Theory of Demand

Economics Notes
Theory of Demand
Demand is the quantity of a good or service that consumers are willing and able to buy at
a given price in a given time period
Each of us has an individual demand for particular goods and services and our demand at each
price reflects the value that we place on a product, linked usually to the enjoyment or usefulness
that we expect from consuming it. Economists give this a term - utility
Effective Demand
Demand is different to desire! Effective demand is when a desire to buy a product is

backed up by an ability to pay for it
Latent Demand
Latent demand exists when there is willingness to buy among people for a good or
service, but where consumers lack the purchasing power to be able to afford the product.
Derived Demand
The demand for a product X might be connected to the demand for a related product Y giving
rise to the idea of a derived demand. For example, demand for steel is strongly linked to the
demand for new vehicles and other manufactured products, so that when an economy goes into a
recession, so we expect the demand for steel to decline likewise.
Steel is a cyclical industry which means that market demand for steel is affected by changes in
the economic cycle and also by fluctuations in the exchange rate.
Zinc is a good example of a product with a strong derived demand. It has a wide-range of end
users such as galvanised zinc used in cars and new buildings, die-casting used in door furniture
and toys, brass and bronze used in taps and pipes. And also rolled zinc (used in roofing, guttering
and batteries) and in chemicals used in making tyres and zinc cream.
Transport as a Derived Demand
The demand for transport is the number of journeys consumers or firms are willing and able to
purchase at various prices in a given time period. Transport is rarely demanded for its own sake,
the journey, but for what the journey enables e.g. commuting, taking a holiday or distribution.
When an economy is growing, there is an increase in derived demand for commuting, business
logistics and transport for holiday purposes.
The Law of Demand
There is an inverse relationship between the price of a good and demand.
#tinotumbu Page 1 of 52
Economics Notes
1. As prices fall, we see an expansion of demand.

2. If price rises, there will be a contraction of demand.
As price falls, a person switches away from rival products towards the product
As price falls, a person's willingness and ability to buy the product increases
As price falls, a person's opportunity cost of purchasing the product falls
Note: Many demand curves are drawn as straight lines to make the diagrams easier to interpret
The chart below shows average season ticket prices for English Premier League clubs. What
factors affect the willingness and ability to pay for a season ticket? Why is there such a large
difference in prices?
Economics Notes
Economics Notes
Average season ticket prices (in s) for Premier League clubs
Supply and Demand
Supply and demand is perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy. Demand refers to how much (quantity) of a product or service is
desired by buyers. The quantity demanded is the amount of a product people are willing to buy at
a certain price; the relationship between price and quantity demanded is known as the demand
relationship. Supply represents how much the market can offer. The quantity supplied refers to
the amount of a certain good producers are willing to supply when receiving a certain price. The
correlation between price and how much of a good or service is supplied to the market is known
as the supply relationship. Price, therefore, is a reflection of supply and demand.
The relationship between demand and supply underlie the forces behind the allocation of
resources. In market economy theories, demand and supply theory will allocate resources in the
most efficient way possible. How? Let us take a closer look at the law of demand and the law of
supply.
A. The Law of Demand

The law of demand states that, if all other factors remain equal, the higher the price of a good,
the less people will demand that good. In other words, the higher the price, the lower the quantity
demanded. The amount of a good that buyers purchase at a higher price is less because as the
price of a good goes up, so does the opportunity cost of buying that good. As a result, people will
naturally avoid buying a product that will force them to forgo the consumption of something else
they value more. The chart below shows that the curve is a downward slope.
Economics Notes
A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation
between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1
and the price will be P1, and so on. The demand relationship curve illustrates the negative
relationship between price and quantity demanded. The higher the price of a good the lower the
quantity demanded (A), and the lower the price, the more the good will be in demand (C).
B. The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a
certain price. But unlike the law of demand, the supply relationship shows an upward slope. This
means that the higher the price, the higher the quantity supplied. Producers supply more at a
higher price because selling a higher quantity at a higher price increases revenue.
A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation
between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the
price will be P2, and so on.
Time and Supply

Unlike the demand relationship, however, the supply relationship is a factor of time. Time is
important to supply because suppliers must, but cannot always, react quickly to a change in
demand or price. So it is important to try and determine whether a price change that is caused by
demand will be temporary or permanent.
Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy
season; suppliers may simply accommodate demand by using their production equipment more
intensively. If, however, there is a climate change, and the population will need umbrellas year-
round, the change in demand and price will be expected to be long term; suppliers will have to
change their equipment and production facilities in order to meet the long-term levels of demand.
Economics Notes
C. Supply and Demand Relationship

Now that we know the laws of supply and demand, let's turn to an example to show how supply
and demand affect price.
Imagine that a special edition CD of your favorite band is released for $20. Because the record
company's previous analysis showed that consumers will not demand CDs at a price higher than
$20, only ten CDs were released because the opportunity cost is too high for suppliers to produce
more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise
because, according to the demand relationship, as demand increases, so does the price.
Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship
shows that the higher the price, the higher the quantity supplied.
If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up
because the supply more than accommodates demand. In fact after the 20 consumers have been
satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers
attempt to sell the remaining ten CDs. The lower price will then make the CD more available to
people who had previously decided that the opportunity cost of buying the CD at $20 was too
high.
D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function
intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its
most efficient because the amount of goods being supplied is exactly the same as the amount of
goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the
current economic condition. At the given price, suppliers are selling all the goods that they have
produced and consumers are getting all the goods that they are demanding.
As you can see on the chart, equilibrium occurs at the intersection of the demand and supply
curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P*
and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.
Economics Notes
In the real market place equilibrium can only ever be reached in theory, so the prices of goods
and services are constantly changing in relation to fluctuations in demand and supply.
E. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.
1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be
allocative inefficiency.
At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1,
however, the quantity that the consumers want to consume is at Q1, a quantity much less than
Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed.
The suppliers are trying to produce more goods, which they hope to sell to increase profits, but
those consuming the goods will find the product less attractive and purchase less because the
price is too high.
2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so
low, too many consumers want the good while producers are not making enough of it.
Economics Notes
In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2.
Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus,
there are too few goods being produced to satisfy the wants (demand) of the consumers.
However, as consumers have to compete with one other to buy the good at this price, the demand
will push the price up, making suppliers want to supply more and bringing the price closer to its
equilibrium.
F. Shifts vs. Movement

For economics, the "movements" and "shifts" in relation to the supply and demand curves
represent very different market phenomena:
1. Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a
change in both price and quantity demanded from one point to another on the curve. The
movement implies that the demand relationship remains consistent. Therefore, a movement
along the demand curve will occur when the price of the good changes and the quantity
demanded changes in accordance to the original demand relationship. In other words, a
movement occurs when a change in the quantity demanded is caused only by a change in price,
and vice versa.
Economics Notes
Like a movement along the demand curve, a movement along the supply curve means that the
supply relationship remains consistent. Therefore, a movement along the supply curve will occur
when the price of the good changes and the quantity supplied changes in accordance to the
original supply relationship. In other words, a movement occurs when a change in quantity
supplied is caused only by a change in price, and vice versa.
2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied
changes even though price remains the same. For instance, if the price for a bottle of beer was $2
and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the
demand for beer. Shifts in the demand curve imply that the original demand relationship has
changed, meaning that quantity demand is affected by a factor other than price. A shift in the
demand relationship would occur if, for instance, beer suddenly became the only type of alcohol
available for consumption.
Economics Notes
Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1
to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift
in the supply curve implies that the original supply curve has changed, meaning that the quantity
supplied is effected by a factor other than price. A shift in the supply curve would occur if, for
instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced
to supply less beer for the same price.
Theory of the Firm
What is the 'Theory Of The Firm'
The theory of the firm is the microeconomic concept founded in neoclassical economics that
states that firms (including businesses and corporations) exist and make decisions to maximize
Economics Notes
profits. Firms interact with the market to determine pricing and demand and then allocate
resources according to models that look to maximize net profits.
BREAKING DOWN 'Theory Of The Firm'

