SubjectEconomics

Assignment No.02

DisciplineM.B.A. (Executive)

TermIII

Submitted BySamiullah Khan

Examination Roll No.056

Q.1: Write a detailed note of Theory of Costs?

Cost theory is related to production theory, they are often used together. However, the question is usually how much to produce, as opposed to which inputs to use. That is, assume that we use production theory to choose the optimal ratio of inputs (eg. 2 fewer engineers than technicians), how much should we produce in order to minimize costs and/or maximize profits? We can also learn a lot about what kinds of costs matter for decisions made by managers, and what kinds of costs do not.Opportunity CostsIn addition to accounting profit, managers must consider the cost of inputs supplied by the owners (owners capital and labor).Accounting Costs: Costs that would appear as costs in an accounting statement.Opportunity Costs: The value of all inputs to a firms production in theirmost valuable alternative use.Fixed costs, variable costs, and sunk costsSome inputs vary with the amount produced and others do not. The firms computer system and accountants may be able to handle a large volume of sales without increasing the number of computers or accountants, for example. Inputs that do not vary with the amount produced, like accountants and computers, are called fixed inputs.Most inputs are fixed only for a certain range of production. A medical office may be able to handle many additional patients without adding and office assistant or extra phones.The phones and office assistants are fixed inputs. But, if the number of extra patients is large enough, the firm needs extra office staff.Reasons for fixed costs:1. Salaried workers. Salaried workers are a fixed input if the worker can work overtime without additional compensation (doctors paid a fee for service are variable inputs, salaried medical staff are fixed inputs).2. Fixed hours at work. An hourly worker sometimes cannot be sent home early if not enough work is available. Therefore, workers may not be busy and be able to handle extra work without additional hours.3. Time to adjust. Some inputs, like machines, take time to purchase and install. Conversely, unskilled labor may be adjusted more quickly through overtime, temps, etc. Therefore, by necessity the firm may only be able to vary production by increasing labor in the short run.Total Variable Cost The total cost of all inputs that change with the amount produced (all variable inputs).Total fixed costs The total cost of all inputs that do not vary with the amount produced (all fixed inputs).Consider the Thompson machine company. The firm uses 5 machines to make machine parts. Because of the time to adjust, machines are a fixed cost, while the number of workers varies with the amount produced. Labor is a variable cost.Sunk costs Are costs that have been incurred and cannot be reversed.Any costs incurred in the past, or indeed any fixed cost for which payment must be made regardless of the decision is irrelevant for any managerial decision. Suppose you hire an executive with a $100,000 signing bonus, plus $200,000 salary. After hiring, you may find the executive does not live up to expectations. However, if the executives marginal revenue product is $200,001, the executive still generates $1 in profits relative to his salary and therefore should be retained. But if his MRP is $199,999, the firm loses an extra $1 each year they keep him, so he should be let go. The bonus is a sunk cost and does not affect the retention decision.The principle of sunk costs is equivalent to the saying dont throw good money after bad.Sometimes a decision can be made to recover part of a fixed cost. Perhaps one could sell a factory and recover part of the fixed costs. Then only the difference is sunk. For example, if we can sell a building for which we paid $500,000 for $300,000, then only $200,000 is sunk.Sunk costs are perhaps one of the most psychologically difficult things to ignore. Examples:1. Finance. Studies show investors let sunk costs enter their decision making. What price the stock was purchased at is sunk and therefore irrelevant. What matters is only whether or not this stock offers the best return for the risk. Yet, investors are reluctant to sell stocks whose price has gone down.2. Cut your losses? Consider the war in Afghanistan. We have sunk billions, but that should not enter our decision about whether or not to stay.3. Pricing in high rent districts. Consider restaurants in a high rent district (say an airport). Should they take the rent into account when setting prices? No. In fact, prices are high not because