental outlook should not change.
 Unit of good should not be very few or small. In such a case, the utility may
not be measured accurately.
Exceptions for the Law of Diminishing Marginal Utility:

The law of diminishing marginal utility states that with the consumption of every
successive unit of commodity yields marginal utility with a diminishing rate. However,
there are certain things on which the law of diminishing marginal utility does not
apply.

 Desire for money.

 Desire for knowledge.
 Use of liquor or wine.
 Collection of rare objects.

Demand Analysis

Meaning and Definition of Demand: The demand for a commodity is its quantity
which consumers are able and willing to buy at various prices during a given period of
time. So, for a commodity to have demand, the consumer must possess willingness to
buy it, the ability or means to buy it, and it must be related to per unit of time i.e. per
day, per week, per month or per year.

According to Prof. Bober, “By demand we mean the various quantities of a given
commodity or service which consumers would buy in one market in a given period of
time at various prices or at various incomes or at various prices of related goods.”
 Determinants of Demand

The determinants of demand are:

1. The price of the good or service.

2. Income of buyers.
3. Prices of related goods or services. These are either complementary, those
purchased along with a particular good or service, or substitutes, those
purchased instead of a certain good or service.
4. Tastes or preferences of consumers.
5. Future Expectations.
6. Fashion
7. Demographic distribution of population.

Price. The law of demand states that when prices rise, the quantity of demand falls.
That also means that when prices drop, demand will grow. People base their
purchasing decisions on price if all other things are equal. The exact quantity bought
for each price level is described in the demand schedule.

Income. When income rises, so will the quantity demanded. When income falls, so will
demand. But if your income doubles, you won't always buy twice as much of a
particular good or service. There's only so many pints of ice cream you'd want to eat,
no matter how wealthy you are. That's where the concept of marginal utility comes
into the picture. The first pint of ice cream tastes delicious. You might have another.
But after that, the marginal utility starts to decrease to the point where you don't want
any more.

Prices of related goods or services. The price of complementary goods or services

raises the cost of using the product you demand, so you'll want less. For example,
when gas prices rose to $4 a gallon in 2008, the demand for Hummers fell. Gas is a
complementary good to Hummers. The cost of driving a Hummer rose along with gas
prices.

The opposite reaction occurs when the price of a substitute rises. When that happens,
people will want more of the good or service and less of its substitute. That's why
Apple continually innovates with its iPhones and iPods. As soon as a substitute, such as
a new Android phone, appears at a lower price, Apple comes out with a better
product. Then the Android is no longer a substitute.

Tastes. When the public’s desires, emotions, or preferences change in favor of a

product, so does the quantity demanded. Likewise, when tastes go against it, that
depresses the amount demanded. Brand advertising tries to increase the desire for
consumer goods. For example, Buick spent millions to make you think its cars are not
only for older people.

Future Expectations. When people expect that the value of something will rise, they
demand more of it. That explains the housing asset bubble of 2005. Housing prices
rose, but people bought more because they expected the price to continue to go up.
Prices increased even more until the bubble burst in 2006. Between 2007 and 2011,
housing prices fell 30 percent. But the quantity demanded didn't grow. Why? People
expected prices to continue falling. Record levels of foreclosures entered the market
due to the subprime mortgage crisis.

Fashion: Changing fashion trends also determine the demand for various products at
different periods. What is demanded today may be out of fashion tomorrow and
would no longer be demanded.

Demographic distribution of population: The distribution of population also has an

effect on the demand for various goods and commodities. The area where the
population mainly comprises of youth will have a different demand than the area
where the elderly population is more. Population per say also has an effect on the
demand. An increase in population will have the effect of an increase in demand for
various goods and services.

Law of Demand

It is our common experience as consumers that those commodities whose price rises
at a point of time are consumed less. This is because we feel we can no longer afford
to purchase the same quantity of the commodity at the increased price, in other
words, the commodity becomes less attractive for us as consumers, so we either
reduce its consumption or totally stop purchasing the commodity. (The recent case of
the increase in price of tomatoes, or the increase in prices of pulses some time back, is
classic examples of this phenomenon).

In economics, this phenomenon is related to the Law of Demand.

The Law of Demand states that, “when the price of a commodity increases, its
demand decreases, and vice-versa, other things remaining the same”. That is, given
prices of related goods, income and tastes and preferences of the consumer, etc, if the
price of the good increases its quantity demanded decreases, while if price of the good
decreases its quantity demanded increases.

The law of demand operates due to the underlying effects of substitution and real
income changes. Any change in the price of the commodity affects the quantity
demanded of the commodity in two ways:

(i) Substitution effect of a price change, and

(ii) Income effect of a price change.

Substitution effect: Due to a change in the price of one good, the consumers tend to
shift their purchase from the now relatively costlier good to the substitute good that is
now relatively cheaper. This phenomenon is called as substitution effect.
Income effect: Due to the consumer’s shift from the now relatively costlier good to the
now relatively cheaper substitute, he is left with some additional purchasing power
(due to the difference between the prices of the original good and the substitute good
which, for the consumer, is now cheap). Thus, his real income (additional purchasing
power) increases, which can be used for purchasing some additional goods in his
consumption bundle. This is called as income effect.

When price of a good decreases it becomes relatively cheaper. Hence, this good is
substituted in place of the now relatively costlier goods. So also, since one of the
goods in the consumption bundle of the consumer has become relatively cheaper, the
consumer is now left with some purchasing power after buying his initial bundle of
goods. With this additional purchasing power, he buys additional quantities of goods in
his consumption bundle.

Demand schedule

Price of good X Quantity demanded

1 500
2 400
3 300
4 200
5 100

Demand Curve
 Why are Demand Curves downward sloping?

Generally the demand curves slope downwards from left to right. There are several
reasons for the downward sloping nature of demand curves.

1. The law of diminishing marginal utility is at the root of the law of demand.
The law of diminishing marginal utility states that as one goes on consuming more
and more units of a commodity its utility to him goes on diminishing. The consumer’s
objective is to maximize his satisfaction from the consumption of a commodity.
Therefore, he buys a commodity in such a way that marginal utility of the commodity
is equal to its price. A rational consumer always tries to equate marginal utility and
price. When the price decreases, he buys more quantity to bring the marginal utility
to the level of price.

2. A commodity tends to be put to more use when it becomes cheaper. Thus,

the existing buyers purchase more and some new buyers also enter the market. The
combined effect is that of an extension of demand when the price falls.
3. A fall in price of a superior good will result in a rise in the consumer’s real
income. Therefore, he can buy more of that good. On the other hand, a rise in the
price of a superior good will result in a decline in the consumer’s real income,
therefore, the consumer will buy less of it. The resultant increase or decrease in the
consumer’s demand may be attributed to the income effect.
4. The downward sloping nature of the demand curve is also due to the
substitution effect. A fall in the price of a good, while the prices of its substitutes
remain unchanged, will make it attractive and affordable to the buyers who will now
demand more of it. On the contrary, a rise in the price of the commodity, while the
prices of its substitutes remaining same, will make it less attractive and affordable to
 the purchasers who will now demand less of the commodity, while some of the
consumers will even exit the market.

