Complementary and

Supplementary Goods
• According to Hicks- Y is a substitute of X if a fall
in the price of X leads to a fall in the
consumption of Y (or increase in the
consumption of X)
• Y is a complement of X if a fall in the price of X
leads to a rise in the consumption of Y (or
decrease in consumption of X)-car and petrol
• In both cases there is a compensating variation
in income
 Elasticity of Demand
• Elasticity of Demand measures the quantum of change in quantity
demanded due to change in price, income or prices of related goods
• There are 3 types of elasticity- price elasticity, income elasticity and cross
elasticity
• Price elasticity-indicates degree of change in quantity demanded due to
price change
• Income elasticity-indicates degree of change in quantity demanded due to
income change
• Cross elasticity-indicates degree of change in quantity demanded due to
change in price of related goods-either substitute or complementary
• Thus price elasticity (ep)=% change in qty demanded/%change in price
• When % change in qty demanded>% change in price, then ep>1 and
demand is said to be elastic (TV, fridge)
• When % change in qty demanded<% change in price,then ep<1 and
demand is said to be inelastic (salt)
• When % change in qty demanded=% change in price then ep=1-refer
diagram pg25
• Thus difference in elasticity of demand results from possibility of
substitution-easier to find substitutes, greater the ep of that commo.
 Determinants of Ep
• Availability of substitutes-coke/pepsi
• Proportion of consumer’s income spent on the commo. is
sizable-demand for salt, matches are inelastic (smaller
portion of income spent on them)-clothes are elastic
• Number of uses of a commo.eg milk can be used for
various purposes (curd, cream, ghee) when price falls
(normally used only for consumption)
• Complementarity between goods-automobile and petrol
• Time factor-demand is more elastic if time involved is
long because in the long run consumer can substitute
goods-petrol and gas
 Measure of Price Elasticity
• Ep=^q/q*100/^p/p*100=^q/q*p/^p
q-original qty, p-original price, ^-small change in qty and
price
eg if a 2% change in price leads to a 4% change in qty
demanded of X and 8% change in qty demanded of Y
then ep of X =2 and ep of Y=4 (qty demanded of Y
changes more than X)-refer diagram-pg27
- Since slope of demand curve DD’=^p/^q
- Ep=1/slope*p/q=1/PD/PR*OP/OQ
- =PR/PD*OP/OQ=OQ/PD*OP/OQ=OP/PD (vertical axis
formula)
- In right angled triangle DOD’,PR//OD’
- Ep=OP/PD=RD’/RD (lower segment/upper segment)
 Importance of Ep
• Pricing decisions by business firms
• Useful in economic policy making regarding price
regulation eg in deciding prices of agricultural products
(since demand is more or less inelastic)
• Useful in international trade-helps govt to decide whether
currency to be devalued due to adverse balance of
trade-if demand for country’s exports is inelastic, then fall
in price of exports (due to devaluation) will reduce forex
earnings rather than increase
• Importance in fiscal policy making-govt has to keep in
mind the price elasticity of demand for the product on
which tax is proposed to be imposed eg if demand for a
product is inelastic then imposing tax may not yield
expected returns in terms of revenue
 Cross Elasticity of Demand
• It is the degree of responsiveness of demand for
one commo in response to the changes in price
of another commo-refer diagram pg 31
• When price of Y falls from OP1 to OP2,demand
for Y increases from OQ1 to OQ2-if Y is a
substitute for X then the increase in demand for
Y will cause decrease in demand for X from
OM1 to OM2-ie M1M2 of X is substituted by
Q1Q2 of Y
 Income Elasticity of Demand
• It shows the degree of responsiveness of quantity demanded of a
commo to a change in the income of the consumer
• ie IED=% change in commo purchased/% change in income
• ^q/q*100/^y/y*100=^q/^y*y/q
• IED=0-no change in demand with income change
• IED>0-normal commo (income increase causes demand for commo
increase)
• IED<0-inferior commo (income increase causes decrease in demand)
• IED>1-luxury commo (income increase-proportion of income spent on
commo increases )
• IED<1-necessity (income increases-proportion of income spent on the
commo decreases)
• IMPORTANCE
• Useful in decision making by business firms/industries
• Helps in planning economic activities and calculation of national income
• Helps firms in deciding future expansion programme and the type of
products to be produced (whether elastic or inelastic products) and the
areas to set up mktg/sales outlets
 Elasticity of Substitution
• It is a relative measure of the degree of substitution possible between 2
goods for consumption ie it is the proportionate change in the ratio of the
quantities consumed of the 2 commos divided by the proportionate
change in MRSxy
• Es =^qx/^qy/qx/qy divided by ^ MRSxy/MRSxy
• In case of close substitutes (air travel/ac railway)
Es is large because as consumer moves along an IC, proportionate
change in the ratio of the 2 goods consumed (qx/qy) is large compared
to the relative change in the MRS between X and Y-diagram pg 34.
