Economics for Engineers ECO 310
LEARNING OBJECTIVES To understand the relevance of economics for engineers To understand the concept of demand, suply and the market equilibrium. To discuss various types of elasticities of demand. To learn how to measure elasticity by various methods. To understand the relevance and application of elasticities of demand.
Engineering Economics Application of economic techniques for evaluating the engineering design and project alternatives. Concept of Efficiency Economic Efficiency Static Efficiency ▪ Allocative efficiency ▪ Productive Efficiency
Demand Supply Analysis
Demand: effective desire Demand is that desire which backed by willingness and ability to buy a particular commodity. Amount of the commodity which consumers are willing to buy per unit of time, at that price. Things necessary for demand: Time Price of the commodity Amount (or quantity) of the commodity consumers are willing to purchase at the price
Types of Demand Direct and Derived Demand Direct demand is for the goods as they are such as Consumer goods Derived demand is for the goods which are demanded to produce some other commodities; e. g. Capital goods Recurring and Replacement Demand Recurring demand is for goods which are consumed at frequent intervals such as food items, clothes. Durables are purchased to be used for a long period of time Wear and tear over time needs replacement
Complementary and Competing Demand Some goods are jointly demanded hence are complementary in nature, e. g. software and hardware, car and petrol. Some goods compete with each other for demand because they are substitutes to each other, e. g. soft drinks and juices.
Determinants of Demand Price of the product Single most important determinant Negative effect on demand Higher the price-lower the demand Income of the consumer Normal goods: demand increases with increase in consumer’s income Inferior goods: demand falls as income rises Price of related goods Substitutes If the price of a commodity increases, demand for its substitute rises. Complements If the price of a commodity increases, quantity demanded of its complement falls.
Determinants of Demand Tastes and preferences Contd… Very significant in case of consumer goods Expectation of future price changes Gives rise to tendency of hoarding of durable goods Population Size, composition and distribution of population will influence demand Advertising Very important in case of competitive markets
Demand Function Interdependence between demand for a product and its determinants can be shown in a mathematical functional form Dx = f(Px, Y, Py, T, A, N) Independent variables: Px, Y, Py, T, A, N Dependent variable: Dx Px: Price of x Y: Income of consumer Py: Price of other commodity T: Taste and preference of consumer A: Advertisement N: Macro variable like inflation, population growth, economic growth
Law of Demand A special case of demand function which shows relation between price and demand of the commodity Dx = f(Px) Other things remaining constant, when the price of a commodity rises, the demand for that commodity falls or when the price of a commodity falls, the demand for that commodity rises. Price bears a negative relationship with demand
Demand Schedule and Individual Demand Curve Price (Rs per cup) Demand (‘ 000 cups) a 15 50 b 20 40 c 25 30 d 30 20 e 35 10 e 35 Price of Coffee Point on Demand Curve d 30 c 25 b 20 a 15 O 10 20 40 50 30 Quantity of coffee
Exceptions to the Law of Demand Law of demand may not operate due to the following reasons: Giffen Goods Snob Appeal /Prestigious goods Demonstration Effect Future Expectation of Prices(Panic buying) Addiction Neutral goods Life saving drugs Salt Amount of income spent Match box
Market Demand Market: interaction between sellers and buyers of a good (or service) at a mutually agreed upon price. Market demand Aggregate of individual demands for a commodity at a particular price per unit of time. Sum total of the quantities of a commodity that all buyers in the market are willing to buy at a given price and at a particular point of time (ceteris paribus) Market demand curve: horizontal summation of individual demand curves
Supply Indicates the quantities of a good or service that the seller is willing and able to provide at a price, at a given point of time, other things remaining the same. Supply of a product X (Sx) depends upon: Price of the product (Px) Cost of production (C) [Price of Factors of Production] State of technology (T) Government policy regarding taxes and subsidies (G) Number of firms (N) Hence the supply function is given as:
Law of Supply states that other things remaining the same, the higher the price of a commodity the greater is the quantity supplied. Price of the product is revenue to the supplier; therefore higher price means greater revenue to the supplier and hence greater is the incentive to supply. Supply bears a positive relation to the price of the commodity. Supply Schedule Point on Supply Curve a b c d e Price (Rs. Per cup) 15 20 25 30 35 Supply (‘ 000 cups per month) 10 20 30 45 60 Supply Curve Price of Coffee 35 e 30 25 c 20 b 15 0 d a 10 20 30 40 50 60 Quantity of Coffee
Change in Supply Price S 2 S 0 S 1 P O Q 2 Q 0 Q 1 Quantity Shift in the supply curve from S 0 to S 1 More is supplied at each price (Q 1>Q 0) Increase in supply caused by: Improvements in the technology Fall in the price of inputs Shift in the supply curve from S 0 to S 2 Less is supplied at each price (Q 2<Q 0) Decrease in supply caused by: A rise in the price of inputs Change in government policy (VAT)
Market Equilibrium occurs at the price where the quantity demanded and the quantity supplied are equal to each other. At point E demand is equal to supply hence 25 is equilibrium price Price Demand (‘ 000 cups/ month) 15 O 30 Quantity 15 40 25 D 50 30 30 30 25 E 10 20 S Price (Rs) Supply (‘ 000 cups/ month) 45 15 35 70 10
Market Equilibrium For prices below the equilibrium, Quantity demanded exceeds quantity supplied (D>S) (Shortage). ▪ Price pulled upward For prices above the equilibrium, Quantity demanded is less than quantity supplied (D<S) (Excess). ▪ Price pulled downward. At point E demand is equal to supply hence 25 is equilibrium price. Price 25 20 D O 30 Quantity 10 50 15 40 25 E Demand (‘ 000 cups/ month) 20 30 Price (Rs) Supply (‘ 000 cups/ month) 15 S 30 30 30 45 15 35 70 10
Changes in Market Equilibrium (Shifts in Supply Curve) n The original point of equilibrium is n n at E, the point of intersection of curves D 1 and S 1, at price P and quantity Q An increase in supply shifts the supply curve to S 2 Price falls to P 2 and quantity rises to Q 2, taking the new equilibrium to E 2 A decrease in supply shifts the supply curve to S 0. Price rises to P 0 and quantity falls to Q 0 taking the new equilibrium to E 0 Thus an increase in supply raises quantity but lowers price, while a decrease in supply lowers quantity but raises price; demand being unchanged Price S 0 S 1 D 1 P 0 P P 2 S 2 E 0 E S 0 E 2 S 1 S 2 O D 1 Q 0 Q Q 2 Quantity
Changes in Market Equilibrium (Shifts in Demand Curve) The original point of equilibrium is at E, the point of intersection of curves D 1 and S 1, at price P and quantity Q An increase in demand shifts the demand curve to D 2 Price D 2 S 1 D 0 E P P* E 2 D 2 S 1 O E 1 P 1 ▪ Price rises to P 1 and quantity rises to Q 1 taking the new equilibrium to E 1 D 0 Q* Q Q 1 D 1 Quantity A decrease in demand shifts the demand curve to D 0 ▪ Price falls to P* and quantity falls to Q* taking the new equilibrium to E 2. Thus, an increase in demand raises both price and quantity, while a decrease in demand lowers both price and quantity; when supply remains same.
Change in Both Demand Supply Initial equilibrium is at E 1, with price quantity combination (P 1, Q 1). An increase in both demand supply takes place; demand curve shifts to the right from D 1 to D 2 supply curve also shifts to the right from S 1 to S 2. The new equilibrium is at E 2, and price quantity is (P 2, Q 2). An increase in both supply and demand will cause the sales to rise, but the price will increase if increase in D>S (as at E 2 ) No change in price if increase in D=increase in S (as at E 0 ) Price D 2 D 1 S 2 P 1 E 1 S 1 O S 2 E 0 D 1 Q 2 D 2 Quantity
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If the market demand curve is given by D=158 P and the market supply S=2 P, find the equilibrium price and quantity mathematically. Given the following demand supply functions, find the equilibrium price and quantity in the market. Demand=100 -P & S=10+2 P
There are 1000 identical individuals in the market for commodity x given by Qd=12000 -2000 P, ceteris paribus and 100 identical producers of commodity X with a function given by Qs=2000 P Find the equilibrium price and quantity If there is increase in consumer’s income, Qd=140002000 P, Find the new equilibrium price and quantity Suppose there is improvement in the technology of producing commodity and the new market function is Qs=4000+2000 P. Derive the new equilibrium price and quantity.