Exceptions to the Law of Demand:

Normally, the amount demanded of a good increases with the decrease in price of
the good and vice versa. However, in some cases, this may not be true. The
exceptions to the Law of Demand are the following:

(1) Griffin goods: If there is an inferior good in whose case the income effect is
stronger than the substitution effect, the law of demand would not hold. For example,
when the price of potatoes (which is the main food of poor families) decreases
significantly, then these poor households may like to buy superior goods out of the
savings which they can now have due to the decrease in price of potatoes. This would
result in the increased consumption of superior goods like cereals, fruits, etc. not only
from these savings but also by reducing the consumption of potatoes. Here, the
reduction in the price of potatoes results in the reduction in the consumption of
potatoes. Some of the basic food items like bajra, jawar, barley, gram, etc, consumed
in bulk by poor families, are generally categorized under Griffin goods (inferior
goods).
(2) Commodities which are used as status symbols: Some highly expensive
commodities like diamonds, expensive cars, etc. are used as status symbols to display
one’s wealth or status (Demonstration Effect). The more expensive these
commodities become, more will be their value as status symbol and hence greater
will be their demand. The amount demanded of these commodities increases with
the increase in their price and decrease with a decrease in their price.
(3) Expectations of change in the price of the commodity. If the household
expects the price of a commodity to increase, it may start purchasing greater amount
of the commodity even at the presently increased price. Similarly, if a household
expects the price of the commodity to decrease in the future, it may postpone its
purchase to that future time. In such cases, the law of demand does not apply.

Elasticity of Demand

Elasticity means sensitiveness or responsiveness of demand to the change in price.

Demand extends or contracts respectively with a fall or rise in price. This quality of
demand to change when price changes, is called Elasticity of Demand.

This change, sensitiveness or responsiveness, may be small or large. Take the case of
salt. Even a big fall in its price may not induce an appreciable extension in its demand.
On the other hand, a slight fall in the price of oranges may cause a considerable
extension in their demand. That is why we say that the demand in the former case is
‘inelastic’ and in the latter case it is ‘elastic’.

The Elasticity of Demand measures the percentage change in quantity demanded for
a percentage change in the price. Simply, the relative change in demand for a
commodity as a result of a relative change in its price is called as the elasticity of
demand.

The demand is elastic when with a small change in price there is a great change in
demand; it is inelastic or less elastic when even a big change in price induces only a
slight change in demand. Perfectly elastic demand will mean that a slight fall (or rise)
in the price of the commodity concerned induces an infinite extension (or
contraction) in its demand. Perfectly inelastic demand will mean that any amount of
fall (or rise) in the price of the commodity would not induce any extension (or
contraction) in its demand. Both these conditions are unrealistic. That is why we say
that elasticity of demand may be ‘more or less’, but it is seldom perfectly elastic or
absolutely inelastic.
 The degree to which demand for a good or service varies with its price. Normally,
sales increase with drop in prices and decrease with rise in prices. As a general rule,
appliances, cars, confectionary and other non-essentials show elasticity of demand
whereas most necessities (food, medicine, basic clothing) show inelasticity of demand
(do not sell significantly more or less with changes in price).Also called price demand
elasticity.

Determinants of Elasticity of Demand

Demand elasticity is an economic measure of the sensitivity of demand relative to a

change in another variable. The quantity demanded of a good or service depends on
multiple factors, such as price, income and preference. Whenever there is a change in
these variables, it causes a change in the quantity demanded of the good or service.

For example, when there is a relationship between the change in the quantity
demanded and the price of a good or service, the elasticity is known as price elasticity
of demand. The two other main types of demand elasticity are income elasticity of
demand and cross elasticity of demand.

Apart from the price, there are several other factors that influence the elasticity of
demand.

These are:

1. Consumer Income: The income of the consumer also affects the elasticity of
demand. For high-income groups, the demand is said to be less elastic as the rise or
fall in the price will not have much effect on the demand for a product. Whereas, in
case of the low-income groups, the demand is said to be elastic and rise and fall in
the price have a significant effect on the quantity demanded. Such as when the
price falls the demand increases and vice-versa.
2. Amount of Money Spent: The elasticity of demand for a product is
determined by the proportion of income spent by the individual on that product. In
case of certain goods, such as matchbox, salt a consumer spends a very small
amount of his income, let’s say Rs 2, then even if their prices rise the demand for
these products will not be affected to a great extent. Thus, the demand for such
products is said to be inelastic.

Whereas foods and clothing are the items where an individual spends a major
proportion of his income and therefore, if there is any change in the price of these
items, the demand will get affected.

3. Nature of Commodity: The elasticity of demand also depends on the nature

of the commodity. The product can be categorized as luxury, convenience,
necessary goods. The demand for the necessities of life, such as food and clothing is
inelastic as their demand cannot be postponed. The demand for the Comfort Goods
is neither elastic nor inelastic. As with the rise and fall in their prices, the demand
decreases or increases moderately.

Whereas the demand for the luxury goods is said to be highly elastic because even
with a slight change in its price the demand changes significantly. But, however, the
demand for the prestige goods is said to be inelastic, because people are ready to
buy these commodities at any price, such as antiques, gems, stones, etc.

4. Several Uses of Commodity: The elasticity of demand also depends on the

number of uses of the commodity. Such as, if the commodity is used for a single
purpose, then the change in the price will affect the demand for commodity only in
that use, and thus the demand for that commodity is said to be inelastic. Whereas,
if the product has several uses, such as raw material coal, iron, steel, etc., then the
change in their price will affect the demand for these commodities in its many uses.
Thus, the demand for such products is said to be elastic.
5. Whether the Demand can be Postponed or not: If the demand for a
particular product cannot be postponed then, the demand is said to be inelastic.
Such as, Wheat is required in daily life and hence its demand cannot be postponed.
On the other hand, the items whose demand can be postponed is said to have
elastic demand. Such as the demand for the furniture can be postponed until the
time its prices fall.
6. Existence of Substitutes: The substitutes are the goods which can be used in
place of one another. The goods which have close substitutes are said to have
elastic demand. Such as, tea and coffee are close substitutes and if the price of tea
increases, then people will switch to the coffee and demand for the tea will
decrease significantly. Whereas, if there are no close substitutes for a product, then
its demand is said to be inelastic. Such as salt and sugar do not have their close
substitutes and hence lower is their price elasticity.
7. Joint Demand: The elasticity of demand also depends on the complementary
goods, the goods which are used jointly. Such as car and petrol, pen and ink, etc.
Here the elasticity of demand of secondary (supporting) commodity depends on the
elasticity of demand of the major commodity. Such as, if the demand for pen is
inelastic, then the demand for the ink will also be less elastic.
8. Range of Prices: The price range in which the commodities lie also affects the
elasticity of demand. Such as the higher range products are usually bought by the
rich people, and they do not care much about the change in the price and hence the
demand for such higher range commodities is said to be inelastic.

Also, the lower range commodities have inelastic demand because these are already
low priced and can be bought by any sections of the society. But the commodities in
middle range prices are said to have an elastic demand because with the fall in the
prices the middle class and the lower middle class are induced to buy that commodity
and therefore the demand increases. But however, if the prices are increased the
consumption reduces and as a result demand falls.
Thus, these are some of the important determinants of elasticity of demand that
every firm should understand properly before deciding on the price of their offerings.

Types of Elasticity:

Distinction may be made between Price Elasticity, Income Elasticity and Cross
Elasticity. Price Elasticity is the responsiveness of demand to change in price; income
elasticity means a change in demand in response to a change in the consumer’s
income; and cross elasticity means a change in the demand for a commodity owing to
change in the price of another commodity.