of the rent, but typically because of the lack of competitors.II Short run costsWe use short run costs primarily to compute how much to produce while maximizing profits.We use long run costs to answer questions like should the firm expand, contract, merge, etc.Average Costs: Costs divided by output.Marginal Costs: The cost of one additional unit of an input.Here is the notation:Type of Cost Total Cost equals Variable Costs Plus Fixed CostsTotal TC = TV C +TFCAverage ATC = TCQ = AV C = TV CQ +AFC = TFCQMarginal MC = dTCdQ = _TC_QProperties of cost functions in the short run:1. Total costs of increase with Q, the quantity produced.2. Average Total costs decline with Q, but eventually rise. The fixed costs are spread over many more units of production at high Q, reducing average costs. All of the extra workers required for producing additional units when the factory is near capacity starts to increase average costs eventually.3. Marginal costs usually decline then increase, but must eventually increase. At first, producing one additional unit is may cheaper than the last unit, due to specialization. However, eventually diminishing returns sets in and the workers just get in each others way. Then a very large number of additional workers might be needed to produce an additional unit. A Profit maximization with perfect competition Let us suppose that you are a hypothetical manager of a group of cruise ships. Using data from previous years, you estimate the short run cost function is (we will see how to do this estimation below):TC = 60 +Q220 (69)Here Q is the number of cruises the ship takes (not the number of passengers). The cost of the ship is $60 million, which is sunk. Notice in equation (69) that the cost of the ship does not depend on the number of cruises the ship takes. Suppose further that each cruise generates revenue of $3 million.Maximize profits: max _ = TR TC = 3Q 60 Q2 (70)Take the derivative to get the slope and set the slope equal to zero:3 Q10= 0 ! Q = 30. (71)Notice that the fixed costs have dropped out. The math agrees: fixed costs do not matter for our decision. In general, to maximize profits we set marginal revenue (here $3) equal to marginal costs (here Q/10).MR = MC. (72)In a competitive industry, firms have no ability to influence the price. Examples include market makers in stock markets, commodities, and large food markets. For example, an individual farmer may produce as much corn as desired and sell the corn on the commodities markets with no change in price. Regardless of the amount produced by an individual firm, the price is unchanged and MR = P. So in competitive industries, we set:P = MC. (73)The firm should produce one more unit if we can sell it for more than it costs to produce.The firm makes profits in this case. In the next set of notes, we will do the case where firms have pricing power.The marginal revenue is the price of the cruise, equal to $3 million. We can see that marginal revenue equals marginal costs somewhere between 30 and 35 cruises.1Producing the 30th cruise gives us $3 of revenue, enough to cover the costs of producing the 30th cruise, which (using table 6) is approximately $2.75. However, the 35th cruise loses money. The table estimates that cruise would cost $3.25, and since revenues are $3, the cruise would lose an estimated $0.25 million.The fixed costs are irrelevant here. When considering the fixed costs, the firm has negative profits regardless of how many cruises the firm takes. The maximum profits occurs at 30 cruises:_ = TR TC = 3 30 _60 + 30220 _ = $15. (74)We have already paid the fixed costs, so we might as well lose as little as possible.2B Break Even AnalysisAn important consideration when deciding whether to continue operations in a particular market, expand into a market, or start a new business is a break even analysis. We can do a break even analysis with a cost function.In a break even analysis, the question is: how much profit is required to exactly pay off all fixed costs? Alternatively, how much revenue is required to pay off the average variable costs and the fixed costs:_ = 0 = TR TC (75)0 = P Q TFC TV C (76)0 = P Q TFC AV C Q (77)Q =TFCP AV C (78)Here I have assumed linear total costs, so that average variable cost is constant. One could assume (more realistically) that average variable costs depend on Q, and use a table to get the break even point.C Average CostsOften average cost data is easy to get. It is relatively easy to measure total costs and the quantity sold to get average costs. However, many managers then incorrectly base decisions on average costs.Consider the following data:Typical Data