Es is high and IC is close to the straight line in case of close substitutes
- in case of perfect substitutes (pepsi/coke) MRS is almost zero (since
utility is almost same).Thus
Es=^qx/^qy/qx/qy divided by zero=infinity
- in case of poor substitutes (pant/shirt), the IC is highly convex and the
ratio the 2 goods change very little
- in the case of perfect complements (rt.shoe/left shoe),they cannot be
substituted ie Es=0/proportionate change in MRS=0
- Thus Es varies between zero and infinity
 Promotional Elasticity of Demand
• It measures changes in demand to changes in expenses of promotional
activities
• Ea=% change in sales/% change in exp. on promotional activities
• Arc Elasticity of Demand-
• Here we measure elasticity over an arc of the demand curve
• When price variation is sizable (say more than 10%) the Ep is obtained
by taking average of original and subsequent price as well as original
and subsequent qty. fig pg 29
• Ep=^Q/Q1+Q2/2/^P/P1+P2/2=^Q/^P*P1+P2/Q1+Q2
• Thus measuring Ep from P1 to P2 implies measuring average price
elasticity over arc AB of the demand curve DD’
• Arc elasticity is relevant only when the arc is small ie pts A and B are
close to each other
• Ep (price elasticity)= -(minus) % change in qty demanded/% change in
price
 Relationship between Ep, AR and
MR
• This is explained by J. Robinson as Ep =
AR/ AR- MR or A /A- M ie Ep (A-M)=A ie
EpA- EpM=A ie EpA- A=EpM ie A(Ep-1)
=EpM or A=M*Ep/Ep-1 or M=A*Ep-1/Ep
• Thus when Ep= unity, then M=zero
irrespective of price
 Theory of Production

Factors of Production
Land-inelastic in supply,but elastic in usage
-it is renewable (used again and again) and non-
renewable (mineral deposits which are in limited supply)
Capital-includes money,machinery,raw material etc which directly
help in production-fixed capital -plant and machinery, variable cap-raw
material goods in process, human cap-educated people who possess
skill and knowledge
Labour- work force that contribute to production
Entrepreneur-who brings these factors together
Production Function-involves transformation of physical inputs into
physical outputs ie Q=f(L,K,M)-land,labour and capital
-Study of short run production (where only labour is variable)
is known as the Law of Variable Proportion
-Study of long run production (where all factors are variable) is known
as the Law of Returns to Scale
• Concept of product-total product, average
product and marginal product
-total product of a factor is the amt of output
produced by a given amt of the factor (other
factors held constant)-initially total product
(and total product curve ) increases fast and then
at a diminishing rate as more labour is employed
-average product-total product/no.of units of a
factor employed
-marginal product- addition to total product by the
employment of an extra unit of the factor
 Law of Variable Proportion (Law of
Diminishing Returns)
• It refers to input-output relation when output is increased
by varying qty of one input-other factors being constant
• The proportion between variable factor and fixed factor is
altered
• The ratio of use of variable factor to fixed factor goes on
increasing as qty of variable factor is increased
• This law studies the effect on output of variation in factor
proportion
• According to Paul A Samuelson-an increase in some
inputs relative to other fixed inputs will, in a given state of
technology, cause output to increase, but after a point
the extra output resulting from the same addition of extra
inputs will become less.
 Assumptions of the Law
• State of technology is given and unchanged
• Some inputs qty of which is kept fixed
• It is possible to vary the proportion in which the various
factors can be combined to produce a product ie factors
are not used in rigidly fixed proportion because then
increase in one factor would not lead to increase in
output ie marginal product of the factor will be zero and
not diminishing
• Marginal product of labour is the increase in total output
due to use of an extra unit of labour
• Refer diagram pg45
• Causes of stage I
• 1.as more units of variable factors are added, utilisation of
capacity increases and production increases
• 2.efficiency of variable factor itself improves due to
specialisation
• Causes of stage 2
• 1.once the pt of efficient utilisation of factor is achieved,
further increase in variable factor causes decline in output
because fixed factor becomes inadequate to the qty of
variable factor ie marginal and average product of variable
factor declines
• 2.when optimum proportion between fixed and variable
factors is disturbed by further increase in variable factor,
return decreases
• Causes of stage 3
• As amt of variable factor continues to be increased to fixed
qty of other factor, a stage is reached when total product and
marginal product is negative
• Thus Joan Robinson concludes that elasticity of substitution
between factors is not infinite-law of diminishing returns
operates
Production function with 2 variables
• This concept is analysed with the help of
isoquants or iso-product curves or equal product
curves
• Isoquant represents all factor combination which
produce same level of output-producer is thus
indifferent between them
• Also known as Production Indifference Curves-
diagram pg1
• IC indicates levels of satisfaction whereas
isoquants indicate levels of output
 Marginal Rate of Technical Substitution
• Rate at which factors can be substituted at the margin without changing
level of output ie no. of units of capital which can be replaced by one unit
of labour (output unchanged)-eg pg 1
• MRTS at a pt ( G in diagram) on isoquant is given by the slope of
isoquant at that pt ie moving from G to H where ^K of capital is
substituted by ^L of labour, slope at G=^K/^L
• MRTS of labour for capital=slope=^K/^L
• Slope of isoquant at a pt can also be known by slope of tangent drawn to
the isoquant at said pt-diagram pg 2
• MRTS at K =slope =OT/OT’
• MRTS at L =slope=OJ/OJ’
• MRTS = ratio of marginal physical products of 2 factors
• Loss in physical output due to small reduction in capital=gain in physical
output from small increase in labour (total output is unchanged along an
isoquant)
• Thus loss in output=marginal physical product of capital* amt of
reduction in capital and gain in output=marginal physical product of
labour * increase in labour ie (minus)-^K*MPk+^L*MPl=0 ie
^K*MPk=^L*MPl ie ^K/^L= slope =MPl/MPk=MRTSlk
 Diminishing MRTS
• As labour increased and capital decreased
amount of capital reqd to be replaced by an
additional unit of labour, so as to keep output
constant,will diminish because as qty of labour is
increased and capital reduced, marginal
physical product of labour decreases and
marginal physical product of capital increases.
• Therefore less and less of capital reqd to be
substituted by additional unit of labour to
maintain same output
• Rate at which MRTS diminishes indicates the
extent to which the 2 factors can be substituted
for each other-smaller the rate at which MRTS
diminishes greater the degree of substitutability
• If marginal rate of substitution between 2 factors
is constant (does not diminish), the 2 factors are
perfect substitutes –computer and manpower or
tractor and labourers in agric