Consumers' incomes play a very important role in the demand for a good or service.
When there is a change in consumers' incomes, it causes a change in the quantity
demanded of a good or service if all other factors remain the same. The sensitivity of
a change in the quantity demanded of a good or service relative to a change in
consumers' incomes is known as income elasticity of demand. The formula used to
calculate the income elasticity of demand is the percent change in the quantity
demanded of a good or service divided by its percent change in consumers' incomes.

If the income elasticity of demand is greater than 1, the good or service is

considered a luxury and income elastic. A good or service that has an income
elasticity of demand between zero and 1 is considered a normal good and income
inelastic. If a good or service has an income elasticity of demand below zero, it is
considered an inferior good and has negative income elasticity.
Another example of demand elasticity is cross elasticity of demand. This measures
how sensitive the quantity demanded of a good or service is relative to a change in
the price of a similar good or service. The cross elasticity of demand is calculated by
dividing the percent change of the quantity demanded of one good divided by the
percent change in the price of a substitute good.

The measure of responsiveness of the demand for a good towards the change in the
price of a related good is called cross price elasticity of demand.

With the consumption behavior being related, the change in the price of a related
good leads to a change in the demand of another good. Related goods are of two
kinds, i.e. substitutes and complementary goods. In case the two goods are not
related, the Coefficient of Cross Elasticity is zero.

In case the two goods are substitutes for each other like tea and coffee, the cross
price elasticity will be positive, i.e. if the price of coffee increases, the demand for
tea increases. On the other hand, in case the goods are complementary in nature
like pen and ink, then the cross elasticity will be negative, i.e. demand for ink will
decrease if prices of pen increase or vice-versa.

If the cross elasticity of demand of goods is greater than zero, the goods are said to
be substitutes. With goods that have a cross elasticity of demand equal to zero, the
two goods are independent of each other. If the cross elasticity of demand is less
than zero, the two goods are said to be complementary.

Degrees of Elasticity of Demand

The following are the main types of price elasticity of demand:

1. Perfectly Elastic Demand (Ep = ∞): The demand is said to be perfectly elastic
when a slight change in the price of a commodity causes a major change in its
quantity demanded. Such as, even a small rise in the price of a commodity can
result into fall in demand even to zero. Whereas a little fall in the price can result in
the increase in demand to infinity.

In perfectly elastic demand the demand curve is a straight horizontal line which
shows, the flatter the demand curve the higher is the elasticity of demand.

2.Perfectly Inelastic Demand (Ep =0): When there is no change in the demand for a
product due to the change in the price, then the demand is said to be perfectly
inelastic. Here, the demand curve is a straight vertical line which shows that the
demand remains unchanged irrespective of change in the price., i.e. quantity OQ
remains unchanged at different prices, P1, P2, and P3.
2. Relatively Elastic Demand (1 to ∞): The demand is relatively elastic when the
proportionate change in the demand for a commodity is greater than the
proportionate change in its price. Here, the demand curve is gradually sloping
which shows that a proportionate change in quantity from OQ0 to OQ1 is greater
than the proportionate change in the price from OP1 to Op2.

3. Relatively Inelastic Demand (0-1): When the proportionate change in the demand
for a product is less than the proportionate change in the price, the demand is said
to be relatively inelastic demand. It is also called as the elasticity less than unity,
i.e. 1. Here the demand curve is rapidly sloping, which shows that the change in
the quantity from OQ0 to OQ1 is relatively smaller than the change in the price
from OP1 to Op2.
4. Unitary Elastic Demand (Ep =1): The demand is unitary elastic when the
proportionate change in the price of a product results in the same change in the
quantity demanded. Here the shape of the demand curve is a rectangular hyperbola,
which shows that area under the curve is equal to one.Unitary Elastic Demand

Thus, these are some of the types of the price elasticity of demand that helps the firms
to price their product in accordance with the demand patterns of an individual which
changes with the change in the price of the commodity
 Importance of Elasticity of Demand

 The concept of demand elasticity helps in understanding the price

determination by the monopolist. A monopoly is the market structure wherein there
is only one seller whose main objective is to maximize the profits. The price he
chooses for his product depends on the elasticity of demand. Such as, if the demand
for a commodity is high he can choose the higher price as the consumers will buy the
product even when the price rise. But however, if the demand is elastic, he will
choose the lower prices.
 The determination of the price depends on demand for and supply of the
commodity. But however, the demand is governed by the demand elasticity and the
supply too is governed by the elasticity of supply. Therefore, the price of a
commodity depends on both the demand and supply elasticity.
 The concept of demand elasticity also helps in understanding other types of
prices, such as exchange rates, i.e. a rate at which currency unit of one country is
exchanged for the currency unit of another country. Also, the terms of trade, i.e. the
rate at which the exports are changed for imports can be easily understood through
this concept.
 The concept of elasticity of demand also helps the government in its taxation
policies. This helps the government to have a fair idea about the demand elasticity of
goods which are being taxed.
 This concept also helps in the determination of wages, such as if the demand
for labor is inelastic the union can demand higher wages and conversely if the labor
demand is elastic the demand for higher wages could not be raised.

Thus, the concept of elasticity of demand is very important to understand the

economic problems and policies.
Supply

Supply is the total amount of a product (good or service) available for purchase at
any specified price. A fundamental economic theory, supply refers to the quantity
of goods a producer is willing and able to sell at a specific price. A firm's profitability
depends upon its ability to price goods at the market-clearing price.

Unlike demand, supply refers to the willingness of a seller to sell the specified
amount of a product within a particular price and time.

Supply is always defined in relation to price and time. For example, if a seller agrees
to sell 500 kgs of wheat, it cannot be considered as supply of wheat as the price and
time factors are missing.

Apart from this, the supply also depends on the stock and market price of the
product. Stock of a product refers to quantity of a product available in the market
for sale within a specified point of time.

Both stock and market price of a product affect its supply to a greater extent. If the
market price is more than the cost price, the seller would increase the supply of a
product in the market. However, the decrease in market price as compared to cost
price would reduce the supply of product in the market.

Determinants of Supply:

Supply can be influenced by a number of factors that are termed as determinants of

supply. Generally, the supply of a product depends on its price and cost of
production. In simple terms, supply is the function of price and cost of production.

Some of the factors that influence the supply of a product are:

Price: Refers to the main factor that influences the supply of a product to a greater
extent. Unlike demand, there is a direct relationship between the price of a product
and its supply. If the price of a product increases, then the supply of the product
also increases and vice versa. Change in supply with respect to the change in price is
termed as the variation in supply of a product.

Speculation about future price can also affect the supply of a product. If the price of
a product is about to rise in future, the supply of the product would decrease in the
present market because of the profit expected by a seller in future. However, the
fall in the price of a product in future would increase the supply of product in the
present market.

Cost of Production: Implies that the supply of a product would decrease with
increase in the cost of production and vice versa. The supply of a product and cost
of production are inversely related to each other. For example, a seller would
supply less quantity of a product in the market, when the cost of production
exceeds the market price of the product.

In such a case the seller would wait for the rise in price in future. The cost of
production rises due to several factors, such as loss of fertility of land, high wage
rates of labor, and increase in the prices of raw material, transport cost, and tax
rate.

Natural Conditions: Implies that climatic conditions directly affect the supply of
certain products. For example, the supply of agricultural products increases when
monsoon comes on time. However, the supply of these products decreases at the
time of drought. Some of the crops are climate specific and their growth purely
depends on climatic conditions.