Calculate this!Gas Production (Q)Total costs (TC)Average Total costs (ATC)Marginal Costs (MC)For example, a gas refinery might produce different quantities monthly depending on variations in the price of gas and demand. Suppose the price of gas is currently $68.How much gas should be produced? Setting price equal to average cost (48 units) actually produces a loss. We could try to minimize average costs, which occurs at 28 units. Still, this is not the maximum profits. The maximum profits occurs when price equals marginal costs, about 32-34 units. The key is that given the first 3 columns, one can easily calculate the marginal costs and calculate the profit maximizing quantity.IV Long Run CostsWe use long run costs to decide scale issues, for example mergers, but also the optimal size of our operations (e.g. optimal plant size). The long run is when all costs are variable.In the long run, we can build any size factory we wish, based on anticipated demand, profits, and other considerations. Once the plant is built, we move back to the short run as described above. Therefore, it is important to forecast the anticipated demand. Too small a factory and marginal costs will be high as the factory is stretched to over produce.Conversely too large a factory results in large fixed costs (eg. air conditioning, or taxes).Think of each short run average cost curve as a factory of different size. We build the factory, and then operate within the short run average cost curve for the factory that is built. For each size factory, average total costs are initially decreasing as the fixed costs are spread over more and more units. Eventually, however, average total costs rise as the factory becomes over crowded. Suppose we forecast demand at Qd on the graph. Then, from the graph, we create a small sized factory, as that is the cheapest way to build Qd units.Therefore, we must have that the long run average cost curve is tangent to the minimum of the short run average cost curves.B Deriving a long run average cost curve: ExampleSuppose we can build plants of three sizes:Cost Type Plant SizeAV C Small Medium LargeLabor $3.70 $2.50 $1.10Materials $1.80 $1.40 $0.90Other $2.00 $2.60 $3.00TFC $25,000 $75,000 $300,000Capacity 50,000 100,000 200,000What type of plant produces 100,000 units at the lowest long run average costs? We can build either two small plants, 1 medium sized plant, or one large plant. The average costs of two small plants are:ATC = AV C + TFCQ , (79)ATC = $3.70 + $1.80 + $2.00 + $25,000 2100,000= $8. (80)Here, the fixed cost of the small plant is multiplied by two since we need two plants. For a single medium sized plant:ATC = $2.50 + $1.40 + $2.60 + $75,000100,000 = $7.25. (81)The medium sized plant is cheaper. Although the factory is more expensive to build than two small factories, it can produce units at lower average variable cost. A large plant has:ATC = $1.10 + $0.90 + $3.00 + $300,000100,000 = $8.00. (82)The large plant can produce at a very low average variable cost of $5 per unit, but is just too expensive to build.So for Q = 100,000 units, we build a single, medium sized factory. The point on the long run average cost curve for Q = 100,000 is LRAC = $7.25.Suppose instead expected demand is Q = 200,000 units. We can build 1 large, two medium, or 4 small plants. The cost of these options (per unit) are: $6.50, $7.25, and $8, respectively. The large plant is the cheapest, and LRAC = $6.50 for Q = 200,000. We could also build 1 medium and two small factories, but then the costs would be an average of $7.25and $8, which is still worse than a large plant.Finally long run average costs are minimized when we dont have to build any small or medium sized plants, at Q = 200,000, 400,000, and so on.C Factors that affect long run average costsLong run average costs may be decreasing and then increasing, but also may be strictly decreasing. Here are some LRAC curves for some industries.1. Nursing Homes have decreasing LRAC. Nursing homes have many fixed management costs. Further, larger nursing homes are able to negotiate lower prices for many raw materials.2. Cruise Ships have decreasing LRAC. Huge cruise ships have lower average costs than small cruise ships, economizing on many services provided on the ships.3. Hospitals have U-shaped LRAC. Cowing and Holtmann (1983) in fact found many hospitals in New York should in the long run reduce both capital and physicians to lower average costs.When the LRAC curve is decreasing, it is in the interest of the industry to consolidate.A merger with another firm can increase the customer base but reduce the cost per unit, thus increasing profits.Reasons