Consumer Surplus – When Price that the consumer actually pays is less than the Price that the consumer is ready to pay. Producer Surplus – When the price that the producer receives in the market is more than the minimum they would be prepared to supply for.
Elasticity of Demand “Elasticity” is a standard measure of the degree of responsiveness (or sensitivity) of one variable to changes in another variable. Elasticity of Demand measures the degree of responsiveness of demand for a commodity to a given change in any of the independent variables that influence demand for that commodity, such as price of the commodity, price of the other commodities, income, taste, preferences of the consumer and other factors. Responsiveness implies the proportion by which the quantity demanded of a commodity changes, in response to a given change in any of its determinants.
Elasticity of Demand Mathematically, it is the percentage change in quantity demanded of a commodity to a percentage change in any of the (independent) variables that determine demand for the commodity. Three major types of elasticity: Price elasticity, Income elasticity, Cross elasticity In order to assess the impact of one variable on demand, we assume other variables as constant
Price Elasticity of Demand Price is most important among all the independent variables that affect the demand for any commodity Hence price elasticity of demand ( “ep” or “e”) is considered to be the most important of all types of elasticity of demand. Price elasticity of demand means the sensitivity of quantity demanded of a commodity to a given change in its own price.
Formula Price Elasticity of Demand Percentage change in Quantity demanded/Percentage change in Price
Degrees of Price Elasticity Slope of demand curve is used to display price elasticity of demand Perfectly elastic demand ep=∞ (in absolute terms). Horizontal demand curve Unlimited quantities of the commodity can be sold at the prevailing price Perfectly inelastic demand ep=0 (in absolute terms) Vertical demand curve Quantity demanded of a commodity remains the same, irrespective of any change in the price Such goods are termed neutral. Price P D O Q 1 Q 2 Quantity D Price P 1 P 2 O Q 1 Quantity
Degrees of Price Elasticity Highly elastic demand (Or Elastic) Proportionate change in quantity demanded is more than a given change in price ep >1 (in absolute terms) Demand curve is flatter Unitary elastic demand Proportionate change in price brings about an equal proportionate change in quantity demanded ep =1 (in absolute terms). Demand curves are shaped like a rectangular hyperbola, asymptotic to the axes Relatively inelastic demand (Or Inelastic) Proportionate change in quantity demanded is less than a proportionate change in price ep <1 (in absolute terms) Demand curve is steep Price Contd. D P 1 P 2 D O Price Q 1 Q 2 Quantity D P 1 P 2 O Q 1 Q 2 D Quantity
Numerical In india, when the petrol price increases from Rs 54 per litre to Rs. 63 per litre, Rahul decreases petrol consumption from 25 litre to 24 litre per month. Find the price elasticity of demand of petrol.
Ans: e= - 0. 24, So it is < 1, demand is relatively inelastic. Don’t consider negative sign as it only shows the relationship of price and demand. 0. 24 is less than 1 that’s why demand is relatively inelastic.
The demand for apples in a small town was 200 kg when the price was Rs. 20 per Kg. It expanded to 250 Kg when the price was reduced to Rs. 18 Per kg. What is the elasticity of demand for apples in the town.
