Assignment No Economics)

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 2001Steak (kgs) 10 7Eggs (dozens) 10 13Milk (bottles) 8 11PriceSteak (per kg) $9.10 $11.50Eggs (per dozen) $1.10 $1.30Milk (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.svg http://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.svg http://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

Price of

Widgets

Number of Widgets

People Want to Buy

(Demand)

Number of Widgets

Sellers Want to Sell

(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