for decreasing long run average costs:1. Specialization of labor. Producing more units requires more workers. Workers can then specialize in different parts of the production process, and produce more units.2. Indivisibilities. A firm may require one accountant, even if there is less than 40 hours of work to do. But then the firm can increase units produced without increasing the size of the accounting staff.3. Pricing Power. Large firms buy in bulk and therefore negotiate lower prices for inputs.Notice the reasons are similar to increasing returns to scale.Reasons for increasing costs:1. Regulation may exempt smaller firms.2. Coordination and information problems. In a large firm, many individuals do not meaningfully affect profits and thus have the wrong incentives. Smaller operations may know their customers and production processes better.With decreasing returns, spin-offs and divestments may be optimal.A compromise is franchising. Nationalize just the parts for which increasing returns works.D Long run competitive equilibriumIn the long run, firms can enter and exit the market, or grow or shrink in size. As long as economic profits are positive, new entrants arrive as the industry gives higher profits than alternatives. New entrants increases competition and pushes down the price until economic profits are zero. Therefore, in the long run:_ = TR TC = 0, (83)P Q = TC, (84)P = TCQ = LRAC. (85)Now at the firm level, we set P = LRMC. But since also P = LRAC, marginal and average costs are equal in the long run. We can therefore minimize long run average costs and in the long run, we will have P = LRMC = LRAC.V Application of long run average costs: Banking mergersConsider two banks. The first bank services Q = 15 customers and the second (smaller) bank services Q = 5 customers. The long run average cost function in the industry is:LRAC = 700 40Q + Q2 (86)Price is constant at $300 dollars of revenue per customer.Should these two firms merge? The size of the customer base (Q) which minimizes long run average costs is:min LRAC = 700 40Q + Q2 (87) 40 + 2Q = 0 ! Q = 20 (88)Costs per unit fall until Q = 20. Thus these two firms can reduce costs by merging from two firms of size Q = 15 and Q = 5) into one firm with Q = 20.Profit per unit in each case are:_ = 300 700 40Q + Q2_ = 400 + 40Q Q2 (89)_ (Q = 15) = 400 + 40 15 152 = 25 (90)_ (Q = 5) = 400 + 40 5 + 52 = 225 (91)_ (Q = 20) = 400 + 40 20 202 = 0 (92)Individually, the two banks lose money but together they have zero economic profits. At zero economic profits, no incentive exists for firms to enter or exit the market (remember, _ here is economic profits so zero here means that investing in this industry gives the same profits as investing in the next best industry). The choice is essentially to merge and get bigger or exit the market.VI Measuring Cost FunctionsWe use the same procedure as with production functions: Obtain data on total costs and quantity produced, and use Excel to fit the data. Both total cost and total quantity produced may appear to be easier to obtain than input data. However, one must remember that costs represent opportunity costs, which are not always straightforward.Some additional issues:A Choice of Cost FunctionOne choice is whether to use a linear, quadratic, or cubic function:TC = a + bQ (93)TC = a + bQ + cQ2 (94)TC = a + bQ + cQ2 + dQ3 (95)Under most circumstances, the linear cost function does a reasonable job over a narrow range of Q (for example in the short run), but the quadratic and cubic terms must matter theoretically, especially for a wider range of Q. A good strategy might therefore be to estimate the cubic or quadratic.If the t-stats are low for the quadratic and cubic terms, then predictions are likely to be unreliable for Q that falls outside the data. This indicates using some caution before, for example, committing to large mergers. The following graph illustrates the problem.B Data issuesSome problems with the data that often need correcting:1. Definition of cost: as mentioned earlier, we use opportunity costs not accounting costs.2. Price level changes: Historical data is likely to be inaccurate if the price of some inputs or outputs have changed dramatically.3. What costs vary with output: Some costs have a very limited relationship with output.For example, the number of professionals required may vary in some limited way with output. A firm with $1 million in sales may have two accountants. The firm can obviously increase output to some degree without needing more accountants (so the cost would be fixed). But for larger Q additional accountants are needed (like a variable cost).