In the theory of the firm, the behavior of a particular business entity is said to be driven by profit
maximization. This theory governs decision making in a variety of areas including resource
allocation, production technique, pricing adjustments and quantity produced.
The theory of the firm goes along with the theory of the consumer, which states that consumers
seek to maximize their overall utility. In this case, utility refers to the perceived value a
consumer places on a good or service, sometimes referred to as the level of happiness the
customer experiences from the good or service. For example, when consumers purchase a good
for $10, they expect to receive a minimum of $10 in utility from the purchased good.
Expansion on the Theory of the Firm
Modern takes on the theory of the firm sometimes distinguish between long-run motivations,
such as sustainability, and short-run motivations, such as profit maximization. The theory is
always being analyzed and adapted to suit changing economies and markets. Early economic
analysis focused on broad industries, but as the19th century progressed, more economists began
to look at the firm level to answer basic questions about why companies produce what they do,
and what motivates their choices when allocating capital and labor.
Risks Associated with the Theory of the Firm's Profit Maximization Goal
Modern takes on the theory of the firm take such facts as low equity ownership by many decision
makers into account; some feel that chief executive officers (CEOs) of publicly held companies
are interested in profit maximization as well as in goals based on sales maximization, public
relations and market share. Solely focusing on profit maximization comes with a level of risk in
regards to public perception and a loss of a sense of goodwill between the business and other
individuals or entities.
Further risk exists when a firm focuses on a single strategy within the marketplace. If a business
relies on the sale of one particular good for its overall success, and the associated product fails
within the marketplace, this can lead to a financial collapse of that particular company or
department within a company.
For example, Sega, a gaming console producer, had success with its Sega Genesis console. Sega
subsequently released the Dreamcast in Japan in 1998 and in the United States in 1999. First-day
U.S. sales reached $100 million. However, the Dreamcast couldn't play DVDs like the rival
PlayStation 2, which led to the Dreamcast's eventual failure within the marketplace. Even after a
price drop, consumer interest did not rekindle, and Sega's gaming console division ultimately
fell.
Economics Notes
Distribution and Theories of Distribution (With Diagram)
Introduction and Definition:

Distribution refers to the sharing of the wealth that is produced among the different factors of
production.
In the modern time, the production of goods and services is a joint operation. All the different
factors of production i.e., land, labour, capital and enterprise are combined together in productive
activity.
Productive activity is thus the result of the joint effort of these four factors of production which
work collectively to produce more wealth. These factors need to be paid or rewarded for their
services for producing the wealth.
Definition:
Some important definitions of Distribution are as follows:
1. According to Prof. Nicholson Distribution refers to the sharing of wealth of a nation among
the different classes.
2. Prof. Chapman has said that The Economics of Distribution accounts for the sharing of the
wealth produced by a community among the agents or the owners of agents which have been
active in its production.
3. According to Prof. Cannon Distribution like production is a social phenomenon. In

production we study the creation of social income and in distribution we study its distribution in
one case we regard it as national output and in the other as national dividend.
4. According to Prof. Seligman All wealth that is created in society finds its way to the final
disposition of the individual, through certain channels or sources of income, this process is called
distribution. Thus, the theory of distribution deals with the distribution of income. It seeks to
explain the principles governing the determination of factor like rewardsrent, wages, interest
and profitsi.e., how prices of the factors of production are set. The theory of distribution thus
states how the product is functionally distributed among the co-operating factors in the process
of production.
Personal Distribution and Functional Distribution:

In economics, the term distribution has two components:
Economics Notes
(i) Functional distribution,
(ii) Personal distribution.
1. Functional Distribution:
Functional distribution refers to the distinct share of the national income received by the people,
as agents of production per Unit of time, as a reward for the unique functions rendered by them
through their productive services. These shares are commonly described as wages, rent, interest
and profits in the aggregate production. It implies factor price determination of a class of factors.
It has been called as Macro concept.
2. Personal Distribution:
Personal distribution on the other-hand, is a Micro Concept which refers to the given amount of
wealth and income received by individuals in society through their economics efforts, i.e.,
individuals personal earnings of income through various sources.
The concept of equality and inequality of income distribution and social justice is basically
concerned with the personal distribution of income. Taxation measures are designed to influence
personal distribution of income and wealth in a community.
The theory of distribution deals with functional distribution and not with personal distribution of
income. It seeks to explain the principles governing the determination of factor rewards like
rent, wages, interest and profits, i.e., how prices of the factors of production are set.
Importance of Distribution:
At present under the study of economics the study of Distribution has occupied a very
important place. The methods and systems of distribution has high effect on the economic life of
the nation. Therefore, where the work of distribution is done with equity and justice the various
channels of distribution are satisfied with its workings.
The satisfied workers increases their efficiency and they increase the quality and quantity of
production. Contrary to this if the methods of distribution are improper and a particular class is
being exploited then there will be dis-satisfaction feeling will crop up among people. Therefore,
with the study of the distribution, it is clear that in the country with scientific system of
production, equity and scientific way of distribution method is also very essential.
Economics Notes
Main Problems of Distribution:

Main problems of Distribution are as follows:
1. How much property be distributed?
2. Among what factors it should be distributed?
3. What should be the theory of distribution?
1. How much Property be Distributed?

Distribution is made of national income.
But national income is of two types:

(i) Gross National Income and
(ii) Net National Income.
In any country in one year whatever is earned in connection with goods and service, their value
interns of money is called Gross National Income. But it should be remembered that Gross
National Income is never distributed. Distribution is always done of Net National Income.
To earn total income one has to incur certain expenses. Therefore, in the total national income,
after the deduction of the expenses whatever is left out that is known as net national income and
the balance of the remaining money is distributed among the various factors of production.
Therefore, Net National Income = (Gross National Income) (minus) Cost of raw-materials +
Replacement cost of fixed and circulating capital + depreciation and repairs of fixed capital +
Taxes and insurance charges
2. Among What Factors to be Distributed?

National income is distributed among the various factors of production likeland, labour,
capital and enterprise. From national income the rent of land, wages of labourers, interest on
capital and risk part of money to entrepreneur will be deducted and the balance left will be net
profit which will be distributed.
3. What should be the Theory of Distribution?

