ChapterII Theory of Demand and Supply1

8/6/2019 ChapterII Theory of Demand and Supply1

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CHAPTER-IITHEORY OF DEMAND

Introduction:Economics is the study of the ordinary activities of human life. It is thesystematic study of economics activities of human beings. It studies how people

earn income and how do they spend it for the fulfillment of their different wants.Economic activities take place because people have to satisfy different wants.In order to satisfy wants they make demand for goods and services.Demand is the powerful market force and is the basis of market, withoutknowledge of demand; understanding and being successful in business is verydifficult, and therefore, its study is of paramount significance to takeappropriate decisions.

Meaning of demand:Demand is that effective desire which can be fulfilled. It means that desires aresimply imaginations, they may not be fulfilled. Demand pre-supposes the

presence of resources and the willingness to part with the resources to satisfythe desires. Demand is the desire for a commodity or service backed bywillingness to spend and ability to pay. Demand is the quantity thatconsumers demand at alternative prices during a given period of time. It isalways expressed in relation to a certain quantity, time and price.

Definitions of demand:According to Bobber, demand means the various quantities of a givencommodity or service which consumers would buy in one market in agiven period of time at various prices.

According to Benham, Demand for anything at a given price is theamount of it which will be bought per unit of time at that price.

According to Hibdon, demand means the various quantities of goods thatwould be purchased per time period at different prices in a givenmarket.

Features of demand:1. Demand depends upon utility of the commodity. A consumer is rational

and demands only which provide positive utility.

2. Demand means effective demand i.e. demand for commodity or desire toown a commodity should always be backed upby purchasing power andwillingness to spend.

3. Demand is a flow concept. It is always expressed as so much per unit oftime.

4. Demand is a relative term. It is always expressed in relation to certainquantity, time and price.

5. Demand means demand for final consumer goods.

6. Demand is the desired quantity. It shows consumers wish or need to buy thecommodity.

General Economics 2.1 Theory of Demand, ConsumerBehaviour and supply.


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Determinants of demand:The decision of a household to buy a commodity is influenced by a number offactors. Demand is a multivariate relationship, i.e. it is determined by manyfactors simultaneously. The following are the most important factors whichaffect demand.

1.Price of Commodity: The price of a commodity is the most important factor which determinesdemand. Other factor being same, demand for the commodity entirely dependsupon its price. The price of a commodity and its demand are inversely related. Itimplies that a rise in the price of a commodity brings in the fall in demand and afall in the price of a commodity leads to rise in its demand. This of demand iscalled Price Demand.

2. Price of related goods:The demand for a commodity depends upon the price of related goods when

the other things remain same. Related commodities are of two types:

a. Complementary goods:Complementary goods are those goods which are consumedsimultaneously. One good has no utility in the absence of anotherrelated good. For example, car and petrol, food and water etc., arecomplementary goods. Change in the price of one good affects the demand ofthe other commodity. The relationship between price of one good and demandof another good is inverse or negative. The demand curve would be downwardsloping demand curve.

b. Price of Substitutes:Substitutes or competitive goods are those goods that can be

substituted for each other. In other words, consumption of one goodcan be replaced can be replaced by another. For example, a motor cyclecan replace scoter, coffee and tea etc. Change in the price of one good affectsthe demand of the other commodity. The relationship between price of onegood and demand of another good is direct or positive relationship. Thedemand curve would be upward sloping demand curve.

3.Income of the Consumer:Demand for the commodity depends upon the level of money income of theconsumer. Ordinarily, with the increase in the consumers income their demandfor goods increases. However, this may not be true always. In order to see the

impact of change in income on demand for a commodity we have consider threetypes of commodities:

a. Necessities :Necessities occupy a high order of priority in a consumers budgetaryexpenditure. As the income of the consumer, the demand for necessities alsoincreases in the beginning and becomes income inelastic (constant) thereafter.The demand curve is positively relatively inelastic and becomesperfectly inelastic after certain point.

b. Comforts and luxuries:Demand for comforts and luxuries are positively related to income. Asthe money income of the consumer increases, the demand for comforts and



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luxuries also increases. Demand for cars, air-conditioners, high quality cloth andgarments etc, increases with the increase in consumers income. The demandcurve is positively relatively elastic.

c. Inferior goods:

Demand for inferior goods is inversely related to income. At a very lowlevel of income, it is possible that demand for inferior goods may increase withincrease in the income of the consumer. But beyond a certain level of income,the demand for inferior goods decreases with the increase in the income. It is sobecause increased income makes a consumer better off than before and theconsumer starts substituting a superior good to inferior good, As a result, thedemand for inferior good declines. The demand curve of an inferior isbackward sloping demand curve.The above mentioned relationship between income and quantity demanded iscalled income demand.

4. Tastes and preferences of consumer:Other thing remaining same, demand for a commodity depends uponconsumers tastes and preferences. The terms tastes and preferencesembrace all the non-monetary determinants o demand, viz, age , familycomposition, community size, occupation, fashion, rationality, etc. these factors,more or less, remain relatively stable for large body of consumers, and henceare bracketed together as such. Any change in tastes, when it occurs, shall havea direct bearing on the demand for affected commodities. A positive change intastes shall lead to an increase in demand and negative change in tastes shalllead to a decrease in demand.

5. Consumer expectations about future price:If consumer expectation about future is rise in prices then demand rises in thepresent and future expectation is fall in the prices then demand falls in thepresent.

6.Demographic factors:a. Size of population:

Ordinarily, larger the size of population of a country, region or family, more willbe the demand for commodities. Size of population determines the number ofconsumers and number of consumers has a direct bearing on demand forcommodities.

b. Composition of population:If the number of children is large, demand for toys, biscuits, sweets, baby-foods,etc., will be large, similarly, if there are more old people in a region, goods suchas spectacles, sticks, artificial teeth, etc., will be more in demand.

7. Income or wealth distribution:While equitable distribution of income in the community leads to an increase indemand, an unequal distribution of income brings a fall in the quantitydemanded.

8.Sociological conditions:



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Consumers purchases are also influenced by such sociological factors as class,groups family background, education, marital status, age and place ofresidence- particularly urban or rural.