4. The cost data needs to match the output data. Often the cost of producing some output may be accounted for in some other period.5. The firms technology may change over time.When estimating long run costs, it is usually preferable to use a cross section of firms across an industry. An individual firm is unlikely to have changed size significantly enough to generate data for a wide range of Q.

Q.2: Define National Income and point out the problems faced in its estimation?

National Income is the money value of all final goods and services produced in an economy during a financial year. At the level of an economy, value of fined goods and services is equal to the total income of all factors of production viz labour, capital, land and entrepreneurship.This total income is equal to total expenditure on goods and services. Therefore, in an economy,There are different measures of national income like Gross National Product (GNP), Net National Product (NNP), Gross Domestic Product (GDP), Net Domestic Product (NDP), etc.These are often used interchangeably though conceptually there is some difference among them. Difference between GNP and NNP arises because of depreciation (consumption of fixed capital).There is same difference between GDP and NDP.Difference between GNP and GDP arises because of Net Factor Income from Abroad (NFIA).There is same difference between NNP and NDP.All the above measures of national income can be calculated at market prices or factor costs. Difference between market prices and factor costs arises because of Net Indirect Taxes (Indirect taxes Subsidies).All the measures of national income discussed above can be calculated at either current prices or constant prices. When we use current prices (i.e., prices in the year for which national income is being calculated) to calculate value of goods and services, it is called national income at current prices or nominal national income.On the contrary, when prices of a base year are taken to calculate national income then it is called national income at constant (or fixed prices) or real national income. At present, 1999-2000 is the base year for calculating NI at constant prices.Conceptually real NNP at factor costs is the most accurate measure of national income but in India, real GDP at factor costs is mostly used because of some practical problems in measurement of depreciation and net factor income from abroad. Thus, economic growth in India generally refers to increase in real GDP at factor costs.Some related concepts of national income are personal income and disposable personal income.Personal Income:It is that income which is actually obtained by nationals of the economy. It is obtained by subtracting corporate taxes and payments for social securities provisions from national income and adding to it government transfer payments, business transfer payments and net interest paid by the government.Disposable Personal Income:When personal direct taxes are subtracted from personal income, the obtained value is called disposable personal income. In equation form:Circular Flow of Income:Basically there are three ways of looking at the circular flow of income. It arises out of the process of activity chain in which production creates income, income generates spending and spending in turn induces production.Accordingly, there are three different ways in which we can measure the size of the circular flow. We can measure it either at the production stage by measuring the value of output, or at the income accrual stage by measuring the amount of factor income earned, or at the expenditure stage by measuring the size of total expenditure incurred in the economy.Problems in estimating National IncomeAll the countries face some special difficulties in estimating national income. Some of these difficulties are given below:(1) Problems of Definition:What should we include in the National Income?Ideally we should include all goods and services produced in the course of the year, but there are some services which are not calculated in terms of money, e.g., services of housewives.(2) Lack of Adequate Data:The lack of adequate statistical data makes the task of estimation of national income more acute and difficult.(3) Non-availability of Reliable Information:The reason of illiteracy, most producers has no idea of the quantity and value of their output and do not follow the practice of keeping regular accounts.(4) Choice of Method:The selection of method while calculating National Income is also an important task. The wrong method leads to poor results.(5) Lack of Differentiation in Economic Functioning:In all the countries the occupational specialization is still incomplete so that there is a lack of differentiation in economic functioning. An individual may receive income partly from farm ownership and partly from manual work in industry in the slack season.