Regarding the distribution of net national income the following two principles are being adopted.
Economics Notes
They are as follows:

(i) Marginal Productivity Theory of Distribution.
(ii) Modern Theory of Distribution.
(i) Marginal Productivity Theory of Distribution:

Marginal productivity theory of distribution is the most celebrated theory of distribution. It is the
neo-classical theory of distribution and is derived from Ricardos Marginal principle. J.B.
Clark, Marshall and Hicks are the main pro-pounders of this theory. Initially, the theory was
propounded as an explanation for the determination of wages (i.e., the reward for labour) but,
later on, it was generalized as a theory of factor pricing for all the factors of production.
The theory states that the price of a factor of production is governed by its marginal
productivity. To support this hypothesis, it analyses the process of equilibrium pertaining to the
employment of input of various factors by an individual firm under perfect competition. In a
perfectly competitive factor market, a firm can buy any number of units of factors of production,
at the prevailing market price. Now, the question is: given the price of a factor, how much of
each factor will he employ.
According to this theory, an entrepreneur or a firm will employ a factor at a given price till its
marginal productivity tends to be equal to its price. It thus follows that the reward (price) of a
factor tends to be equal to its marginal productivity.
The summary of the marginal productivity theory may thus be laid down in terms of the
following propositions:
The marginal productivity of a factor determines its price. In the long-run, the price or reward
of a factor tends to be equal to its marginal as well as average products. When the reward of each
factor in the economy tends to be equal to its marginal productivity, there is optimum allocation
of resources (factors) in different uses. Further, when all factors receive their shares according to
their respective marginal products, the total product will be exhausted.
Assumptions of Marginal Productivity Theory:

The Marginal Productivity Theory of distribution is based on the following implicit and
explicit assumptions:
(i) There is perfect competition, both in the product market as well as in the factor market.
Economics Notes
(ii) There should not be any technological change. Therefore, the techniques of production
should remain the same, though the scales and proportions of factors may change.
(iii) All units of a factor should be perfectly homogeneous i.e., they should be of equal
efficiency. This means that all units of a factor should receive the same price. The homogeneity
of factors of units should imply that they are perfectly substitutes of each other.
(iv) The firm aims at maximisation of profit. Therefore, it should seek and observe the most
efficient allocation of resources.
(v) The economy as a whole, should operate at the full employment level.
(vi) There should be perfect mobility of factors of production.
(vii) The bargaining power of the seller and the buyers of a factor of production should be equal.
(viii) The marginal productivity of an individual should be measurable.
(ix) There should not be any government intervention in the fixation of factor price, such as
minimum wage legislation or price control etc.
(x) The theory essentially considers long-run analysis in order to prove that the price of a factor
will tend to be equal to both average and marginal productivity.
The Concepts of Productivity:

Productivity means the quantity of the output turned out by the use of factor or factors of
production.
For example:
How much wheat can be produced on 5 hectares of land under certain conditions or how much
earth-digging can be done by 10 labourers.
Productivity of a factor may be viewed in two senses:

(i) Physical productivity, and
(ii) Revenue productivity.
Economics Notes
(i) Physical Productivity:

Physical productivity of a factor is measured, in terms of physical units of output of a commodity
produced by it per unit of time. When physical productivity is expressed in terms of money it is
called revenue productivity.
Again physical productivity has two concepts:

(a) Average Physical product, and
(b) Marginal Physical product.
(a) Average Physical Product:

The average physical product or the average product of a factor is the total product dividend by
the number of units of the factor employed in the process of production. To put this in symbolic
terms
AP = TP/n
(b) Marginal Physical Product:
The marginal physical product of a factor is the increase in total product resulting from the
employment of an additional unit of that factor, other factors remaining constant. The physical
product or the marginal product of a particular factor is thus measured as MP = TPn TPn-1.
Once the average and marginal products are calculated it is easy to measure the respective
revenue productivity of the factor concerned. Here, we measure the quantity of the product in
physical terms.
For example:
We may express in terms of quintals of wheat or the number of chairs produced. But we are not
concerned here with the total quantity of wheat or the average yield. We are concerned here with
the marginal product which means an addition made to the total output of the commodity by the
addition of one unit of a factor of production.
Suppose 3 hectares of land yield 30 quintals of wheat and 4 hectares, 40 quintals. The use of the
third hectare has added 10 quintals. This is the marginal physical product. The total product has
been increased by 10 quintals by the employment of the third or the marginal hectare. That is
why it is called marginal product. But it is the physical product and not product in terms of value.
Economics Notes
Value of Marginal Product (VMP):

This is also called Value of Marginal Physical Product (VMPP) and is usually referred to as the
marginal productivity of a factor, and is obtained by multiplying the marginal physical product
of the factor by the price of output.
To put it symbolically:
Marginal Productivity of VMPP = MPP x P where, MPP stands for the marginal physical
product of the factor, and P for the price of output. The marginal value product means the value
of additional product obtained by the employment of another unit of a factor of production. We
can get value product by multiplying the physical product i.e., the quantity of the commodity by
its price in the market.
For example:
When we say that it is an addition to the total product by the addition of one more unit of a factor
of production, say one hectare or one worker, or a unit of Rs. 1,000 in capital. When this
marginal product is expressed not in physical terms but in terms of its value in the market, it is
called Marginal Value Product.
Marginal Revenue Productivity:

The marginal revenue at any level of firms output is the net revenue earned by selling another
(additional) unit of the product. Algebraically, it is the addition to total revenue earned by selling
n units of product. In other-words, Marginal Revenue Product (MRP) of a factor is the net
addition to total revenue made by the employment of an additional unit of that factor, assuming
other factors to be fixed under a given state of technology. Thus, marginal revenue product is
obtained by multiplying the marginal revenue.
To put it symbolically:
MRP = MPP x MR
where, MRP indicates marginal revenue product,
MPP stands for the marginal physical product
and MR stands for the marginal revenue.
Economics Notes
Thus, there is a conceptual difference between marginal revenue product (MRP) and value of
marginal physical product (VMPP). In the former, we consider marginal revenue to be multiplied
by the MPP and, in latter, we take price to multiply it by the MPP.
In perfectly competitive market conditions for the product, however, MPP = VPP. This is
because under Perfect CompetitionPrice = MR. But if the commodity-market has imperfect
competition price or AR tends to be greater than the marginal revenue, then VMPP will be
higher than MRP.
Marginal Productivity Theory of Distribution:

Marginal Productivity Theory of Distribution is the reward of a factor equals its marginal
product. Marginal product, also known as marginal physical product, is the increment made to
the total output by employing an additional unit of a factor, keeping all other factors constant. If
the increase in the output is multiplied by the prevailing price of the product, the result is the
marginal value product of that factor. But it is better to measure marginal product of a factor in
terms of its marginal revenue product (MRP) which may be defined as the addition made to total
revenue resulting from the employment of one more unit of a factor of production, other factors
remaining unchanged.
In other words, by the marginal productivity of a factor of production we mean the addition
made to total output by the employment of the marginal unit i.e., the unit which the employer
thinks just worth-while employing. At the margin of employment, the payment made to the
factor concerned is just equal to the value of the addition made to the total output on account of
the employment of the additional unit of a factor.
For example:
If the prevailing wage is less than the marginal productivity, then more labour will be employed.
Competition among employers will raise the wage to the level of marginal productivity. If on the
other-hand, the marginal productivity is less than the wage, the employers are losing and they
will reduce their demand for labour. As a result, the wage rate will come down to the level of
marginal productivity. In this way by competition, wage tends to equal the marginal productivity.
This applies also to the other factors of production and their rewards.
Thus, it must be noted that in a position of competitive equilibrium:

(a) The marginal productivity of a factor of production is the same in all employments,
Economics Notes
(b) The marginal productivity of a factor of production is measured by the price of the factor of
production; and
(c) Marginal productivities of various factors are proportional to their respective prices.
Further, over the whole field of employment, therefore, each factor of production tends to be
paid in proportion to its marginal productivity. Thus, the distribution of national income or the
total aggregate output of an economy is not a scramble as the strikes or lock-outs make it appear
to be. It is governed by a definite economic principle viz. marginal productivity.
Criticisms of the Marginal Productivity Theory:

Most of the economists are of this opinion that though the marginal productivity theory is
logically sound and perfect, it has many inherent shortcomings and they have criticised the
theory on the following grounds:
1. The Basic Assumption Underlying the Theory is Unrealistic:

The theory is based on the assumption of perfect competition in the product as well as factor
markets. Modern economists, likeMrs. Robinson and Chamberlin have rightly pointed out that
perfect competition is not a very large relative phenomenon. In reality, there is imperfect
competition in the market. Further, other assumptions of the theory have also been criticised and
they are as such:
2. All Units of Factor are not Homogeneous:

The theory assumes that all units of a factor are homogeneous. In reality, however, all factor
units can never be alike. Especially, the different labour units differ in efficiency and skill.
Similarly, plots of land differ in fertility and so on.
3. Factors are not fully Employed:

The theory assumes that all factors are fully employed. But, as Keynes pointed out, in reality
there is a likelihood of under-employment rather than full employment.
4. Factors are not Perfectly Mobile:

Next, the theory assumes perfect mobility of factors. But in reality, factors are imperfectly
mobile between regions and occupations. There is no automatic movement of factors units from
one place to another. The greater the degree of specialisation in an industry, the less is the factor
mobility from one industry to another.
Economics Notes
5. All Factors are not Divisible:

The theory assumes the divisibility of factors. But lumpy factors like factory plant, machines and
the manager are indivisible. In a large factory the addition or subs-traction of one factor units
will have practically no effect on the total productivity. It may be true in domestic production.
Thus, the equality between marginal productivity and price of a factor cannot be brought about
by varying its quantities a little less or more.
6. This Theory not Applicable in the Short-run:

The theory is applicable only in the long-run, when the reward of a factor service tends to equal
its marginal revenue product. But in reality, we are concerned with short-run problems. As said
by Prof. KeynesIn the long-run we are all dead. This assumption makes the problem of
pricing the factor-services unrealistic.
7. This Theory is a Static Theory:

The marginal productivity theory is applicable only to a static economy as it regards no change
in technology. Since the modern economy is dynamic and there are technological advances from
time to time, the theory becomes inapplicable to modern conditions.
8. This Theory has been considered as One-sided:

Because it considers only demand for factors in terms of its Marginal Revenue Product but it
fails to analyse the conditions of supply in the factor market. The factor price may be high when
the factor is relatively scarce.
9. Marginal Productivity of all Factors cannot be Measured Separately:

In this theory it has been assumed that the marginal physical product of an individual factor can
be measured by keeping other factors unchanged. Critics have said that one cannot consider the
specific marginal productivity of a factor in isolation, when production is not the result of only
one factor. It is the outcome of collective efforts of all factors at a time. Therefore, it is difficult
to measure the marginal productivity of each factor separately. Since variation in output cannot
be attributed to a single factor alone, marginal productivity appears to be a make-believe
concept.
10. The Theory is based on the Law of Diminishing Returns as Applied to the Organisation
of a Business:
Economics Notes
This means that a factor like capital with improved technology has increasing returns and it also
enhances the productivity of other factors like labour. This theory misses this vital point of
practical consideration.
11. Wage Determination Theory:

This Theory has been Criticised by Keynes and he is of this Opinion that theory is Basically
Explained for Wage Determination and is Loosely Extended for Pricing of the Other Factors of
Production. But other factors like rent and capital have their distinctive factors likerent and
capital have their distinctive characteristics, so their rewards are also fixed distinctly. Again, the
entrepreneur earns profit which is a residual income, which can be negative as well. Then, is it
not ridiculous to lack of negative marginal product of an entrepreneur to explain loss in the
business, which is improper.
12. The Theory cannot apply to Personal Distribution:

The theory only explains functional distribution. It does not deal or explains anything of personal
distribution of income and inequalities of earnings.
13. The Theory Lacks Normative Aspect of the Dealings:

This theory contains only the positive aspect of the analysis. It does not consider anything or it
does not have any ethical justification or social norm in determining the reward factor.
Modern Theory of Distribution Demand and Supply Theory:

We have seen earlier that the marginal productivity theory only tells us that how many workers
will an employer engage at a given level in order to earn maximum of profit. It does not tells us
how that wage-level is determined. Further, the marginal productivity theory describes the
problem of the determination of the reward of a factor of production from the side of demand
only. It has not said anything from the supply side.
Therefore, the marginal productivity theory cannot be said to be an adequate explanation of the
determination of the factor prices. The modern theory of pricing which gives us a satisfactory
explanation of factor prices in the Demand and Supply Theory. As we are aware that the price of
a commodity is determined by the demand for and supply of, a commodity, similarly the price of
a productive service also is determined by demand for and supply of that particular factor.
Economics Notes
Demand for a Factor:

First we are going to consider the demand side of the factor. Here, we should remember that the
demand for a factor of production is not a direct demand. It is on indirect or derived demand, It is
derived from the demand for the product that, the factor produces. For example, we can say that
labour does not satisfy our w ants directly. The demand for labour entirely depends upon the
demand for goods. If the demand for goods increases, the demand for the factors which help to
produce those goods will also increase.
The demand for a factor of production will also depend on the quantity of the other factors
required for the process. The demand price for a given quantity of a factor of production will be
higher, the greater the quantities of the co-operating productive services. If in production more of
a factor of production is employed, the marginal productivity of the factor will fall and the
demand price will be lower of the unit of a productive service.
Further, the demand price of a factor of production also depends upon the value of the finished
product in the production of which the factor is used. The demand price of a commodity is
normally higher, if more valuable is the finished product in which the factor is used. Next, the
more productive the factor is, the higher will be the demand price of a given quantity of the
factor.
From the following diagramme the given explanation given can be explained:
In the diagramme given the wage is OW, the firm is in equilibrium at the point E and the demand
for the factor is ON. Similarly at OW wage the demand is ON and at OW the demand is ON .
MRP (Marginal Revenue Productivity) curve is the demand curve for a factor of production by
an individual firm.
Economics Notes
For determining the price of a factor, it is not the demand of the individual firm that matters but
it is the total demand, i.e., the sum-total of the demands of all firms in the industry. The total
demand curve is derived by the total summation of the marginal revenue productivity curves all
the firms. This curve DD is shown in the figure. Thus, from this figure it can be ascertained that-
according to the law of diminishing marginal productivity, the more a factor is employed, the
lower is the marginal productivity.
Supply Side:
The supply curve of a factor depends on the various conditions of its supply.
For example:
The supply of labour entirely depends upon the size and composition of population, the
occupational and geographical distribution, labour efficiency their training, expected income,
relative preference for work and leisure etc. By considering all these relevant factors, it is
possible to construct the supply curve of a productive service.
Further, the supply of labour does not depend only on economic factors but many non-economic
considerations also. Therefore, we can say that if the price of a factor increases, it supply will
also increase and vice-versa. Hence, the supply curve of a factor rises from left to right upwards.
This can be shown by the figure given below:
Economics Notes
Interaction of Demand and Supply:

We have studied up to this stage the demand curve and the supply curve of the factor of
production while in price fixation both curves are needed. Therefore, the price will tend to
prevail in the market at which the demand and supply are in equilibrium. This equilibrium is at
the point of intersection of the demand and supply curves.
In the diagram above the demand and supply curves intersect at the point R and the price of the
factor will be OW at OW demand W M is less than the supply W L. In this case competition
among the sellers of the service will tend to bring down the price to OW. On the other hand, at
OW price the demand W L is greater than the supply W M , hence price will tend to go up
to OW at which the demand and supply will be equal.
To conclude, this is how that the price of a factor of production in the factor market is
determined by the interaction of the forces of demand and supply in connection with the factor of
production. Thus eminent economists are of this opinion that this is the proper, correct and
satisfactory theory of distribution.
International Trade
Trade is the exchange of products between countries. When conditions are right, trade brings
benefits to all countries involved and can be a powerful driver for sustained GDP growth and
rising living standards
Economics Notes
One way of expressing the gains from trade in goods and services is to distinguish between static
gains (i.e. improvements in allocative and productive efficiency) and dynamic gains (i.e. gains in
welfare that occur from improved product quality, increased choice and faster innovative
behaviour).
Gains from Trade Understanding Comparative Advantage
First introduced by David Ricardo in 1817, comparative advantage exists when a country has a
margin of superiority in the supply of a good or service i.e. where the marginal cost of
production is lower
Countries will generally specialise in and export products which use intensively the factors
inputs which they are most abundantly endowed
If each country specializes, total output can be increased leading to better allocative efficiency
and welfare.
Because production costs are lower, providing that a good price can be found from buyers,
specialisation should focus on goods and services that provide the best value
In many countries, comparative advantage is shifting towards specialising in producing and

exporting high-value and high-technology manufactured goods and high-knowledge services
Example of Comparative Advantage
Usually we take a standard two-country + two-product example to illustrate comparative

advantage.
Consider two countries producing digital cameras and vacuum cleaners

With the same factor resources (inputs) evenly allocated by each country to the
production of both goods, the production possibilities are as shown in the table below:
OUTPUT BEFORE SPECIALISATIONDigital CamerasVacuum Cleaners

UK 600 600
United States 2400 1000
Total 3000 1600
Stage 1: Working out the comparative advantage
To identify who should specialise in a particular product, consider the internal

opportunity costs
Were the UK to shift their resources into supplying more vacuum cleaners, the
opportunity cost of each vacuum cleaner is one digital television
Economics Notes
For the United States the same decision has an opportunity cost of 2.4 digital cameras.
Therefore, the UK has a comparative advantage in vacuum cleaners
If the UK chose to reallocate resources to digital cameras the opportunity cost of an

extra camera is one vacuum cleaner. But for the USA the opportunity cost is only 5/12ths
of a vacuum cleaner.
USA has comparative advantage in producing digital cameras because its opportunity
cost is lowest
Stage 2: Showing the Output after Specialisation
output after specialisationDigital CamerasVacuum Cleaners

UK 0 (-600) 1200 (+600)
United States 3360 (+960) 600 (-400)
Total 3360 1800
The UK specializes totally in producing vacuum cleaners doubling its output -

now1200
The United States partly specializes in digital cameras increasing output by 960 having
given up 400 units of vacuum cleaners
As a result of specialisation output of both products has increased - a gain in economic

welfare.
Key point:
For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of
exchange of one product for another. If the two countries trade at a rate of exchange of two
digital cameras for one vacuum cleaner, the post-trade position will be as follows:
The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras
The USA exports 840 digital cameras and imports 420 vacuum cleaners
Stage 3: Showing the Gains from Trade - Post Trade Output / Consumption
Digital CamerasVacuum Cleaners

UK 840 780
United States2520 1020
Total 3360 1800
Compared with the pre-specialisation output levels, consumers now have an increased supply of
both goods
Economics Notes
Exam tip: It is useful to learn a numerical example to illustrate comparative advantage for use in
an exam
What are the key assumptions behind this theory of trade?
This theory of trade based on comparative advantage rests on a number of assumptions:
1. Occupational mobility of factors of production (land, labour, capital) - this means

that switching factor resources from one industry to another involves no loss of efficiency
and productivity. In reality we know that factors of production are not perfectly mobile
labour immobility is a root cause of structural unemployment.
2. Constant returns to scale (i.e. doubling the inputs used in the production process leads
to a doubling of output) this is merely a simplifying assumption. Specialisation might
lead to diminishing returns in which case the benefits from trade are reduced. Conversely
increasing returns to scale means that specialisation brings even greater increases in
output.
3. Insignificant externalities from production and/or consumption no discussion about
the overall costs and benefits of specialisation and trade should ignore environmental
considerations arising from increased production and trade between countries.
Value of Money and the Price Level (With Diagram)
Subject Matter:
The average level of all prices in a country is called the price level. There are thousands of waves
in a sea, each wave having a different height.
Nevertheless, we can calculate the average level of the sea and call it the sea- level. Similarly, we
can calculate the price level, although there are thousands of prices, all moving in different ways.
When the price level rises money can buy less goods and services. So we say that its purchasing
power has fallen. Conversely, when the price level falls, money can buy more and we can say its
purchasing power has gone up. Thus, the value of money changes inversely with the price level.
In our country, the price level increased by about 400% during World War n (1939-1945). The
value of the rupee fell by the same percentage.
Why Does the Price Level Change?

Changes in the price level are caused by two factors:
(a) changes in the supply of money, and
(b) changes in the supply of goods and services.
Economics Notes
When the quantity of money in circulation in a country is increased (e.g., by printing new notes)
more money is available to the people for making purchases, the demand for goods and services
goes up and the price level tends to rise.
Conversely, if the supply of money decreases people can buy less and the price level tends to go
down. Again, if there is an increase in the supply of goods and services, the price level tends to
fall and, in the converse case, it tends to rise.
Thus, if the supply of money increases by 25% and the supply of goods and services also
increases by the same 25%, there will ordinarily be no effect on the price level. There are other
factors which influence the price level (e.g., the number of times money changes hands or the
velocity of circulation) but the first two factors are the most important of all.
In India, during World War II, there was a large increase in the volume of notes printed by the
Government. There was, at the same time, a decrease in the supply of goods (due to reduction of
imports, etc.). Consequently, the price level increased many times.
It is possible to analyse the causes of price changes in a different way. Modern writers believe
that price level changes are brought about by changes in the level of income, i.e., the average
amount of money earned by that people when more income is earned, the demand for the goods
and services goes up and price rise. When income falls, less goods and services are demanded
and price fall. [Changes in the level of income depend on two factors, the volume of savings and
the volume of investment in the country.]
The Inflation Machine:

When inflation is reduced to its simplest elements, its proximate causes can easily be identified.
Figure 19.1 represents the inflation machine. Let us assume for a moment that the value of the
consumable goods and services produced is in balance with the money paid to all those who
compete for the purchase of the goods and services.
Then prices will remain unchanged. Of course, prices of individual items will fluctuate due to
changes in demand and supply conditions, but the aggregate price level will be stable. In fact, the
inflation machine is nothing more than or less than a broad view of supply and demand and the
market clearing price.
Economics Notes
Now, if we load the left hand side of the inflation machine with more money than the value of
goods and services on the right side, prices will surely increase. Competition for the limited
amount of goods that is available will rare prices. Another way to load the left hand side of the
inflation machine is for the same number of rupees to be spent with greater frequency. This is
called increasing the velocity of money.
The rupees flow through the economic system faster and this creates a similar effect.
Alternatively, if people take money out of savings and spend it, that increases the number of
rupees in competition for the available goods. The effect is the samecompetition for what is
available on the right side will drive prices up.
Quantity theory of money
Value of money
What gives money value? We know that intrinsically, a dollar bill is just worthless paper and ink.
However, the purchasing power of a dollar bill is much greater than that of another piece of
paper of similar size. From where does this power originate?
Like most things in economics, there is a market for money. The supply of money in the money
market comes from the Fed. The Fed has the power to adjust the money supply by increasing or
Economics Notes
decreasing the number of bills in circulation. Nobody else can make this policy decision. The
demand for money in the money market comes from consumers.
The determinants of money demand are infinite. In general, consumers need money to purchase
goods and services. If there is an ATM nearby or if credit cards are plentiful, consumers may
demand less money at a given time than they would if cash were difficult to obtain. The most
important variable in determining money demand is the average price level within the economy.
If the average price level is high and goods and services tend to cost a significant amount of
money, consumers will demand more money. If, on the other hand, the average price level is low
and goods and services tend to cost little money, consumers will demand less money.
Figure %: Sample money market
The value of money is ultimately determined by the intersection of the money supply, as
controlled by the Fed, and money demand, as created by consumers. Figure 1 depicts the money
market in a sample economy. The money supply curve is vertical because the Fed sets the
amount of money available without consideration for the value of money. The money demand
curve slopes downward because as the value of money decreases, consumers are forced to carry
more money to make purchases because goods and services cost more money. Similarly, when
the value of money is high, consumers demand little money because goods and services can be
purchased for low prices. The intersection of the money supply curve and the money demand
curve shows both the equilibrium value of money as well as the equilibrium price level.
Economics Notes
Figure %: Sample shift in the money market
The value of money, as revealed by the money market, is variable. A change in money demand
or a change in the money supply will yield a change in the value of money and in the price level.
Notice that the change in the value of money and the change in the price level are of the same
magnitude but in opposite directions. An increase in the money supply is depicted in Figure 2.
Notice that the new intersection of the money supply curve and the money demand curve is at a
lower value of money but a higher price level. This happens because more money is in
circulation, so each bill becomes worth less. It takes more bills to purchase goods and services,
and thus the price level increases accordingly.
The quantity theory of money is based directly on the changes brought about by an increase in
the money supply. The quantity theory of money states that the value of money is based on the
amount of money in the economy. Thus, according to the quantity theory of money, when the
Fed increases the money supply, the value of money falls and the price level increases. Inflation
is defined as an increase in the price level. Based on this definition, the quantity theory of money
also states that growth in the money supply is the primary cause of inflation.
Economics Notes
Velocity
While the relationship between money supply, money demand, the price level, and the value of
money presented above is accurate, it is a bit simplistic. In the real world economy, these factors
are not connected as neatly as the quantity theory of money and the basic money market diagram
present. Rather, a number of variables mediate the effects of changes in the money supply and
money demand on the value of money and the price level.
The most important variable that mediates the effects of changes in the money supply is the
velocity of money. Imagine that you purchase a hamburger. The waiter then takes the money that
you spent and uses it to pay for his dry cleaning. The dry cleaner then takes that money and pays
to have his car washed. This process continues until the bill is eventually taken out of circulation.
In many cases, bills are not removed from circulation until many decades of service. In the end, a
single bill will have facilitated many times its face value in purchases.
Velocity of money is defined simply as the rate at which money changes hands. If velocity is
high, money is changing hands quickly, and a relatively small money supply can fund a
relatively large amount of purchases. On the other hand, if velocity is low, then money is
changing hands slowly, and it takes a much larger money supply to fund the same number of
purchases.
As you might expect, the velocity of money is not constant. Instead, velocity changes as
consumers' preferences change. It also changes as the value of money and the price level change.
If the value of money is low, then the price level is high, and a larger number of bills must be
used to fund purchases. Given a constant money supply, the velocity of money must increase to
fund all of these purchases. Similarly, when the money supply shifts due to Fed policy, velocity
can change. This change makes the value of money and the price level remain constant.
The relationship between velocity, the money supply, the price level, and output is represented
by the equation M * V = P * Y where M is the money supply, V is the velocity, P is the price
Economics Notes
level, and Y is the quantity of output. P * Y, the price level multiplied by the quantity of output,
gives the nominal GDP. This equation can thus be rearranged as V = (nominal GDP) / M.
Conceptually, this equation means that for a given level of nominal GDP, a smaller money
supply will result in money needing to change hands more quickly to facilitate the total
purchases, which causes increased velocity.
The equation for the velocity of money, while useful in its original form, can be converted to a
percentage change formula for easier calculations. In this case, the equation becomes (percent
change in the money supply) + (percent change in velocity) = (percent change in the price level)
+ (percent change in output). The percentage change formula aids calculations that involve this
equation by ensuring that all variables are in common units.
The velocity equation can be used to find the effects that changes in velocity, price level, or
money supply have on each other. When making these calculations, remember that in the short
run, output (Y), is fixed, as time is required for the quantity of output to change.
Let's try an example. What is the effect of a 3% increase in the money supply on the price level,
given that output and velocity remain relatively constant? The equation used to solve this
problem is (percent change in the money supply) + (percent change in velocity) = (percent
change in the price level) + (percent change in output). Substituting in the values from the
problem we get 3% + 0% = x% + 0%. In this case, a 3% increase in the money supple results in a
3% increase in the price level. Remember that a 3% increase in the price level means that
inflation was 3%.
In the long run, the equation for velocity becomes even more useful. In fact, the equation shows
that increases in the money supply by the Fed tend to cause increases in the price level and
therefore inflation, even though the effects of the Fed's policy is slightly dampened by changes in
velocity. This results a number of factors. First, in the long run, velocity, V, is relatively constant
because people's spending habits are not quick to change. Similarly, the quantity of output, Y, is
Economics Notes
not affected by the actions of the Fed since it is based on the amount of production, not the value
of the stuff produced. This means that the percent change in the money supply equals the percent
change in the price level since the percent change in velocity and percent change in output are
both equal to zero. Thus, we see how an increase in the money supply by the Fed causes
inflation.
Let's try another example. What is the effect of a 5% increase in the money supply on inflation?
Again, we being by using the equation (percent change in the money supply) + (percent change
in velocity) = (percent change in the price level) + (percent change in output). Remember that in
the long run, output not affected by the Fed's actions and velocity remains relatively constant.
Thus, the equation becomes 5% + 0% = x% + 0%. In this case, a 5% increase in the money
supply results in a 5% increase in inflation.
The velocity of money equation represents the heart of the quantity theory of money. By
understanding how velocity mitigates the actions of the Fed in the long run and in the short run,
we can gain a thorough understanding of the value of money and inflation.
Government Intervention in price systems
Market Failure
In a market where there is equilibrium, the resources are allocated in the best possible
manner and there is 'allocative efficiency'.
Allocative efficiency is when situation where Marginal cost is equal to Marginal revenue.
Market failure exists when the resources are not allocated efficiently. Community surplus
is not maximized and thus there is market failure. From a community's point of view,
producer surplus is not equal to consumer surplus.
Market failure is thus caused by
Abuse of monopoly power
Lack of public goods
Economics Notes
Under provision of merit goods
Overprovision of demerit goods
Environmental degradation
Inequality in distribution of wealth
Immobility of factors of production
Problems of information
Short termism
Externalities
A loss or gain in the welfare of one party resulting from an activity of another party,
without there being any compensation for the losing party.
This activity can be due to consumption or production of a good or service.
If the third party suffers due to this activity then it is known as negative externality. Its
the production or consumption activity that creates an external cost.
When the third party gains from this activity is it known as positive externality. Its the
production or consumption activity that creates an external benefit.
Externalities occur when there is a divergence between social and private costs and
benefits.
Private costs - costs involved in an action that accrue to the decision maker.
Social costs - all costs that are associated with a particular action.
Private benefits - benefits that accrue solely to the decision maker.
Social benefits - all the benefits that accrue from a particular action. (
The market demand and supply curves therefore reflect the MPB and MPC accruing to
buyers and sellers.
MPC= MPB P & Q equilibrium reflected at this point are socially optimum.
Economics Notes
Social cost (SC) = Private costs (PC) + External costs (EC)
In marginal terms (when each additional unit of good is produced),
Marginal Social Costs (MSC) = Marginal Private Costs (MPC) + Marginal