9.Weather conditions:Changes in weather conditions also influence consumers demand. For example,a sudden rainfall on a hot summer day brings down the demand for ice.

Prolonged cold-spell tends to push up the demand for firewood, room heaters,etc.

10. Advertisement effect:Advertisement is informative in nature. Advertisement brings in the awarenessabout the commodities and services in the minds of consumers. This awarenessaffects the demand of the commodities.

Law of Demand:The law of demand expresses the functional relationship between priceand quantity demanded. Price and demand are inversely related, rise in theprice of a commodity brings fall in its demand and fall in price of a commodityleads to rise in its demand.According to Marshall there is inverse relationship between price and demand.Other things being same if price of a commodity falls, the quantitydemanded of it will rise or extend, and if price of the commodity rises,its quantity demanded will decline or contract.

Assumptions:1. No change in Income.2. No change in the tastes and preferences of the consumer.3. Price of related goods remains constant.

4. Commodity should be a normal commodity.5. No change in population size and composition.6. No expectations of future changes in prices of commodity in question or

study.

Features of Law of demand:1.There is functional relationship between price of a good and quantity

demanded of that good.2.There is definite inverse relationship between the price of the good and the

quantity demanded of that good.3.The demand curve slopes downwards from left to rightwards.

Demand Schedule:Demand schedule is tabular presentation showing the differentquantities of a good that buyers are willing to buy at different pricesduring a given period of time. If refers to the response of quantitydemanded to change in price of a commodity.The law of demand can beillustrated with the help of the demand schedule and the demand curve.Demand schedule and curve may be two types:

1.Individual demand schedule:An individual demand means quantity demanded of a commodity by an

individual consumer at various prices per time period.



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This above table shows an inverse relationship between price and quantitydemanded, if other things being equal.

2.Market demand schedule:Market demand schedule is the aggregate of the quantities demanded by allconsumers in the market at different prices per time period. When we add theindividual demands for various schedules we get market demand schedule.

Price of X Rs. CONSUMERS Total market demand(A+B+C)A B C

1 50 40 10 100

2 40 35 5 803 30 30 3 634 20 25 2 475 10 20 1 31

It indicates that market demand also inverse relationship between price andquantity demanded.

Factors Affecting Individual and Market Demand:Individual demand Market demand

1.Price of a good

2.Price of related goods3.Income of the consumer4.Tastes and preferences of the

consumer5.Advertisement

1.Price of a good

2.Price of related goods3.Income of the consumer4.Tastes and preferences of the

consumer5.Number of consumers in the

market6.Distribution of income7.Age and gender of population8.Sociological conditions9.Weather conditions10. Advertisement.

Demand Curve:Demand Curve is a graphic presentation of quantities of good orcommodity demanded by the consumer at various possible prices in aperiod of time. Graphical presentation of demand schedule is known asdemand curve.Both Individual and market demand curves slopes downward from left to rightindicating an inverse relationship between price and quantity demanded.Market demand curve is horizontal summation of individual demand curves. Thelaw of demand is a qualitative statement because it explains trend notexactness of demand for the commodities.


Price of X (Rs.) Quantity Demanded of X1 502 403 304 205 10


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Why Demand curve slopes downwards or rationale for Law ofDemand.1. Substitution effect:When the price of a commodity falls, it becomes relatively cheaper than othersubstitute commodities. This induces the consumer to substitute the commoditywhose price has fallen for other commodities, which have now become

relatively expensive. As result of this substitution effect, the quantity demandedof the commodity, whose price has fallen, rises.

2. Income Effector Real Income effect:When the price of a commodity falls, the consumer can buy more quantity ofthe commodity with his given income, as a result of a fall in the price of thecommodity, consumers real income or purchasing power increases. Thisincrease induces the consumer to buy more of that commodity. This is calledincome effect.3. Number of consumers:When price of a commodity is relatively high, only few consumers can afford to

buy it, and when its price falls, more numbers of consumers would start buyingit because some of those who previously could not afford to buy may now buy it.Thus, when the price of a commodity falls, the number of consumers for thecommodity increases and this also tends to raise the market demand for thecommodity.

4. Law of diminishing Marginal Utility:The law of demand is based on the law of diminishing marginal utility whichstates that as the consumer purchases more and more units of a commodity,the utility derived from each successive unit goes on decreasing. It means asthe price of commodity falls, consumer purchases more of that commodity untilthe consumer reaches the saturation point i.e. until his or her marginal utilitybecomes zero for the commodity.

5. Several uses:Some commodities can be put to several uses which lead to downward slope ofdemand curve. When the price of such commodities goes up they will used forimportant purposes, so their demand will limited. On the other hand, when theprice falls, the commoditys demand extends.

Exceptions to the Law of demand:1. Conspicuous goods or Articles of Distinction: Some consumers measure the utility of a commodity by its price i.e., if thecommodity is expensive they think that it has got more utility. As such, they buyits less of this commodity at low price and more of it at high price. Diamondsare often given as an example of this case. The higher the price of diamonds,higher is the prestige value attached to them and hence higher is the demandfor them.

2.Giffen Goods:Giffen goods are those goods, which are considered inferior by consumers, andexamples of such goods are low quality of rice and wheat. Sir Robert Giffen,found that when price of bread increased, the British workers purchased morebread not less of it. This was something against the law of demand. Why did this

happen? The reason given for this is that when the price of bread went up, it



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caused such a large decline in the purchasing power of the poor people thatthey were forced to cut down the consumption of meat and other moreexpensive foods. Since bread, even when its price was higher than before wasstill the cheapest food article; people consumed more of it and not less when itsprice went up. Such goods which exhibit direct price demand relationship arecalled Giffen goods. In case of a Giffen good, demand curve will be backward

falling to the left.3.Conspicuous necessities:The demand for certain goods is affected by the demonstration effect of theconsumption pattern of a social group. These goods, due to their constantusage, have become necessities of life. For example the prices of televisionsets, refrigerators, coolers, cooking gas etc. have been continuously rising, buttheir demand does not fall.