(6) Double Counting:Double counting is also an important problem while calculating national income. If the value of all goods and services totaled, the total will overtake the national output, because some goods are currently consumed being used in the making of others. The best way to avoid this error is to calculate only the value of those goods and services that enter into final consumption.Q.3: Write a detailed note on monopolistic competition?The model of monopolistic competition describes a common market structure in which firms have many competitors, but each one sells a slightly different product. Monopolistic competition as a market structure was first identified in the 1930s by American economist Edward Chamberlin, and English economist Joan Robinson.Many small businesses operate under conditions of monopolistic competition, including independently owned and operated high-street stores and restaurants. In the case of restaurants, each one offers something different and possesses an element of uniqueness, but all are essentially competing for the same customers.CharacteristicsMonopolistically competitive markets exhibit the following characteristics:1. Each firm makes independent decisions about price and output, based on its product, its market, and its costs of production.2. Knowledge is widely spread between participants, but it is unlikely to be perfect. For example, diners can review all the menus available from restaurants in a town, before they make their choice. Once inside the restaurant, they can view the menu again, before ordering. However, they cannot fully appreciate the restaurant or the meal until after they have dined.3. The entrepreneur has a more significant role than in firms that are perfectly competitive because of the increased risks associated with decision making.4. There is freedom to enter or leave the market, as there are no major barriers to entry or exit.5. A central feature of monopolistic competition is that products are differentiated. There are four main types of differentiation:1. Physical product differentiation, where firms use size, design, colour, shape, performance, and features to make their products different. For example, consumer electronics can easily be physically differentiated.2. Marketing differentiation, where firms try to differentiate their product by distinctive packaging and other promotional techniques. For example, breakfast cereals can easily be differentiated through packaging.3. Human capital differentiation, where the firm creates differences through the skill of its employees, the level of training received, distinctive uniforms, and so on.4. Differentiation through distribution, including distribution via mail order or through internet shopping, such as Amazon.com, which differentiates itself from traditional bookstores by selling online. 6. Firms are price makers and are faced with a downward sloping demand curve. Because each firm makes a unique product, it can charge a higher or lower price than its rivals. The firm can set its own price and does not have to take' it from the industry as a whole, though the industry price may be a guideline, or becomes a constraint. This also means that the demand curve will slope downwards.7. Firms operating under monopolistic competition usually have to engage in advertising. Firms are often in fierce competition with other (local) firms offering a similar product or service, and may need to advertise on a local basis, to let customers know their differences. Common methods of advertising for these firms are through local press and radio, local cinema, posters, leaflets and special promotions.9. Monopolistically competitive firms are assumed to be profit maximisers because firms tend to be small with entrepreneurs actively involved in managing the business.10. There are usually a large numbers of independent firms competing in the market. Equilibrium under monopolistic competitionIn the short run supernormal profits are possible, but in the long run new firms are attracted into the industry, because of low barriers to entry, good knowledge and an opportunity to differentiate. Monopolistic competition in the short runAt profit maximisation, MC = MR, and output is Q and price P. Given that price (AR) is above ATC at Q, supernormal profits are possible (area PABC).

As new firms enter the market, demand for the existing firms products becomes more elastic and the demand curve shifts to the left, driving down price. Eventually, all super-normal profits are eroded away. Monopolistic competition in the long runSuper-normal profits attract in new entrants, which shifts the demand curve for existing firm to the left. New entrants continue until only normal profit is available. At this point, firms have reached their long run equilibrium.