Technology: Refers to one of the important determinant of supply. A better and

advanced technology increases the production of a product, which results in the
increase in the supply of the product. For example, the production of fertilizers and
good quality seeds increases the production of crops. This further increase the
supply of food grains in the market.

Transport facilities: Refer to the fact that better transport facilities increase the
supply of products. Transport is always a constraint to the supply of products, as the
products are not available on time due to poor transport facilities. Therefore even if
the price of a product increases, the supply would not increase.

Factor Prices and their Availability: Act as one of the major determinant of supply.
The inputs, such as raw material man, equipment, and machines, required at the
time of production are termed as factors. If the factors are available in sufficient
quantity and at lower price, then there would be increase in production. This would
increase the supply of a product in the market. For example, availability of cheap
labor and raw material nearby the manufacturing plant of an organization would
help in reducing the labor and transportation costs. Consequently, the production
and supply of the product would increase.

Government’s Policies: Implies that the different policies of government, such as

fiscal policy and industrial policy, has a greater impact on the supply of a product.
For example, increase in tax on excise duties would decrease the supply of a
product. On the other hand, if the tax rate is low, then the supply of a product
would increase.

Prices of Related Goods: Refer to fact that the prices of substitutes and
complementary goods also affect the supply of a product. For example, if the price
of wheat increases, then farmers would tend to grow more wheat than needed.
This would decrease the supply of rice in the market.
Law of Supply

Law of supply states that other factors remaining constant, price and quantity
supplied of a good are directly related to each other. In other words, when the price
paid by buyers for a good rises, then suppliers increase the supply of that good in the
market.

Law of supply depicts the producer behavior at the time of changes in the prices of
goods and services. When the price of a good rises, the supplier increases the supply
in order to earn a profit because of higher prices.

Supply schedule shows a tabular representation of law of supply. It presents the

different quantities of a product that a seller is willing to sell at different price levels
of that product.

The graphical representation of supply schedule is called supply curve. In a graph,

price of a product is represented on Y-axis and quantity supplied is represented on X-
axis.
 Assumptions in Law of Supply:

The law of supply expresses the change in supply with relation to change in price. In
other words the main assumption of law of supply is that it studies the effect of price
on supply of a product, while keeping other determinants of supply at constant.

Apart from this, there are certain assumptions that are necessary for the application
of law of supply:

1. The price of the product changes but there is no change in the cost of
production. This is because if the cost of production rises with increase in price,
then sellers would not supply more due to the reduction in their profit margin.
Therefore, law of supply would be applicable only when the cost of production
remains constant.
2. There is no change in the technique of production. This is because the
advanced technique would reduce the cost of production and make the seller
supply more at a lower price.
3. There is no change in the scale of production. This is because if the scale of
production changes with a period of time, then it would affect the supply. In such a
case, the law of supply would not be applicable.
4. Government policies remain constant. If there is an increase in tax rates, then
the supply of product would decrease even at the higher price. Therefore, for the
 application of law of supply, it is necessary that government policies should remain
constant.
5. Transportation cost remains constant. In case the transportation cost
reduces, then the supply would increase, which is invalid according to the law of
supply.
6. No speculation about prices in future. This would otherwise affect the supply
of a product. If there is no speculation about products, then the economy is
assumed to be at balance and people are satisfied with the available products and
do not require any change.

Elasticity of Supply

Meaning of Elasticity of Supply: The law of supply indicates the direction of change—
if price goes up, supply will increase. But how much supply will rise in response to an
increase in price cannot be known from the law of supply. To quantify such change
we require the concept of elasticity of supply that measures the extent of quantities
supplied in response to a change in price.

Elasticity of supply measures the degree of responsiveness of quantity supplied to a

change in own price of the commodity. It is also defined as the percentage change in
quantity supplied divided by percentage change in price.

ES = % change in quantity supplied/% change in price

Since price and quantity supplied, in usual cases, move in the same direction, the
coefficient of ES is positive.
Types of Elasticity of Supply:

Like elasticity of demand, there are five cases of Elasticity of Supply

(a) Elastic Supply (ES>1):

Supply is said to be elastic when a given percentage change in price leads to a larger
change in quantity supplied. Under this situation, the numerical value of Es will be
greater than one but less than infinity. Here quantity supplied changes by a larger
magnitude than does price.

(b) Inelastic Supply (ES< 1):

 Supply is said to be inelastic when a given percentage change in price causes a
smaller change in quantity supplied. Here the numerical value of elasticity of supply
is greater than zero but less than one. Fig. depicts inelastic supply curve where
quantity supplied changes by a smaller percentage than does price.

(c) Unit Elasticity of Supply (ES = 1):

If price and quantity supplied change by the same magnitude, then we have unit
elasticity of supply. Any straight line supply Curve passing through the origin,
such as the one shown in Fig. has an elasticity of supply equal to 1. This can be
verified in this way.

For any straight line positively-sloped supply curve drawn through the origin, the
ratio of P/Q at any point on the supply curve is equal to the ratio ∆ P/∆ Q. Note
 that ∆ P/∆ Q is the slope of the supply curve while elasticity is (1/∆P/∆Q =
∆Q/∆P).Thus, in the formula (∆Q/∆P. P/Q), the two ratios cancel out each other.

(d) Perfectly Elastic Supply (ES = ∞):

The numerical value of elasticity of supply, in exceptional cases, may reach up to

infinity. The supply curve PS1 drawn in Fig. has an elasticity of supply equal to
infinity. Here the supply curve has been drawn parallel to the horizontal axis. The
economic interpretation of this supply curve is that an unlimited quantity will be
offered for sale at the price OS. If price slightly drops down below OS, nothing will
be supplied.

(e) Perfectly Inelastic Supply (ES = 0):

Another extreme is the completely or perfectly inelastic supply or zero elasticity.

SS1 curve drawn in Fig. illustrates the case of zero elasticity. This curve describes
that whatever the price of the commodity, it may even be zero, quantity supplied
remains unchanged at OQ. This sort of supply curve is conceived when we consider
the supply curve of land from the viewpoint of a country, or the world as a whole.
One important point to note here. Any straight line supply curve that intersects the
vertical axis above the origin has an elasticity of supply greater than one. Elasticity of
supply will be less than one if the straight line supply curve cuts the horizontal axis
on any point to the right of the origin, i.e. the quantity axis.

Determinants of Elasticity of Supply:

(a) The Nature of the Good:

As with demand elasticity, the most important determinant of elasticity of supply is

the availability of substitutes. In the context of supply, substitute goods are those to
which factors of production can most easily be transferred. For example, a farmer
can easily move from growing wheat to producing jute. Of course, mobility of
factors is very important for such substitution.

As a general rule, the more easily the factors can be transferred from the
production of one good to that of another, the greater will be the elasticity of
supply. Since durable goods can be stored for a long time, its elasticity of supply is
very high. But for non-durable goods and perishable goods elasticity of supply tends
to be very low.

(b) The Definition of the Commodity:

As in the case of demand, elasticity of supply also depends on the definition of the
commodity. The narrowly a commodity is defined the greater is its elasticity of
supply. For example, it is easier for a tailor to transfer resources from producing red
skirts to green skirts than from skirts to men’s trousers.

(c) Time:

Time also exerts considerable influence on the elasticity of supply. Supply is more
elastic in the long run than in the short run. The reason is easy to find out. The
longer the time period, the easier it is to shift resources among products, following
a change in their relative prices.

This is usually true in the case of most agricultural commodities, because of the
natural time lag between planting and harvesting of crops. In agriculture,
production plans have to be made months or even years ahead and they cannot be
altered quickly.