4.Future expectations about prices:It has been observed that when price are rising, households expecting that theprices in the future will be still higher, tend to buy larger quantities of

commodities. For example, when there is an expectation that prices of sharewould rise in future, and then demand for the same rises at present.5.Demonstration effect:Sometimes, a section of society tends to imitate the consumption patterns ofhigher income groups. In this case, law of demand gets violated becausedemand more of that commodity which higher income group people are buying,even at higher prices.

6.Ignorance effect:Generally, it is assumed that a household has perfect knowledge about priceand quality of goods. However, in practice, a household may demand larger

quantity of a commodity even at a higher price because it may be ignorant ofthe ruling price of the commodity.

7.Emergency :In case emergencies like war, curfew, drought, famine etc, the law of demanddoes not hold. In such situations, there is general insecurity and fear of shortageof necessities. Hence, consumers demand more goods even at higher prices.

8.Snob appeal:Certain items of historical, cultural or sociological importance have a snobappeal. These are classic pieces of art. More are demanded at higher prices.

Analysis of change in demand:1. Extension and contraction in demand:

A movement along the demand curve is caused by a change in theprice of the commodity, other thing remaining constant. It is also calledchange in the quantity demanded of the commodity. Movement is alwaysalong the same demand curve, i.e. no new demand curve is drawn. Movementalong demand can bring about:

A. Expansion or Extension of demand, orB. Contraction of demand

A. Expansion or Extension of demand:



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Expansion or extension of demand refers to rise in demand due to fall in price ofthe commodity. A downward movement along the demand curve representsextension of demand.

B. Contraction of demand:Contraction of demand refers to fall in demand due to rise in price ofcommodity. An upward movement along the demand curve represents

contraction of demand.

2. Increase and decrease in demand:A shift of demand curve is caused by changes in factors other thanprice of the commodity. The factors are price of related goods,consumers income, consumers taste and preferences etc, a change inany of these factors causes shift of demand curve. It is also calledchange in demand. In a shift, a new demand curve is drawn. A shift of thedemand curve can bring about:

A. Increase in Demand, orB. Decrease in demand

A. Increase in Demand:It refers to more demand at a given price or same quantity demanded at ahigher price. A rightward shift in demand curve represents increase in demand.

Causes of increase in demand:1.Rise in price of substitutes2.Fall in price of a complementary good3.Rise in income4.Taste and preference becoming stronger in favour of the commodity5.Increase in population

B. Decrease in demandIt refers to less quantity demanded at a given price or same quantity demandedat a lesser price. A leftward shift in demand curve represents increase indemand.

Causes of Decrease in Demand:1.Fall in price of substitutes2.Rise in price of a complementary goods3.Fall in income4.Taste and preferences becoming towards the commodity

5.Decrease in populationDifference between expansion of demand and increase in demand

Expansion in demand Increase of demand1. It refers to movement along the demand

curve.2. In this, the consumer moves downwards

on the same demand curve.3. It is due to fall in the price of the

commodity.4. Expansion of demand is defined as rise in

demand due to fall in the price ofcommodity.

1. It refers to shift of a demandcurve.

2. In this, there is a rightward shiftof demand curve.

3. It is due to shift factors.4. Increase in demand is defined

as the rise in demand at the

same price of the commodity.



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Difference between contraction of demand and decrease indemand

contraction in demand Decrease of demand1. It refers to movement along the demand

curve.

2. In this, the consumer moves upwards onthe same demand curve.3. It is due to rise in the price of the

commodity.4. Contraction of demand is defined as fall

in demand due to rise in the price of thecommodity.

1. It refers to shift of a demandcurve.

2. In this, there is a leftward shiftof demand curve.3. It is due to shift factors.4. Decrease in demand is defined

as the fall in demand at thesame price of the commodity.

Demand function:The relation between the consumers optimal choice of the quantity of a goodand its price is called function. Demand is the combined effect of all the

determinants of demand, it can expressed in a mathematical form known asdemand function.Qd =f (Px, I, Pr, T, A etc)Qd = Quantity demanded.Px = Price of commodity x.I = Income of the consumer.Pr = Price of related goods.T = Tastes and preferences of the individual consumer.A = Advertising effect on consumer.

Linear Form of demand function:Qd = f ( Px) , If other factors except price are constant.

Qd = a- b PxQd = Quantity demanded.a = constant parameter signifying initial demand irrespective of the price.b = a constant parameter which represents a functional relationship betweenprice and

demand. b having a minus sign a negative function. It implies that thedemand for a

commodity is a decreasing function of its price p. In fact it measures theslope of the

demand curve. b indicates that the demand curve is downward sloping.

Elasticity of Demand:Elasticity of demand may be defined as the degree of responsiveness ofquantity demanded of a good to a change in the variable on which demand ofgood depend, the variable may be the priceof the commodity,Income ofthe consumer, or the prices of related goods or commodities.

Types of Elasticity of demand:1. Price Elasticity of demand.2. Income elasticity of demand.3. Cross elasticity of demand.

1. Price Elasticity of demand:



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Price elasticity of demand measures the responsiveness of demand ofa good to a change in its price.

Degrees of price elasticity:1. Perfectly elastic demand2. perfectly inelastic demand3. Unitary elastic demand

4. Relatively elastic demand5. Relatively inelastic demand.

1. Perfectly elastic demand (Ed= ):When the demand for a commodity rises or falls to any extent withoutany change in price, the demand for the commodity is said to beperfectly elastic. It exists under perfect competition, which is an ideal andimaginary situation. It means demand of commodity is perfectly flexible incase of perfectly elastic demand. In perfectly elastic demand, the demandcurve will be horizontal.

2.More than unitary elastic demand (Ed>1):When a change in price leads to a more than proportionate change indemand, the demand is said to be elastic or more than unit elastic, thecoefficient of elasticity of demand is greater than unity. The demand curve isdownward sloping and flatter.It exists in case of luxuries.

3. Unitary elastic demand (Ed=1):When the percentage change in demand of a commodity is equal topercentage change in price, the demand for commodity is said to beunitary elastic. The elasticity is unitary elastic. The unitary elastic demandcurve is a straight line forming 45o angles with both the axes. It is also

a rectangular hyperbola. It exists in case of normal goods.4.Less than unit elastic demand (Ed


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The demand for luxury is usually elastic as people buy more of them at a lowerprice and less at a higher price.