Clearly, the firm benefits most when it is in its short run and will try to stay in the short run by innovating, and further product differentiation.Examples of monopolistic competitionExamples of monopolistic competition can be found in every high street.Monopolistically competitive firms are most common in industries where differentiation is possible, such as: The restaurant business Hotels and pubs General specialist retailing Consumer services, such as hairdressingThe survival of small firmsThe existence of monopolistic competition partly explains the survival of small firms in modern economies. The majority of small firms in the real world operate in markets that could be said to be monopolistically competitive.EvaluationThe advantages of monopolistic competitionMonopolistic competition can bring the following advantages:1. There are no significant barriers to entry; therefore markets are relatively contestable.2. Differentiation creates diversity, choice and utility. For example, a typical high street in any town will have a number of different restaurants from which to choose.3. The market is more efficient than monopoly but less efficient than perfect competition - less allocatively and less productively efficient. However, they may be dynamically efficient, innovative in terms of new production processes or new products. For example, retailers often constantly have to develop new ways to attract and retain local custom.The disadvantages of monopolistic competitionThere are several potential disadvantages associated with monopolistic competition, including:1. Some differentiation does not create utility but generates unnecessary waste, such as excess packaging. Advertising may also be considered wasteful, though most is informative rather than persuasive.2. As the diagram illustrates, assuming profit maximisation, there is allocative inefficiency in both the long and short run. This is because price is above marginal cost in both cases. In the long run the firm is less allocatively inefficient, but it is still inefficient.InefficiencyThe firm is allocatively and productively inefficient in both the long and short run.

There is a tendency for excess capacity because firms can never fully exploit their fixed factors because mass production is difficult. This means they are productively inefficient in both the long and short run. However, this is may be outweighed by the advantages of diversity and choice.As an economic model of competition, monopolistic competition is more realistic than perfect competition - many familiar and commonplace markets have many of the characteristics of this model.Q.4: Write Economics in its historical background?Economics is the science that deals with the production, allocation, and use of goods and services. It is important to study how resources can best be distributed to meet the needs of the greatest number of people. As we are more connected globally to one another, the study of economics becomes extremely important. While there are many subdivisions in the study of economics, two major ones are macroeconomics and microeconomics. Macroeconomics is the study of the entire system of economics. Microeconomics is the study of how the systems affect one business or parts of the economic system. History of EconomicsThe first writings on the subject of economics occurred in early Greek times as Plato, in The Republic, and Aristotle wrote on the topic. Later such Romans as Cicero and Virgil also wrote about economics.In medieval times the system of feudalism dominated. With feudalism, there was a strict class system consisting of nobles, clergy and the peasants. In the system, the king owned almost all the land and under him were a series of nobles that had land holdings of various sizes. On these landholdings were series of manors. These were akin to large farming tracts in which the peasants or serfs worked the land in exchange for protection by the nobles. Later the system of mercantilism predominated. It was an economic system of the major trading nations during the 16th, 17th, and 18th centuries, based on the idea that national wealth and power were best served by increasing exports and collecting precious metals in return. Manufacturing and commerce became more important in this system.In the mid eighteenth century, the Industrial Revolution ushered in an era in which machines rather than tools were used in the factory system. More workers were employed in factories in urban areas rather than on farms. The Industrial Revolution was fueled by great gains in technology and invention. This also made farms more efficient, although fewer people were working the farms. During this time the idea of "laissez faire" became popular. This means that economies work best without lots of rules and regulations from the government. This philosophy of economics is a strong factor in capitalism, which favors private ownership.In the nineteenth century, there was reaction to the "laissez-faire" thinking of the eighteenth century due to the writings of Thomas Malthus. He felt that population would always advance faster than the science and technology needed to support such population growth. David Ricardo later stated that wages tend to settle at a poor or subsistence level for most workers. John Stuart Mill provided the backdrop for socialism with his theories that supported farm cooperatives and labor unions, less competition. These theories were brought to a high