Ans: e= -2. 5, Ignore – sign. So, 2. 5 is > 1, so demand is Highly elastic
Factors Influencing Elasticity of Demand Nature of commodity Availability of substitutes Number of uses Proportion of expenditure (Income spent) Durability of the commodity Habit Time Possibility of postponement
Determinants of Price Elasticity of Demand Nature of commodity Necessities are relatively price inelastic, while luxuries are relatively price elastic Availability and proximity of substitutes Price elasticity of demand of a brand of a product would be quite high, given availability of other substitute brands Alternative uses of the commodity If a commodity can be put to more than one use, it would be relatively price elastic
Contd… Proportion of income spent on the commodity The greater the proportion of income spent on a commodity, the more sensitive would the commodity be to price Reason is income effect Time Demand for any commodity is more price elastic in the long run Durability of the commodity Perishable commodities like eatables are relatively price inelastic in comparison to durable items Items of addiction Items of intoxication and addiction are relatively price inelastic
Income Elasticity of Demand (ey) ey measures the degree of responsiveness of demand for a good to a given change in income, ceteris paribus. Types: Positive income elasticity ▪ Demand rises as income rises and vice versa ▪ Normal good Negative income elasticity ▪ Demand falls as income rises and vice versa ▪ Inferior good Zero Income Elasticity ▪ Neutral goods
Positive Income Elasticity >1 then Good is luxury Good and Income Elasticity<1 (Between 0 and 1), then Good is normal Good and Income-inelastic.
Numerical Following pay revision, Mr. Sharma’s monthly income increases from Rs. 25000 to Rs 60, 000. Consequently, his demand for an item increases from 150 to 180. Find the income elasticity of demand.
Ans: e= 0. 142
Cross Elasticity of Demand ec measures the responsiveness of demand of one good to changes in the price of a related good Degrees Negative Cross Elasticity ▪ Complementary goods Positive Cross Elasticity ▪ Substitute goods Zero Cross Elasticity ▪ Unrelated goods
Consider two goods X and Y. There was no change in price of X but its demand decreased from 6000 units to 5500 units. On analysis, it was found that price of another commodity Y has increased from 225 to 250. Find out the cross elasticity between X and Y and the relationship between the two goods.
Ans: e= -7. 5, as e is -, so X and Y are complements
Importance of Elasticity Determination of price Elasticity is the basis of determining the price of a product keeping its possible effects on the demand of the product in perspective Basis of price discrimination Products having elastic demand may be sold at lower price, while those having inelastic demand may be sold at high prices Determination of rewards of factors of production Factors having inelastic demand are rewarded more than factors that have relatively elastic demand. Government policies of taxation Goods having relatively elastic demand are taxed less than those having relatively inelastic demand.
Consumer's Equilibrium Through Indifference Curve Analysis: Definition: "The term consumer’s equilibrium refers to the amount of goods and services which the consumer may buy in the market given his income and given prices of goods in the market". The aim of the consumer is to get maximum satisfaction from his money income. Given the price line or budget line and the indifference map:
Indifference Curve Analysis (J. R. Hicks and R. G. D. Allen ) Indifference curve: Locus of points which show the different combinations of two commodities among which the consumer is indifferent, i. e. derives same utility. ▪ Since all these points render equal utility to the consumer, an indifference curve is also known as an isoutility (“iso” meaning equal) curve. Indifference map: group of indifference curves
Combination Commodity X Commodity Y Utility a 25 5 U b 15 7 U c 10 12 U d 6 20 U
Properties of Indifference Curves Indifference curve do not touch the horizontal or vertical axis. Y A Good Y Indifference curves are downward sloping. (negatively sloped) Higher indifference curve represents higher utility. Indifference curves can never intersect. Indifference curves are convex to the origin. O B C D Good X IC 1 IC 2 X
BUDGET LINE The budget line is the locus of combinations of two goods that an individual can afford to buy with his/her income. Sifts in Budget Line When prices of both products are constant but there is change in the income of the customer. When income of the customer and price of one product is constant.
Revision 1. If the price of milk increases, what do you think will happen to the demand for cornflakes? 2. Suppose the technology to manufacture computers improves but due to some recession in the economy, the income of the consumers falls. Assuming the computers to be normal goods, what will be the equilibrium quantity and price for computers in this case.
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