Manufacturing industries, on the other hand, can usually adjust their output
upwards or downwards fairly quickly in response to changing conditions in the
market.

(d) The Cost of Attracting Resources:

If supply is to be increased it is necessary to attract resources from other industries.

This usually involves raising the prices of these resources. As their prices rise, cost of
production also increases. So supply becomes relatively inelastic.

If these resources can be obtained cheaply then supply is likely to be relatively

elastic. These considerations become very important at times of full employment
when the only available factors of production are those which can be attracted from
other industries and uses.

(e) The Level of Price:

Elasticity of supply is also likely to vary at different prices. Thus, when the price of a
commodity is relatively high, the producers are likely to be supplying near the limits
of their capacity and would, therefore, be unable to make much response to a still
higher price. When the price is relatively low, however, producers may well have
surplus capacity which a higher price would induce them to use.

Macroeconomics

Malthusian Theory Of Population

The Malthusian Theory of Population is a theory of exponential population growth

and arithmetic food supply growth. Thomas Robert Malthus, an English cleric, and
scholar published this theory in his 1798 writings, An Essay on the Principle of
Population.

He believed that through preventative checks and positive checks, the population
would be controlled to balance the food supply with the population level.

1. Population and Food Supply

Thomas Malthus theorized that populations grew in geometric progression. A

geometric progression is a sequence of numbers where each term after the first is
found by multiplying the previous one by a fixed, non-zero number called the
common ratio. For example, in the sequence 2, 10, 50, 250, 1250, the common ratio
is 5.

For example, if every member of a family tree reproduces, the tree will continue to
grow with each generation. On the other hand, food production increases
arithmetically, so it only increases at given points in time. Malthus wrote that, left
unchecked, populations can outgrow their resources.
Additionally, he stated that food production increases in arithmetic progression. An
arithmetic progression is a sequence of numbers such that the difference between
the consecutive terms is constant. For example, in the sequence 2, 5, 8, 11, 14, 17,
the common difference of 3. He derived this conclusion due to the Law of
Diminishing Returns.

From this, we can conclude that populations will grow faster than the supply of
food. This will lead to a shortage of food.

2. Population Control

Malthus then argued that because there will be higher population than the
availability of food, many people will die from the shortage of food. He theorized
that this correction will take place in the form of Positive Checks (or Natural Checks)
and Preventative Checks. These checks would lead to the Malthusian catastrophe,
which would bring the population level back to a ‘sustainable level’.

A. Positive Checks or Natural Checks

Positive checks exercise their influence on the growth of population by increasing

the death rate. They are applied by nature. The positive checks to population are
various and include every cause, whether arising from vice or misery, which in any
degree contributes to shorten the natural duration of human life.

He believed that natural forces will correct the imbalance between food supply and
population growth in the form of natural disasters such as floods and earthquakes
and man-made actions such as wars and famines. Positive checks to population
growth are things that may shorten the average lifespan, such as disease, warfare,
famine, and poor living and working environments. According to Malthus,
eventually these positive checks would result in a Malthusian catastrophe (also
sometimes called a Malthusian crisis), which is a forced return of a population to
basic survival.
B. Preventative Checks

To correct the imbalance, Malthus also suggested using preventative measures to

control the growth of the population. These measures include family planning, late
marriages, and celibacy.

Preventive checks exercise their influence on the growth of population by bringing

down the birth rate. Preventive checks are those checks which are applied by man.
Preventive checks arise from man’s fore-sight which enables him to see distant
consequences He sees the distress which frequently visits those who have large
families.

According to Malthus, there are two types of 'checks' that can reduce a
population's growth rate. Preventive checks are voluntary actions people can take
to avoid contributing to the population. Because of his religious beliefs, he
supported a concept he called moral restraint, in which people resist the urge to
marry and reproduce until they are capable of supporting a family. This often
means waiting until a later age to marry. He also wrote that there are 'immoral'
ways to check a population, such as vices, adultery, prostitution, and birth control.
Due to his beliefs, he favored moral restraint and didn't support the latter
practices.
 Criticism of Malthusian Theory:

(i) It is pointed out that Malthus’s pessimistic conclusions have not been borne
out by the history of Western European countries. Gloomy forecast made by
Malthus about the economic conditions of future generations of mankind has been
falsified in the Western world. Population has not increased as rapidly as predicted
by Malthus; on the other hand, production has increased tremendously because of
the rapid advances in technology. As a result, living standards of the people have
risen instead of falling as was predicted by Malthus.
(ii) Malthus asserted that food production would not keep pace with
population growth owing to the operation of the law of
diminishing returns in agriculture. But by making rapid advances in
technology and accumulating capital in larger quantity, advanced
countries have been able to postpone the stage of diminishing
 returns. By making use of fertilizers, pesticide better seeds,
tractors and other agricultural machinery, they have been able to
increase their production greatly.
In fact, in most of the advanced countries the rate of increase of
food production has been much greater than the rate of
population growth. Even in India now, thanks to the Green
Revolution, the increase in food production is greater than the
increase in population. Thus, inventions and improvements in the
methods of production have belied the gloomy forecast of
Malthus by holding the law of diminishing returns in check almost
indefinitely.
(iii) Malthus compared the population growth with the increase in
food production alone. Malthus held that because land was
available in limited quantity, food production could not rise faster
than population. But he should have considered all types of
production in considering the question of optimum size of
population. England did feel the shortage of land and food.
(iv) Malthus held that the increase in the means of subsistence or
food supplies would cause population to grow rapidly so that
ultimately means of subsistence or food supply would be in level
with population, and everyone would get only bare minimum
subsistence. In other words, according to Malthus, living standards
of the people cannot rise in the long run above the level of
minimum subsistence. But, as already pointed out, living
standards of the people in the Western world have risen greatly
and stand much above the minimum subsistence level.
There is no evidence of birth-rate rising with the increases in the
standard of living. Instead, there is evidence that birth-rates fall as
 the economy grows. In Western countries, attitude towards
children changed as they developed economically. Parents began
to feel that it was their duty to do as much as they could for each
child.
(v) Malthus gave no proof of his assertion that population increased
exactly in geometric progression and food production increased
exactly in arithmetic progression. It has been rightly pointed out
that population and food supply do not change in accordance with
these mathematical series. Growth of population and food supply
cannot be expected to show the precision or accuracy of such
series.

Its Applicability:

Despite these weaknesses, the Malthusian doctrine contains much truth.

The Malthusian doctrine may not be applicable to the Western Europe
and England but its principal tools have become the part and parcel of the
people of these countries. If these lands do not face the problems of
over-population and misery, it is all due to the bogey and pessimism of
Malthusianism.

In fact, the people of Europe were made wiser by Malthus who

forewarned them of the evils of over-population and they started
adopting measurers toward it off. The very fact that people use
preventive checks, like late marriage and various contraceptives and birth
control measures on an extensive scale proves the vitality of the
Malthusian law.

The Malthusian doctrine may not be applicable now to its place of origin,
but its influence spreads over two-third of this universe. Excluding Japan,
the whole of Asia, Africa and South America come under its purview.
 India is one of the first countries to adopt family planning on state level to
control population. Positive checks like floods, wars, droughts, disuses,
etc. operate.

Marx’s Theory of population

The debate about the Malthusian theory has continued down to the present.
Economists such as J.S. Mill and J.M. Keynes supported his theory whereas
others, especially, sociologists, have argued against it. According to them, the
widespread poverty and misery of the working class people was, not due to
an eternal law of nature as propounded by Malthus but to the misconceived
organization of society.