2. Number of Uses:Elasticity of demand for any commodity depends on its number of uses.Demand is elastic; if a commodity has more uses and inelastic if it hasonly one use.

3. Substitutes:Demand is elastic for those goods which have substitutes and inelastic forthose goods which have no substitutes.

4. Raw Materials and Finished Goods:The demand for raw materials is inelastic but the demand for finished goods isusually elastic.

5. Postponement:Demand is more elastic for goods the use of which can be postponed. Demand

is inelastic for those goods the use of which is urgent and therefore, cannot bepostponed.

6. Price Level:The demand is elastic for moderate prices but inelastic for lower andhigher prices.

7. Income Level:The demand is inelastic for higher and lower income groups and elasticfor middle income groups.

8. Habits:

Habits usually have inelastic demand.

Methods of Measurement of price elasticity:1. Total expenditure method.2. Proportionate method.3. Point elasticity of demand method.4. Arc or average elasticity of demand method.5. Revenue method.

1. Total expenditure or outlay method:Total outlay or expenditure by consumers is the revenue earned by the sellers.When price of a good changes, it brings about a change in the total revenue ofthe seller. The change in the total revenue (expenditure for theconsumer) depends upon the price elasticity of demand. When price of acommodity changes three situations can take place:

(a)E = 1: When as a result of a change in price, the total expenditureremains the same, the commodity is said to have a unitary elasticdemand.



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(b)E>1: When as a result of a risein price,the total expenditure on thecommodity falls and as a result of a fall in price, the total expenditurerises, the commodity is said to have more than unit elastic demand.

(c)E


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marginal revenue. The formula to measure elasticity of demand can bewritten as,

MA

AEp

=

Where Ed = elasticity of demand, A= Average revenue. M= Marginal revenue.

Note:

Due to negative relation between price and quantity, we ignore thenegative sign and consider only the numerical value of the elasticity.

Importance of price elasticity of demand:The concept of price elasticity of demand is very useful formonopolists, business firms, government, farmers, international tradeand factor pricing. It helps in determination of exact change in price andquantity demanded of the commodity. The various uses of the concept of priceelasticity of demand are:

1. To the monopolist:

A monopolist is a price maker. He will fix high prices for those commoditieswhich have inelastic demand and low prices for the ones having elastic demand.

2. To the finance minister:The government aims at maximizing tax revenue. Therefore, it levies heavytaxes on those goods which have an inelastic demand less taxes for goodshaving elastic demand.

3. In factor pricing:A factor with inelastic supply gets higher price compared to a factor whosesupply is elastic.

4. International trade:Devaluation of currency helps in increasing the exports of the country becausegoods become cheaper in the international market. Devaluation is successfulonly if elasticity of demand for exports is inelastic and for imports is elastic.

5. Paradox of plenty:The paradox of plenty states that a bumper harvest will generally bring povertyto farmers. The reason for this lies in the elasticity of demand for food stuffs.The demand for food products, which is a necessity, is inelastic. An increase intheir supply tends to lower price. The lower price does not increase quantitydemanded very much due to its inelastic demand.

2.Income elasticity of demand:Income elasticity if demand shows the degree of responsiveness ofquantity demand of a good to a small change in the income of theconsumers or customers.

Types of Income Elasticity:It may be ofthree types:1. Positive EyIn case ofNormal / Luxury good, there will be positive relation betweenincome and demand because as income increases demand increases and viceversa. Positive income elasticity may be ofthree types:(a) Ey = 1 (Equal to one) unitary elasticity.



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(b) Ey > 1 (Greater than one) relatively elastic.(c) Ey < 1 (Less than one) relatively in elasticSometimes its found in necessities. The above elasticities are also calledgreater than zero.

2. Negative Ey (Ey


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3. Zero Ec :When we examine the relation between two goods which are not having any

relation it can be called as Zero Cross Elasticity. For example price of cementand demand for school bags.

Methods of measuring cross elasticity of demand:3. Proportionate or percentage or ratio method

4. Arc method

3. Proportionate method or Percentage Method or RatioMethod:

It is measured as percentage change in quantity demanded divided by thepercentage change in price, other things remaining equal.

y

x

P

Qor

XdemandedofQunatityinChangePercentageEd

=

%

%

YofpriceinChangePercentage

0

0

Qx

Pyx

P

QEp

y

x

=

Where Ed = Income elasticity of demand P = Price Q = quantity = Change

4. Arc method:When there is a large change in price of one commodity and quantitydemanded of another commodity, such that it relates to a stretch over thedemand curve, then the percentage formula is modified. It is called Arcelasticity. In Arc elasticity, we use the average of the two price levels of onecommodity and quantities figures (original and new) of another commodity.Thus, the formula of measuring cross Arc elasticity of demand is:

2/)(

2/)(

10

10

QxQx

PyPyx

Py

QxEp

+

+

=

or

10

10

10

10

PyPy

PyPyx

QQx

QQxEp

+

+

=

Consumer BehaviourIntroduction:The law of demand states that quantity demanded of a commodity is inverselyrelated to its price. The theory of demand attempts to explain why law ofdemand operates. In other words, the theory gives the logical basis of the law ofdemand from the analysis of consumers behaviour. The various theories orapproaches of study consumer behaviour are as follows:

1. Cardinal utility theory of consumer behavior and,2. Ordinal utility theory of consumer behavior, popularly known as the

indifference curve analysis.

Concept of Utility:



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When the consumer consumes or buys a commodity, he derives some benefit inthe form of satisfaction of a certain want. This benefit or satisfactionexperienced by the consumer is referred to by economists as utility.Utility is something experienced by the consumer about the givencommoditys significance relating to its want-satisfying power. Utility isthe ability and capacity of a commodity or a service to satisfy a human want.

Utility is want satisfying power in the commodity or service.Characteristics of utility:1. Utility depends upon the intensity of consumers desire or want.2.Utility is a relative term. In other words, It changes from person to person,

place to place and time to time.3. Utility has no social or ethical implication.4. Utility is subjective phenomenon and cannot be quantified objectively.5. Utility is different from usefulness.6. Utility can be expected satisfaction or realized satisfaction. Utility as expected

satisfaction to consumer is represented by willingness to spend money on astock of commodity by the consumer which has the capacity to satisfy his/her

want. Expected satisfaction takes place when the commodity has not beenbought but the consumer is willing to buy it.Realised satisfaction is the actual utility derived by the consumer afterconsuming the good or service.

Cardinal Utility theory of consumer behaviourThe Marshallian approach of the theory of consumer behaviour is based on thefollowing postulates.1.Concept of utility and its cardinal (numerical) measurement.2.The law of diminishing marginal utility; and3.The law of Equi-marginal utility.

4.Concept of consumer surplus

Basic Concepts and Postulates of the Marshallian Cardinal UtilityApproach:1. Cardinal Measurement of Utility:Marshall assumes cardinal measurement of utility. Cardinal measurement is anumerical expression. Marshall believed that utility could be measured innumerical terms in its own units called Utils. To him, utility ofcommodity is quantifiable, hence measurable numerically.2.Total Utility:The concept of total utility and marginal utility are the basic concepts in the

cardinal measurement of utility. Total utility means total satisfactionexperienced or attained by the consumer regarding all the units of acommodity taken together in consumption or acquired at a time. It isthe sum of utility derived form different units of commodity consumed by aconsumer. TU = MU or TU = MU1 + MU2 + MU3MUn etc.

Marginal Utility:Marginal utility is the extra utility obtained from an extra unit of anycommodity consumed or acquired. Marginal utility may be defined as thesatisfaction derived by a consumer from the consumption of an additional unitof a particular good.

MU = TU / Qty. consumer or Tun Tun-1.



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Units of applesConsumed

Totalutility

Marginal

Utility

Analysis

1 10 10 MU decreases and TUincreases

MU is zero, TU maximumMU is negative, TUdecreases

2 18 83 24 6

4 28 45 30 26 30 07 28 (-2)

The utility schedule provides the following information:1. As the consumer has more and more of the good, the total utilityincreases at a diminishing rate and marginal utility gradually declines.2. When no unit of x is consumed, total utility is zero and marginal utility ismaximum.3. When total utility is maximum, marginal utility is zero, it indicates

saturation point.4. If consumer is rational, he will stop at 6 units. This is because if heconsumes more than 6 units, then total utility will decline and marginal utilitywill become negative. At that point the commodity will give disutility.5. If any one of the schedule is given the other can be easily derived.6. The utility schedule illustrates the law of diminishing marginal utility whichstates that as consumer has more and more of a good, the marginal utilityderived from the good diminishes.

Relation between total utility and marginal utility curves:1. Total utility curve starts from the origin, increases at a decreasing rate,reaches a maximum level and then starts falling.2. Marginal utility curve is the slope of total utility curve.3. When total utility curve is maximum, marginal utility curve is zero, whichindicates saturation point.4. When total utility curve is rising, marginal utility curve falls.5. When total utility curve is falling, marginal utility curve becomes negative.6. The falling of marginal utility curve exhibits the law of diminishingmarginal utility.

Marginal utility Analysis:Alfred Marshall explains how a consumer spends his income on differentgoods and services so as to attain maximum satisfaction.

Basic Assumptions of Marshallian Utility Analysis:The basic premises underlying the Marshallian theory of demand may, however,be enlisted as under:

1. The cardinal measurability of utility: - According to this theory,utility is measurable and quantifiable entity in the terms of money, which a

person is ready to pay



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2. Constancy of the MU of money: The MU of money remainsconstant throughout when the individual is spending money on a good.

3. The hypothesis of independent utility: - It means independentunit have independent utility and it ignores complementarily between goods.

4. Rationality: It is assumed that consumer is rational while spendingmoney. He is not making impulsive purchases.

5. Additive Utility: it is assumed that utility can be added to totalutility.

1. The Law of Diminishing Marginal Utility:The law of Diminishing Marginal Utility (DMU) lies at the center of the cardinalityapproach. The law of diminishing utility or diminishing marginal utility is basedon the satiability characteristics of human wants, that a single want takenseparately at a time, can be fully satisfied.

Assumptions of the Law:The law of diminishing marginal utility is conditional. Its validity is subject to

the following assumptions or conditions:1. Taste, income of the consumer remains unchanged.2. The units of the commodity are identical in all aspects i.e. Homogeneity.3. There is no time gap between the consumption i.e. Continuity in consumption.4. Reasonability.5. Constancy.6. Rationality.7. Constancy of Marginal Utility of Money.8. Cardinal Measurement of Utility.

Statement of the Law:

According to Alfred Marshall, Other things being equal, as the quantityof commodity consumed or acquired by the consumer increases, themarginal utility of the Commodity tends to diminish.In mathematical terms, the law implies a decreasing functional relationshipbetween the quantity of a commodity consumed and marginal utility derived.This means each additional unit of consumption adds relatively less and less tothe total utility obtained by the consumer.Law of Diminishing Marginal Utility (DMU) states that after consuming a certainamount of a good or service, the marginal utility from it diminishes as more andmore of it is consumed. As a consumer consumes successive units of acommodity, its total utility increases up to a certain level but at a diminishingrate, then it becomes constant and starts decreasing gradually.The laws of DMU can be understood with the help of following table and figure

Units of applesconsumer

Totalutility

MarginalUtility

1 10 102 18 83 24 64 28 45 30 26 30 0

7 28 (-2)



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In the table as MU decreases, TU increases and when MU is zero then TU ismaximum. This is called Saturation point and after the saturation point whenMU becomes negative then TU decreases.

Limitations of the law of diminishing marginal utility:1. Cardinal measurement of utility is not possible.2. Marginal utility of money (MUm) does not remain constant.

3. Law is applicable if there are identical units.4. Law is applicable if there is no change in habits, taste & preferences and

income of the consumer.5. Law is applicable if there is standard unit sufficient unit-not more not less.6. Law is applicable if there is no time gap or interval between the consumption.7.The law may not apply to some articles like gold, money, music and hobbies.8. The shape of utility curve may be affected by the presence of substitutes or

complementary goods.

2.The Law of Equi- Marginal Utility or the Proportionality Rule:The law of equi-marginal utility was propounded by a French engineer Gossen.

The law of Equi-marginal is the logical extension of the law of diminishingmarginal utility. The law of diminishing marginal utility applies in case of asingle commodity however in reality consumers consume a number ofcommodities at a given time. Therefore, the extension of law of diminishingmarginal utility is done to explain realistic situation, the extended law is knownas the law of Equi-marginal utility. It is also known as Gossens second law, thelaw of maximum satisfaction, the law of rational consumer and the law ofsubstitution.

Statement of Law:According to Alfred Marshall, Other things being equal, a consumer

gets maximum total utility from spending his given income, when heallocates his expenditure to the purchase of different goods in such away that the marginal utilities derived from the last unit of moneyspent on each term of expenditure tends to be equal. The law essentiallymeans, the consumer maximizes his satisfaction when he obtains equi-marginalutilities from all the goods purchased at a time.

The Proportionality Rule:When the ratios of marginal utility to prices of different goods are equalized withthe given marginal utility of money income of the consumer, total utility soderived would be the maximum.

Assumptions of the Law:The law of Equi-marginal utility is based on the following assumptions:1. The consumer is rational economic man who seeks maximum total

satisfaction.2. Utility is measurable in cardinal terms.3. The consumer has given scale of preferences for the goods in consideration.

He has perfect knowledge of utilities derived.4. Prices of goods are unchanged.5. Income of the consumer is fixed.

6. The marginal utility of money is constant. The law of equi-marginal utility isbased on the following assumptions.



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Limitations of the Law:The law has been subject to certain criticisms and it also has certain limitations.These are outlined below:1. The law is based on unrealistic assumptions. It being an extension of the law

of diminishing marginal utility, it, too, involves all the unrealistic ceterisparibus assumptions and conditions such as homogeneity, continuity,

constancy, etc., on which the law of diminishing marginal utility is based.2. The Proportionality rule presumes cardinal measurement of utility, but it is

not a realistic approach.3. The law is cannot be applied to indivisible goods. On practical grounds, it

looks ridiculous to equate utility of a TV set to coffee per rupee.4. The consumer does not behave rationally all the time. Quite often, his

behaviour is influenced by habit, social customs, fashions, advertising,propaganda, occasional requirements etc.,

5. It has also been pointed out by many critics that it is wrong to assume thatmarginal utility of money will remain constant. Actually, when money isspent, the remaining units of money will tend to have a greater marginalutility. Thus, here there is a backward operation of the law of diminishingmarginal utility.

CONSUMERS SURPLUSDupuit originated the concept of consumers surplus. But it was Marshall whopopularized it by presenting it in a most refined way.Definition:Consumers Surplus (CS) is the difference between the total amount ofmoney the consumer would have been willing to pay for a quantity of acommodity and the amount he actually had to pay for it.

Consumer surplus is the difference between maximum price a person is willingto pay for a goods and its market price or say it is the difference between whata consumer is ready to pay and what he actually pays.CS = what a consumer is ready to pay What he actually pays.What a consumer ready to pay is taken in terms of MU and what he actuallypays is taken in terms of Price. So, CS = MU P

The concept is derived form the law of diminishing utility. As the consumerpurchase more units of a good its marginal utility goes on diminishing. Theconsumer is in equilibrium when MU = P. But for the proceeding units, the MU >P he actually pays for them. This is because the price is constant for him.

Schedule showing marginal utility, price and consumer surplus:

No. ofunits

MarginalUtility (Ready

to pay)

Price (Rs.)Actually Pays (in

Rs.)

ConsumerSurplus (in

Rs.)1 30 20 102 28 20 83 26 20 64 24 20 45 22 20 26 20 20 0 (MU = P)

7 18 20 ------



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In the above table and figure consumer is in equilibrium at the 6th unit becausehere MU = P i.e., 20 and in this way when he will consume 6 units then he istotal ready to pay 150 (30+28+26+24+22+20) but total amount actually paid is120 (20+20+20+20+20+20), So total consumer surplus will be Rs. 150-120 =30, which is maximum.

Assumptions:

Marshall bases his concept of consumers surplus on the followingassumptions:1. Cardinal Measurement of Utility.2. Diminishing Marginal Utility

Limitations:1. Consumers surplus cannot be measured because it is difficult to measure

the MU2. In the cases of necessaries, the marginal utilities of the earlier units are

highest, In such case the consumers surplus is always infinite.3. CS is affected by the availability of substitutes.

4. There is no simple rule of deriving the utility of articles of prestige value (e.g.diamonds)5. Marginal utility of money does not remain constant and this assumption is

unrealistic6. It is a Hypothetical and illusory Concept.

Importance of the Concept of Consumer Surplus: The theoretical and practical importance of the concept of CS may bepinpointed as under:1. It Clarifies the Paradox of Value.2. It gives assessment of enjoyment of real income.

3. Importance to the Monopolist.4. Importance in Taxation Policy.5. Importance in Welfare Economics.6. Importance of International Trade.

Limitations of the Marshallian Approach:Following are the major limitations of Marshalls marginal utility approach.1. Untenable cardinal measurement of utility2. Wrong conception of additive utility3. Marshalls separate measurement of utility of each commodity is not always

correct4. Constancy of marginal utility of money:5. Inapplicability in case of indivisible or bulky goods:6. Inadequate explanation of Giffen goods:7. Limited scope8. No empirical test.

Indifference curve analysis:Indifference Curve Analysis or Ordinal Utility ApproachIndifference curve analysis is an alternative approach to the theory of demand.Indifference curves have been devised to represent the ordinal measurement ofutility.

The Concept of Scales of Preferences: Ordinal Utility



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Professor Hicks introduced the concept of Scale of Preferences of a consumeras the base of indifference curve technique. Hicks discarded the Marshallianassumption of cardinal measurement of utility and suggested ordinalmeasurement.Ordinal measurement implies comparison and ranking without quantification ofthe magnitude of differences of satisfaction enjoyed by the consumer.

In the ordinal sense, utility is viewed as the level of satisfaction rather than theamount of satisfaction. The level of satisfaction is relatively comparable but notquantifiable. Hicks mention that it is possible to observe from the experienceand by experiment the preferences which consumers display when choosingbetween different goods. He, however, asserts that people are not interested inany one commodity at a time as assumed by the marginal utility approach.Generally consumers are at a time, interested in a number of commodities, andthe satisfaction result from their combinations. Besides, they can alwayscompare the level of satisfaction yielded by one particular combination of goodswith that of another combination. In fact the level of satisfaction is anincreasing function of the stock of goods. A larger stock of goods, apparently,

yields, and a higher level of satisfaction than a smaller stock of goods wouldyield.A rational consumer, obviously, prefers that stock or combination of goodswhich yields a higher level of satisfaction than the one which yields a lower one.Thus, the consumer can conceptually arrange goods and their combinations inthe order of their significance or the level of satisfaction. This Conceptual(mental) arrangement of combination of goods and services set in the order ofthe level of significance is called the scale of preferences.

Scale of preference:The conceptual or mental arrangement of combination of two goods

and services set in the order of the level of significance is called thescale of preference. The indifference curve is a geometrical device representing all suchcombinations of two goods yielding equal satisfaction of a particular level.An indifference curve represents different combinations of two goods that givethe same level of satisfaction. Any point on a single indifferent curve indicatesthe same level of satisfaction as any other point on the same curve. Eachindifference curve indicates only one level of satisfaction. Higher theindifference curve, higher is the level of satisfaction, and lower it is, lower willbe the level of satisfaction.

Definition of indifference Curve:According to Hicks, It is the locus of the points representing parts ofquantities between which the individual is indifferent and so it istermed as an indifference curve.According to Meyers, An indifference curve may be defined as a scheduleof various combinations of goods which will be equally satisfactory tothe consumer concerned.

Assumptions:1. Rational Behaviour: The behaviour of the consumer will be rational. It

means that the consumer will like to get maximum satisfaction out of his total

income.



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2. Ordinal Utility: Consumer will determine his preferences on the basis ofsatisfaction derived from different goods or combinations. Utility can beexpressed in terms of ordinal numbers i.e. first, second so on.

3. Diminishing marginal rate of substitution: It means as the stock ofcommodity increases with the consumer, he will substitute if for the othercommodity at a diminishing rate.

4.Non-Satiety: A consumer does not like to possess any good more than therequired quantity. He does not reach the level of satiety. He prefers morequantity if a good to less quantity.

5. Consistency in selection: There is consistency in the behaviour of theconsumer. It means that at a given time a consumer prefers. A combinationto B combination. Then at another time, he will not prefer B combination toA combination (A>B=B>A).

6. Transitivity: It means if a consumer prefers A combination to Bcombination and B combination to C combination , he will prefer ACombination to C Likewise if he is different to A and B and he is alsoindifferent toward B and C then he will also be indifferent to A and C.

7. Independent Scale of Preference: Consumers scale of preference isindependent of his income and price in the market.

Indifference Schedule:The indifference curve schedule may be defined as a schedule ofvarious combinations of two goods that will be equally satisfactory tothe individual concerned. In other words, an indifference schedule is a list ofcombinations to which the consumer is indifferent.

Indifference Curve:An indifference curve is the locus of the combination of two goods thatare equally satisfactory to the consumer or to which the consumer isindifferent. In other words, it is graph of an indifferent schedule. Any point onthe curve denotes a particular level of satisfaction. So combination ofcommodities of X and Y that yields the same satisfaction when joined gives acurve, known as indifference curve.

Indifference map:An indifference map may show all the indifference curves which rankpreferences of the consumer. These curves are like contour lines on a mapwhich shows all places in the same height above the sea level. Each curverepresents equal level of utility. In short; it is a device of ranking of consumerpreference. We can show different schedules graphically each with its own

curve.

Properties of Indifference Curves:1. Indifference Curves slope from Left Downward to Right.An indifference curve has a negative slope that implies that it slopes downwardfrom left to right. The reason underlying this property is that if the consumerhas to stay at the same level of satisfaction, the quantity of one commoditymust decrease when the quantity of the other commodity increases.Indifference curves slope from left downward to right means when the amountof one commodity in the combination increases, the amount of other commodityreduces. If for instance the amount of commodity X is increased in the

combination and the amount of commodity Y remains unaltered, the consumer



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will prefer new combinations to the original one and two combinations will notlie on the same indifference curve.2. Indifference Curves are Convex to the Origin.The other property of indifference curves is that they are convex to the origin. Itmeans as we move from left down to the right along the IC, the marginal rate ofSubstitution between the two commodities goes on diminishing. It has been

observed that as more and more of one commodity (X) is substituted for another(Y), the consumer is willing to part with less and less of the commodity beingsubstituted (i.e. Y). This is called law of diminishing marginal (Law of DMRS xy)rate of substitution between X and Y goods.

3. Indifference Curve will not Touch either X-axis or Y-axis.The indifference curve will not touch either X-axis or Y-axis as we have assumedthat the individual is interested in different combinations of two commodities. Ifit touches either of the axes, it will mean that the consumer is interested in onecommodity only.

4. Indifference Curve neither Touches nor intersects Each Other.

Another property of indifference curve is that indifference curves can neithertouch nor intersect each other so that only one indifference curve can passthrough any one point of the indifference map.

5.Higher indifference Curve represents Higher Level of Satisfaction.An indifference curve which lies above and right to another indifference curverepresents a higher level of satisfaction. In other words, the consumer willprefer the combination which lies on a higher indifference curve as compared tothe combinations lying on a lower indifference curve.

6. Indifference Curves need that not be parallel to Each Other. This is because they are not based on the cardinal number system ofmeasurability of utility. Secondly, the rate of substitution between twocommodities need not be the same in all indifference schedules. From this itfollows that curves may be drawn in any way parallel to each other orotherwise. The only condition is that the two indifference curves should nottouch or cut each other.

Marginal rate of substitution (MRS):Marginal rate of substitution (MRS) is the rate at which the consumer isprepared to exchange good X and Y. In the following table we can define theMRS of X and Y as the amount of Y whose loss can just be compensated by aunit gaming of X in such a manner that the level of satisfaction remains the

same.

COMBINATION

X Y MRSxy

A 1 12

------

B 2 6 6C 3 4 2D 4 3 1

In the above table as good X increases; good Y decreases at a diminishing rate.This is called Law of Diminishing Marginal Rate of substitution between X and Ycommodities (Law of DMRSxy).



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Budget line:Budget line shows all those combinations of two goods which the consumer canbuy spending his given money income on the two goods at their given prices.A consumer is in equilibrium when he is deriving maximum possible satisfactionfrom the goods and is in no position to rearrange his purchases of goods.Assumptions:1.

The consumer has a given indifference map.2. He has fixed money income.3. Prices of goods are fixed.4. Goods are homogeneous and divisible.

Consumers equilibrium can be understood with the help of IC MAP and BUDGETLINE.To show which combination of two goods x and y the consumer will buy to be inequilibrium we bring his indifference map and budget line together. Thus at the equilibrium point E, MRSxy =

Py

Px

MUy

MUx=

We can therefore express the condition for the consumers equilibrium in twoways:(i) Price line must be tangent to the indifference curve.(ii) The marginal rate of substitution of good X for good Y must be equal to the

ratio between the prices of the two goods.

Supply and Law of SupplyIntroduction:Supply is one of the two forces that determine the price a commodity in the

market. The study of supply, therefore, is as important as the study of demand.In simple words, supply means the quantity offered for sale in the market. Justas demand for a product is always at a price, supply of a product is also at aprice. The supply of a product then varies with the change in price. The supplyalso depends upon time. Thus supply means the quantity of a commodityoffered for sale at a particular price during a given period of time.

Definition:Supply refers to the quantity of a commodity offered for sale at givenprice in a given market at a given time.The term supply refers to the amount of a good or service that the producers

are willing and able to offer to the market at various prices during a period oftime. Supply is a flow. Thus stock is not supply, because supply is the part ofstock. S = f (P, Pr, Pf, T, G, E, O)

Determinants Influencing Supply:1.Price of the product (P):Other things being equal, when price increases supply increase and when pricedecreases then supply decreases. Thus there is positive relation between priceand supply.

2. Price of related goods (Pr):The supply of a commodity depends upon the prices of all other commodities. If

prices of related commodities (substitutes or complementary goods) rise, they



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will become relatively more attractive to produce and the supply of thatcommodity rises. But supply of another commodity will fall. So there is aninverse relationship substitutes and positive relationship betweencomplementary goods.

3.Prices of factors of production (Pf):A rise in prices of factors of production of a commodity will make the production

of that commodity less profitable, so supply will decrease. If costs of productionDecreases then supply will increase. There is also an inverse relation betweensupply and cost of production.4.New Inventions and State of Technology (T):Technology advances based on new discoveries and innovations reduce theCost of production and results in more and more supply of the commodity. Withthe traditional technology supply can not be increased.

5.Government policy (G): The Govt., policy may affect the supply by imposing taxes and providingsubsidy. If Govt., policies are favorable (decrease in taxes and increase in

subsidy) then supply will increase and if Govt., policies are unfavourable(increase in taxes and decrease in subsidy) then supply will fall.

6.Future Expectation about price (E):If there is future expectation about rise in price then supplier will not increasethe supply at present and if thee is future expectation about fall in price thensupplier will increase his supply.

7.Other factors (O):a. Use of Inputs.b. Development of Transportation and Communication.c. Agreement among the producers. The supply of product also depends upon natural factors, governmentsindustrial and foreign policies, infrastructure facilities, market structure andproduction capacity.

Law of Supply:Other things remaining the same, as the price of a commodity rises,its supply is extended and as the price falls supply is contracted. Thismeans that when the price rises, the quantity of commodity produced andoffered for sale will increase and when price falls, the quantity of commodityoffered for sale will decrease. According to Dooley The law of supply statesthat the higher the price, the greater the quantity supplied or the lower the

price the smaller the quantity supplied. Thus supply varies directly with theprice. In other words, the relationship between supply and price is direct.Higher the price larger is the supply, the lower the price, the smaller is thesupply. Hence the law indicates the direction in which the supply will move as aresult change in price. Thus supply has positive relation with price. S = f (P)

Assumptions :1. No change in Price of related goods (Pr)2. No change in Price of factor of production (Pf)3. No change in Technology (T)4. No change in Government policy (G)

5. No change in future expectation about prices (E)



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An upward shift in supply curve irrespective of any change in price is calledincrease in supply. Increase in supply refers to more supply at the same priceor same supply at lower price. On the contrary, if the same amount is suppliedat a higher price or less is supplied at the same price, supply is said to bedecreased.

Increase in Supply:

Increase in supply refers to more supply at same price or same supply at fewerprices. This increase in supply is of two types.

Same Price More Supply:Suppose, the price of a commodity is Rs.3, quantity supplied 3 units. If the priceof commodity remains Rs. 3 quantity supplied increases to 4 units it is called theincrease in supply at same price.Less Price same supply:When the price of commodity is Rs. 3 quantity supplied 3 units. If the price fallsto Rs. 2, quantity supplied remain 3 units is called same supply at less price.

Causes of Increase in supply

1. Decrease in price of related goods2. Decrease in factor price (cost of production)3. Advanced technology4. Favourable Govt. policy (Decrease in taxes and increase in subsidy)5. Future expectation about decrease in price6. Others

Decrease in Supply:Decrease in supply refers to less supply at same price and same supply at highprice it is of two types.

Same Price less supply:Suppose price of commodity is Rs. 3 its quantity supplied is 3 units. If priceremains Rs.3 quantity supplied falls to 2 units is called less supply at sameprice.

More Price Same Supply:When the price of the commodity is Rs.3 units. If the price increase to Rs. 4quantity supplied remains 3 units is called same supply at more price.When supply of a commodity changes due to change in factors other than pricei.e., Pr, Pf, T, G, E, O.

Causes of Decrease in supply:

1. Increase in price of related goods.2. Increase in factor price (cost of production).3.Traditional technology.4. Unfavourable govt. policy (Increase in taxes and decrease in subsidy).5. Future expectation about increase in price.6. Others.

ELASTICITY OF SUPPLY:The elasticity of supply is defined as the responsiveness of the quantity suppliedof a good to a change in its independent variable. Elasticity of supply ismeasured by dividing the percentage change in quantity supplied of a good by



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ChapterII Theory of Demand and Supply1

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Transcript of ChapterII Theory of Demand and Supply1