point by Karl Marx who attacked the capitalistic, "laissez-faire" theories of competition and instead favored socialisms, marked more government control and state rather than private ownership of property.Another important idea at this time was the change in how items are valued. While formerly an item's value stayed the same according to what the item was, now the worth of an item was determined by how many people wanted the item and how great the supply of the item was. This was the beginning of the laws of supply and demand.In the first half of the twentieth century, John Maynard Keynes wrote about business cycles - when the economy is doing well and when it is in a slump. His theories led to governments seeking to put more controls on the economy to prevent wide swings. After World War II, emphasis was placed on the analysis of economic growth and development using more sophisticated technological tools.In recent years, economic theory has been broadly separated into two major fields: macroeconomics, which studies entire economic systems; and microeconomics, which observes the workings of the market on an individual or group within an economic system. In the later twentieth century such ideas as supply side economics which states that a healthy econonomy is very necessary for the health of the nation and Milton Friedman's ideas that the money supply is the most important influence on the economy were favored.In the twenty-first century, the rapid changes and growth in technology have spawned the term "Information Age" in which knowledge and information have become important commodities.Q.5: Briefly explain the Price Elasticity of Demand?The Price Elasticity of Demand (commonly known as just price elasticity) measures the rate of response of quantity demanded due to a price change. The formula for the Price Elasticity of Demand (PEoD) is:PEoD = (% Change in Quantity Demanded)/(% Change in Price)Calculating the Price Elasticity of DemandYou may be asked the question "Given the following data, calculate the price elasticity of demand when the price changes from $9.00 to $10.00" Using the chart on the bottom of the page, I'll walk you through answering this question. First we'll need to find the data we need. We know that the original price is $9 and the new price is $10, so we have Price(OLD)=$9 and Price(NEW)=$10. From the chart we see that the quantity demanded when the price is $9 is 150 and when the price is $10 is 110. Since we're going from $9 to $10, we have QDemand(OLD)=150 and QDemand(NEW)=110, where "QDemand" is short for "Quantity Demanded". So we have:Price(OLD)=9Price(NEW)=10QDemand(OLD)=150QDemand(NEW)=110To calculate the price elasticity, we need to know what the percentage change in quantity demand is and what the percentage change in price is. It's best to calculate these one at a time.Calculating the Percentage Change in Quantity DemandedThe formula used to calculate the percentage change in quantity demanded is:[QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)By filling in the values we wrote down, we get: [110 - 150] / 150 = (-40/150) = -0.2667We note that % Change in Quantity Demanded = -0.2667 (We leave this in decimal terms. In percentage terms this would be -26.67%). Now we need to calculate the percentage change in price.Calculating the Percentage Change in PriceSimilar to before, the formula used to calculate the percentage change in price is:[Price(NEW) - Price(OLD)] / Price(OLD)By filling in the values we wrote down, we get:[10 - 9] / 9 = (1/9) = 0.1111We have both the percentage change in quantity demand and the percentage change in price, so we can calculate the price elasticity of demand.Final Step of Calculating the Price Elasticity of DemandWe go back to our formula of:PEoD = (% Change in Quantity Demanded)/(% Change in Price)We can now fill in the two percentages in this equation using the figures we calculated earlier.PEoD = (-0.2667)/(0.1111) = -2.4005When we analyze price elasticities we're concerned with their absolute value, so we ignore the negative value. We conclude that the price elasticity of demand when the price increases from $9 to $10 is 2.4005.How Do We Interpret the Price Elasticity of Demand?A good economist is not just interested in calculating numbers. The number is a means to an end; in the case of price elasticity of demand it is used to see how sensitive the demand for a good is to a price change. The higher the price elasticity, the more sensitive consumers are to price changes. A very high price elasticity suggests that when the price of a good goes up, consumers will buy a great deal less of it and when the price of that good goes down, consumers will buy a great deal more. A very low price elasticity implies just the opposite, that changes in price have little influence on demand.Often an assignment or a test will ask you a follow up question such as "Is the good price elastic or inelastic between $9 and $10". To answer that question, you use the following rule of thumb: If PEoD > 1 then Demand is Price Elastic (Demand is sensitive to price changes) If PEoD = 1 then Demand is Unit Elastic If PEoD < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes)Recall that we always ignore the negative sign when analyzing price elasticity, so PEoD is always positive. In the case of our good, we calculated the price elasticity of demand to be 2.4005, so our good is price elastic and thus demand is very sensitive to price changes.THE END