Karl Marx’s theory of population was christened as theory of surplus

population. Karl Marx completely rejected Malthusian theory. He did not
separately propose any theory of population, but his surplus population
theory has been deduced from his theory of communism. Marx opposed and
criticized the Malthusian theory of population.

Karl Marx went one step further and argued that starvation was caused by
the unequal distribution of the wealth and its accumulation by capitalists. It
has nothing to do with the population. Population is dependent on economic
and social organization. The problems of overpopulation and limits to
resources, as enunciated by Malthus, are inherent and inevitable features
associated with the capitalist system of production.

According to Marx, population increase must be interpreted in the context of

the capitalistic economic system. A capitalist gives to labor as wage a small
share of labor’s productivity, and the capitalist himself takes the lion’s share.
The capitalist introduces more and more machinery and thus increases the
surplus value of labor’s productivity, which is pocketed by the capitalist. The
surplus is the difference between labor’s productivity and the wage level. A
worker is paid less than the value of his productivity. When machinery is
introduced, unemployment increases and, consequently, a reserve army of
labor is created. Under these situations, the wage level goes down further,
the poor parents cannot properly rear their children and a large part of the
population becomes virtually surplus. Poverty, hunger and other social ills are
the result of socially unjust practices associated with capitalism.

Population growth, according to Marx, is therefore not related to the alleged

ignorance or moral inferiority of the poor, but is a consequence of the
capitalist economic system. Marx points out that landlordism, unfavorable
and high man-land ratio, uncertainty regarding land tenure system and the
like are responsible for low food production in a country. Only in places
where the production of food is not adequate does population growth
become a problem.

Marx believed that the creation of a surplus population of unemployed “is a

necessary product of accumulation or of the development of wealth on a
capitalist basis, this surplus population also becomes, conversely, the lever of
capitalist accumulation, indeed it becomes a condition for the existence of
the capitalist mode of production. Within the working class, the capitalist
system, according to Marx, requires a pool or army of unemployed. This
reserve puts pressure on those who are employed by making them submit to
over work and a low level of wages.

During times when business is depressed, workers are laid off and eventually
profits begin to rise again. Thus business (capitalism) benefits by exploiting
labour. While wages are kept low everywhere, the members in this surplus
labour army are destined to have the lowest wages. Thus the working class
produces wealth (capital), but because there is a constant oversupply of
labour, it will never share in much of the wealth it produces. Since this means
that most working people are kept poor, their birth rates will remain high and
the labour surplus will continue to grow.

Thus for Marx, high levels of population growth were not the cause of
poverty (as Malthus believed). Rather, it was the other way around. Marx
believed that capitalism was an unjust economic system that profited at the
expense of those who laboured in it, and by keeping its workers poor also
caused high rates of population growth. His answer was revolution, replacing
capital ism with what he believed was a more just economic system.

Karl Marx argued that starvation was caused by the unequal distribution of
the wealth and its accumulation by capitalists. It has nothing to do with the
population. Population is dependent on economic and social organization.
The problems of overpopulation and limits to resources are inevitable
features and result associated with the capitalist system of production.

A capitalist gives to labor as wage a small share of labor's productivity, and

the capitalist himself takes the lion's share. The capitalist introduces more
and more machinery and thus increases the surplus value of labor's
productivity, which is pocketed by the capitalist. The surplus is the difference
between labor's productivity and the wage level. A worker is paid less than
the value of his productivity.

Theory of Demographic Transition:

Demographic transition is a term, first used by Warren S. Thompson (1929),

and later on by Frank W. Notestein (1945), referring to a historical process of
change which accounts the trends in births, deaths and population growth
that occurred in today’s industrialized societies, especially European
societies. This process of demographic change began for the most part in the
later 18th century.

Demographic transition should not be regarded as a ‘law of population

growth’, but as a generalized description of the evolutionary process. In
simple terms, it is a theory which attempts to specify general laws by which
human populations change in size and structure during industrialization. It is
frequently accepted as a useful tool in describing the demographic history of
a country.

The theory postulates a particular pattern of demographic change from a

high fertility and high mortality to a low fertility and low mortality when a
society progresses from a largely rural agrarian and illiterate society to a
dominant urban, industrial, literate and modern society.

It is typically viewed as a three-stage process:

(i) That the decline in immortality comes before the decline in fertility,

(ii) that the fertility eventually declines to match mortality, and

(iii) that socio-economic transformation of a society takes place simulta-

neously with its demographic transformation.

The demographic transition theory is characterized by conspicuous transition

stages.

The transition from high birth and death rates to low rates can be divided
into three stages

i. Pre-transition stage:

High and fluctuating birth and death rates with little population growth.
ii. Stage I:

High birth rates and declining death rates with rapid population growth.

iii. Stage II:

Low birth and death rates with slow population growth.

iv. Stage III:

Birth and death rates both decline appreciably leading to zero population
growth. The theory holds that pre-industrial societies were characterized by
stable populations which had both a high death rate and birth rate. It
postulates a little and slows population growth. The theory states that the
high mortality rates characteristic of undeveloped areas will decline before
fertility rates which are also high.

In the first stage of transition, death rates (especially the infant deaths) begin
to fall as a result of advances in public health and sanitation as well as
improvements in nutrition and food supply. Since the birth rate continues to
remain high relative to the declining death rate, there is a rapid ‘transitional’
growth as we find in India today.

In the second stage, changes in social attitudes, the introduction of cheap

forms of contraception and increases in life expectancy create social
pressures for smaller families and for a reduction of fertility.

The diffusion of knowledge and cheap medical technology has brought many
non-industrial societies into this stage of the demographic transition
however, these societies have been unable to enter the third stage. The
result has been very high rates of population growth in countries that are not
experiencing corresponding economic growth.
In the last (third) stage of demographic transition birth and death rates
decline appreciably which eventually becomes approximately equal, and in
time it will result in zero population growth. Before this stage begins, there
can be one more stage in which low birth and death rates lead to slow
population growth.

The populations of advanced, urban industrial societies, which have entered

the last stage, are now stable with low birth and death rates. In some cases
(e.g., Eastern and Central Europe) birth rates have fallen so slow that the rate
of natural increase was actually zero or negative. In this stage, the technical
know-how is abundant, the deliberate controls on family planning are
common and the literacy and education levels are also very high.

Death rates are high because of lack of adequate nutritive food, primitive
sanitary conditions and absence of any preventive and curative measures of
control over diseases. A high birth rate, on the other hand, is a functional
response to high death rates, particularly among infants and children.

Criticism:

Although the theory of demographic transition has been appreciated widely

by the demographers, it has been criticized on many grounds also. There are
even critics who have gone to the extent of saying that it cannot be called a
theory.

The main points of criticism are:

Firstly, this theory is merely based upon the empirical observations or the
experiences of Europe, America and Australia.

Secondly, it is neither predictive nor its stages are segmental and inevitable.
Thirdly, the role of man’s technical innovations cannot be underrated,
particularly in the field of medicine, which can arrest the rate of mortality.

Fourthly, neither does it provide a fundamental explanation of the process of

fertility decline, nor does it identify the crucial variables involved in it.

Fifthly, it does not provide a time frame for a country to move from one
stage to another.

Finally, it does not hold good for the developing countries of the world,
which have recently experienced unprecedented growth in population due to
drastic decline in death rates.

