ASSIGNMENT No.

1
Q.1 (a) What is PEST analysis? Explain in detail.
(b) What is opportunity cost and why today’s manager calculate opportunity cost?
Differentiate between scarcity and shortage.
Q.2 Consider an imaginary economy that produces only three goods: steaks, eggs and
milk information on the quantities and prices of each good sold for two years is
given below.
Output 1997 2001
Steak (kgs) 10 7
Eggs (dozens) 10 13
Milk (bottles) 8 11
Price
Steak (per kg) $9.10 $11.50
Eggs (per dozen) $1.10 $1.30
Milk (per bottle) $6.00 $6.50
For this hypothetical economy, calculate each of the following:
a) Nominal GDP.
b) Real GDP in constant 1997 dollars (i.e., 1997 is the base year).
c) GDP deflator.
d) The percentage change in real GDP and the GDP deflator between 1997 and
2001.
Q.3 (a) Describe the role of price as rationing device.
(b) Explain the supply and demand model in detail.
Q.4 (a) Discuss why the price elasticity of demand is greater or goods and services
that have better close substitutes.
(b) If demand is price inelastic, does revenue increase when price rises? Explain
with examples.
Q.5 Critically write about the present economic situation of Pakistan and its
consequences.
Question 1(a) What is PEST analysis? Explain in detail?
Answer 1(a)
 PEST analysis It stands for "Political, Economic, Social, and Technological
analysis" and describes a framework of macro-environmental factors used in the
environmental scanning component of strategic management.
o Political factors How and to what degree a government intervenes in the
economy. Specifically, political factors include areas such as tax policy,
labour law, environmental law, trade restrictions, tariffs, and
political stability. Political factors may also include goods and services
which the government wants to provide or be provided (merit goods) and
those that the government does not want to be provided (demerit goods or
merit bads). Furthermore, governments have great influence on the health,
education, and infrastructure of a nation.
o Economic factors Include economic growth, interest rates,
exchange rates and the inflation rate. These factors have major impacts
on how businesses operate and make decisions. For example, interest rates
affect a firm's cost of capital and therefore to what extent a business grows
and expands. Exchange rates affect the costs of exporting goods and the
supply and price of imported goods in an economy
o Social factors Include the cultural aspects and include health
consciousness, population growth rate, age distribution, career
attitudes and emphasis on safety. Trends in social factors affect the
demand for a company's products and how that company operates. For
example, an aging population may imply a smaller and less-willing
workforce (thus increasing the cost of labor). Furthermore, companies may
change various management strategies to adapt to these social trends
(such as recruiting older workers).

o Technological factors Include technological aspects such as R&D activity,

automation, technology incentives and the rate of technological change.
 They can determine barriers to entry, minimum efficient production level
and influence outsourcing decisions. Furthermore, technological shifts can
affect costs, quality, and lead to innovation.

o Environmental factors Include ecological and environmental aspects

such as weather, climate, and climate change, which may especially
affect industries such as tourism, farming, and insurance. Furthermore,
growing awareness of the potential impacts of climate change is affecting
how companies operate and the products they offer, both creating new
markets and diminishing or destroying existing ones.

 Legal factors Include discrimination law, consumer law, antitrust law,

employment law, and health and safety law. These factors can affect how a
company operates, its costs, and the demand for its products.
 Application of the Factors The model's factors will vary in importance to a
given company based on its industry and the goods it produces. For example,
consumer companies tend to be more affected by the social factors, while a global
defense contractor would tend to be more affected by political factors. Additionally
factors that are more likely to change in the future or more relevant to a given
company will carry greater importance. For example, a company which has
borrowed heavily will need to focus more on the economic factors (especially
interest rates)

Question 1(b) What is opportunity cost and why today’s manager. Calculate
Opportunity cost? Differentiate between Scarcity and Shortage.
Answer 1(b)

 Opportunity cost The cost related to the next-best choice available to someone
who has picked between several mutually exclusive choices. It is a key concept in
economics. It has been described as expressing "the basic relationship between
scarcity and choice. The notion of opportunity cost plays a crucial part in ensuring
 that scarce resources are used efficiently. Thus, opportunity costs are not
restricted to monetary or financial costs the real cost of output forgone, lost time,
pleasure or any other benefit that provides utility should also be considered
opportunity costs. The concept of an opportunity cost was first developed by John
Stuart Mill

 Scarcity of resources is one of the more basic concepts of economics. Scarcity

necessitates trade-offs, and trade-offs result in an opportunity cost. While the
cost of a good or service often is thought of in monetary terms, the opportunity cost
of a decision is based on what must be given up (the next best alternative) as a
result of the decision. Any decision that involves a choice between two or more
options has an opportunity cost.
 Examples
o Opportunity cost contrasts to accounting cost in that accounting costs do not

consider forgone opportunities. Consider the case of an MBA student who

pays Rs 60,000 per year in tuition and fees at a private university. For a two-
year MBA program, the cost of tuition and fees would be Rs 120,000. This is
the monetary cost of the education. However, when making the decision to
go back to school, one should consider the opportunity cost, which includes
the income that the student would have earned if the alternative decision of
remaining in his or her job had been made. If the student had been earning
RS 50,000 per year and was expecting a 10% salary increase in one year, Rs
55,000 in salary would be foregone as a result of the decision to return to
school. Adding this amount to the educational expenses results in a cost of
Rs230,000 for the degree.
o A person who has Rs 150 can either buy a CD or a shirt. If he buys the shirt
the opportunity cost is the CD and if he buys the CD the opportunity cost is
the shirt. If there are more choices than two, the opportunity cost is still
only one item, never all of them.
o A person who invests Rs 10,000 in a stock denies herself or himself the
interest that could have accrued by leaving the Rs 10,000 in a bank
account. The opportunity cost of the decision to invest in stock is the value
of the interest.

