Economics for Business: Analysis of Economic Concepts

This economics assignment delves into fundamental economic principles. The first section defines and explains three core economic ideas: people are rational, people respond to incentives, and optimal decisions are made at the margin. It elaborates on these concepts with examples. The second part focuses on income elasticity of demand, providing a formula and classifying goods based on their income elasticity (normal, necessity, luxury, comfort, and inferior). The assignment then provides examples of different products (cigarettes, salt, and Porsche cars), calculating their income elasticity of demand and interpreting the results. The analysis includes references to relevant economic literature to support the claims. The document is contributed to Desklib, a platform offering AI-based study tools, past papers and solved assignments for students.

Running Head: Economics for Business
Economics for Business

Economics for Business 1
Question 1: Define and explain the three key economic ideas:
People are rational: Economic theories are based on the assumption of rationality. People
aim to achieve their optimum bundle which gives them the highest level of satisfaction and
benefit, from the given resources or alternatives. Individuals make their decisions that are
logical and prudent. Agents work at the margin. A consumer tries to maximise his level of
satisfaction while a producers tries to maximise his profits. A consumer consumes a
commodity up to the point where his satisfaction from the successive unit turns to zero, with
given level of income and prices (Krstic & Krstic, 2015). For example, if John consumes
pizza, he will eat till his stomach is full but will stop after that even if the prices decline. This
happens because of law of diminishing marginal utility. Satisfaction from every next slice of
pizza decreases as his hunger reduces.
People respond to incentives: Incentives can influence the buying behaviour of the
consumers and selling behaviour of the suppliers. As people are rational and they compare
the costs with benefits, they respond to incentives. It may have a positive or negative impact.
When the price of a good falls, people consume more of the same good. On the other hand,
the producers reduce their production and lay-off its labour when the prices decline in the
market. Here, the price fall acts as an incentive for consumers to buy more of the commodity
and acts negatively in case of producers. Producers decline their output because their profit
margins decline and vice versa. This will continue till the point when the increase in demand
will push the prices back to the original point and production will increase (Matthew
McCaffrey, 2014). For example, decrease in price of cell phones will increase the demand.
Supplier of the same will reduce their production because price fall acts as a disincentive for
them.
Optimal decisions are made at the margin: There are relative trade-offs associated with
economic decisions based on the individual’s preferences and priorities. The decisions made
are relative to the current scenario, there are additions or subtractions to it. The decision is not
on the extremes of all or none. The decision is based on the additional benefit that is derived
from the subsequent unit along with its additional cost. If the expected additional cost
exceeds the expected additional benefit, the decision is unfavourable. This leads to optimum
decision based on the preferences and the given circumstances. The optimum is achieved
when the two are equal. But as the additional units increase, the marginal utility from each
successive units keep on decreasing until it turns to zero where the consumption or

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production stops. For example, a shoe producer can use marginal analysis to determine the
benefits associated with the increase in production of shoes. Based on it he can allocate the
scarce resources to their best use to minimise the costs and increase the profits. He will
increase the production to the level where marginal cost of producing another good is equal
to the benefits derived from the increased production.
Question 2: Using the economics or other literature to identify estimates of the income
elasticity of demand for at least three different products.
Income Elasticity of Demand estimates:
Income elasticity of demand refers to the sensitivity of quantity demanded of a given
commodity for a change in the income of the consumer, at given price level. It can be
calculated as follows:
Income elasticity of demand (η)¿ % change∈quantity demanded
% change∈income
The magnitude ranges from 0 to ∞ (infinity). The closer the magnitude is to ∞, the more
elastic is the demand of the commodity is. Closer the magnitude is to 0, the more it is
inelastic. Elasticity range:
0 - Perfectly Inelastic
0< η <1 - Relatively Inelastic
1 - Unit Elastic
1< η <∞ - Relatively Elastic
∞ - Perfect Elastic
Goods can be divided on the basis of income elasticity as follows:
 Normal goods: Income Elasticity is positive
 Necessity goods: Income Elasticity is positive but low
 Luxury goods: Income Elasticity is positive and high
 Comfort goods: Income Elasticity is unitary (=1)
 Inferior goods: Income Elasticity is negative

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High income elasticity of demand implies that a small change in the income of the consumer,
changes the demand significantly. That is the demand is very sensitive to the change in
income (Fouquet, 2010). The negative sign is an indicator of negative relation between the
income of the consumer and demand of the good. This implies it is an inferior good. Positive
sign implies normal good, which can be necessity, luxury or comfort good (King & Weimer,
2012). Examples:
1. Assume that the income of the consumer increases by 15%, the demand for cigarettes
falls by 30%. Income elasticity of demand of cigarettes can be calculated as follows:
Income elasticity of Cigarettes(η)=−0.30
0.15 =−2
This shows that the income elasticity of cigarettes is -0.33. It is negative and high,
implying the good is inferior in nature. Inferior good is the one whose demand
decreases with the increase in income. Their quality is low and elasticity is relatively
high. With increase in income, people switch to higher quality goods like cigars.
2. Suppose the income of consumer increases by 20%, the demanded of salt increases by
5%. Income elasticity of demand of salt can be can be calculated as follows:
Income elasticity of Salt ( η )= 0.05
0.20 =0.25
Salt being a necessity is not income sensitive to demand. Necessities have income
elasticity of demand positive and less than 1. The magnitude is 0.25, which is positive
but not high. This implies the demand is income inelastic in case of salt. Necessities
are not affected much by the income change because people do not change their
consumption significantly. Necessities will be consumed irrespective of the changes
in income.
3. Suppose the income of consumer increases by 30%, the demand of Porsche car
increases by 90%. The income elasticity in this case will be:

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Income elasticity of Porsche car ( η ) = 0.90
0.30 =3
Porsche car is a luxury and hence the magnitude is 2. Luxury goods have income
elasticity positive and high. Since, a relatively small change in the income of
consumer affects the demand of Porsche car significantly, the elasticity is high.
References:
Fouquet, R. (2010). Trends in Income and Price Elasticities of Transport Demand (1850-
2010). Energy Policy, 50, 50-61.
King, M. K., & Weimer, D. L. (2012). Price and Income Elasticities of Demand for Energy.
Theory and Practices for Energy Education, Training, Regulation and Standards.
Krstic, B., & Krstic, M. (2015). Rational Choice Theory and Random Behvaviour. Original
Scientific Article, 61(01), 1-13.
Matthew McCaffrey. (2014). Incetive and Economic Point of View: The Case of Popular
Economics. The Review of Social and Economic Issues, 01(01), 71-87.