In spite of these criticisms and shortcomings, the demographic transition

theory does provide an effective portrayal of the world’s demographic history
at macro level of generalizations. As an empirical generalization developed
on the basis of observing the demographic trend in the West, the transition
process for any country can easily be understood.

The Classical Theory of Employment:

The classical economists believed in the existence of full employment in the

economy. To them, full employment was a normal situation and any
deviation from this regarded as something abnormal. According to Pigou, the
tendency of the economic system is to automatically provide full
employment in the labour market when the demand and supply of labour are
equal.

Unemployment results from the rigidity in the wage structure and

interference in the working of free market system in the form of trade union
legislation, minimum wage legislation etc. Full employment exists “when
everybody who at the running rate of wages wishes to be employed.”

Those who are not prepared to work at the existing wage rate are not
unemployed because they are voluntarily unemployed. Thus full employment
is a situation where there is no possibility of involuntary unemployment in
the sense that people are prepared to work at the current wage rate but they
do not find work.

The basis of the classical theory is Say’s Law of Markets which was carried
forward by classical economists like Marshall and Pigou. They explained the
determination of output and employment divided into individual markets for
labour, goods and money. Each market involves a built-in equilibrium
mechanism to ensure full employment in the economy.

The classical theory of output and employment is based on the following

assumptions:

1. There is the existence of full employment without inflation.

2. There is a laissez-faire capitalist economy without government

interference.

3. It is a closed economy without foreign trade.

4. There is perfect competition in labour and product markets.

5. Labour is homogeneous.

6. Total output of the economy is divided between consumption and

investment expenditures.

7. The quantity of money is given and money is only the medium of

exchange.
8. Wages and prices are perfectly flexible.

9. There is perfect information on the part of all market participants.

10. Money wages and real wages are directly related and proportional.

11. Savings are automatically invested and equality between the two is
brought about by the rate of interest

12. Capital stock and technical knowledge are given.

13. The law of diminishing returns operates in production.

14. It assumes long run.

Say’s Law of Markets:

Say’s law of markets is the core of the classical theory of employment. J.B.
Say, enunciated the proposition that “supply creates its own demand.”
Therefore, there cannot be general overproduction and the problem of
unemployment in the economy.

If there is general overproduction in the economy, then some labourers may

be asked to leave their jobs. The problem of unemployment arises in the
economy in the short run. In the long run, the economy will automatically
tend toward full employment when the demand and supply of goods become
equal.

When a producer produces goods and pays wages to workers, the workers, in
turn, buy those goods in the market. Thus the very act of supplying
(producing) goods implies a demand for them. It is in this way that supply
creates its own demand.
In the labour market, the demand for labour and the supply of labour
determine the level of output and employment. The classical economists
regard the demand for labour as the function of the real wage rate.

The demand for labour is a decreasing function of the real wage rate. It is by
reducing the real wage rate that more workers can be employed. The supply
of labour also depends on the real wage rate. But it is an increasing function
of the real wage rate. It is by increasing the real wage rate that more workers
can be employed.

The classical economists believed that there was always full employment in
the economy. In case of unemployment, a general cut in money wages would
take the economy to the full employment level. This argument is based on
the assumption that there is a direct and proportional relation between
money wages and real wages.

When money wages are reduced, they lead to reduction in cost of production
and consequently to the lower prices of products. When prices fall, demand
for products will increase and sales will be pushed up. Increased sales will
necessitate the employment of more labour and ultimately full employment
will be attained.

The goods market is in equilibrium when saving equals investment. At that

point of time, total demand equals total supply and the economy is in a state
of full employment. According to the classicists, what is not spent is
automatically invested.

Thus saving must equal investment. If there is any divergence between the
two, the equality is maintained through the mechanism of the rate of
interest. To them, both saving and investment are the functions of the
interest rate.
To the classicists, interest is a reward for saving. The higher the rate of
interest, the higher the saving, and lower the investment. On the contrary,
the lower the rate of interest, the higher the demand for investment funds,
and lowers the saving. If at any given period, investment exceeds saving, (I >
S) the rate of interest will rise.

Saving will increase and investment will decline till the two are equal at the
full employment level. This is because saving is regarded as an increasing
function of the interest rate and investment as a decreasing function of the
rate of interest.

The money market equilibrium in the classical theory is based on the

Quantity Theory of Money which states that the general price level (P) in the
economy depends on the supply of money (M). The equation is MV= PT,
where M = supply of money, V= velocity of circulation of M, P = Price level,
and T = volume of transaction or total output.

Keynes’s Criticism of Classical Theory:

1. Underemployment Equilibrium:

Keynes rejected the fundamental classical assumption of full employment

equilibrium in the economy. He considered it as unrealistic. He regarded full
employment as a special situation. The general situation in a capitalist
economy is one of underemployment.

This is because the capitalist society does not function according to Say’s law,
and supply always exceeds its demand. We find millions of workers are
prepared to work at the current wage rate, and even below it, but they do
not find work.
Thus the existence of involuntary unemployment in capitalist economies
(entirely ruled out by the classicists) proves that underemployment
equilibrium is a normal situation and full employment equilibrium is
abnormal and accidental.

2. Refutation of Say’s Law:

Keynes refuted Say’s Law of markets that supply always created its own
demand. He maintained that all income earned by the factor owners would
not be spent in buying products which they helped to produce. A part of the
earned income is saved and is not automatically invested because saving and
investment are distinct functions.

So when all earned income is not spent on consumption goods and a portion
of it is saved, there results in a deficiency of aggregate demand.

This leads to general overproduction because all that is produced is not sold.
This, in turn, leads to general unemployment. Thus Keynes rejected Say’s Law
that supply created its own demand. Instead he argued that it was demand
that created supply. When aggregate demand rises, to meet that demand,
firms produce more and employ more people.

3. Self-adjustment not Possible:

Keynes did not agree with the classical view that the laissez-faire policy was
essential for an automatic and self-adjusting process of full employment
equilibrium. He pointed out that the capitalist system was not automatic and
self-adjusting because of the non-egalitarian structure of its society. There
are two principal classes, the rich and the poor.

4. Equality of Saving and Investment through Income Changes:

The classicists believed that saving and investment were equal at the full
employment level and in case of any divergence the equality was brought
about by the mechanism of rate of interest. Keynes held that the level of
saving depended upon the level of income and not on the rate of interest.

Similarly investment is determined not only by rate of interest but by the

marginal efficiency of capital. A low rate of interest cannot increase
investment if business expectations are low. If saving exceeds investment, it
means people are spending less on consumption.

As a result, demand declines. There is overproduction and fall in investment,

income, employment and output. It will lead to reduction in saving and
ultimately the equality between saving and investment will be attained at a
lower level of income. Thus it is variations in income rather than in interest
rate that bring the equality between saving and investment.

Keynesian Theory of Employment

As per Keynes theory of employment, effective demand signifies the money

spent on the consumption of goods and services and on investment.

The total expenditure is equal to the national income, which is equivalent to

the national output.

Therefore, effective demand is equal to total expenditure as well as national

income and national output.

The theory of Keynes was against the belief of classical economists that the
market forces in capitalist economy adjust themselves to attain equilibrium.
He has criticized classical theory of employment in his book. Vie General
Theory of Employment, Interest and Money. Keynes not only criticized
classical economists, but also advocated his own theory of employment.
His theory was followed by several modern economists. Keynes book was
published post-Great Depression period. The Great Depression had proved
that market forces cannot attain equilibrium themselves; they need an
external support for achieving it. This became a major reason for accepting
the Keynes view of employment.

The Keynes theory of employment was based on the view of the short run. In
the short run, he assumed that the factors of production, such as capital
goods, supply of labor, technology, and efficiency of labor, remain unchanged
while determining the level of employment. Therefore, according to Keynes,
level of employment is dependent on national income and output.

In addition, Keynes advocated that if there is an increase in national

income, there would be an increase in level of employment and vice versa.
Therefore, Keynes theory of employment is also known as theory of
employment determination and theory of income determination.

Principle of Effective Demand:

The main point related to starting point of Keynes theory of employment is
the principle of effective demand. Keynes propounded that the level of
employment in the short run is dependent on the aggregate effective
demand of products and services.
According to him, an increase in the aggregate effective demand would
increase the level of employment and vice-versa. Total employment of a
country can be determined with the help of total demand of the country. A
decline in total effective demand would lead to unemployment.

As per Keynes theory of employment, effective demand signifies the money

spent on the consumption of goods and services and on investment. The total
expenditure is equal to the national income, which is equivalent to the
national output. Therefore, effective demand is equal to total expenditure as
well as national income and national output.

The effective demand can be expressed as follows:

Effective demand = National Income = National Output
Therefore effective demand affects employment level of a country, national
income, and national output. It declines due to the mismatch of income and
consumption and this decline lead to unemployment.

With the increase in the national income the consumption rate also
increases, but the increase in consumption rate is relatively low as compared
to the increase in national income. Low consumption rate leads to a decline
in effective demand.

Therefore, the gap between the income and consumption rate should be
reduced by increasing the number of investment opportunities.
Consequently, effective demand also increases, which further helps in
reducing unemployment and bringing full employment condition.

Moreover, effective demand refers to the total expenditure of an economy at

a particular employment level. The total equal to the total supply price of
economy (cost of production of products and services) at a certain level of
employment. Therefore, effective demand refers to the demand of
consumption and investment of an economy

Determination of Effective Demand:

Keynes has used two key terms, namely, aggregate demand price and
aggregate supply price, for determining effective demand. Aggregate demand
price and aggregate supply price together contribute to determine effective
demand, which further helps in estimating the level of employment of an
economy at a particular period of time.

In an economy, the employment level depends on the number of workers

that are employed, so that maximum profit can be drawn. Therefore, the
employment level of an economy is dependent on the decisions of
organizations related to hiring of employee and placing them.

The level of employment can be determined with the help of aggregate

supply price and aggregate demand price. Let us study these two concepts in
detail.

Aggregate Supply Price:

Aggregate supply price refers to the total amount of money that all
organizations in an economy should receive from the sale of output produced
by employing a specific number of workers. In simpler words, aggregate
supply price is the cost of production of products and services at a particular
level of employment.
It is the total amount of money paid by organizations to the different factors
of production involved in the production of output. Therefore, organizations
would not employ the factors of production until they can recover the cost of
production incurred for employing them.

A certain minimum amount of price is required for inducing employers to

offer a specific amount of employment. According to Dillard, “This minimum
price or proceeds, which will just induce employment on a given scale, is
called the aggregate supply price of that amount of employment.”

If an organization does not get an adequate price so that cost of production is

covered, then it employs less number of workers. Therefore the aggregate
supply price varies according to different number of workers employed. So,
aggregate supply price schedule Id Tut can be prepared as per the total
number of workers employed.

Aggregate supply price schedule is a schedule of minimum price required to

induce the different quantities of employment. Thus, higher the price
required to induce the different quantities of employment, greater the level
of employment would be. Therefore, the slope of the aggregate supply curve
is upward to the right.

Aggregate Demand Price:

Aggregate demand price is different from demand for products of individual
organizations and industries. The demand for individual organizations or
industries refers to a schedule of quantity purchased at different levels of
price of a single product.

On the hand, aggregate demand price is the total amount of money that an
organization expects to receive from the sale of output produced by a specific
number of workers. In other words, the aggregate demand price signifies the
expected sale receipts received by the organization by employing a specific
number of workers.

Aggregate demand price schedule refers to the schedule of expected

earnings by selling the product at different level of employment Mo higher
the level of employment, greater the level of output would be.

Consequently, the increase in the employment level would increase the

aggregate demand price. Thus, the slope of aggregate demand curve would
be upward to the right. However, the individual demand curve slopes
downward.
The basic difference between the aggregate supply price and aggregate
demand price should be analyzed carefully as both of them seem to be same.
In aggregate supply price, organizations should receive money from the sale
of output produced by employing a specific number of workers.

However, in aggregate demand price, organizations expect to receive from

the sale of output produced by a specific number of workers. Therefore, in
aggregate supply price, the amount of money is the necessary amount that
should be received by the organization, while in aggregate demand price the
amount of money may or may not be received.

Determination of Equilibrium Level of Employment:

The aggregate demand price and aggregate supply price help in determining
the equilibrium level of employment.

The aggregate demand (AD) and aggregate supply (AS) curve are used for
determining the equilibrium level of employment, as shown in Figure-3:
In Figure-3, AD represents the aggregate demand curve, while AS represents
the aggregate supply curve. It can be interpreted from Figure-3 that although
the aggregate demand and aggregate supply curve are moving in the same
direction, but they are not alike. There are different aggregate demand price
and aggregate supply price for different levels of employment.

For example, in Figure-3, at AS curve, the organization would employ ON 1

number of workers, when they receive OC amount of sales receipts. Similarly,
in case of AD curve, the organization would employ ON 1 number of workers
with the expectation that they would produce OH amount of sales receipt for
them.

The aggregate demand price exceeds the aggregate supply price or vice versa
at some levels of employment. For example, at ON 1 employment level, the
aggregate demand price (OH) is greater than the aggregate supply price (OC).
However, at certain level of employment, the aggregate demand price and
aggregate supply price become equal.

At this point, aggregate demand and aggregate supply curve intersect each
other. This point of intersection is termed as the equilibrium level of
employment. In Figure-3, point E represents the equilibrium level of
employment because at this point, the aggregate demand curve and
aggregate supply curve intersect each other.

In Figure-3, initially, there is a slow movement in the AS curve, but after a

certain point of time it shows a sharp rise. This implies that when a number
of workers increases initially, the cost incurred for production also increases
but at a slow rate. However, when the amount of sales receipt increases, the
organization starts employing more and more workers. In Figure-3, the ON 1
numbers of workers are employed, when OT amount of sales receipts are
received by the organization.

On the other hand, the AD curve shows a rapid increase initially, but after
some time it gets flattened. This means that the expected sales receipts
increase with an increase in the number of workers. As a result, the
expectations of the organization to earn more profit increases. As a result,
the organization starts employing more workers. However, after a certain
level, the increase in employment level would not show an increase in the
amount of sales receipts.

In Figure-3, before reaching the employment level of ON 2, the employment

level keeps on increasing as the organizations want to higher more and more
workers to get the maximum profit. However, when the employment level
crosses the ON21 level, the AD curve is below the AS curve, which shows that
the aggregate supply price exceeds the aggregate demand price. As a result,
the organization would start incurring losses; therefore would reduce the
employment rate.

Thus, the economy would be in equilibrium when the aggregate supply price
and aggregate demand price become equal. In other words, equilibrium can
be achieved when the amount of sales receipt necessary and the amount of
sales receipt expected to be received by the organization at a specified level
of employment are equal.