External(MEC)
Net External benefit = External benefit external cost
External benefit arises when social benefit exceeds private benefit. It refers to the benefit
from production (consumption) experienced by people other than the producer
(consumer).
Positive externality
Social benefit- the full benefit to society from consumption and production of any good.
From the society's point of view, the price system must consider both private benefit and
external benefit.
Social benefit (SB) = Private benefit (PB) + External benefit (EB)
In marginal terms (when each additional unit of good is produced),
Marginal Social benefit (MSB) =Marginal Private benefit (MPB) + Marginal

External benefit (MEB)
Negative Production Externalities
Side effects of production activities.
An individual / firm making a decision does not have to pay the full cost of the decision.
Pollution
producers don't take responsibility for external costs that exist--these are passed on to
society.
Economics Notes
Producers have lower marginal costs than they would otherwise have and the supply
curve is effectively shifted down (to the right) of the supply curve that society faces.
Because the supply curve is increased, more of the product is bought than the efficient
amount--that is, too much of the product is produced and sold.
Since marginal benefit is not equal to marginal cost, a deadweight welfare loss results.
How to reduce negative production externalities?
Legislation and regulation
Legislations will lower the quantity of goods produced and bring it closer to the optimal
quantity Q* by shifting the MPC curve upward towards the MSC curve. It might include
legislations to
Limit the emission of pollutants by setting limits to the extent of pollutants produced
by a firm.
Limit the production to a certain level.
Economics Notes
Force polluting units to install technologies which reduce emissions.
Taxes
Government may impose a tax on the firm either on per unit of production or per unit
of pollutants emitted.
Tradable permits
Market-driven approach to reducing greenhouse gas emissions. A government must

start by deciding how many tons of a particular gas may be emitted each year.
Tradable permits will result in firms to lower the quantity of goods produced so that it
equals Q* and to raise the price of the goods
Government impose Tax
Positive Production Externalities
When firms train their employees which result in better manpower or invest in research
and development and succeed in developing new technologies which benefits the society.
Due to the fact that positive externality is produced, the MSC lies below the MPC. The
diagram below illustrates positive production externalities.
Economics Notes
Corrective positive production externalities
Subsidies can be provided to firms which produce these goods. The effect will be the lowering of
MPC and thus the MPC will more downward to MSC.
This will increase the output to a level Q2 near to the socially optimal level Q*. The price will
also fall from P1 to P2.
Negative Consumption Externalities
Economics Notes
By smoking in public places, the consumer is creating negative externalities, in the form
of passive smoking, for non-smokers. Other examples :- using fossil fuels that pollute
atmosphere, playing loud music and disturbing neighbours, discarding garbage in public
places.
MPB is not reflecting social benefit and thus MSB lies below MPB. The vertical
difference between MPB and MSB is the negative externality. The optimal level of
consumption is where MSB=MSC i.e. Q*.
However the negative externality is being ignored and thus there is an over consumption
of the goods at Q1.
How to reduce negative consumption externalities?
Advertising
Legislations and regulations
Imposing indirect taxes
Positive Consumption Externalities
consumption of education and health care. Both these will lead to more productive
workforce and hence high rate of economic growth for the society.
Economics Notes
The MSB lies above the MPB and the difference between the two consists of positive
externality.
The socially optimal level is where MSB=MSC i.e Q*, however, due to under-allocation
of resources the output/consumption is at Q1.
Corrective Positive consumption externalities
Subsidies - MSC curve shifting to MSC+subsidy which means high

output/consumption at socially optimal level Q* and at lower prices from P1 to P*.
Advertising - Consumers to increase their consumption and thus lead to a shift of

MPB to the right i.e. increase in demand. If the MPB curve shifts enough, it will
coincide with MSB and Q* will be produced and consumed.
Economics Notes
Goods
Demerit Goods - goods which are deemed to be socially undesirable, and which are likely
to be over-produced and over-consumed through the market mechanism. Examples :-
cigarettes, alcohol and all other addictive drugs such as heroine and cocaine.
The consumption of demerit goods imposes considerable negative externalities on society

as a whole, such that the private costs incurred by the individual consumer are less than
the social costs experienced by society in general.
Economics Notes
Merit Goods - Benefits on society in excess of the benefits conferred on individual

consumers; in other words, there is a divergence between private and social costs and
benefits, as the social benefits accruing to society as a whole from the consumption of
such goods tend to be greater than the private benefits to the individual.
Individual consumers and producers make their decisions on the basis of their own,
internal costs and benefits, but, from the standpoint of the welfare of society at large,
externalities must be considered.
Private Goods and Public Goods
Economics Notes
Consumer Surplus and Producer Surplus
Consumer Surplus - difference between total benefit of consuming a given quantity of

output and the total expenditures consumers pay to obtain that quantity.
Producer Surplus - difference between the amount that a producer of a good receives and
the minimum amount that he or she would be willing to accept for the good.
Community Surplus - the welfare of society and it is made up of a consumer surplus plus
a producer surplus. It exists when it is impossible to make someone better off without
making someone else worse off.
Consumer Surplus
Economics Notes
Producer Surplus
Indirect Taxes
tax collected by an intermediary i.e. seller, from the person who bears the ultimate
economic burden of the tax i.e. consumer.
it is a tax which is imposed on goods and services sold. It is usually added to the cost of
the good or service and charged from the ultimate consumer. The seller will then file a
return to the government on all the taxes he has collected from the consumer.
Example :- sales tax and excise duty
Economics Notes
Reasons for imposing taxes
To generate Government revenues: excise duties on beers, wines and spirits are price
inelastic in demand, so tax price increases by levying specific alcohol and tobacco taxes
raise consumer expenditures as a whole on these categories and therefore taxation
revenues.
To discourage consumption: Government might use taxes to discourage consumption of

certain demerit goods such as cigarettes.
To alter the pattern of consumption: Government might use direct taxes a a mean to alter
the consumption patter of its population. Certain goods can be made more price attractive
through lower taxes while goods which have high marginal social cost can be made
expensive through taxation.
Distinction between specific and ad valorem taxes
Specific tax is a flat rate of tax whereas ad valorem tax is a percentage tax.
Ad valorem literally the term means according to value. It is imposed on the basis of
the monetary value of the taxed item.
Consequences of imposing indirect tax
Imposition of tax results in three economic observations.