o A person who sells stock for Rs 10,000 denies himself or herself the
opportunity to sell the stock for a higher price (say Rs 12,000) in the future,
inheriting an opportunity cost equal to the future price of Rs 12,000 (and
not the future price minus the sale price). Note that in this case, the
opportunity cost can only be determined in hindsight.

o A person who decides to quit their job and go back to school to increase
their future earning potential has an opportunity cost equal to their lost
wages for the period of time they are in school. Conversely, if they elect to
remain employed and not return to school then the opportunity cost of that
action is the lost potential wage increase.

o An organization that invests Rs 1 million in acquiring a new asset instead of

spending that money on maintaining its existing asset portfolio incurs the
increased risk of failure of its existing assets. The opportunity cost of the
decision to acquire a new asset is the financial security that comes from
the organization's spending the money on maintaining its existing asset
portfolio.

o If a city decides to build a hospital on vacant land it owns, the opportunity

cost is the value of the benefits forgone of the next best thing that might
have been done with the land and construction funds instead. In building
the hospital, the city has forgone the opportunity to build a sports center on
that land, or a parking lot, or the ability to sell the land to reduce the city's
debt, since those uses tend to be mutually exclusive. Also included in the
opportunity cost would be what investments or purchases the private sector
 would have voluntarily made if it had not been taxed to build the hospital.
The total opportunity costs of such an action can never be known with
certainty, and are sometimes called "hidden costs" or "hidden losses" as
what has been prevented from being produced cannot be seen or known.
o Opportunity cost is assessed in not only monetary or material terms, but
also in terms of anything which is of value. For example, a person who
desires to watch each of two television programs being broadcast
simultaneously, and does not have the means to make a recording of one,
can watch only one of the desired programs. Therefore, the opportunity
cost of watching Geo could be enjoying dancing. Of course,
o If an individual records one program while watching the other, the
opportunity cost will be the time that individual spends watching one
program versus the other.
o In a restaurant situation, the opportunity cost of eating steak could be
trying the salmon. For the diner, the opportunity cost of ordering both
meals could be twofold - the extra Rs 200 to buy the second meal, and his
reputation with his peers, as he may be thought gluttonous or extravagant
for ordering two meals.
o A family might decide to use a short period of vacation time to visit
Disneyland rather than doing household improvements. The opportunity
cost of having happier children could therefore be a remodeled bathroom.
 Relative Price
Opportunity cost is expressed in relative price, that is, the price of one choice
relative to the price of another. For example, if milk costs $4 per gallon and bread
costs $2 per loaf, then the relative price of milk is 2 loaves of bread. If a consumer
goes to the grocery store with only $4 and buys a gallon of milk with it, then one
can say that the opportunity cost of that gallon of milk was 2 loaves of bread
(assuming that bread was the next best alternative).In many cases, the relative
price provides better insight into the real cost of a good than does the monetary
price.
 Applications of Opportunity Cost The concept of opportunity cost has a wide range
of applications including:-
o Consumer choice
o Production possibilities
o Cost of capital
o Time management
o Career choice
o Analysis of comparative advantage

 Evaluation of Opportunity Cost The consideration of opportunity costs is one of

the key differences between the concepts of economic cost and accounting
cost. Assessing opportunity costs is fundamental to assessing the true cost of any
course of action. In the case where there is no explicit accounting or monetary cost
(price) attached to a course of action, or the explicit accounting or monetary cost
is low, then, ignoring opportunity costs may produce the illusion that its benefits
cost nothing at all. The unseen opportunity costs then become the implicit hidden
costs of that course of action. Note that opportunity cost is not the sum of the
available alternatives when those alternatives are, in turn, mutually exclusive to
each other. The opportunity cost of the city's decision to build the hospital on its
vacant land is the loss of the land for a sporting center, or the inability to use the
land for a parking lot, or the money which could have been made from selling the
land, as use for any one of those purposes would preclude the possibility to
implement any of the others. However, most opportunities are difficult to compare.
Opportunity cost has been seen as the foundation of the marginal theory of
value as well as the theory of time and money. In some cases it may be possible
to have more of everything by making different choices; for instance, when an
economy is within its production possibility frontier. In microeconomic models
this is unusual, because individuals are assumed to maximise utility, but it is a
feature of Keynesian macroeconomics. In these circumstances opportunity cost is
a less useful concept.
 Shortage In a perfect world, supply and demand would work flawlessly and there
would always be an appropriate supply of every product. However, things are not
always that simple. To produce a good or service, certain resources are required.
These resources may be natural in form like water, wood, ore or any number of
other types of raw materials. Resources can also be in the form of human labor,
which means the need for people that have a certain level of skill, knowledge or
natural ability. When products are manufactured and placed in the marketplace, the
price placed on an item will determine the demand for it. If the price is set too high,
the demand will be low. The converse is true also; a lower price will increase the
demand. Fluctuations in the price will occur until the supply and demand are equal.
The supply of a product will rise and fall based on its profitability. If the price the
market will bear on an item realizes a lower profit than a different item the
manufacturer makes, then it is in the best interest of the manufacturer to produce
less of the first item and more of the alternate item. This increases the overall profit
for the manufacturer. Decreased production results in the supply of the first item
dropping, at which point the price will adjust to a higher value until the new price
matches the demand for the reduced supply. The reduction in the supply of the
item is then termed a shortage. A shortage occurs when a producer cannot or
will not produce an item for the current price. A good example of this is what
happens during a gas shortage. During the 1970’s, the gas shortage experienced in
the US was due to the fact that the oil companies were raising the price of gas and
consumers were forced to cut back on the amount that they used due to the high
cost. Government stepped in, established an excess profits tax on the oil
companies, and fixed the price of gasoline. The oil companies had plenty of gas in
their storage facilities but were unwilling to sell more than a certain amount at the
price dictated by the government. Because of this, the market had less gas to
distribute to consumers at the government defined price. The results of this were
lines to buy gas and rationing.
 Scarcity The scarcity of a product, on the other hand, is due to the unavailability of
resources or materials to manufacture the product. When the demand of a
 product is limitless because of need or desire on the part of the consumer and the
resources to manufacture the product are limited, the market experiences a scarcity
of the product. When a scarcity exists, the market price of the product will be driven
up until the purchase price of the product is equal to the available supply. An
example of a scarcity is the availability of fresh strawberries year-round. Strawberries
are a resource that has limited availability based on growing season and crop
production. During the strawberry season, the price of fresh strawberries is low and
the availability is high. As the season wanes, the amount of fresh strawberries on the
market drops off and the price rises significantly. By the middle of winter, there are
no fresh strawberries to be found and there is a scarcity of them.
 Difference between scarcity and shortage The main difference between scarcity
and shortage, then, is that one is based on limited resources and the other is
based on the decision of the seller to not sell more than a certain amount of a
product at the current selling price. Economics is the study of how to distribute
scarce resources over our unlimited wants. Scarcity has the meaning of finite
amount or limited. Clean air is a good example. Since air can be cleaned at any
one time there is only so much clean air. Another example, copper has been used as
a metal for several thousand years but there is only so much copper. It can be
reused and reused so that it is available but it is always limited given the potential
uses for it. Copper is always scarce. Where, as shortage has to do with the
relationship between the quantity the suppliers are willing to supply and the given
price in a specific time period. Therefore as prices go up, the suppliers will work to
supply more of the product and as the prices go down the supplier will cut back the
amount they are willing to supply. However if prices are fixed for some reason, say
by the government, then the demand (what people want at that price) and the
supply may not be equal. Therefore a shortage may occur. However, if prices are
allowed to move, as the price goes up, the suppliers increase the quantity supplied
and the consumers reduce the quantity they are willing to buy. The shortage goes
away over time. In very short time periods you still may have temporary shortages.
The difference between scarcity and shortage must be viewed with an economic eye
 on the problem. These terms are related to goods and services that are produced for
public consumption. When the public chooses to consume a good or service, they
pay a monetary price for the ability to use the item or service. All of these things are
interrelated in the economic sense. Supply is the availability of a good or service.
Demand is the number of consumers that desire the good or services. The price of
a good or service is set by measuring the point at which the supply equals the
demand.

Question 2(a) Consider an imaginary economy that produces only three

goods: steaks, eggs and milk information on the quantities and prices
of each good sold for two years is given below.
Output 1997 2001
Steak (kgs) 10 7
Eggs (dozens) 10 13
Milk (bottles) 8 11
Price
Steak (per kg) $9.10 $11.50
Eggs (per dozen) $1.10 $1.30
Milk (per bottle) $6.00 $6.50
For this hypothetical economy, calculate each of the following:
a) Nominal GDP.
b) Real GDP in constant 1997 dollars (i.e., 1997 is the base year).
c) GDP deflator.
d) The percentage change in real GDP and the GDP deflator
between 1997 and 2001.
Answer 2
(a) Nominal GDP in1997=10*9.10+1.10*10+6*8=150$
(b) Nominal GDP in2001=(7*11.50)+(13*1.30)+(11*6.50)
=80.5+16.9+71.5=168.9 dollars
(c) Real GDP in constant 1997= (7*9.10)+(1.1*13)+(6*11)=144$
 (d)GDP deflator in1997=base year=1 by definition
GDP deflator in2001=$y/y=$168.90/$144=1.17
(e)% Change in y=-4%
(f)% change in the deflator is17%

Question 3 (a) Describe the role of prices as rationing device?

Answer 2(a)
 Rationing In economics, it is often common to use the word "rationing" to refer
to one of the roles that prices play in markets, while rationing (as the word is
usually used) is called "non-price rationing." Using prices to ration means that
those with the most money (or other assets) and who want a product the most are
first to receive it. Such rationing happens daily in a market economy. Non-price
rationing follows other principles of distribution. Below, we discuss only the latter,
dropping the "non-price" qualifier, to refer only to marketing done by an authority
of some sort (often the government). In market economics, rationing artificially
restricts demand. It is done to keep price below the equilibrium (market-clearing)
price determined by the process of supply and demand in an unfettered market.
Thus, rationing can be complementary to price controls. An example of rationing in
the face of rising prices took place in the Netherlands, where there was rationing
of gasoline in the 1973 energy crisis. A reason for setting the price lower than
would clear the market may be that there is a shortage, which would drive the
market price very high. High prices, especially in the case of necessities, are
unacceptable with regard to those who cannot afford them. Economists argue,
however, that high prices act to reduce waste of the scarce resource while also
providing incentive to produce more. In wartime, it is usually imperative for a
government to maintain the support of this part of the population, to maintain
"equality of sacrifice," especially since in most countries, the working-class and
poor families contribute most of the soldiers. Rationing using coupons is only one
kind of non-price rationing. For example, scarce products can be rationed using
queues. This is seen, for example, at amusement parks, where one pays a price to
get in and then need not pay any price to go on the rides. Similarly, in the absence
of road pricing,
 Price rationing Prices serve to ration scarce resources when demand in a market
outstrips supply. When there is a shortage of a product, the price is bid up –
leaving only those with sufficient willingness and ability to pay with the effective
demand necessary to purchase the product. Be it the demand for tickets among
England supporters for the 2006 World Cup or the demand for a rare antique, the
market price acts a rationing device to equate demand with supply. First,
prices perform a means of rationing scarce goods and services. This price
rationing function answers the third basic question that economic systems must
address: who gets the goods and services that are produced? Remember, goods
are not freely available (there is no free lunch). For a good to be freely available,
there must be enough to go around freely to everyone who wants it. While this
may be true for a handful of goods, virtually all of the millions of goods and
services exchanged in any economic system are not freely available. Because there
is not enough to go around freely, not everyone who wants a good will be able to
get it. Such goods must be rationed, which means there must be some mechanism
for deciding who gets some of the goods and who does not. In market systems,
such rationing is done by price. You can have a particular good if you are willing
and able to pay the market price. If not, you look for some alternative. Consider
the following figure that shows the effects of closing some of the lobster waters off
the coast of Maine in order to reduce over-harvesting.
  Since some of the lobster waters are closed, fewer lobsters will be harvested. A
shifting of the supply curve to the left indicates this decrease in supply. There
are fewer lobsters to go around, which means some people that used to eat
lobsters will not be eating any, or at least not eating as many as they were
before. Who decides which people will be cutting back and by how much? We
do! As a result of the decrease in supply, there is an increase in price. Fewer
people will be willing and able to pay the new, higher price for lobster. It is the
price itself that rations the available lobsters.

Question 3 (b) Explain the supply & demand model in detail?

Answer 3(b)

 Supply & Demand Supply and demand is an economic model of price

determination in a market. It concludes that in a competitive market, price will
function to equalize the quantity demanded by consumers, and the quantity
supplied by producers, resulting in an economic equilibrium of price and
quantity.
 The graphical representation of supply and demand The supply-demand
model is a partial equilibrium model representing the determination of the
price of a particular good and the quantity of that good which is traded.
Although it is normal to regard the quantity demanded and the quantity
supplied as functions of the price of the good, the standard graphical
representation, usually attributed to Alfred Marshall, has price on the vertical
axis and quantity on the horizontal axis, the opposite of the standard
convention for the representation of a mathematical function. Determinants of
supply and demand other than the price of the good in question, such as
consumers' income, input prices and so on, are not explicitly represented in the
supply-demand diagram. Changes in the values of these variables are
represented by shifts in the supply and demand curves. By contrast, responses
to changes in the price of the good are represented as movements along
unchanged supply and demand curves.

 Supply schedule The supply schedule, depicted graphically as the supply

curve, represents the amount of some good that producers are willing and
able to sell at various prices, assuming ceteris paribus, that is, assuming all
determinants of supply other than the price of the good in question, such as
technology and the prices of factors of production, remain the same.

o Under the assumption of perfect competition, supply is determined by

marginal cost. Firms will produce additional output as long as the cost of
producing an extra unit of output is less than the price they will receive.

o By its very nature, conceptualizing a supply curve requires that the firm
be a perfect competitor—that is, that the firm has no influence over the
market price. This is because each point on the supply curve is the
answer to the question "If this firm is faced with this potential price,
how much output will it be able to sell?" If a firm has market power, so
its decision of how much output to provide to the market influences the
 market price, then the firm is not "faced with" any price and the
question is meaningless.

o Economists distinguish between the supply curve of an individual firm

and the market supply curve. The market supply curve is obtained by
summing the quantities supplied by all suppliers at each potential price.
Thus in the graph of the supply curve, individual firms' supply curves are
added horizontally to obtain the market supply curve.

o Economists also distinguish the short-run market supply curve from the
long-run market supply curve. In this context, two things are assumed
constant by definition of the short run: the availability of one or more
fixed inputs (typically physical capital), and the number of firms in the
industry. In the long run, firms have a chance to adjust their holdings of
physical capital, enabling them to better adjust their quantity supplied at
any given price. Furthermore, in the long run potential competitors can
enter or exit the industry in response to market conditions. For both of
these reasons, long-run market supply curves are flatter than their
short-run counterparts.

 Demand schedule The demand schedule, depicted graphically as the

demand curve, represents the amount of some good that buyers are willing
and able to purchase at various prices, assuming all determinants of demand
other than the price of the good in question, such as income, personal tastes,
the price of substitute goods, and the price of complementary goods,
remain the same. Following the law of demand, the demand curve is almost
always represented as downward-sloping, meaning that as price decreases,
consumers will buy more of the good.

o Just as the supply curves reflect marginal cost curves, demand curves
are determined by marginal utility curves. Consumers will be willing to
 buy a given quantity of a good, at a given price, if the marginal utility of
additional consumption is equal to the opportunity cost determined by
the price, that is, the marginal utility of alternative consumption choices.
The demand schedule is defined as the willingness and ability of a
consumer to purchase a given product in a given frame of time.

o As described above, the demand curve is generally downward-sloping.

There may be rare examples of goods that have upward-sloping demand
curves. Two different hypothetical types of goods with upward-sloping
demand curves are Giffen goods (an inferior but staple good) and
Veblen goods (goods made more fashionable by a higher price).

o By its very nature, conceptualizing a demand curve requires that the

purchaser be a perfect competitor—that is, that the purchaser has no
influence over the market price. This is because each point on the
demand curve is the answer to the question "If this buyer is faced with
this potential price, how much of the product will it purchase?" If a
buyer has market power, so its decision of how much to buy influences
the market price, then the buyer is not "faced with" any price and the
question is meaningless.

o As with supply curves, economists distinguish between the demand

curve of an individual and the market demand curve. The market
demand curve is obtained by summing the quantities demanded by all
consumers at each potential price. Thus in the graph of the demand
curve, individuals' demand curves are added horizontally to obtain the
market demand curve.
 Equilibrium It is defined to the price-quantity pair where the quantity
demanded is equal to the quantity supplied, represented by the intersection of
the demand and supply curves.

 Changes in market equilibrium Practical uses of supply and demand

analysis often center on the different variables that change equilibrium price
and quantity, represented as shifts in the respective curves. Comparative
statics of such a shift traces the effects from the initial equilibrium to the new
equilibrium.
 Demand curve shifts http://en.wikipedia.org/wiki/File:Supply-demand-right-
shift-demand.svghttp://en.wikipedia.org/wiki/File:Supply-demand-right-shift-
demand.svgAn outward (rightward) shift in demand increases both
equilibrium price and quantity. When consumers increase the quantity
demanded at a given price, it is referred to as an increase in demand.
Increased demand can be represented on the graph as the curve being shifted
to the right. At each price point, a greater quantity is demanded, as from the
initial curve D1 to the new curve D2. In the diagram, this raises the
equilibrium price from P1 to the higher P2. This raises the equilibrium quantity
from Q1 to the higher Q2. A movement along the curve is described as a
"change in the quantity demanded" to distinguish it from a "change in
demand," that is, a shift of the curve. In the example above, there has been an
increase in demand which has caused an increase in (equilibrium) quantity. The
increase in demand could also come from changing tastes and fashions,
incomes, price changes in complementary and substitute goods, market
expectations, and number of buyers. This would cause the entire demand
curve to shift changing the equilibrium price and quantity. Note in the diagram
that the shift of the demand curve, by causing a new equilibrium price to
emerge, resulted in movement along the supply curve from the point (Q1, P1)
to the point Q2, P2).If the demand decreases, then the opposite happens: a
shift of the curve to the left. If the demand starts at D2, and decreases to D1,
the equilibrium price will decrease, and the equilibrium quantity will also
decrease. The quantity supplied at each price is the same as before the
demand shift, reflecting the fact that the supply curve has not shifted; but the
equilibrium quantity and price are different as a result of the change (shift) in
demand.
 Supply curve shifts http://en.wikipedia.org/wiki/File:Supply-demand-right-
shift-supply.svghttp://en.wikipedia.org/wiki/File:Supply-demand-right-shift-
supply.svgAn outward (rightward) shift in supply reduces the equilibrium price
but increases the equilibrium quantity When the suppliers' unit input costs
change, or when technological progress occurs, the supply curve shifts. For
example, assume that someone invents a better way of growing wheat so that
the cost of growing a given quantity of wheat decreases. Otherwise stated,
producers will be willing to supply more wheat at every price and this shifts the
supply curve S1 outward, to S2—an increase in supply. This increase in supply
causes the equilibrium price to decrease from P1 to P2. The equilibrium
quantity increases from Q1 to Q2 as consumers move along the demand curve
to the new lower price. As a result of a supply curve shift, the price and the
quantity move in opposite directions. If the quantity supplied decreases, the
opposite happens. If the supply curve starts at S2, and shifts leftward to S1,
the equilibrium price will increase and the equilibrium quantity will decrease as
consumers move along the demand curve to the new higher price and
associated lower quantity demanded. The quantity demanded at each price is
the same as before the supply shift, reflecting the fact that the demand curve
has not shifted. But due to the change (shift) in supply, the equilibrium
quantity and price have changed.

 Elasticity It is a central concept in the theory of supply and demand. In this

context, elasticity refers to how strongly the quantities supplied and demanded
respond to various factors, including price and other determinants. One way to
define elasticity is the percentage change in one variable (the quantity supplied
or demanded) divided by the percentage change in the causative variable. For
discrete changes this is known as arc elasticity, which calculates the elasticity
over a range of values. In contrast, point elasticity uses differential calculus to
determine the elasticity at a specific point. Elasticity is a measure of relative
changes. Often, it is useful to know how strongly the quantity demanded or
supplied will change when the price changes. This is known as the price
elasticity of demand or the price elasticity of supply.

o If a monopolist decides to increase the price of its product, how will

this affect the amount of their good that customers purchase? This
knowledge helps the firm determine whether the increased unit price will
offset the decrease in sales volume. Likewise, if a government imposes a
tax on a good, thereby increasing the effective price, knowledge of the
price elasticity will help us to predict the size of the resulting effect on
the quantity demanded.

o Elasticity is calculated as the percentage change in quantity divided by

the associated percentage change in price. For example, if the price
moves from $1.00 to $1.05, and as a result the quantity supplied goes
from 100 pens to 102 pens, the quantity of pens increased by 2%, and
the price increased by 5%, so the price elasticity of supply is 2%/5% or
0.4.

o Since the changes are in percentages, changing the unit of

measurement or the currency will not affect the elasticity. If the quantity
demanded or supplied changes by a greater percentage than the price
did, then demand or supply is said to be elastic. If the quantity changes
by a lesser percentage than the price did, demand or supply is said to be
inelastic. If supply is perfectly inelastic; that is, has zero elasticity, then
there is a vertical supply curve.

o Short-run supply curves are not as elastic as long-run supply curves,

because in the long run firms can respond to market conditions by
varying their holdings of physical capital, and because in the long run
new firms can enter or old firms can exit the market.
 o Elasticity in relation to variables other than price can also be considered.
One of the most common to consider is income. How strongly would the
demand for a good change if income increased or decreased? The
relative percentage change is known as the income elasticity of
demand.

o Another elasticity sometimes considered is the cross elasticity of

demand, which measures the responsiveness of the quantity demanded
of a good to a change in the price of another good. This is often
considered when looking at the relative changes in demand when
studying complements and substitute goods. Complements are goods
that are typically utilized together, where if one is consumed, usually the
other is also. Substitute goods are those where one can be substituted
for the other, and if the price of one good rises, one may purchase less
of it and instead purchase its substitute.

 At this point, we have developed two behavioral statements, or assertions,

about how people will act. The first says that the amount buyers are willing
and ready to buy depends on price and other factors that are assumed
constant. The second says that the amount sellers are willing and ready to sell
depends on price and other factors that are assumed constant. In
mathematical terms our model is

Qd = f (price, constants)

Qs = g (price, constants)

This is not a complete model. Mathematically, the problem is that we have three
variables (Qd, Qs, price) and only two equations, and this system will not have a
solution. To complete the system, we add a simple equation containing the
equilibrium condition:
 Qd = Qs.

 In other words, equilibrium exists if the amount sellers are willing to sell is
equal to the amount buyers are willing to buy.

 Supply and Demand Curve If we combine the supply and demand tables in
earlier sections, we get the table below. It should be obvious that the price of
$3.00 is the equilibrium price and the quantity of 70 is the equilibrium quantity.
At any other price, sellers would want to sell a different amount than buyers
want to buy.

Supply and Demand Together

Number of Widgets Number of Widgets
Price of
People Want to Buy Sellers Want to Sell
Widgets
(Demand) (supply)
$1.00 100 10
$2.00 90 40
$3.00 70 70
$4.00 40 140

 The same information can be shown with a graph. On the graph, the equilibrium
price and quantity are indicated by the intersection of the supply and demand
curves.
 If one of the many factors that is being held constant changes, then equilibrium
price and quantity will change. Further, if we know which factor changes, we can
often predict the direction of changes, though rarely the exact magnitude. For
example, the market for wheat fits the requirements of the supply and demand
model quite well. Suppose there is a drought in the main wheat-producing areas of
the United States. How will we show this on a supply and demand graph? Should
we move the demand curve, the supply curve, or both? What will happen to
equilibrium price and quantity?

 A dangerous way to answer these questions is to first try to decide what will
happen to price and quantity and then decide what will happen to the supply and
demand curves. This is a route to disaster. Rather, one must first decide how the
curves will shift, and then from the shifts in the curves decide how price and
quantity would change.

 What should happen as the result of the drought? One begins by asking whether
buyers would change the amount they purchased if price did not change and
whether sellers would change the amount sold if price did not change. On
reflection, one realizes that this event will change seller behavior at the given
price, but is highly unlikely to change buyer behavior (unless one assumes that
more than the drought occurs, such as a change in expectations caused by the
drought). Further, at any price, the drought will reduce the amount sellers will sell.
 Thus, the supply curve will shift to the left and the demand curve will not change.
There will be a change in supply and a change in quantity demanded. The new
equilibrium will have a higher price and a lower quantity. These changes are
shown below.

 What should one predict if a new diet calling for the consumption of two loaves of
whole wheat bread sweeps through the U.S.? Again one must ask whether the
behavior of buyers or sellers will change if price does not change. Reflection
should tell you that it will be the behavior of buyers that will change. Buyers would
want more wheat at each possible price. The demand curve shifts to the right,
which results in higher equilibrium price and quantity. Sellers would also change
their behavior, but only because price changed. Sellers would move along the
supply curve.

Question 4 (a) Discuss why the price elasticity of demand is greater or goods
and services that have better close substitute?

Answer 4(a)

 Price Elasticity of Demand Price elasticity of demand refers to the way prices
change in relationship to the demand, or the way demand changes in relationship
to pricing. Price elasticity can also reference the amount of money each individual
consumer is willing to pay for something. People with lower incomes tend to have
lower price elasticity, because they have less money to spend. A person with a
higher income is thought to have higher price elasticity, since he can afford to
spend more. In both cases, ability to pay is negotiated by the intrinsic value of
what is being sold. If the thing being sold is in high demand, even a consumer
with low price elasticity is usually willing to pay higher prices.

o Elasticity implies stretch and flexibility. The flexibility or the price elasticity of
demand will change based on each item. Changing nature of both price and
demand are affected by a number of factors.

o Generally, goods or services offered at a lower price lead to a demand for

greater quantity. If you can get socks on sale you might buy several pairs or
several packages, instead of just a pair. This means that though the seller
offers the socks at a lower price, he usually ends up making more money,
because demand for the product has increased. However if the price is set too
low, the retailer may lose money by selling too many pairs of socks at a
reduced rate.

o Price elasticity of demand evaluates how change in price influences demand. In

certain circumstances, demand remains inelastic, despite higher prices. This is
true of a number of medications that are available to treat certain conditions,
where there is no substitute. Demand remains constant in spite of high prices.

o It’s also true of fuel consumption, where few substitutes exist. In 2006, when
gasoline prices skyrocketed, demand for gasoline was only slightly affected.
Some people were able to use less gas for their cars, or to purchase cars that
were hybrids, but these were in short supply. Since few alternatives existed,
people continued to buy gasoline, and demand was thus considered inelastic.
Price didn’t significantly alter demand. Other utilities, like water, often are
 highly inelastic in price because they have no substitute to which a consumer
can turn.

o Price elasticity of demand also explains that price becomes more elastic when
higher prices may turn away most consumers who can choose to buy
something else that is less expensive. When a good or service has numerous
substitutes, prices are more elastic and will change with demand. In fact,
availability of substitution is often a better predictor of price elasticity than is
demand. Amount of competition, numerous companies offering the same
items, can also affect price elasticity of demand. Usually, competition in the
marketplace keeps prices lower and more flexible. Generic equivalents of
certain items have lowered the demand for brand name items, thus lowering
their price.

o In economics, complex formulas show how the price elasticity of demand can
be either profitable or detrimental to the seller. These formulas describe how
good or bad price elasticity of demand functions. Examples of good (for the
seller) price elasticity of demand include inelastic pricing. In this example, a
small drop in demand is made up for by higher prices. A unit price elasticity
that raises demand can also be profitable for a company. On the other hand,
bad price elasticity occurs when quantity demand increases, but does not make
up for discounted price, causing a drop in company profits.

Question 4 (b) If demand is priced in elastic, Does revenue increases when

price rises? Explain with examples.

Answer 4(b)

 Elasticity The degree to which a demand or supply curve reacts to a change in

price is the curve's elasticity. Elasticity varies among products because some
products may be more essential to the consumer. Products that are necessities are
 more insensitive to price changes because consumers would continue buying these
products despite price increases. Conversely, a price increase of a good or service
that is considered less of a necessity will deter more consumers because the
opportunity cost of buying the product will become too high.
 A good or service is considered to be highly elastic if a slight change in price leads
to a sharp change in the quantity demanded or supplied. Usually these kinds of
products are readily available in the market and a person may not necessarily need
them in his or her daily life. On the other hand, an inelastic good or service is
one in which changes in price witness only modest changes in the quantity
demanded or supplied, if any at all. These goods tend to be things that are more
of a necessity to the consumer in his or her daily life.
 To determine the elasticity of the supply or demand curves, we can use this
simple equation:

Elasticity = (% change in quantity / % change in price)

 Elastic Demand If elasticity is greater than or equal to one, the curve is considered to be
elastic. If it is less than one, the curve is said to be inelastic. As we know, the demand curve
is a negative slope, and if there is a large decrease in the quantity demanded with a small
increase in price, the demand curve looks flatter, or more horizontal. This flatter curve
means that the good or service in question is elastic.
 Inelastic Demand It is represented with a much more upright curve as quantity
changes little with a large movement in price.

 Elastic supply works similarly. If a change in price results in a big change in the
amount supplied, the supply curve appears flatter and is considered elastic.
Elasticity in this case would be greater than or equal to one.
  Inelastic supply On the other hand, if a big change in price only results in a
minor change in the quantity supplied, the supply curve is steeper and its elasticity
would be less than one.

 Factors Affecting Demand Elasticity There are three main factors that
influence a demand's price elasticity:-
o The availability of substitutes This is probably the most important factor
influencing the elasticity of a good or service. In general, the more
substitutes, the more elastic the demand will be. For example, if the price of
a cup of coffee went up by $0.25, consumers could replace their morning
caffeine with a cup of tea. This means that coffee is an elastic good because
 a raise in price will cause a large decrease in demand as consumers start
buying more tea instead of coffee. However, if the price of caffeine were to
go up as a whole, we would probably see little change in the consumption of
coffee or tea because there are few substitutes for caffeine. Most people are
not willing to give up their morning cup of caffeine no matter what the price.
We would say, therefore, that caffeine is an inelastic product because of its
lack of substitutes. Thus, while a product within an industry is elastic due to
the availability of substitutes, the industry itself tends to be inelastic. Usually,
unique goods such as diamonds are inelastic because they have few if any
substitutes.
o Amount of income available to spend on the good - This factor
affecting demand elasticity refers to the total a person can spend on a
particular good or service. Thus, if the price of a can of Coke goes up from
$0.50 to $1 and income stays the same, the income that is available to spend
on coke, which is $2, is now enough for only two rather than four cans of
Coke. In other words, the consumer is forced to reduce his or her demand of
Coke. Thus if there is an increase in price and no change in the amount of
income available to spend on the good, there will be an elastic reaction in
demand; demand will be sensitive to a change in price if there is no change
in income.
o Time - The third influential factor is time. If the price of cigarettes goes up
$2 per pack, a smoker with very few available substitutes will most likely
continue buying his or her daily cigarettes. This means that tobacco is
inelastic because the change in price will not have a significant influence on
the quantity demanded.  However, if that smoker finds that he or she cannot
afford to spend the extra $2 per day and begins to kick the habit over a
period of time, the price elasticity of cigarettes for that consumer becomes
elastic in the long run.
Question 5 Critically write the present economic situation of Pakistan and its
consequences?
Answer 5

 Economy – Overview Pakistan, an impoverished and underdeveloped country, has

suffered from decades of internal political disputes and low levels of foreign
investment. Between years 2001-07 however, poverty levels decreased by 10%, as
Islamabad steadily raised development spending. Between 2004-07 GDP growth in
the 5-8% range was spurred by gains in the industrial and service sectors despite
severe electricity shortfalls. But growth slowed in 2008-09 and unemployment rose.
Inflation remains the top concern among the public, jumping from 7.7% in 2007 to
20.8% in 2008, and 14.2% in 2009. In addition, the Pakistani rupee has depreciated
since 2007 as a result of political and economic instability. The government agreed to
an International Monetary Fund Standby arrangement in November 2008 in response
to a balance of payments crisis, but during 2009 its current account strengthened and
foreign exchange reserves stabilized - largely because of lower oil prices and record
remittances from workers abroad. Textiles account for most of Pakistan's export
earnings, but Pakistan's failure to expand a viable export base for other manufactures
have left the country vulnerable to shifts in world demand. Other long term challenges
include expanding investment in education, healthcare, and electricity production, and
reducing dependence on foreign donors.
o GDP (purchasing power parity)

$448.1 billion (2009 est.)

$436.4 billion (2008 est.)
$422 billion (2007 est.)
note: data are in 2009 US dollars

o GDP (official exchange rate)

$166.5 billion (2009 est.)

o GDP - real growth rate

 2.7% (2009 est.)
3.4% (2008 est.)
6% (2007 est.)

o GDP - per capita (PPP)

$2,600 (2009 est.)

$2,500 (2008 est.)
$2,500 (2007 est.)
note: data are in 2009 US dollars

o GDP - composition by sector

agriculture: 20.8%
industry: 24.3%
services: 54.9% (2009 est.)

o Population below poverty line

24% (FY05/06 est.)

o Labor force

55.88 million
note: extensive export of labor, mostly to the Middle East, and use of child
labor (2009 est.)

o Labor force - by occupation

agriculture: 43%
industry: 20.3%
services: 36.6% (2005 est.)
o Unemployment rate

15.2% (2009 est.)

13.6% (2008 est.)
note: substantial underemployment exists

o Household income or consumption by percentage share

lowest 10%: 3.9%

highest 10%: 26.5% (2005)

o Distribution of family income - Gini index

30.6 (FY07/08)
41 (FY98/99)

o Investment (gross fixed)

18.1% of GDP (2009 est.)

o Budget

revenues: $23.21 billion

expenditures: $30.05 billion (2009 est.)

o Public debt

45.3% of GDP (2009 est.)

51.2% of GDP (2008 est.)

o Inflation rate (consumer prices)

14.2% (2009 est.)

20.3% (2008 est.)
o Central bank discount rate

15% (31 December 2008)

10% (31 December 2007)

o Commercial bank prime lending rate

NA% (31 December 2008)

o Stock of money

$NA (31 December 2008)

$52.76 billion (31 December 2007)

o Stock of quasi money

$NA (31 December 2008)

$18.42 billion (31 December 2007)

o Stock of domestic credit

$NA (31 December 2008)

$65.05 billion (31 December 2007)

o Industries

textiles and apparel, food processing, pharmaceuticals, construction

materials, paper products, fertilizer, shrimp

o Industrial production growth rate

-3.6% (2009 est.)

o Electricity - production
 90.8 billion kWh (2007 est.)

o Electricity - production by source

fossil fuel: 68.8%

hydro: 28.2%
nuclear: 3%
other: 0% (2001)

o Electricity - consumption

72.2 billion kWh (2007 est.)

o Electricity - exports

0 kWh (2008 est.)

o Electricity - imports

0 kWh (2008 est.)

o Oil - production

61,870 bbl/day (2008 est.)

o Oil - consumption

383,000 bbl/day (2008 est.)

o Oil - imports

319,500 bbl/day (2007 est.)

o Oil - exports
 30,090 bbl/day (2007 est.)

o Oil - proved reserves

339 million bbl (1 January 2009 est.)

o Natural gas - production

37.5 billion cu m (2008 est.)

o Natural gas - consumption

37.5 billion cu m (2008 est.)

o Natural gas - exports

0 cu m (2008 est.)

o Natural gas - imports

0 cu m (2008 est.)

o Natural gas - proved reserves

885.3 billion cu m (1 January 2009 est.)

o Current Account Balance

-$2.42 billion (2009 est.)

-$15.68 billion (2008 est.)

o Agriculture - products

cotton, wheat, rice, sugarcane, fruits, vegetables; milk, beef, mutton, eggs
o Exports

$17.87 billion (2009 est.)

$21.09 billion (2008 est.)

o Exports - commodities

textiles (garments, bed linen, cotton cloth, yarn), rice, leather goods, sports
goods, chemicals, manufactures, carpets and rugs

o Exports - partners

US 16.1%, UAE 11.7%, Afghanistan 8.6%, UK 4.5%, China 4.2% (2008)

o Imports

$28.31 billion (2009 est.)

$38.19 billion (2008 est.)

o Imports - commodities

petroleum, petroleum products, machinery, plastics, transportation

equipment, edible oils, paper and paperboard, iron and steel, tea

o Imports - partners

China 14.3%, Saudi Arabia 12.2%, UAE 11.3%, Kuwait 5.5%, US 4.8%,
Malaysia 4.1% (2008)

o Reserves of foreign exchange and gold

$15.68 billion (31 December 2009 est.)

$8.903 billion (31 December 2008 est.)
o Debt - external

$52.12 billion (31 December 2009 est.)

$46.39 billion (31 December 2008 est.)

o Stock of direct foreign investment - at home

$27.95 billion (31 December 2009 est.)

$25.44 billion (31 December 2008 est.)

o Stock of direct foreign investment - abroad

$1.078 billion (31 December 2009 est.)

$1.017 billion (31 December 2008 est.)

o Market value of publicly traded shares

$23.49 billion (31 December 2008)

$70.26 billion (31 December 2007)
$45.52 billion (31 December 2006)

o Currency (code)

Pakistani rupee (PKR)

o Exchange rates

Pakistani rupees (PKR) per US dollar - 81.41 (2009), 70.64 (2008), 60.6295
(2007), 60.35 (2006), 59.515 (2005)

o Fiscal year

1 July - 30 June