Incidence: Incidence of tax means the party who actually pays the tax.
Government revenue: the amount of tax government will receive as revenue
Resource allocation: the amount of fall in quantity demanded and produced created by
the tax.
Incidence or tax burden
When a tax imposed on a good or service increases the price by the amount of the tax, the
burden of the tax falls on consumers.
If instead it lowers wages or lowers prices for some of the other factors of production
used in the production of the good or service taxed, the burden of the tax falls on owners
of these factors.
Economics Notes
Tax incidence and price elasticity of demand and supply
Scenario 1: When PED is greater than PES
Where PED is greater than PES, it implies that consumers are more sensitive to price
changes as compared to suppliers. Thus the incidence of tax will be more on the suppliers
because if too much burden of tax is passed on to the consumers then the demand will fall
drastically.
Scenario 2: When PES is greater than PED
When the supply curve is relatively elastic, the bulk of the tax burden is borne by buyers.
This is because PED as compared to PES is elastic, which means; consumers are not that
price sensitive and will not reduce their consumption even if the prices rise. Because the
PES is elastic, suppliers will stop the supply if the cost of production goes up.
Scenario 3 : PED is equal to PES
Subsidy and Elasticity
A subsidy is a form of financial assistance paid by the government to a business or

economic sector.
Why subsidies are given?
Economics Notes
Subsidies might be given to

Lower the cost of necessary goods which might affects a major part of population.
Example, subsidies given to essential food items and oil (in India).
Guarantee the supply of merit goods, which the government thinks consumers
should consume.
Help domestic firms become more competitive in the international market, also
known as protectionism.
Effect of subsidy
Subsidy reduces the cost of production. Thus the supply curve for the product shifts
vertically downwards by the amount of subsidy provided.
Impacts of Subsidies on Producers
Subsidies are monetary benefits provided to the producer by the Government on account
of production of certain commodity. Subsidies lead to increase in producer revenue. Due
to subsidy the supply curve (S-subsidy) will shift vertically downwards by the amount of
subsidy. This reduces the cost of production and more is now being supplied at every
price. Through the diagram, we can see, initially the market was at equilibrium with Qe
being supplied & demanded at Price (Pe).
Government provides subsidy WZ per unit.
Producers lower their prices to P1 Increase output till a new equilibrium is reached at Q1
The producer will however not pass all the subsidy benefit to the consumer.
Initial producer revenue was OPeXQe which now increases to ODWQ1.
Economics Notes
Impacts of Subsidies on Consumers
Consumers will now consume more of the product due to lower prices. Consumers
pay less as the prices fall from Pe to P1.
They however end up consuming more from Qe to Q1. It is difficult to say by how
much the consumer expenditure will increase or fall as it will depend on their relative
saving and extra expenditure.
Economics Notes
Subsidies and elasticity
Scenario 1: When PED is elastic relative to PES
The consumers do not benefit from a great fall but, because their demand is relative
elastic, they increase their consumption by a significant amount.
Scenario 2: When PED is inelastic relative to PES
Consumption of the product is increased and so is the revenue of the producer.
The consumer benefit from a relatively large price fall, but their demand is relative
inelastic, their consumption does not increase by a great amount.
Government Intervention in Market Prices
Maximum Price or PRICE CEILINGS
In some markets, governments intervene to keep prices of certain items higher or lower
than what would result from the market finding its own equilibrium price.
A price ceiling occurs when the government puts a legal limit on how high the price of a
product can be. In order for a price ceiling to be effective, it must be set below the natural
market equilibrium.
Minimum Prices or Price Floor
A minimum allowable price set above the equilibrium price is a price floor.
With a price floor, the government forbids a price below the minimum Price Floors are
minimum prices set by the government for certain commodities and services that it
Economics Notes
believes are being sold in an unfair market with too low of a price and thus their
producers deserve some assistance.

Theory of Demand

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Theory of Demand

Uploaded by

Copyright:

Available Formats

Economics Notes

Demand is different to desire! Effective demand is when a desire to buy a product is

Transport as a Derived Demand

The Law of Demand

There is an inverse relationship between the price of a good and demand.

1. As prices fall, we see an expansion of demand.

Average season ticket prices (in s) for Premier League clubs

Supply and Demand

A. The Law of Demand

B. The Law of Supply

Time and Supply

C. Supply and Demand Relationship

Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.

F. Shifts vs. Movement

Theory of the Firm

What is the 'Theory Of The Firm'

BREAKING DOWN 'Theory Of The Firm'

Expansion on the Theory of the Firm

Distribution and Theories of Distribution (With Diagram)

Introduction and Definition:

3. According to Prof. Cannon Distribution like production is a social phenomenon. In

Personal Distribution and Functional Distribution:

(i) Functional distribution,

(ii) Personal distribution.

Main Problems of Distribution:

2. Among what factors it should be distributed?

3. What should be the theory of distribution?

1. How much Property be Distributed?

But national income is of two types:

(ii) Net National Income.

2. Among What Factors to be Distributed?

3. What should be the Theory of Distribution?

They are as follows:

(ii) Modern Theory of Distribution.

(i) Marginal Productivity Theory of Distribution:

Assumptions of Marginal Productivity Theory:

(vi) There should be perfect mobility of factors of production.

(viii) The marginal productivity of an individual should be measurable.

The Concepts of Productivity:

Productivity of a factor may be viewed in two senses:

(ii) Revenue productivity.

(i) Physical Productivity:

Again physical productivity has two concepts:

(b) Marginal Physical product.

(a) Average Physical Product:

Value of Marginal Product (VMP):

Marginal Revenue Productivity:

where, MRP indicates marginal revenue product,

MPP stands for the marginal physical product

and MR stands for the marginal revenue.

Marginal Productivity Theory of Distribution:

Thus, it must be noted that in a position of competitive equilibrium:

Criticisms of the Marginal Productivity Theory:

1. The Basic Assumption Underlying the Theory is Unrealistic:

2. All Units of Factor are not Homogeneous:

3. Factors are not fully Employed:

4. Factors are not Perfectly Mobile:

5. All Factors are not Divisible:

6. This Theory not Applicable in the Short-run:

7. This Theory is a Static Theory:

8. This Theory has been considered as One-sided:

9. Marginal Productivity of all Factors cannot be Measured Separately:

11. Wage Determination Theory:

12. The Theory cannot apply to Personal Distribution: