THEORY OF DEMAND AND SUPPLY – CA Foundation, CPT notes, PDF

This article is about THEORY OF DEMAND AND SUPPLY–Business Economics and Business commercial knowledge for CA foundation CPT students. we also provide PDF file at the end.

THEORY OF DEMAND AND SUPPLY

What we will study in this chapter: THEORY OF DEMAND AND SUPPLY

UNIT 1: LAW OF DEMAND AND ELASTICITY OF DEMAND

LEARNING OUTCOMES

At the end of this Unit, you should be able to:

♦       Explain the Meaning of Demand.

♦       Describe what Determines Demand.

♦       Explain the Law of Demand.

♦       Explain the Difference between Movement along the Demand Curve and Shift of the Demand Curve.

♦       Define and measure elasticity.

♦       Apply the concepts of price, cross and income elasticities.

♦       Explain the determinants of elasticity.

♦       Explain the importance of demand forecasting in business.

♦       Describe the various demand forecasting techniques.

Consider the following hypothetical situation:

Aroma Tea Limited is considering diversifying its business. A meeting of the board of directors is called. While discussing the matter, Rajeev Aggarwal, the CEO of Aroma Tea Limited asks, Sanjeev Bhandari, the marketing head, “What do you think Sanjeev, should we enter into green tea also? What does the market pulse say? Who all are there in this market? How will the demand for green tea affect the demand for our black tea? Is green tea a luxury good or is it a necessity now? What are the key determinants of the demand for green tea? Will coffee drinkers or soft drinkers shift to green tea? The answers to these questions will help us better understand how to price and position our brand in the market. “Before we rush into this line, I want a report on exactly why you believe green tea will be the star of our company in the coming five years?”

As an entrepreneur of a firm or as a manager of a company, you would often face situations in which you have to answer questions similar to the above. The answers to these and a thousand other questions can be found in the theory of demand and supply.

The market system is governed by market mechanisms. In a market system, the price of a commodity or service is determined by the forces of demand and supply. Since business firms produce goods and services to be sold in the market, they have to understand and be responsive to the needs of the customers. While buyers constitute the demand side of the market, sellers make the supply side of that market. The quantity that consumers buy at a given price determines the size of the market. As we are aware, as far as the firm is concerned, the size of the market is a significant determinant of its prospects. A thorough understanding of demand and supply theory is therefore essential for any business firm.

We shall study the theory of demand in this Unit. The theory of supply will be discussed in Unit-3.

1.0 MEANING OF DEMAND

The concept ‘demand’ refers to the quantity of a good or service that consumers are willing and able to purchase at various prices during a given period of time. It is to be noted that demand, in Economics, is something more than the desire to purchase, though the desire is one element of it. A beggar, for instance, may desire food, but due to lack of means to purchase it, his demand is not effective. Thus, effective demand for a thing depends on (i) desire (ii) means to purchase and (iii) willingness to use those means for that purchase. Unless desire is backed by purchasing power or ability to pay, and willingness to pay, it does not constitute demand. Effective demand alone would figure in economic analysis and business decisions.

Two things are to be noted about the quantity demanded.

1. The quantity demanded is always expressed at a given price. At different prices, different quantities of a commodity are generally demanded.
2. The quantity demanded is a flow. We are concerned not with a single isolated purchase, but with a continuous flow of purchases and we must, therefore, express demand as ‘so much per period of time’ i.e., one thousand dozens of oranges per day, seven thousand dozens of oranges per week and so on.

In short “By demand, we mean the various quantities of a given commodity or service which consumers would buy in one market during a given period of time, at various prices, or at various incomes, or at various prices of related goods”.

1.1 WHAT DETERMINES DEMAND?

Knowledge of the determinants of demand for a product and the nature of the relationship between demand and its determinants is essential for a business firm for estimating the market demand for its products. There are a number of factors which influence demand for a commodity. All of these factors are not equally important. Moreover, some of these factors cannot be easily measured or quantified. The important factors that determine demand are given below.

factors that determine demand

(i) Price of the commodity: Ceteris paribus i.e. other things being equal, the demand for a commodity is inversely related to its price. It implies that a rise in the price of a commodity brings about a fall in the quantity purchased and vice-versa. This happens because of income and substitution effects.

(ii) Price of related commodities: Related commodities are of two types: (a) complementary goods and (ii) competing for goods or substitutes. Complementary goods are those goods which are consumed together or simultaneously. For example; tea and sugar, automobile and petrol and pen and ink. When two commodities are complements, a fall in the price of one (other things being equal) will cause the demand for the other to rise. For example, a fall in the price of petrol-driven cars would lead to a rise in the demand for petrol. Similarly, a fall in the price of fountain pens will cause a rise in the demand for ink. The reverse will be the case when the price of a complement rises. Thus, we find that there is an inverse relationship between the demand for a good and the price of its complement.

Two commodities are called competing for goods or substitutes when they satisfy the same want and can be used with ease in place of one another. For example, tea and coffee, ink pen and ball pen are substitutes for each other and can be used in place of one another easily. When goods are substitutes, a fall in the price of one (ceteris paribus) leads to a fall in the quantity demanded of its substitutes. For example, if the price of tea falls, people will try to substitute it for coffee and demand more of it and less of coffee i.e. the demand for tea will rise and that of coffee will fall. Therefore, there is a direct or positive relation between the demand for a product and the price of its substitutes.

(iii) The income of the consumer: Other things being equal, the demand for a commodity depends upon the money income of the consumer. The purchasing power of the consumer is determined by the level of his income. In most cases, the larger the average money income of the consumer, the larger is the quantity demanded of a particular good.

The nature of the relationship between income and quantity demanded depends upon the nature of consumer goods. Most of the consumption goods fall under the category of normal goods. These are demanded in increasing quantities as consumers’ income increases. Household furniture, clothing, automobiles, consumer durables, and semi durables, etc. fall in this category. Essential consumer goods such as food grains, fuel, cooking oil, necessary clothing, etc., satisfy the basic necessities of life and are consumed by all individuals in a society. A change in consumers’ income, although will cause an increase in demand for these necessities, this increase will be less than proportionate to the increase in income. This is because as people become richer, there is a relative decline in the importance of food and other nondurable goods in the overall consumption basket and a rise in the importance of durable goods such as a TV, car, house, etc.

There are some commodities for which the quantity demanded rises only up to a certain level of income and decreases with an increase in money income beyond this level. These goods are called inferior goods. A same good may be normal for one condition and may be inferior in another. For example Bajra may become an inferior good for a person when his income increases above a certain level and he can now afford better substitutes such as wheat. Demand for luxury goods and prestige goods arise beyond a certain level of consumers’ income and keep rising as income increases.

Business managers should be fully aware of the nature of goods which they produce (or the nature of need which their products satisfy) and the nature of the relationship of quantities demanded with changes in consumer incomes. For assessing the current as well as future demand for their products, they should also recognize the movements in the macroeconomic variables that affect the incomes of the consumers.

(iv) Tastes and preferences of consumers: The demand for a commodity also depends upon the tastes and preferences of consumers and changes in them over a period of time. Goods which are modern or more in fashion command higher demand than goods which are of old design and out of fashion. Consumers may perceive a product as obsolete and discard it before it is fully utilized and prefer another good which is currently in fashion. For example, there is greater demand for LCD/LED televisions and more and more people are discarding their ordinary television sets even though they could have used it for some more years.

‘Demonstration effect’ or ‘bandwagon effect’ plays an important role in determining the demand for a product. An individual’s demand for LCD/LED television may be affected by his seeing one in his neighbor’s or friend’s house, either because he likes what he sees or because he figures out that if his neighbor or friend can afford it, he too can. A person may develop a taste or preference for wine after tasting some, but he may also develop it after discovering that serving it enhances his prestige. On the contrary, when a product becomes common among all, some people decrease or altogether stop its consumption. This is called ‘snob effect’ Highly-priced goods are consumed by status-seeking rich people to satisfy their need for conspicuous consumption. This is called the ‘Veblen effect’ (named after the American economist Thorstein Veblen). In any case, people have tastes and preferences and these change, sometimes, due to external and sometimes, due to internal causes and influence demand.

Knowledge regarding tastes and preferences is valuable for the manufacturers as it would help them plan production appropriately and design new models of products and services to suit the changing tastes and needs of the customers.

(v)   Consumers’ Expectations:

Consumers’ expectations regarding future prices, income, supply conditions, etc. influence current demand. If consumers expect an increase in future prices, an increase in income and shortages in supply, more quantities will be demanded. If they expect a fall in price, they will postpone their purchases of nonessential commodities and therefore, the current demand for them will fall.

Other factors: Apart from the above factors, the demand for a commodity depends upon the following factors:

(a)  Size of the population: Generally, the larger the size of the population of a country or a region, the greater is the demand for commodities in general.

(b)  Composition of the population: If there are more old people in a region, the demand for spectacles, walking sticks, etc. will be high. Similarly, if the population consists of more children, demand for toys, baby foods, toffees, etc. will be more.

(c)  The level of National Income and its Distribution: The level of national income is a crucial determinant of market demand. Higher the national income, higher will be the demand for all normal goods and services. The wealth of a country may be unevenly distributed so that there are a few very rich people while the majority are very poor. Under such conditions, the propensity to consume of the country will be relatively less, because the propensity to consume of the rich people is less than that of the poor people. Consequently, the demand for consumer goods will be comparatively less. If the distribution of income is more equal, then the propensity to consume the country as a whole will be relatively high indicating higher demand for goods.

1. d) Consumer-credit facility and interest rates: Availability of credit facilities induces people to purchase more than what their current incomes permit them. Credit facilities mostly determine the demand for durable goods which are expensive and require bulk payments at the time of purchase. Low rates of interest encourage people to borrow and therefore demand will be more.

Apart from above, factors such as government policy in respect of taxes and subsidies, business conditions, wealth, socioeconomic class, group, level of education, marital status, weather conditions, salesmanship and advertisements, habits, customs, and conventions also play an important role in influencing demand.

Demand Function

As we know, a function is a symbolic statement of a relationship between the dependent and the independent variables.

The demand function states the relationship between the demand for a product (the dependent variable) and its determinants (the independent or explanatory variables). A demand function may be expressed as follows:

D_x=f (P_x M, P_y P_C T, A)

Where   D_x the quantity demanded of product X

P_x is the price of the commodity

M is the money income of the consumer

P_y is the price of its substitutes

P_C is the price of its complementary goods

T is consumer tastes, and preferences

A is advertisement expenditure

1.2 LAW OF DEMAND

Most of us have an implicit understanding of the law of demand. The law of demand is one of the most important laws of economic theory. The law states the nature of the relationship between the quantity demanded of a product and its price. According to the law of demand, other things being equal, if the price of a commodity falls, the quantity demanded of it will rise and if the price of a commodity rises, its quantity demanded will decline. Thus, there is an inverse relationship between price and quantity demanded, ceteris paribus. The other things which are assumed to be equal or constant are the prices of related commodities, the income of consumers, tastes and preferences of consumers, and such other factors which influence demand. If these factors which determine demand also undergo a change, then the inverse price-demand relationship may not hold good. For example, if the income of consumers increases, then an increase in the price of a commodity, may not result in a decrease in the quantity demanded of it. Thus, the constancy of these other factors is an important assumption of the law of demand.

Definition of the Law of Demand

Prof. Alfred Marshall defined the Law thus: “The greater the amount to be sold, the smaller must be the price at which it is offered in order that it may find purchasers or in other words, the amount demanded increases with a fall in price and diminishes with a rise in price”.

The Law of Demand may be illustrated with the help of a demanding schedule and a demand curve.

1.2.0 Demand Schedule

A demand schedule is a table that presents the different prices of a good and the corresponding quantity demanded per unit of time. To illustrate the relation between the quantity of a commodity demanded and its price, we may take a hypothetical data for prices and quantities of commodity X. A demand schedule is drawn upon the assumption that all the other influences remain unchanged. It thus attempts to isolate the influence exerted by the price of the goods upon the amount sold.

Table 1: Demand schedule of an individual consumer

When the price of commodity X is Rs. 5 per unit, the consumer purchases 10 units of the commodity. When the price falls to Rs. 4, he purchases 15 units of the commodity. Similarly, when the price further falls, the quantity demanded by him goes on rising until, at price Rs. 1, the quantity demanded by him rises to 60 units. The above table depicts an inverse relationship between price and quantity demanded; as the price of the commodity X goes on rising, its demand goes on falling.

Demand curve: A demand curve is a graphical presentation of the demand schedule. It is obtained by plotting a demanding schedule. We can now plot the data from Table 1 on a graph with price on the vertical axis and quantity on the horizontal axis. In Fig. 1, we have shown such a graph and plotted the five points corresponding to each price-quantity combination shown in Table 1. Point A shows the same information as the first row of Table 1, that at Rs. 5 per unit, only 10 units of X will be demanded. Point E shows the same information as does the last row of the table when the price is Re 1, the quantity demanded will be 60 units.

Demand Curve

Fig. 1: Demand Curve for Commodity X

We now draw a smooth curve through these points. The curve is called the demand curve for commodity ‘X’. It has a negative slope. The curve shows the quantity of ‘X’ that a consumer would like to buy at each price; its downward slope indicates that the quantity of ‘X’ demanded increases as its price falls. Briefly put, more of goodwill be purchased at lower prices. Thus the downward sloping demand curve is in accordance with the law of demand which, as stated above, describes an inverse price-demand relationship.

1.2.1 Market Demand Schedule

Market demand is defined as the sum of individual demands for a product at a price per unit of time. In other words, it is the total quantity that all consumers of a commodity are willing to buy per unit of time at a given price, all other things remaining constant. When we add up the various quantities demanded by different consumers in the market, we can obtain the market demand schedule. How the summation is done is illustrated in Table 2. Suppose there are only three individual buyers of the goods in the market namely, P, Q and R. Table 2 shows their individual demands at various prices.

Table 2: Market Demand Schedule

Quantity demanded by

When we add the quantities demanded at each price by consumers P, Q, and R, we get the total market demand. Thus, when the price is Rs. 5 per unit, the market demand for commodity X is 30 units (i.e. 10+8+12). When the price falls to Rs. 4, the market demand is 45 units. At Rs. 1,140 units are demanded in the market. The market demand schedule also indicates the inverse relationship between price and quantity demanded of X.

market demand curve

Fig. 2: Market Demand Curve

Market Demand Curve: If we plot the market demand schedule on a graph, we get the market demand curve. Figure 2 shows the market demand curve for commodity X The market demand curve, like the individual demand curve, slopes downwards to the right because it is nothing but the lateral summation of individual demand curves. Besides, as the price of the good falls, it is very likely that new buyers will enter the market which will further raise the quantity demanded of the good.

1.2.2   Rationale of the Law of Demand

Normally, the demand curves slope downwards. This means people buy more at lower prices. We shall now try to understand why do demand curves slope downwards? Different economists have given different explanations for the operation of the law of demand. These are given below:

(1)  Law of diminishing marginal utility: A consumer is in equilibrium (i.e. maximizes his satisfaction) when the marginal utility of the commodity and its price equalize. According to Marshall, the consumer has diminishing utility for each additional unit of a commodity and therefore, he will be willing to pay only less for each additional unit. A rational consumer will not pay more for lesser satisfaction. He is induced to buy additional units only when the prices are lower. The operation of diminishing marginal utility and the act of the consumer to equalize the utility of the commodity with its price result in a downward sloping demand curve.

(2)  Price effect: The total fall in quantity demanded due to an increase in price is termed as Price effect. The law of demand can be dubbed as a “Negative Price Effect” with some exceptions. The price effect manifests itself in the form of income effect and substitution effect.

(a)  Substitution effect: Hicks and Allen have explained the law in terms of the substitution effect and income effect. When the price of a commodity falls, it becomes relatively cheaper than other commodities. Assuming that the prices of all other commodities remain constant, it induces consumers to substitute the commodity whose price has fallen for other commodities which have now become relatively expensive. The result is that the total demand for the commodity whose price has fallen increases. This is called the substitution effect.

(b)  Income effect: When the price of a commodity falls, the consumer can buy the same quantity of the commodity with lesser money or he can buy more of the same commodity with the same amount of money. In other words, as a result of the fall in the price of the commodity, consumer’s real income or purchasing power increases. This increase in the real income induces him to buy more of that commodity. Thus, the demand for that commodity (whose price has fallen) increases. This is called the income effect.

(3)  Arrival of new consumers: When the price of a commodity falls, more consumers start buying it because some of those who could not afford to buy it earlier may now be able to buy it. This raises the number of consumers of a commodity at a lower price and hence the demand for the commodity in question.

(4)  Different uses: Certain commodities have multiple uses. If their prices fall, they will be used for varied purposes and therefore their demand for such commodities will increase. When the price of such commodities is high (or rises) they will be put to limited uses only. Thus, different uses of a commodity make the demand curve slope downwards reacting to changes in price. For example, Olive oil can be used for cooking as well as for cosmetic purposes. So if the price of olive oil rises we can limit our usage and thus the demand will fall.

1.2.3   Exceptions to the Law of Demand

According to the law of demand, other things being equal, more of a commodity will be demanded at lower

prices than at higher prices. The law of demand is valid in most cases; however, there are certain cases where

this law does not hold good. The following are important exceptions to the law of demand.

(i)   Conspicuous goods: Articles of prestige value or snob appeal or articles of conspicuous consumption are demanded only by the rich people and these articles become more attractive if their prices go up. Such articles will not conform to the usual law of demand. This was found out by Veblen in his doctrine of “Conspicuous Consumption” and hence this effect is called the Veblen effect or prestige goods effect. Veblen effect takes place as some consumers measure the utility of a commodity by its price i.e., if the commodity is expensive they think that it has got more utility. As such, they buy less of this commodity at a low price and more of it at a high price. Diamonds are often given as an example of this case. Higher the price of diamonds, the higher is the prestige value attached to them and hence higher is the demand for them.

(ii)  Giffen goods: Sir Robert Giffen, a Scottish economist, and statistician, was surprised to find out that as the price of bread increased, the British workers purchased more bread and 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 caused such a large decline in the purchasing power of the poor people that they were forced to cut down the consumption of meat and other more expensive foods. Since bread, even when its price was higher than before, was still the cheapest food article, people consumed more of it and not less when its price went up.

Such goods which exhibit direct price-demand relationship are called ‘Giffen goods’. Generally, those goods which are inferior, with no close substitutes easily available and which occupy a substantial place in the consumer’s budget are called ‘Giffen goods’. All Giffen goods are inferior goods, but all inferior goods are not Giffen goods. Inferior goods ought to have a close substitute. Moreover, the concept of inferior goods is related to the income of the consumer i.e. the quantity demanded of an inferior good falls as income rises, price remaining constant as against the concept of Giffen goods which is related to the price of the product itself. Examples of Giffen goods are coarse grains like bajra, low-quality rice, and wheat, etc.

(iii) Conspicuous necessities: The demand for certain goods is affected by the demonstration effect of the consumption pattern of a social group to which an individual belongs. These goods, due to their constant usage, become necessities of life. For example, in spite of the fact that the prices of television sets, refrigerators, coolers, cooking gas etc. have been continuously rising, their demand does not show any tendency to fall.

(iv) Future expectations about prices: It has been observed that when the prices are rising, households expecting that the prices in the future will be still higher, tend to buy larger quantities of such commodities. For example, when there is wide-spread drought, people expect that prices of food grains would rise in the future. They demand greater quantities of food grains as their price rises. However, it is to be noted that here it is not the law of demand which is invalidated but there is a change in one of the factors which was held constant while deriving the law of demand, namely change in the price expectations of the people.

(v)  The law has been derived assuming consumers to be rational and knowledgeable about market- conditions. However, at times, consumers tend to be irrational and make impulsive purchases without any rational calculations about the price and usefulness of the product and in such contexts the law of demand fails.

(vi) Demand for necessaries: The law of demand does not apply much in the case of necessaries of life. Irrespective of price changes, people have to consume the minimum quantities of necessary commodities.

Similarly, in practice, a household may demand a larger quantity of a commodity even at a higher price because it may be ignorant of the ruling price of the commodity. Under such circumstances, the law will not remain valid. For example Food, power, water, gas.

(vii) Speculative goods: In the speculative market, particularly in the market for stocks and shares, more will be demanded when the prices are rising and less will be demanded when prices decline.

The law of demand will also fail if there is any significant change in other factors on which demand for a commodity depends. If there is a change in income of the household, or in prices of the related commodities or in tastes and fashion, etc., the inverse demand and price relation may not hold good.

1.3 EXPANSION AND CONTRACTION OF DEMAND

The demand schedule, demand curve and the law of demand all show that when the price of a commodity falls, its quantity demanded increases, other things being equal. When, as a result of a decrease in price, the quantity demanded increases, in Economics, we say that there is an expansion of demand and when, as a result of the increase in price, the quantity demanded decreases, we say that there is the contraction of demand. For example, suppose the price of apples at any time is Rs. 100/ per kilogram and a consumer buys one kilogram at that price. Now, if other things such as income, prices of other goods and tastes of the consumers remain the same but the price of apples falls to Rs. 80 per kilogram and the consumer now buy two kilograms of apples, we say that there is a change in quantity demanded or there is an expansion of demand. On the contrary, if the price of apples rises to Rs. 150 per kilogram and the consumer then buys only half a kilogram, we say that there is a contraction of demand.

The phenomena of expansion and contraction of demand are shown in Figure 3. The figure shows that when the price is OP, the quantity demanded is OM, given other things equal. If, as a result of the increase in price (OP”), the quantity demanded falls to OL, we say that there is ‘a fall in quantity demanded’ or ‘contraction of demand’ or ‘an upward movement along the same demand curve’. Similarly, as a result of fall in price to OP’, the quantity demanded rises to ON, we say that there is ‘expansion of demand’ or ‘a rise in quantity demanded ‘or’ a downward movement on the same demand curve.’

Expansion and Contraction of Demand

Fig. 3 : Expansion and Contraction of Demand

1.4 INCREASE AND DECREASE IN DEMAND

Till now we have assumed that other determinants of demand remain constant when we are analyzing demand for a commodity. It should be noted that expansion and contraction of demand take place as a result of changes in the price while all other determinants of price viz. income, tastes, propensity to consume and price of related goods remain constant. The ‘other factors remaining constant’ means that the position of the demand curve remains the same and the consumer moves downwards or upwards on it. What happens if there is a change in consumers’ tastes and preferences, income, the prices of the related goods or other factors on which demand depends? Let us consider the demand for commodity X:

Table 3 shows the possible effect of an increase in the income of the consumer on the quantity demanded of commodity X.

Table 3 : Two demand schedules for commodity X

two demand curves with different incomes

Fig. 4: Figure showing two demand curves with different incomes

These new data are plotted in Figure 4 as demand curve D’D’ along with the original demand curve DD. We say that the demand curve for X has shifted [in this case it has shifted to the right]. The shift from DD to D’D’ indicates an increase in the desire to purchase ‘X’ at each possible price. For example, at the price of Rs. 4 per unit, 15 units are demanded when the average household income is Rs. 20,000 per month. When the average household income rises to Rs. 25,000 per month, 20 units of X are demanded at price Rs. 4. A rise in income thus shifts the demand curve to the right, whereas a fall in income will have the opposite effect of shifting the demand curve to the left.

Rightward shift in the Demand Curve Fig. 5(a): Rightward shift in the Demand Curve	A leftward shift in the demand curve Fig. 5(b): Leftward shift in the demand curve

5(a) A rightward shift in the demand curve (when more is demanded at each price) can be caused by a rise in income, a rise in the price of a substitute, a fall in the price of a complement, a change in tastes in favor of this commodity, an increase in population, and a redistribution of income to groups who favor this commodity.

5(b) A leftward shift in the demand curve (when less is demanded at each price) can be caused by a fall in income, a fall in the price of a substitute, a rise in the price of a complement, a change in tastes against this commodity, a decrease in population, and a redistribution of income away from groups who favor this commodity.

1.5 MOVEMENTS ALONG THE DEMAND CURVE VS. SHIFT OF DEMAND CURVE

It is important for business decision-makers to understand the distinction between a movement along a demand curve and a shift of the whole demand curve.

A movement along the demand curve indicates changes in the quantity demanded because of price changes, other factors remaining constant. A shift of the demand curve indicates that there is a change in demand at each possible price because one or more other factors, such as incomes, tastes or the price of some other goods, have changed.

Thus, when an economist speaks of an increase or a decrease in demand, he refers to a shift of the whole curve because one or more of the factors which were assumed to remain constant earlier have changed. When economists speak of change in quantity demanded the means movement along the same curve (i.e., expansion or contraction of demand) which has happened due to fall or rise in the price of the commodity.

In short ‘change in demand’ represents shift of the demand curve to right or left resulting from changes in factors such as income, tastes, prices of other goods, etc. and ‘change in quantity demanded’ represents movement upwards or downwards on the same demand curve resulting from a change in the price of the commodity.

When demand increases due to factors other than price, firms can sell more at the existing prices resulting in increased revenue. The objective of advertisement and all other sales promotion activities by any firm is to shift the demand curve to the right and to reduce the elasticity of demand. (The latter will be discussed in the next section). However, the additional demand is not free of cost as firms have to incur expenditure on advertisement and sales promotion devices.

1.6 ELASTICITY OF DEMAND

Till now we were concerned with the direction of the changes in prices and quantities demanded. From the point of view of a business firm, it is more important to know the extent of the relationship or the degree of responsiveness of demand to changes in its determinants. Now we will try to measure these changes or to say, we will try to answer the question “by how much does demand change due to a change in price”?

Consider the following situations:

(1)  As a result of a fall in the price of radio from Rs. 500 to Rs. 400, the quantity demanded increases from 100 radios to 150 radios.

(2)  As a result of the fall in the price of wheat from Rs. 20 per kilogram to Rs. 18 per kilogram, the quantity demanded increases from 500 kilograms to 520 kilograms.

(3)  As a result of the fall in the price of salt from Rs. 9 per kilogram to Rs. 7.50, the quantity demanded increases from 1000 kilograms to 1005 kilograms.

What do you notice? You notice that as a result of a fall in the price of radios, the quantity demanded of radios increases. The same is the case with wheat and salt. Thus, we can say that demand for radios, wheat, and salt all respond to price changes. Then, what is the difference? The difference lies in the degree of response of demand which can be found out by comparing the percentage changes in prices and quantities demanded. Here lies the concept of elasticity.

Definition: Elasticity of demand is defined as the responsiveness of the quantity demanded of a good to changes in one of the variables on which demand depends. More precisely, the elasticity of demand is the percentage change in quantity demanded divided by the percentage change in one of the variables on which demand depends.

These variables are the price of the commodity, prices of the related commodities, the income of the consumers and other factors on which demand depends. Thus, we have price elasticity, cross elasticity, income elasticity, advertisement elasticity and elasticity of substitution. It is to be noted that when we talk of elasticity of demand, unless and until otherwise mentioned, we talk of price elasticity of demand. In other words, it is the price elasticity of demand which is usually referred to as elasticity of demand.

1.6.0 Price Elasticity

Price elasticity of demand expresses the response of quantity demanded of a good to a change in its price, given the consumer’s income, tastes, and prices of all other goods. In other words, it is measured as the percentage change in quantity demanded divided by the percentage change in price, other things remaining equal. That is,

Price Elasticity = Ep = 

Or

Ep =  OR Ep =  ×

In symbolic terms

Ep

where  stands for price elasticity

stands for quantity

stands for price

stands for a very small change,

strictly speaking, the value of price elasticity varies from minus infinity to approach zero from the negative sign, because it has negative other words since price and quantity are inversely related (with a few exceptions) price elasticity is negative. But, for the sake of convenience, we ignore the negative sign and consider only the numerical value of the elasticity. Thus if a 1 % change in price leads to 2% change in quantity demanded of good A and 4% change in quantity demanded of good B, then we get elasticity of A and B as 2 and 4 respectively, showing that demand for B is more elastic or responsive to price changes than that of A. Had we considered minus signs, we would have concluded that the demand for A is more elastic than that for B, which is not correct. Hence, by convention, we take the absolute value of price elasticity and draw conclusions.

A few examples for price elasticity of demand case as follows:

Illustration 1:- The price of a commodity decreases from Rs. 6 to Rs. 4 and quantity demanded of the good increases from 10 units to 15 units. Find the coefficient of price elasticity.

Solution: Price elasticity = (-)    Δ q / Δ p × p/q = 5/2 × 6/10    = (-) 1.5

Illustration 2:- A 5% fall in the price of a good      leads to a    15% rise in its demand. Determine the elasticity and comment on its value.

Solution

Price elasticity =

= 15%/5%

= 3

Comment: The good in question has elastic demand.

Illustration 3:- The price of a good decreased from Rs. 100 to Rs. 60 per unit. If the price elasticity of demand for it is 1.5 and the original quantity demanded is 30 units, calculate the new quantity demanded.

Solution:-

Ep = ∆q/∆p *p/q, Here 1.5 =  ×

∆q =  = 18

Therefore new quantity demanded = 30+18 = 48 units.

Point elasticity: In point elasticity, we measure elasticity at a given point on a demand curve. The concept of point elasticity is used for measuring price elasticity where the change in price is infinitesimal. Point elasticity makes use of derivative rather than finite changes in price and quantity. It may be defined as:

Ep =

where is the derivative of quantity with respect to the price at a point on the demand curve, and p and q are the price and quantity at that point? Point elasticity is, therefore, the product of the price-quantity ratio at a particular point on the demand curve and the reciprocal of the slope of the demand line.

It is to be noted that elasticity is different at different points on the same demand curve. Given a straight-line demand curve tT, point elasticity at any point say R can be found by using the formula

=

Elasticity at a point on the demand curve

Fig. 6: Elasticity at a point on the demand curve

Using the above formula we can get elasticity at various points on the demand curve.

Elasticity at different points on the demand curve

Fig.: 6(a): Elasticity at different points on the demand curve

Arc Elasticity

Fig. 7: Arc Elasticity

Thus, we see that as we move from T towards t, elasticity goes on increasing. At the mid-point it is equal to one, at point t it is infinity and at T it is zero.

Arc-elasticity: When the price change is somewhat larger or when price elasticity is to be found between two prices [or two points on the demand curve say, A and B in figure 7], the question arises which price and quantity should be taken as base. This is because elasticities found by using original price and quantity figures as the base will be different from the one derived by using new price and quantity figures. Therefore, in order to avoid confusion, generally, the mid-point method is used i.e. the averages of the two prices and quantities are taken as (i.e. original and new) base. The arc elasticity can be found out by using the formula:

where p₁, q₁ are the original price and quantity and p₂, q₂ are the new ones.

Thus, if we have to find elasticity of radios between:

p₁ = Rs.500 q₁ = 100

p₂ = Rs. 400 q₂ = 150

We will use the formula

Ep

Or  or

Interpretation of the numerical values of elasticity of demand

The numerical value of elasticity of demand can assume any value between zero and infinity.

Elasticity is zero if there is no change at all in the quantity demanded when price changes i.e. when the quantity demanded does not respond at all to a price change.

Elasticity is one, or unitary if the percentage change in quantity demanded is equal to the percentage change in price.

Elasticity is greater than one when the percentage change in quantity demanded is greater than the percentage change in price. In such a case, demand is said to be elastic.

Elasticity is less than one when the percentage change in quantity demanded is less than the percentage change in price. In such a case, demand is said to be inelastic.

Elasticity is infinite when a ‘small price reduction raises the demand from zero to infinity. Under such a case, consumers will buy all that they can obtain the commodity at some price. If there is a slight increase in price, they would not buy anything from a particular seller. This type of demand curve is found in a perfectly competitive market.

Demand curve of zero

Fig. 8(a): Demand curve of zero, unitary and infinite elasticity

Elasticity is greater than one (Ep > 1) Elasticity is less than one (Ep < 1)

Demand curves of greater than one and less than one

Fig. 8(b): Demand curves of greater than one and less than one elasticities

Table 4: Elasticity measures, meaning, and nomenclature

Now that we are able to classify goods according to their price elasticity, let us see whether the goods which we considered in our example on page 2.37, are price elastic or inelastic.

What do we note in the above hypothetical example? We note that the demand for radios is quite elastic, while demand for wheat is quite inelastic and the demand for salt is almost the same even after a reduction in price.

Generally, in real-world situations also, we find that demand for goods like radios, TVs, refrigerators, fans, etc. is elastic; demand for goods like wheat and rice is inelastic, and demand for salt is highly inelastic or perfectly inelastic. Why do we find such a difference in the behavior of consumers in respect of different commodities? We shall explain later at length those factors which are responsible for the differences in elasticity of demand for various goods. First, we will consider another method of calculating price-elasticity which is called the total outlay method.

Total Outlay Method of Calculating Price Elasticity: The price elasticity of demand for a commodity and the total expenditure or outlay made on it are greatly related to each other. As the total expenditure (price of the commodity multiplied by the quantity of that commodity purchased) made on a commodity is the total revenue received by the seller (price of the commodity multiplied by quantity of that commodity sold of that commodity), we can say that the price elasticity and total revenue received are closely related to each other. By analyzing the changes in total expenditure (or revenue), we can know the price elasticity of demand for the good. However, it should be noted that by this method we can only say whether the demand for a good is elastic or inelastic; we cannot find out the exact coefficient of price elasticity.

When, as a result of the change in the price of a good, the total expenditure on the good or total revenue received from that good remains the same, the price elasticity for the good is equal to unity. This is because total expenditure made on the good can remain the same only if the proportional change in quantity demanded is equal to the proportional change in price. Thus, if there is a 100% increase in the price of a good and if the price elasticity is unitary, a total expenditure of the buyer on the good or the total revenue received from it will remain unchanged.

When, as a result of increase in the price of a good, the total expenditure made on the good or the total revenue received from that good falls or when as a result of decrease in price, the total expenditure made on the good or total revenue received from that good increases, we say that price elasticity of demand is greater than unity. In our example of radios, as a result of a fall in the price of radios from Rs. 500 to Rs. 400, the total revenue received from radios increases from Rs. 50,000 (500 x 100) to Rs. 60,000 (400 x 150), indicating elastic demand for radios. Similarly, had the price of radios increased from Rs. 400 to Rs. 500, the demand would have fallen from 150 radios to 100 radios indicating a fall in the total revenue received from Rs. 60,000 to Rs. 50,000 showing elastic demand for radios.

When, as a result of increase in the price of a good, the total expenditure made on the good or total revenue received from that good increases or when as a result of decrease in its price, the total expenditure made on the good or total revenue received from that good falls, we say that price elasticity of demand is less than unity. In our example of wheat, as a result of fall in the price of wheat from Rs. 20 per kg. to Rs. 18 per kg., the total revenue received from wheat falls from 10,000 (20 x 500) to Rs. 9360 (18 x 520) indicating inelastic demand for wheat. Similarly, we can show that as a result of an increase in the price of wheat from Rs. 18 to Rs. 20 per kg, the total revenue received from wheat increased from Rs. 9360 to Rs. 10,000 indicating inelastic demand for wheat. The whole argument can be summarized in the following table.

Table 5: The Relationship between Price elasticity and Total Revenue (TR)

Demand

Determinants of Price Elasticity of Demand: In the above section we have explained what is price elasticity and how it is measured. Now an important question is: what are the factors which determine whether the demand for a good is elastic or inelastic? We will consider the following important determinants of price elasticity.

(1) Availability of substitutes: One of the most important determinants of elasticity is the degree of availability of close substitutes. Some commodities like butter, cabbage, Maruti Car, Coca Cola, etc. have close substitutes. There are margarine, other green vegetables, Santro or other cars, Pepsi or any other cold drink respectively. A change in the price of these commodities, the prices of the substitutes remaining constant, can be expected to cause quite a substantial substitution – a fall in price leading consumers to buy more of the commodity in question and a rise in price leading consumers to buy more of the substitutes. Commodities such as salt, housing, and all vegetables taken together, have few, if any, satisfactory substitutes and a rise in their prices may cause a smaller fall in their quantity demanded. Thus, we can say that goods that typically have close or perfect substitutes have highly elastic demand curves. Moreover, the wider the range of substitutes available, the greater will be the elasticity. For example, toilet soaps, toothpaste, etc have a wide variety of brands and each brand is a close substitute for the other.

It should be noted that while as a group, a good or service may have inelastic demand, but when we consider its various brands, we say that a particular brand has elastic demand. Thus, while the demand for a generic good like petrol is inelastic, the demand for Indian Oil’s petrol is elastic. Similarly, while there are no general substitutes for health care, there are substitutes for one doctor or hospital. Likewise, the demand for common salt and sugar is inelastic because good substitutes are not available for these.

(2)  Position of a commodity in a consumer’s budget: The greater the proportion of income spent on a commodity; generally the greater will be its elasticity of demand and vice-versa. The demand for goods like common salt, matches, buttons, etc. tend to be highly inelastic because a household spends only a fraction of their income on each of them. On the other hand, demand for goods like clothing tends to be elastic since households generally spend a good part of their income on clothing.

(3)  Nature of the need that a commodity satisfies: In general, luxury goods are price elastic while necessities are price inelastic. Thus, while the demand for television is relatively elastic, the demand for food and housing, in general, is inelastic. If it is possible to postpone the consumption of a particular good, such goodwill has elastic demand. Consumption of necessary goods cannot be postponed and therefore, their demand is inelastic.

(4)  A number of uses to which a commodity can be put: The more the possible uses of a commodity, the greater will be its price elasticity and vice versa. When the price of a commodity that has multiple uses decreases, people tend to extend their consumption to its other uses. To illustrate, milk has several uses. If its price falls, it can be used for a variety of purposes like preparation of curd, cream, ghee, and sweets. But, if its price increases, its use will be restricted only to essential purposes like feeding the children and sick persons.

(5)  Time period: The longer the time-period one has, the more completely one can adjust. A simple example of the effect can be seen in motoring habits. In response to a higher petrol price, one can, in the short run, make fewer trips by car. In the longer run, not only can one make fewer trips, but he can purchase a car with a smaller engine capacity when the time comes for replacing the existing one. Hence one’s demand for petrol falls by more when one has made long term adjustments to higher prices.

(6)  Consumer habits: If a consumer is a habitual consumer of a commodity, no matter how much its price change, the demand for the commodity will be inelastic.

(7)  Tied demand: The demand for those goods which are tied to others is normally inelastic as against those whose demand is of autonomous nature. For example printers and ink cartridges.

(8)  Price range: Goods which are in very high price range or in very low price range have inelastic demand, but those in the middle range have elastic demand.

    Knowledge of the price elasticity of demand and the factors that may change it is of key importance to business managers because it helps them recognize the effect of a price change on their total sales and revenues. Firms aim to maximize their profits and their pricing strategy is highly decisive in attaining their goals. Price elasticity of demand for the goods they sell helps them in arriving at an optimal pricing strategy. If the demand for a firm’s product is relatively elastic, the managers need to recognize that lowering the price would expand the volume of sales, and result in an increase in total revenue. On the other hand, if demand were relatively inelastic, the firm may safely increase the price and thereby increase its total revenue as they know that the fall in sales would be less than proportionate. On the contrary, if demand is elastic, a price increase will lead to a decline in total revenue as a fall in sales would be more than proportionate.

Knowledge of price elasticity of demand is important for governments while determining the prices of goods and services provided by them, such as transport and telecommunication. Further, it also helps the governments to understand the nature of responsiveness of demand to the increase in prices on account of additional taxes and the implications of such responses on the tax revenues. The elasticity of demand explains why Governments are inclined to raise indirect taxes on those goods that have relatively inelastic demand, like alcohol and tobacco products.

1.6.1 Income Elasticity of Demand

Income elasticity of demand is the degree of responsiveness of quantity demanded of a good to changes in the income of consumers. In symbolic form,

E_i =

This can be given mathematically as follows:

E_i =  ÷

=  ×

=  ×

E_i = Income elasticity of demand

ΔQ = Change in demand

Q = Original demand

Y = Original money income

ΔY = Change in money income

There is a useful relationship between income elasticity for a good and the proportion of income spent on it. The relationship between the two is described in the following three propositions:

1. If the proportion of income spent on a good remains the same as income increases, then income elasticity for the good is equal to one.
2. If the proportion of income spent on a good increase as income increases, then the income elasticity for the good is greater than one.
3. If the proportion of income spent on a good decrease as income rises, then income elasticity for the good is less than one.

Income elasticity of goods reveals a few very important features of demand for the goods in question. If income elasticity is zero, it signifies that the demand for the good is quite unresponsive to changes in income. When income elasticity is greater than zero or positive, then an increase in income leads to an increase in demand for the good. This happens in the case of most of the goods and such goods are called normal goods. For all normal goods, income elasticity is positive. However, the degree of elasticity varies according to the nature of commodities. As against this, goods having negative income elasticity are known as inferior goods and their demand falls as income increases. The reason is that when income increases, consumers choose to consume superior substitutes. Another significant value of income elasticity is that of unity. When income elasticity of demand is equal to one, the proportion of income spent on goods remains the same as consumer’s income increases. This represents a useful dividing line. If the income elasticity for a good is greater than one, it shows that the good bulks larger in consumer’s expenditure as he becomes richer. Such goods are called luxury goods. On the other hand, if the income elasticity is less than one, it shows that the good is either relatively less important in the consumer’s eye or, it is a necessity.

The following examples will make the above concepts clear:

(a)   The income of a household rises by 10%, the demand for wheat rises by 5%.

(b)   The income of a household rises by 10%, the demand for T.V. rises by 20%.

(c)   The incomes of a household rises by 5%, the demand for bajra falls by 2%.

(d)   The income of a household rises by 7%, the demand for commodity X rises by 7%.

(e)   The income of a household rises by 5%, the demand for buttons does not change at all. Using the formula for income elasticity,

i.e. E_i =

we will find income-elasticity for various goods. The results are as follows:

It is to be noted that the words ‘luxury’, ‘necessity’, ‘inferior good’ do not signify the strict dictionary meanings here. In economic theory, we distinguish them in the manner shown above.

Knowledge of income elasticity of demand is very useful for a business firm in estimating future demand for its products. Knowledge of income elasticity of demand helps firms predict the outcome of a business cycle on its market demand. This enables the firm to carry out appropriate production planning and management.

1.6.2 Cross Elasticity of Demand

Price of Related Goods and Demand:

The demand for a particular commodity may change due to changes in the prices of related goods. These related goods may be either complementary goods or substitute goods. This type of relationship is studied under ‘Cross Demand’. Cross demand refers to the quantities of a commodity or service which will be purchased with reference to changes in price, not of that particular commodity, but of other inter-related commodities, other things remaining the same. It may be defined as the quantities of a commodity that consumers buy per unit of time, at different prices of a ‘related article’, ‘other things remaining the same’. The assumption ‘other things remaining the same’ means that the income of the consumer and also the price of the commodity in question will remain constant.

Substitute Products

In the case of substitute commodities, the cross demand curve slopes upwards (i.e. positively) showing that more quantities of a commodity, will be demanded whenever there is a rise in the price of a substitute commodity. In figure 9, the quantity demanded of tea is given on the X-axis. Y-axis represents the price of coffee which is a substitute for tea. When the price of coffee increases, due to the operation of the law of demand, the demand for coffee falls. The consumers will substitute tea in the place of coffee. The price of tea is assumed to be constant. Therefore, whenever there is an increase in the price of one commodity, the demand for the substitute commodity will increase.

Substitutes

Fig. 9: Substitutes

Complementary Goods

In the case of complementary goods, as shown in the figure below, a change in the price of goodwill have an opposite reaction on the demand for the other commodity which is closely related or complementary. For instance, an increase in demand for pen will necessarily increase the demand for ink. The same is the case with complementary goods such as bread and butter; car and petrol electricity and electrical gadgets etc. Whenever there is a fall in the demand for fountain pens due to a rise in prices of fountain pens, the demand for ink will fall, not because the price of ink has gone up, but because the price of the fountain pen has gone up. So, we find that there is an inverse relationship between the price of a commodity and the demand for its complementary good (other things remaining the same).

Complementary Goods

Fig. 10: Complementary Goods

A change in the demand for one good in response to a change in the price of another good represents the cross elasticity of demand of the former good for the latter good. Here, we consider the effect of changes in relative prices within a market on the pattern of demand.

Symbolically, (mathematically)

Where E_C stands for cross elasticity.

q_x stands for the original quantity demanded of X.

∆q_x stands for change in quantity demanded of X.

p_y stands for the original price of good Y.

∆p_y stands for a small change in the price of Y.

If two goods are perfect substitutes for each other, the cross elasticity between them is infinite. Greater the cross elasticity, the closer is the substitute. If two goods are totally unrelated, cross elasticity between them is zero.

If two goods are substitutes (like tea and coffee), the cross elasticity between them is positive, that is, in response to a rise in the price of one good, the demand for the other good rises. On the other hand, when two goods are complementary (tea and sugar) to each other, the cross elasticity between them is negative so that a rise in the price of one leads to a fall in the quantity demanded of the other. Higher the negative cross elasticity, higher will be the extent of complementarity.

However, one need not base the classification of goods on the basis of the above definitions. While the goods between which cross elasticity is positive can be called substitutes, the goods between which cross elasticity is negative are not always complimentary. This is because negative cross elasticity is also found when the income effect of the price change is very strong.

The concept of cross elasticity of demand is useful for a manager while making decisions regarding changing the prices of his products which have substitutes and complements. If cross elasticity to changes in the price of substitutes is greater than one, the firm may lose by increasing the prices and gain by reducing the prices of his products. With proper knowledge of cross elasticity, the firm can plan policies to safeguard against fluctuating prices of substitutes and complements.

Illustration 1:-The price of 1kg of tea is Rs. 30. At this price 5kg of tea is demanded. If the price of coffee rises from Rs. 25 toRs.35 per kg, the quantity demanded of tea rises from 5kg to 8kg. Find out the cross-price elasticity of tea.

Solution:-

=  ×  =  ×  = +1.5

The elasticity of demand for tea is +1.5 showing that the demand for tea is highly elastic with respect to coffee. The positive sign shows that tea and coffee are substitute goods.

Illustration 2:- The price of 1 kg of sugar is Rs. 50. At this price, 10 kg is demanded. If the price of tea falls from Rs.30 toRs.25 per kg, the consumption of sugar rises from 10 kg to 12 kg. Find out the cross-price elasticity and comment on its value.

Solution:-

=  ×  = (-) 1 -2

Since the elasticity is -1.2, we can say that sugar and tea are complimentary in nature.

1.6.3 Advertisement Elasticity

Advertisement elasticity of sales or promotional elasticity of demand is the responsiveness of a good’s demand to changes in the firm’s spending on advertising. The advertising elasticity of demand measures the percentage change in demand that occurs given a one percent change in advertising expenditure. Advertising elasticity measures the effectiveness of an advertisement campaign in bringing about new sales.

Advertising elasticity of demand is typically positive. The higher the value of advertising elasticity greater will be the responsiveness of demand to change in an advertisement. Advertisement elasticity varies between zero and infinity. It is measured by using the formula;

Ea =

Ea =

Where ΔQd denotes the change in demand.

ΔA denotes change in expenditure on advertisement.

Qd denotes initial demand.

A denotes initial expenditure on advertisement.

Elasticity            Interpretation

Ea = 0                Demand does not respond to an increase in advertisement expenditure.

Ea >0 but < 1    Change in demand is less than proportionate to the change in advertisement expenditure.

Ea = 1               Demand changes in the same proportion in which advertisement expenditure changes.

Ea > 1               Demand changes at a higher rate than change in advertisement expenditure.

As far as a business firm is concerned, the measure of advertisement elasticity is useful in understanding the effectiveness of advertising and in determining the optimum level of advertisement expenditure.

1.7 DEMAND FORECASTING

1.7.0 Meaning

Forecasting, in general, refers to knowing or measuring the status or nature of an event or variable before it occurs. Forecasting of demand is the art and science of predicting the probable demand for a product or a service at some future date on the basis of certain past behavior patterns of some related events and the prevailing trends in the present. It should be kept in mind that demand forecasting is no simple guessing, but it refers to estimating demand scientifically and objectively on the basis of certain facts and events relevant to forecasting.

1.7.1  Usefulness

The significance of demand or sales forecasting in the context of business policy decisions can hardly be overemphasized. The effectiveness of the plans of business managers depends upon the level of accuracy with which future events can be predicted. Forecasting of demand plays a vital role in the process of planning and decision-making, whether at the national level or at the level of a firm. The importance of demand forecasting has increased all the more on account of mass production and production in response to demand. A good forecast enables the firm to perform efficient business planning. Forecasts offer information for budgetary planning and cost control in functional areas of finance and accounting. Good forecasts help inefficient production planning, process selection, capacity planning, facility layout, and inventory management. A firm can plan production schedule well in advance and obtain all necessary resources for production such as inputs, and finances. Capital investments can be aligned to demand expectations and this will check the possibility of overproduction and underproduction, excess of unused capacity and idle resources. Marketing relies on sales forecasting in making key decisions. Demand forecasts also provide the necessary information for the formulation of suitable pricing and advertisement strategies.

It is said that no forecast is completely fool-proof and correct. However, the very process of forecasting helps in evaluating various forces that affect demand and is in itself a reward because it enables the forecasting authority to know about various forces relevant to the study of demand behavior.

1.7.2   Scope of Forecasting

Demand forecasting can be at the international level depending upon the area of operation of the given economic institution. It can also be confined to a given product or service supplied by a small firm in a local area. The scope of the forecasting task will depend upon the area of operation of the firm in the present as well as what is proposed in the future. Much would depend upon the cost and time involved in relation to the benefit of the information acquired through the study of demand. The necessary trade-off has to be struck between the cost of forecasting and the benefits flowing from such forecasting.

1.7.3   Types of forecasts

(1)  Macro-level forecasting deals with the general economic environment prevailing in the economy as measured by the Index of Industrial Production (IIP), national income and general level of employment, etc.

(ii)   Industry-level forecasting is concerned with the demand for the industry’s products as a whole. For example, the demand for cement in India.

(iii)  Firm-level forecasting refers to forecasting the demand for a particular firm’s product, say, the demand for ACC cement.

(2)  Based on time period, demand forecasts may be short-term demand forecasting and long-term demand forecasting.

(i)   Short-term demand forecasting covers a short span of time, depending on the nature of the industry. It is done usually for six months or less than one year and is generally useful in tactical decisions.

(ii)   Long-term forecasts are for longer periods of time, say two to five years and more. It provides information for major strategic decisions of the firm such as expansion of plant capacity.

1.7.4    Demand Distinctions

Business managers should have a clear understanding of the kind of demand which their products have. Before we analyze the different methods of forecasting demand, it is important for us to understand the demand distinctions which are as follows:

1. a) Producer’s goods and Consumer’s goods
2. b) Durable goods and Non-durable goods
3. c) Derived demand and Autonomous demand
4. d) Industry demand and Company demand
5. e) Short-run demand and Long-run demand
6. a) Producer’s goods and Consumer’s goods

Producer’s goods are those which are used for the production of other goods – either consumer goods or producer goods themselves. Examples of such goods are machines, plant, and equipment. Consumer’s goods are those which are used for final consumption. Examples of consumer’s goods are readymade clothes, prepared food, residential houses, etc.

1. b) Demand for Durable goods and Non-durable goods

Goods may be further subdivided into durable and non-durable goods. Nondurable goods are those which cannot be consumed more than once. Raw materials, fuel, and power, packing items, etc are examples of nondurable producer goods. Beverages, bread, milk, etc are examples of non-durable consumer goods. These will meet only the current demand. On the other hand, durable goods do not quickly wear out, can be consumed more than once and yield utility over a period of time. Examples of durable consumer goods are cars, refrigerators and mobile phones. The building, plant, and machinery, office furniture, etc are durable producer goods. The demand for durable goods is likely to be derived demand. Further, there are semi-durable goods such as clothes and umbrella.

1. c) Derived demand and Autonomous demand

The demand for a commodity that arises because of the demand for some other commodity called ‘parent product’ is called ‘derived demand’. For example, the demand for cement is derived demand, being directly related to building activity. In general, the demand for producer goods or industrial inputs is derived demand. Also, the demand for complementary goods is derived from the demand. If the demand for a product is independent of the demand for other goods, then it is called autonomous demand.lt arises on its own out of an innate desire of the consumer to consume or to possess the commodity. But this distinction is purely arbitrary and it is very difficult to find out which product is entirely independent of other products.

1. d) Demand for a firm’s product and industry demand

The term industry demand is used to denote the total demand for the products of a particular industry, e.g. the total demand for steel in the country. On the other hand, the demand for a firm’s product denotes the demand for the products of a particular firm, i.e. the quantity that a firm can dispose of at a given price over a period of time. E.g. demand for steel produced by the Tata Iron and Steel Company. The demand for a firm’s product, when expressed as a percentage of industry demand, signifies the market share of the firm.

1. e) Short-run demand and Long-run demand

This distinction is based on the time period. Short-run demand refers to demand with its immediate reaction to changes in the product price and prices of related commodities, income fluctuations, the ability of the consumer to adjust their consumption pattern, their susceptibility to an advertisement of new products, etc. Long-run demand refers to demand which exists over a long period. Most generic goods have long- term demand. Long term demand depends on long-term income trends, availability of substitutes, credit facilities, etc. In short, long-run demand is that which will ultimately exist as a result of changes in pricing, promotion or product improvement, after enough time is allowed to let the market adjust to the new situation. For example, if electricity rates are reduced, in the short run, the existing users will make greater use of electric appliances. In the long-run, more and more people will be induced to use electric appliances.

The above distinction is important because each of these goods exhibit distinctive characteristics which should be taken into account while analyzing demand for them.

Factors affecting demand for non-durable consumer goods: There are three basic factors which influence the demand for these goods:

(i)   Disposable income: Other things being equal, the demand for a commodity depends upon the disposable income of the household. Disposable income is found out by deducting personal taxes from personal income.

(ii)   Price: Other things being equal, the demand for a commodity depends upon its own price and the prices of related goods (its substitutes and complements). While the demand for a good is inversely related to its own price and the price of its complements, it is positively related to the price of its substitutes.

(iii)  Demography: This involves the characteristics of the population, human as well as non-human, using the product concerned. For example, it may pertain to the number and characteristics of children in a study of demand for toys and characteristics of automobiles in a study of the demand for tyres or petrol.

Non-durables are purchased for current consumption only. From a business firm’s point of view, demand for non-durable goods gets repeated depending on the nature of the nondurable goods. Usually, nondurable goods come in wide varieties and there is competition among the sellers to acquire and retain customer loyalty.

Factors affecting the demand for durable-consumer goods:

Demand for durable goods has certain special characteristics. The following are the important factors that affect the demand for durable goods.

(i)   A consumer can postpone the replacement of durable goods. Whether a consumer will go on using the good for a long time or will replace it depends upon factors like his social status, prestige, level of money income, rate of obsolescence, etc.

(ii)   These goods require special facilities for their use e.g. roads for automobiles, and electricity for refrigerators and radios. The existence and growth of such factors is an important variable that determines the demand for durable goods

(iii)  As consumer durables are used by more than one person, the decision to purchase may be influenced by family characteristics like the income of the family, size, age distribution, and sex composition. Likely changes in the number of households should be considered while determining the market size of durable goods.

(iv)  Replacement demand is an important component of the total demand for durables. Greater the current holdings of durable goods, greater will be the replacement demand. Therefore, all factors that determine replacement demand should be considered as a determinant of the demand for durable goods.

(v)  Demand for consumer durables is very much influenced by their prices and credit facilities available to buy them.

Factors affecting the demand for producer goods: Since producers’ goods or capital goods help in further production, the demand for them is derived demand, derived from the demand for consumer goods they produce. The demand for them depends upon the rate of profitability of the user industry and the size of the market of the user industries. Hence data required for estimating demand for producer goods (capital goods) are:

(i)   growth prospects of the user industries;

(ii)   norms of consumption of capital goods per unit of installed capacity.

An increase in the price of a substitutable factor of production, say labor, is likely to increase the demand for capital goods. On the contrary, an increase in the price of a factor which is complementary may cause a decrease in the demand for capital.

Higher the profit-making prospects, the greater will be the inducement to demand capital goods. If firms are optimistic about selling a higher output in the future, they will have a greater incentive to invest in producer goods. Advances in technology enabling higher efficiency at reduced cost on account of higher productivity of capital will have a positive impact on investment in capital goods. Investments in producer goods will be greater when lower interest rates prevail as firms will have a lower opportunity cost of investments and lower cost of borrowing.

1.7.5   Methods of Demand Forecasting

There is no easy method or simple formula which enables an individual or a business to predict the future with certainty or to escape the hard process of thinking. The firm has to apply a proper mix of judgment and scientific formulae in order to correctly predict the future demand for a product. The following are the commonly available techniques of demand forecasting:

(i)   Survey of Buyers’ Intentions: The most direct method of estimating demand in the short run is to ask customers what they are planning to buy during the forthcoming time period, usually a year. This method involves a direct interview with potential customers. Depending on the purpose, time available and costs to be incurred, the survey may be conducted by any of the following methods:

1. a) Complete enumeration method where nearly all potential customers are interviewed about their future purchase plans
2. b) Sample survey method under which only a scientifically chosen sample of potential customers are interviewed
3. c) End-use method, especially used in forecasting demand for inputs, involves identification of all final users, fixing suitable technical norms of consumption of the product under study, application of the norms to the desired or targeted levels of output and aggregation.

Thus, under this method, the burden of forecasting is put on the customers. However, it would not be wise to depend wholly on the buyers’ estimates and they should be used cautiously in the light of the seller’s own judgment. A number of biases may creep into the surveys. The customers may themselves misjudge their requirements, may mislead the surveyors or their plans may alter due to various factors that are not identified or visualized at the time of the survey. This method is useful when the bulk of sales is made to industrial producers who generally have definite future plans. In the case of household customers, this method may not prove very helpful for several reasons viz. irregularity in customers’ buying intentions, their inability to foresee their choice when faced with multiple alternatives, and the possibility that the buyers’ plans may not be real, but only wishful thinking.

(ii)   Collective opinion method: This method is also known as the sales force opinion method or grassroots approach. Firms having a wide network of sales personnel can use the knowledge, experience, and skills of the sales force to forecast future demand. Under this method, salesmen are required to estimate expected sales in their respective territories. The rationale of this method is that salesmen being closest to the customers are likely to have the most intimate feelings of the reactions of customers to changes in the market. These estimates of salesmen are consolidated to find out the total estimated sales. These estimates are reviewed to eliminate the bias of optimism on the part of some salesmen and pessimism on the part of others. These revised estimates are further examined in the light of factors like proposed changes in selling prices, product designs and advertisement programs, expected changes in competition and changes in secular forces like purchasing power, income distribution, employment, population, etc. The final sales forecast would emerge after these factors have been taken into account.

Although this method is simple and based on firsthand information of those who are directly connected with sales, it is subjective as personal opinions can possibly influence the forecast. Moreover, salesmen may be unaware of the broader economic changes which may have a profound impact on future demand. Therefore, forecasting could be useful in the short run, for long-run analysis however, a better technique is to be applied.

(iii)  Expert Opinion method: In general, professional market experts and consultants have specialized knowledge about the numerous variables that affect demand. This, coupled with their varied experience, enables them to provide reasonably reliable estimates of probable demand in the future. Information is elicited from them through appropriately structured unbiased tools of data collection such as interviews and questionnaires.

The Delphi technique, developed by Olaf Helmer at the Rand Corporation of the USA, provides a useful way to obtain informed judgments from diverse experts by avoiding the disadvantages of conventional panel meetings. Under this method, instead of depending upon the opinions of buyers and salesmen, firms solicit the opinion of specialists or experts through a series of carefully designed questionnaires. Experts are asked to provide forecasts and reasons for their forecasts. Experts are provided with information and opinion feedbacks of others at different rounds without revealing the identity of the opinion provider. These opinions are then exchanged among the various experts and the process goes on until convergence of opinions is arrived at. This method is best suited in circumstances where intractable changes are occurring and the relevant knowledge is distributed among experts. Delphi technique is widely accepted due to its broader applicability and ability to address complex questions. It also has the advantages of speed and cheapness.

(iv)  Statistical methods: Statistical methods have proved to be very useful in forecasting demand. Forecasts using statistical methods are considered as superior methods because they are more scientific, reliable and free from subjectivity. The important statistical methods of demand forecasting are:

(a)  Trend Projection method: This method, also known classical method, is considered as a ‘naive’ approach to demand forecasting. A firm that has been in existence for a reasonably long time would have accumulated considerable data on sales pertaining to different time periods. Such data, when arranged chronologically, yield a time series’. The time series relating to sales represent the past pattern of effective demand for a particular product. Such data can be used to project the trend of the time series. The trend projection method assumes that factors responsible for the past trend in demand will continue to operate in the same manner and to the same extent as they did in the past in determining the magnitude and direction of demand in the future. The popular techniques of trend projection based on time series data are;

1. a) graphical method and
2. b) Fitting trend equation or least square method.

(b)  Graphical Method: This method, also known as the ‘ freehand projection method’ is the simplest and least expensive. This involves plotting the time series data on a graph paper and fitting a freehand curve to it passing through as many points as possible. The direction of the curve shows the trend. This curve is extended into the future for deriving the forecasts. The direction of this freehand curve shows the trend. The main draw-back of this method is that it may show the trend but the projections made through this method are not very reliable.

(c)  Fitting trend equation: Least Square Method: It is a mathematical procedure for fitting a line to a set of observed data points in such a manner that the sum of the squared differences between the calculated and observed value is minimized. This technique is used to find a trend line that best fits the available data. This trend is then used to project the dependent variable in the future. This method is very popular because it is simple and inexpensive. Moreover, the trend method provides fairly reliable estimates of future demand.

The least-square method is based on the assumption that the past rate of change of the variable under study will continue in the future. The forecast based on this method may be considered reliable only for the period during which this assumption holds. The major limitation of this method is that it cannot be used where the trend is cyclical with sharp turning points of troughs and peaks. Also, this method cannot be used for short term forecasts.

(d)  Regression analysis: This is the most popular method of forecasting demand. Under this method, a relationship is established between the quantity demanded (dependent variable) and the independent variables (explanatory variables) such as income, price of the goods, prices of related goods, etc. Once the relationship is established, we derive a regression equation assuming the relationship to be linear. The equation will be of the form Y = a + bX. There could also be a curvilinear relationship between the dependent and independent variables. Once the regression equation is derived, the value of Y i.e. quantity demanded can be estimated for any given value of X.

(v)  Controlled Experiments: Under this method, future demand is estimated by conducting market studies and experiments on consumer behavior under actual, though controlled, market conditions. This method is also known as the market experiment method. An effort is made to vary separately certain determinants of demand which can be manipulated, for example, price, advertising, etc., and conduct the experiments assuming that the other factors would remain constant. Thus, the effect of demand determinants like price, advertisement, packaging, etc., on sales can be assessed by either varying them over different markets or by varying them over different time periods in the same market. The responses of demand to such changes over a period of time are recorded and are used for assessing the future demand for the product. For example, different prices would be associated with different sales and on that basis, the price-quantity relationship is estimated in the form of the regression equation and used for forecasting purposes. It should be noted, however, that the market divisions here must be homogeneous with regard to income, tastes, etc.

The method of controlled experiments is used relatively less because this method of demand forecasting is expensive as well as time-consuming. Moreover, controlled experiments are risky too because they may lead to unfavorable reactions from dealers, consumers, and competitors. It is also difficult to determine what conditions should be taken as constant and what factors should be regarded as a variable so as to segregate and measure their influence on demand. Besides, it is practically difficult to satisfy the condition of homogeneity of markets.

Market experiments can also be replaced by ‘controlled laboratory experiments’ or ‘consumer clinics’ under which consumers are given a specified sum of money and asked to spend in a store on goods with varying prices, packages, displays, etc. The responses of the consumers are studied and used for demand forecasting.

(vi) Barometric method of forecasting: The various methods suggested till now are related to the product concerned. These methods are based on past experience and try to project the past into the future. Such projection is not effective where there are economic ups and downs. As mentioned above, the projection of trends cannot indicate the turning point from slump to recovery or from the boom to the recession. Therefore, in order to find out these turning points, it is necessary to find out the general behavior of the economy. Just as meteorologists use the barometer to forecast weather, economists use economic indicators to forecast trends in business activities. This information is then used to forecast demand prospects of a product, though not the actual quantity demanded. For this purpose, an index of relevant economic indicators is constructed. Movements in these indicators are used as a basis for forecasting the likely economic environment in the near future. There are leading indicators, coincidental indicators, and lagging indicators. The leading indicators move up or down ahead of some other series. For example, the heavy advance orders for capital goods give an advance indication of economic prosperity. The lagging indicators follow a change after some time lag. The heavy household electrical connections confirm the fact that heavy construction work was undertaken during the past with a lag of some time. The coincidental indicators, however, move up and down simultaneously with the level of economic activities. For example, the rate of unemployment.

SUMMARY

♦    Buyers constitute the demand side of the market; sellers make the supply side of that market. The quantity that consumers buy at a given price determines the size of the market.

♦    Demand means desire or wishes to buy and consume a commodity or service backed by adequate ability to pay and willingness to pay.

♦ The important factors that determine demand are the price of the commodity, price of related commodities, the income of the consumer, tastes, and preferences of consumers, consumer expectations regarding future prices, size of population, the composition of population, the level of national income and its distribution, consumer-credit facility and interest rates.

♦    The law of demand states that people will buy more at lower prices and less at higher prices, other things being equal.

♦    A demand schedule is a table that shows various prices and the corresponding quantities demanded. The demand schedules are of two types; individual demand schedule and market demand schedule.

♦    According to Marshall, the demand curve slopes downwards due to the operation of the law of diminishing marginal utility. However, according to Flicks and Allen, it is due to the income effect and the substitution effect.

♦    The demand curve usually slopes downwards; but exceptionally slopes upwards under certain circumstances as in the case of conspicuous goods, Giffen goods, conspicuous necessities, future expectations about prices, etc.

♦    Other things being equal, when the price rises and as a response, the quantity demanded decreases, it is a contraction of demand. On the contrary, when the price falls and the quantity demanded increases it is the extension of demand.

♦    The demand curve will shift to the right when there is a rise in income (unless the good is an inferior one), a rise in the price of a substitute, a fall in the price of a complement, a rise in population and a change in tastes in favor of commodity. The opposite changes will shift the demand curve to the left.

♦    The elasticity of demand refers to the degree of sensitiveness or responsiveness of demand to a change in any one of its determinants. The elasticity of demand is classified mainly into four kinds. They are price elasticity of demand, income elasticity of demand, advertisement elasticity and cross elasticity of demand.

♦    Price elasticity of demand refers to the percentage change in quantity demanded of a commodity as a result of a percentage change in the price of that commodity. Because demand curve slopes downwards and to the right, the sign of price elasticity is negative. We normally ignore the sign of elasticity and concentrate on the coefficient. Greater the absolute coefficient, the greater is the price elasticity.

♦    In point elasticity, we measure elasticity at a given point on a demand curve. When the price change is somewhat larger or when price elasticity is to be found between two prices or two points on the demand curve, we use arc elasticity

♦    Income elasticity of demand is the percentage change in quantity demanded of a commodity as a result of a percentage change in income of the consumer. Goods and services are classified as luxuries, normal or inferior, depending on the responsiveness of spending on a product relative to the percentage change in income.

♦    The cross elasticity of demand is the percentage change in the quantity demanded of commodity X as a result of a percentage change in the price of some related commodity Y. Products can be substitutes, and their cross elasticity is then positive; cross elasticity is negative for products that are complements.

♦    Advertisement elasticity of sales or promotional elasticity of demand measures the responsiveness of a good’s demand to changes in the firm’s spending on advertising.

♦    Forecasting of demand is the art and science of predicting the probable demand for a product or a service at some future date on the basis of certain past behavior patterns of some related events and the prevailing trends in the present.

♦    The commonly available techniques of demand forecasting are a survey of buyers’ intentions, collective opinion method, expert opinion method, barometric method, and statistical methods such as trend projection method, graphical method, least square method, regression analysis, and market studies such as controlled experiments, and controlled laboratory experiments,

UNIT 2: THEORY OF CONSUMER BEHAVIOUR

LEARNING OUTCOMES

At the end of this Unit, you should be able to:

♦ Explain the meaning of utility.

♦ Describe how consumers try to maximize their satisfaction by spending on different goods.

♦ Explain the Law of Diminishing Marginal Utility with examples.

♦ Describe the concept of Consumer Surplus with examples.

♦ Describe the meaning of Indifference Curve and Price Line and how these help in explaining consumer equilibrium.

2.0 NATURE OF HUMAN WANTS

All desires, tastes, and motives of human beings are called wants in Economics. Wants may arise due to elementary and psychological causes. Since the resources are limited, we have to choose between the urgent wants and the not so urgent wants.

All wants of human beings exhibit some characteristic features.

1. Wants are unlimited in number. They are never completely satisfied.
2. Wants differ in intensity. Some are urgent, others are felt less intensely.
3. Each want is satiable.
4. Wants are competitive. They compete with each other for satisfaction because resources are scarce to satisfy all wants.
5. Wants are complementary. Some wants can be satisfied only by using more than one good or group of goods.
6. Wants are alternative.
7. Wants are subjective and relative.
8. Wants vary with time, place, and person.
9. Some want to recur again whereas others do not occur again and again.
10. Wants may become habits and customs.
11. Wants are affected by income, taste, fashion, advertisements and social customs.
12. Wants arise from multiple causes such as natural instincts, social obligation, and an individual’s economic and social status.

Classification of wants

In Economics, wants are classified into three categories, viz., necessaries, comforts, and luxuries.

Necessaries

Necessaries are those which are essential for living. Necessaries are further sub-divided into necessaries for life or existence, necessaries for efficiency and conventional necessaries. Necessaries for life are things necessary to meet the minimum physiological needs for the maintenance of life such as a minimum amount of food, clothing, and shelter. Man requires something more than the necessities of life to maintain longevity, energy, and efficiency of work, such as nourishing food, adequate clothing, clean water, comfortable dwelling, education, recreation, etc. These are necessary for efficiency. Conventional necessaries arise either due to the pressure of habit or due to compelling social customs and conventions. They are not necessary either for existence or for efficiency.

Comforts

While necessaries make life possible comforts make life comfortable and satisfying. Comforts are less urgent than necessaries. Tasty and wholesome food, good house, clothes that suit different occasions, audio-visual and labor-saving equipment, etc .make life more comfortable.

Luxuries

Luxuries are those wants which are superfluous and expensive. They are not essential for living. Items such as expensive clothing, exclusive motor cars, classy furniture, goods used for vanity, etc fall under this category.

The above categorization is not rigid as a thing which is comfort or luxury for one person or at one point in time may become a necessity for another person or at another point in time. As all of us are aware, the things which were considered luxuries in the past have become comforts and necessaries today.

What is Utility?

The concept of utility is used in neo-classical Economics to explain the operation of the law of demand. The utility is the want satisfying power of a commodity. It is the expected satisfaction to a consumer when he is willing to spend money on a stock of commodity which has the capacity to satisfy his want. The utility is the anticipated satisfaction by the consumer, and satisfaction is the actual satisfaction derived.

A commodity has utility for a consumer even when it is not consumed. It is a subjective entity and varies from person to person. A commodity has different utility for the same person at different places or at different points of time. It should be noted that utility is not the same thing as usefulness. From an economic standpoint, even harmful things like liquor may be said to have utility because people want them. Thus, in Economics, the concept of utility is ethically neutral.

The utility hypothesis forms the basis of the theory of consumer behavior. From time to time, different theories have been advanced to explain consumer behavior and thus to explain his demand for the product. Two important theories are (i) Marginal Utility Analysis propounded by Marshall, and (ii) Indifference Curve Analysis propounded by Hicks and Allen.

2.1 MARGINAL UTILITY ANALYSIS

This theory which is formulated by Alfred Marshall, a British economist, seeks to explain how a consumer spends his income on different goods and services so as to attain maximum satisfaction. This theory is based on certain assumptions. But before stating the assumptions, let us understand the meaning of total utility and marginal utility.

Total utility: Assuming that utility is measurable and additive, the total utility may be defined as the sum of utility derived from different units of a commodity consumed by a consumer. Total utility is the sum of marginal utilities derived from the consumption of different units i.e.

TU = MU₁ + MU₂ + ….. + MU_n

Where MU₁, MU₂, ….., MU_n, etc are marginal utilities of the successive units of a commodity

Marginal utility: It is the addition made to total utility by the consumption of an additional unit of a commodity. In other words, it is the utility derived from the marginal or one additional unit consumed or possessed by the individual.

Marginal utility = the addition made to the total utility by the addition of consumption of one more unit of a commodity.

Symbolically,

MU_n =TU_n –TU_n-1

Where,

MU_n is the marginal utility of the nth unit,

TU_n is the total utility of the nth unit, and

TU_{n – 1} is the total utility of the (n-1)^th unit.

2.1.0 Assumptions of Marginal Utility Analysis

(1) Rationality: A consumer is rational and attempts to attain maximum satisfaction from his limited money income.

(2) Cardinal Measurability of Utility: According to neoclassical economists, the utility is a cardinal concept

i.e., the utility is a measurable and quantifiable entity. It implies that utility can be measured in cardinal numbers and assigned a cardinal number like 1, 2, 3, etc. Marshall and some other economists used a psychological unit of measurement of utility called utils. Thus, a person can say that he derives utility equal to 10 utils from the consumption of 1 unit of commodity A and 5 from the consumption of 1 unit of commodity B. Since a consumer can quantitatively express his utility, he can easily compare different commodities and express which commodity gives him greater utility and by how much. Utilities from different units of the commodity can be added as well.

According to this theory, money is the measuring rod of utility. The amount of money which a person is prepared to pay for a unit of a good, rather than go without it, is a measure of the utility which he derives from the good.

(3) The constancy of the Marginal Utility of Money: The marginal utility of money remains constant throughout when the individual is spending money on a good. This assumption, although not realistic, has been made in order to facilitate the measurement of utility of commodities in terms of money. If the marginal utility of money changes as income changes, the measuring-rod of utility becomes unstable and therefore would be inappropriate for measurement.

(4) The Hypothesis of Independent Utility: The total utility which a person gets from the whole collection of goods purchased by him is simply the sum total of the separate utilities of the goods. The theory ignores complementarity between goods.

2.1.1 The Law of Diminishing Marginal Utility

One of the important laws under Marginal Utility analysis is the Law of Diminishing Marginal Utility.

The law of diminishing marginal utility is based on an important fact that while the total wants of a person are virtually unlimited, every single want is satiable i.e., each want is capable of being satisfied. Since each want is satiable, as a consumer consumes more and more units of a good, the intensity of his want for the good goes on decreasing and a point is reached where the consumer no longer wants it. Thus, the greater the amount of a good a consumer has, the less an additional unit is worth to him or her.

Marshall who was the exponent of the marginal utility analysis, stated the law as follows:

“The additional benefit which a person derives from a given increase in the stock of a thing diminishes with every increase in the stock that he already has.”

In other words, as a consumer increases the consumption of anyone commodity keeping constant the consumption of all other commodities, the marginal utility of the variable commodity must eventually decline.

This law describes a very fundamental tendency of human nature. In simple words, it says that as a consumer takes more units of a good, the extra satisfaction that he derives from an extra unit of a good goes on falling. It is to be noted that it is the marginal utility and not the total utility which declines with the increase in the consumption of a good.

Table 6: Total and marginal utility schedule

Let us illustrate the law with the help of an example. Consider Table 6, in which we have presented the total utility and marginal utility derived by a person from the chocolate bars consumed. When one chocolate bar is consumed, the total utility derived by the person is 30 utils (unit of utility) and the marginal utility derived is also 30 utils. With the consumption of the 2nd chocolate bar, the total utility rises to 50 but marginal utility falls to 20. We see that until the consumption of chocolate bars increases to 9, the marginal utility from the additional chocolate bars goes on diminishing (i.e., the total utility goes on increasing at a diminishing rate). The 10th chocolate bar adds no utility and therefore, the total utility remains the same at 98. However, when the chocolate bars consumed increases to 11, instead of giving positive marginal utility, the eleventh chocolate bar gives negative marginal utility or disutility as it may cause him discomfort.

From Table 6, we can conclude the following important relationships between total utility and marginal utility

1. Total utility rises as long as MU is positive, but at a diminishing rate because MU is diminishing.
2. Marginal utility diminishes throughout.
3. When marginal utility is zero, total utility is maximum. It is a saturation point.
4. When marginal utility is negative, total utility is diminishing.
5. MU is the rate of change of TU or the slope of TU.
6. MU can be positive, zero or negative.

Graphically we can represent the relationship between total utility and marginal utility (fig. 11).

Marginal utility of chocolates consumed

Fig. 11: Marginal utility of chocolates consumed

As will be seen from the figure, the marginal utility curve goes on declining throughout. The diminishing marginal utility curve applies to almost all commodities. A few exceptions, however, have been pointed out by some economists. According to them, this law does not apply to money, music, and hobbies. While this may be true in initial stages, beyond a certain limit these will also be subjected to diminishing utility.

The Law of diminishing marginal utility helps us to understand how a consumer reaches equilibrium in case of a single good. It states that as the quantity of a good with the consumer increases, the marginal utility of the good decreases. In other words, the marginal utility curve is downward sloping. Now, a consumer will go on buying a good till the marginal utility of the good becomes equal to the market price. In other words, the consumer will be in equilibrium (will be deriving maximum satisfaction) in respect of the quantity of the good when the marginal utility of the good is equal to its price. Here his satisfaction will be maximum.

What happens when there is a change in the price of a good? The equality between marginal utility and price is disturbed when the price of the good falls. The consumer will consume more of the good so as to restore the equality between the marginal utility and price. The marginal utility from the goodwill falls when he consumes more of the good. He will continue consuming more until the marginal utility becomes equal to the new lower price. On the other hand, when the price of the good increases, he will buy less so as to equate the marginal utility to the higher price. We can say that the downward sloping demand curve is directly derived from the marginal utility curve.

In reality, a consumer spends his income on more than one good. In such cases, consumer equilibrium is explained with the law of Equi-Marginal utility. According to this, the consumer will be in equilibrium when he is spending his money on goods and services in such a way that the marginal utility of each good is proportional to its price and the last rupee spent on each commodity yields him equal marginal utility.

The law states that the consumer is said to be at equilibrium when the following condition is met:

(MU_X/P_X) = (MU_Y/P_Y) or

(MU_x/MU_Y) = (P_x/P_Y)

Limitations of the Law

The law of diminishing marginal utility is applicable only under certain assumptions.

(i) Homogenous units: The different units consumed should be identical in all respects. The habit, taste, temperament, and income of the consumer also should remain unchanged.

(ii) Standard units of Consumption: The different units consumed should consist of standard units. If a thirsty man is given water by successive spoonfuls, the utility of the second spoonful of water may conceivably be greater than the utility of the first.

(iii) Continuous Consumption: There should be no time gap or interval between the consumption of one unit and another unit i.e. there should be continuous consumption.

(iv) The Law fails in the case of prestigious goods: The law may not apply to articles like gold, cash, diamonds, etc. where a greater quantity may increase the utility rather than diminish it. It also fails to apply in the case of hobbies, alcohol, cigarettes, rare collections, etc.

(v) Case of related goods: Utility is not in fact independent. The shape of the utility curve may be affected by the presence or absence of articles which are substitutes or complements. The utility obtained from tea may be seriously affected if no sugar is available and the utility of bottled soft drinks will be affected by the availability of fresh juice.

(vi) Based on unrealistic assumptions: The assumptions of cardinal measurability of utility, the constancy of marginal utility of money, continuous consumption, and consumer rationality are unrealistic.

2.1.2 Consumer’s Surplus

The concept of consumer’s surplus was propounded by Alfred Marshall. This concept occupies an important place not only in economic theory but also in the economic policies of the government and in the decision-making of monopolists.

The demand for a commodity depends on the utility of that commodity to a consumer. If a consumer gets more utility from a commodity, he would be willing to pay a higher price and vice-versa. It has been seen that consumers generally are ready to pay more for certain goods than what they actually pay for them. This extra satisfaction that consumers get from their purchase of a good is called by Marshall as consumer’s surplus.

Marshall defined the concept of consumer’s surplus as the “excess of the price which a consumer would be willing to pay rather than go without a thing over that which he actually does pay”, is called consumer’s surplus.”

Thus consumer surplus = what a consumer is ready to pay – what he actually pays.

The concept of consumer’s surplus is derived from the law of diminishing marginal utility. As we know from the law of diminishing marginal utility, the more of a thing we have, the lesser marginal utility it has. In other words, as we purchase more of a good, its marginal utility goes on diminishing. The consumer is in equilibrium when the marginal utility of a good is equal to its price i.e., he purchases that many units of a good at which marginal utility is equal to price (It is assumed that perfect competition prevails in the market). Since the price is the same for all units of the good he purchases, he gets extra utility for all units consumed by him except for the one at the margin. This extra utility or extra surplus for the consumer is called the consumer’s surplus.

Consider Table 7 in which we have illustrated the measurement of consumer surplus in the case of commodity X. The price of X is assumed to be Rs. 20.

Table 7: Measurement of Consumer’s Surplus

We see from the above table that when consumer’s consumption increases from 1 to 2 units, his marginal utility falls from Rs. 30 to Rs. 28. His marginal utility goes on diminishing as he increases his consumption of good X. Since marginal utility for a unit of good indicates the price the consumer is willing to pay for that unit, and since price is assumed to be fixed at Rs. 20, the consumer enjoys a surplus on every unit of purchase till the 6th unit. Thus, when the consumer is purchasing 1 unit of X, the marginal utility is worth Rs. 30 and price fixed is Rs. 20, thus he is deriving a surplus of Rs. 10. Similarly, when he purchases 2 units of X, he enjoys a surplus of Rs. 8 [Rs. 28 – Rs. 20], This continues and he enjoys consumer’s surplus equal to Rs. 6, 4, 2 respectively from 3rd, 4th and 5th unit. When he buys 6 units, he is in equilibrium because his marginal utility is equal to the market price or he is willing to pay a sum equal to the actual market price and therefore, he enjoys no surplus. Thus, given the price of Rs. 20 per unit, the total surplus which the consumer will get, isRs.10 + 8 + 6 + 4 + 2 + 0 = 30.

The concept of consumer’s surplus can also be illustrated graphically. Consider figure 12. On the X-axis we measure the amount of the commodity and on the Y-axis the marginal utility and the price of the commodity. MU is the marginal utility curve that slopes downwards, indicating that as the consumer buys more units of the commodity, its marginal utility falls. The marginal utility shows the price in which a person is willing to pay for the different units rather than go without them. If OP is the price that prevails in the market, then the consumer will be in equilibrium when he buys OQ units of the commodity, since, at OQ units, marginal utility is equal to the given price OP. The last unit, i.e., Q^th unit does not yield any consumer’s surplus because here price paid is equal to the marginal utility of the Q^th unit. But for units before the Q^th unit, marginal utility is greater than price and thus these units fetch consumer’s surplus to the consumer.

Marshall’s Measure of Consumer’s Surplus

Fig. 12: Marshall’s Measure of Consumer’s Surplus

In Figure 12, the total utility is equal to the area under the marginal utility curve up to point Q i.e. ODRQ. But, given the price equal to OP, the consumer actually pays OPRQ. The consumer derives extra utility equal to DPR which is nothing but consumer’s surplus.

Limitations:

It is often argued that this concept is hypothetical and illusory. The surplus satisfaction cannot be measured precisely.

(1) Consumer surplus cannot be measured precisely – because it is difficult to measure the marginal utilities of different units of a commodity consumed by a person.

(2) In the case of necessaries, the marginal utilities of the earlier units are infinitely large. In such a case, the consumer’s surplus is always infinite.

(3) The consumer’s surplus derived from a commodity is affected by the availability of substitutes.

(4) There is no simple rule for deriving the utility-scale of articles which are used for their prestige value (e.g., diamonds).

(5) Consumer surplus cannot be measured in terms of money because the marginal utility of money changes as purchases are made and the consumer’s stock of money diminishes. (Marshall assumed that the marginal utility of money remains constant. But this assumption is unrealistic).

(6) The concept can be accepted only if it is assumed that utility can be measured in terms of money or otherwise. Many modern economists believe that this cannot be done.

The concept of consumer surplus has important practical applications. Few such applications are listed

below:

♦ Consumer surplus is a measure of the welfare that people gain from consuming goods and services. It is very important to a business firm to reflect on the amount of consumer surplus enjoyed by different segments of their customers because consumers who perceive large surplus are more likely to repeat their purchases.

♦ Understanding the nature and extent of surplus can help business managers make better decisions about setting prices. If a business can identify groups of consumers with different elasticity of demand within their market and the market segments which are willing and able to pay higher prices for the same products, then firms can profitably use price discrimination.

♦ Large scale investment decisions involve cost-benefit analysis which takes into account the extent of consumer surplus which the projects may fetch.

♦ Knowledge of consumer surplus is also important when a firm considers raising its product prices Customers who enjoyed only a small amount of surplus may no longer be willing to buy products at higher prices. Firms making such decisions should expect to make fewer sales if they increase prices.

♦ Consumer surplus usually acts as a guide to finance ministers when they decide on the products on which taxes have to be imposed and the extent to which a commodity tax has to be raised. It is always desirable to impose taxes or increase the rates of taxes on commodities yielding high consumer surplus because the loss of welfare to citizens will be minimal.

2.2 INDIFFERENCE CURVE ANALYSIS

In the last section, we have discussed the marginal utility analysis of demand. A very popular alternative and a more realistic method of explaining consumer demand is the ordinal utility approach used a different tool namely the indifference curve to analyze consumer behavior. This approach to consumer behavior is based on consumer preferences. It believes that human satisfaction, being a psychological phenomenon, cannot be measured quantitatively in monetary terms as was attempted in Marshall’s utility analysis. In this approach, it is felt that it is much easier and scientifically more sound to order preferences than to measure them in terms of money.

The consumer preference approach is, therefore, an ordinal concept based on the ordering of preferences compared with Marshall’s approach of cardinality.

2.2.0 Assumptions Underlying Indifference Curve Approach

(i) The consumer is rational and possesses full information about all the relevant aspects of the economic environment in which he lives.

(ii) The indifference curve analysis assumes that utility is only ordinally expressible. The consumer is capable of ranking all conceivable combinations of goods according to the satisfaction they yield. Thus, if he is given various combinations say A, B, C, D, and E, he can rank them as first preference, second preference and so on. However, if a consumer happens to prefer A to B, he cannot tell quantitatively how much he prefers A to B.

(iii) Consumer’s choices are assumed to be transitive. If the consumer prefers combination A to B and B to C, then he must prefer combination A to C. In other words, he has a consistent consumption pattern.

(iv) If combination A has more commodities than combination B, then A must be preferred to B.

2.2.1 Indifference Curves

What are Indifference Curves? The ordinal analysis of demand (here we will discuss the one given by Hicks and Allen) is based on indifference curves. An indifference curve is a curve that represents all those combinations of two goods that give the same satisfaction to the consumer. Since all the combinations on an indifference curve give equal satisfaction to the consumer, the consumer is indifferent among them. In other words, since all the combinations provide the same level of satisfaction the consumer prefers them equally and does not mind which combination he gets.

If a consumer equally prefers two product bundles, then the consumer is indifferent between the two bundles. An Indifference curve is also called iso- utility curve or equal utility curve.

To understand indifference curves, let us consider the example of a consumer who has one unit of food and 12 units of clothing. Now, we ask the consumer how many units of clothing he is prepared to give up to get an additional unit of food, so that his level of satisfaction does not change. Suppose the consumer says that he is ready to give up 6 units of clothing to get an additional unit of food. We will have then two combinations of food and clothing giving equal satisfaction to the consumer: Combination A which has 1 unit of food and 12 units of clothing, and combination B which has 2 units of food and 6 units of clothing. Similarly, by asking the consumer further how much of clothing he will be prepared to forgo for successive increments in his stock of food so that his level of satisfaction remains unaltered, we get various combinations as given below:

Table 8: Indifference Schedule

Now, if we plot the above schedule, we will get the following figure.

In Figure 13, an indifference curve IC is drawn by plotting the various combinations given in the indifference schedule. The quantity of food is measured on the X-axis and the quantity of clothing on the Y-axis. As in the indifference schedule, the combinations lying on an indifference curve will give the consumer the same level of satisfaction.

A Consumer’s Indifference Curve

Fig. 13: A Consumer’s Indifference Curve

2.2.2 Indifference Map

An Indifference map represents a collection of many indifference curves where each curve represents a certain level of satisfaction. In short, a set of indifference curves is called an indifference map.

An indifference map depicts the complete picture of a consumer’s tastes and preferences. In Figure 14, an indifference map of a consumer is shown which consists of three indifference curves.

We have taken good X on X-axis and the good Yon Y-axis. It should be noted that while the consumer is indifferent among the combinations lying on the same indifference curve, he certainly prefers the combinations on the higher indifference curve to the combinations lying on a lower indifference curve because a higher indifference curve signifies a higher level of satisfaction. Thus, while all combinations of IC₁ give him the same satisfaction, all combinations lying on IC₂. give him greater satisfaction than those lying on IC₁.

Indifference Map

Fig. 14: Indifference Map

2.2.3. Marginal Rate of Substitution

Marginal Rate of Substitution (MRS) is the rate at which a consumer is prepared to exchange goods X and Y. Consider Table-8. In the beginning, the consumer is consuming 1 unit of food and 12 units of clothing. Subsequently, he gives up 6 units of clothing to get an extra unit of food, his level of satisfaction remaining the same. The MRS here is 6. Likewise, when he moves from B to C and from C to D in his indifference schedule, the MRS are 2 and 1 respectively. Thus, we can define MRS of X for Y as the amount of Y whose loss can just be compensated by a unit gain of X in such a manner that the level of satisfaction remains the same.

The marginal rate of substitution of X for Y (MRSxy) is equal to

We notice that MRS is falling i.e., as the consumer has more and more units of food, he is prepared to give up less and less units of clothing. There are two reasons for this.

1. The want for a particular good is satiable so that when a consumer has more of it, his intensity of want for it decreases. Thus, in our example, when the consumer has more units of food, his intensity of desire for additional units of food decreases.
2. Most goods are imperfect substitutes of one another. MRS would remain constant if they could substitute one another perfectly.

2.2.4 Properties of Indifference Curves

The following are the main characteristics or properties of indifference curves:

(i) Indifference curves slope downward to the right: This property implies that the two commodities can be substituted for each other and when the amount of one good in the combination is increased, the amount of the other good is reduced. This is essential if the level of satisfaction is to remain the same on an indifference curve.

(ii) Indifference curves are always convex to the origin : 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 being substituted (i.e. Y). This is called diminishing marginal rate of substitution. Thus, in our example of food and clothing, as a consumer has more and more units of food, he is prepared to forego less and less units of clothing. This happens mainly because the want for a particular good is satiable and as a person has more and more of a good, his intensity of want for that good goes on diminishing. In other words, the subjective value attached to the additional quantity of a commodity decreases fast in relation to the other commodity whose total quantity is decreasing. This diminishing marginal rate of substitution gives convex shape to the indifference curves. However, there are two extreme situations. When two goods are perfect substitutes of each other, the indifference curve is a straight line on which MRS is constant. And when two goods are perfect complementary goods (e.g. printer and cartridge), the indifference curve will consist of two straight lines with a right angle bent which is convex to the origin, or in other words, it will be L shaped.

(iii) Indifference curves can never intersect each other: No two indifference curves will intersect each other although it is not necessary that they are parallel to each other. In case of intersection the relationship becomes logically absurd because it would show that higher and lower levels are equal, which is not possible. This property will be clear from Figure 15.

Intersecting Indifference Curves

Fig. 15: Intersecting Indifference Curves

In figure 15, IC₁ and IC₂ intersect at A. Since A and B lie on IC₁, they give same satisfaction to the consumer. Similarly since A and C lie on IC₂, they give the same satisfaction to the consumer. This implies that combination B and C are equal in terms of satisfaction. But a glance will show that this is an absurd conclusion because certainly combination C is better than combination B because it contains more units of commodities X and Y. Thus we see that no two indifference curves can touch or cut each other.

(iv) A higher indifference curve represents a higher level of satisfaction than the lower indifference curve: This is because combinations lying on a higher indifference curve contain more of either one or both goods and more goods are preferred to less of them.

(v) Indifference curve will not touch either axes: Another characteristic feature of indifference curve is that it will not touch the X axis or Y axis. This is born out of our assumption that the consumer is considering different combination of two commodities. If an indifference curve touches the Y axis at a point P as shown in the figure 16, it means that the consumer is satisfied with OP units of y commodity and zero units of x commodity. This is contrary to our assumption that the consumer wants both commodities although in smaller or larger quantities. Therefore an indifference curve will not touch either the X axis or Y axis.

Indifference Curve

Fig. 16: Indifference Curve

2.2.5 The Budget Line

A higher indifference curve shows a higher level of satisfaction than a lower one. Therefore, a consumer, in his attempt to maximise satisfaction will try to reach the highest possible indifference curve. But in his pursuit of buying more and more goods and thus obtaining more and more satisfaction, he has to work under two constraints: first, he has to pay the prices for the goods and, second, he has a limited money income with which to purchase the goods.

A consumer’s choices are limited by the budget available to him. As we know, his total expenditure for goods and services can fall short of the budget constraint but may not exceed it.

Algebraically, we can write the budget constraint for two goods X and Y as:

P_xQ_x+ P_YQ_Y ≤ B

Where

P_x and P_Y are the prices of goods X and Y and Q_x and Q_Y are the quantities of goods X and Y chosen and B is the total money available to the consumer.

The budget constraint can be explained by the budget line or price line. In simple words, a budget line shows all those combinations of two goods which the consumer can buy spending his given money income on the two goods at their given prices. All those combinations which are within the reach of the consumer (assuming that he spends all his money income) will lie on the budget line.

Price Line

Fig. 17 : Price Line

It should be noted that any point outside the given price line, say H, will be beyond the reach of the consumer and any combination lying within the line, say K, shows under spending by the consumer.

This slope of budget line is equal to ‘Price Ratio’ of two goods, i.e. P_x/P_Y

2.2.6 Consumer’s Equilibrium

Having explained indifference curves and budget line, we are in a position to explain howa consumer reaches equilibrium position. A consumer is in equilibrium when he is deriving maximum possible satisfaction from the goods and therefore is in no position to rearrange his purchases of goods. We assume that:

(i) The consumer has a given indifference map which shows his scale of preferences for various combinations of two goods X and Y.

(ii) He has a fixed money income which he has to spend wholly on goods X and Y.

(iii) Prices of goods X and Y are given and are fixed.

(iv) All goods are homogeneous and divisible, and

(v) The consumer acts ‘rationally’ and maximizes his satisfaction.

Consumer’s Equilibrium

Fig. 18: Consumer’s Equilibrium

To show which combination of two goods X and Y the consumer will buy to be in equilibrium we bring his indifference map and budget line together.

We know by now, that the indifference map depicts the consumer’s preference scale between various combinations of two goods and the budget line shows various combinations which he can afford to buy with his given money income and prices of the two goods. Consider Figure 18, in which IC₁, IC₂, IC₃, IC₄ and IC₅ are shown together with budget line PL for good X and good Y. Every combination on the budget line PL costs the same. Thus combinations R, S, Q,T and H cost the same to the consumer. The consumer’s aim is to maximise his satisfaction and for this, he will try to reach the highest indifference curve.

Since there is a budget constraint, he will be forced to remain on the given budget line, that is he will have to choose combinations from among only those which lie on the given price line.

Which combination will our hypothetical consumer choose? Suppose he chooses R. We see that R lies on a lower indifference curve IC₁, when he can very well afford S, Q or T lying on higher indifference curves. Similar is the case for other combinations on IC₁, like H. Again, suppose he chooses combination S (or T) lying on IC₂. But here again we see that the consumer can still reach a higher level of satisfaction remaining within his budget constraints i.e., he can afford to have combination Q lying on IC₃ because it lies on his budget line. Now, what if he chooses combination Q? We find that this is the best choice because this combination lies not only on his budget line but also puts him on the highest possible indifference curve i.e., IC₃. The consumer can very well wish to reach IC₄ or IC₅, but these indifference curves are beyond his reach given his money income. Thus, the consumer will be at equilibrium at point Q on IC₃. What do we notice at point Q? We notice that at this point, his budget line PL is tangent to the indifference curve IC₃. In this equilibrium position (at Q), the consumer will buy OM of X and ON of Y.

We have seen that the consumer attains equilibrium at the point where the budget line is tangent to the indifference curve and

MUx / Px = MUy /Py

At the tangency point Q, the slopes of the price line PL and the indifference curve IC₃ are equal. The slope of the indifference curve shows the marginal rate of substitution of X for Y (MRSxy) which is equal to

while the slope of the price line indicates the ratio between the prices of two goods i.e.,

At equilibrium point Q,

MRS_xy =  =

Thus, we can say that the consumer is in equilibrium position when the price line is tangent to the indifference curve or when the marginal rate of substitution of goods X and Y is equal to the ratio between the prices of the two goods.

The indifference curve analysis is superior to utility analysis: (i) it dispenses with the assumption of measurability of utility (ii) it studies more than one commodity at a time (iii) it does not assume constancy of marginal utility of money (iv) it segregates income effect from substitution effect.

SUMMARY

♦ The existence of human wants is the basis for all economic activities in the society. All desires, tastes and motives of human beings are called wants in Economics.

♦ In Economics, wants are classified in to necessaries, comforts and luxuries.

♦ Utility refers to the want satisfying power of goods and services. It is not absolute but relative. It is a subjective concept and it depends upon the mental attitude of people.

♦ There are two important theories of utility, the cardinal utility analysis and ordinal utility analysis.

♦ The law of diminishing marginal utility states that as a consumer increases the consumption of a commodity, every successive unit of the commodity gives lesser and lesser satisfaction to the consumer.

♦ Consumer surplus is the difference between what a consumer is willing to pay for a commodity and what he actually pays for it.

♦ The indifference curve theory, which is an ordinal theory, shows the household’s preference between alternative bundles of goods by means of indifference curves.

♦ Marginal rate of substitution is the rate at which the consumer is prepared to exchange goods X and Y.

♦ The important properties of an Indifference curve are: Indifference curve slopes downwards to the right, it is always convex to the origin, two ICs never intersect each other, it will never touch the axes and higher the indifference curve higher is the level of satisfaction.

♦ The budget line or price line shows all those combinations of two goods that the consumer can buy spending his given money income on the two goods at their given prices.

♦ A consumer is said to be in equilibrium when he is deriving maximum possible satisfaction from the goods and is in no position to rearrange his purchase of goods.

♦ The consumer attains equilibrium at the point where the budget line is tangent to the indifference curve and MU_x/P_x = MU_y/P_y = MU_z/P_z

UNIT 3: SUPPLY

LEARNING OUTCOMES

At the end of this Unit, you should be able to:

♦ Explain the meaning of supply.

♦ List and provide specific examples of determinants of supply.

♦ Describe the law of supply.

♦ Describe the difference between movements on the supply curve and the shift of the supply curve.

♦ Explain the concept of elasticity of supply with examples.

♦ Illustrate how the concepts of demand and supply can be used to determine the price.

3.0 INTRODUCTION

In a market economy, sellers for products and services constitute the supply side. As the term ‘demand’ refers to the quantity of a good or service that the consumers are willing and able to purchase at various prices during a given period of 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 given period of time.

Two important points apply to supply:

(i) Supply refers to what a firm offer for sale in the market, not necessarily to what they succeed in selling. What is offered may not get sold.

(ii) Supply is a flow. The quantity supplied is ‘so much’ per unit of time, per day, per week, or per year.

3.1 DETERMINANTS OF SUPPLY

Although the price is an important consideration in determining the willingness and desire to part with commodities, there are many other factors that determine the supply of a product or a service. These are discussed below:

(i) Price of the good: Other things being equal, the higher the relative price of a good the greater the quantity of it that will be supplied. This is because goods and services are produced by the firm in order to earn profits and, ceteris paribus, profits rise if the price of its product rises.

(ii) Prices of related goods: If the prices of other goods rise, they become relatively more profitable to the firm to produce and sell than the good in question. It implies that, if the price of Y rises, the quantity supplied of X will fall. For example, if the price of wheat rises, the farmers may shift their land to wheat production away from corn and soya beans.

(iii) Prices of factors of production: Cost of production is a significant factor that affects supply. A rise in the price of a particular factor of production will cause an increase in the cost of making those goods that use a great deal of that factors than in the costs of producing those that use a relatively small amount of the factor. For example, a rise in the cost of land will have a large effect on the cost of producing wheat and a very small effect on the cost of producing automobiles. Thus, a change in the price of one factor of production will cause changes in the relative profitability of different lines of production and will cause producers to shift from one line to another and thus supplies of different commodities will change.

(iv) State of technology: The supply of a particular product depends upon the state of technology also. Inventions and innovations tend to make it possible to produce more or better goods with the same resources, and thus they tend to increase the quantity supplied of some products and to reduce the quantity supplied of products that are displaced. The availability of spare production capacity and the ease with which factor substitution can be made and the cost of such substitution also determine supply.

(v) Government Policy: The production of a good may be subject to the imposition of commodity taxes such as excise duty, sales tax, and import duties. These raise the cost of production and so the quantity supplied of a good would increase only when its price in the market rises. Subsidies, on the other hand, reduce the cost of production and thus provide an incentive to the firm to increase supply. When a government imposes restrictions such as import quota on inputs, rationing of input supply, etc, production tends to fall.

(vi) Nature of competition and size of the industry: Under competitive conditions, supply will be more than that under monopolized conditions. If there are a large number of firms in the market, supply will be more. Besides, entry of new firms, either domestic or foreign, causes the industry supply curve to shift rightwards.

Other Factors: The quantity supplied of goods also depends upon the government’s industrial and foreign policies, goals of the firm, infrastructural facilities, natural factors such as weather, floods, earthquake and man-made factors such as war, labor strikes, communal riots and etc.

3.2 LAW OF SUPPLY

This refers to the relationship of quantity supplied of a good with one or more related variables which have an influence on the supply of the good. Normally, supply is related to price but it can be related to the type of technology used, the scale of operations, etc.

The law of supply can be stated as: Other things remaining constant, the quantity of a good produced and offered for sale will increase as the price of the good rises and decrease as the price falls.

This law is based upon common sense, because of the higher the price of the good, the greater the profits that can be earned and thus greater the incentives to produce the good and offer it for sale. The law is known to be correct in a large number of cases. There is an exception, however. If we take the supply of labor at very high wages, we may find that the supply of labor has decreased instead of increasing. Thus, the behavior of supply depends upon the phenomenon considered and the degree of possible adjustment in supply.

The behavior of supply is also affected by the time taken into consideration. In the short run, it may not be easy to increase supply, but in the long-run supply can be easily adjusted in response to changes in price.

The law of supply can be explained through a supply schedule and a supply curve. A supply schedule is the tabular presentation of the law of supply. It shows the different prices of a commodity and the corresponding quantities that suppliers are willing to offer for sale. Consider the following hypothetical supply schedule of good X.

Table 9: Supply Schedule of Good ‘X’

The table shows the quantities of good X that would be produced and offered for sale at a number of alternative prices. At Rs. 1, for example, 5 kilograms of good X is offered for sale and at Rs. 3 per kg. 45 kg. would be forthcoming.

We can now plot the data from Table 9 on a graph. In Figure 19, price is plotted on the vertical axis and quantity on the horizontal axis, and various price-quantity combinations of schedule 9 are plotted.

Supply Curve

Fig. 19: Supply Curve

When we draw a smooth curve through the plotted points, what we get is the supply curve for good X. The supply curve is a graphical presentation of the supply schedule. It shows the quantity of X that will be offered for sale at each price of X. It slopes upwards towards the right (positive slope) showing that as price increases, the quantity supplied of X increases and vice-versa.

The market supply, like market demand, is the sum of supplies of a commodity made by all individual firms or their supply agencies. The market supply is governed by the law of supply. The market supply curve for ‘X’ can be obtained by adding horizontally the supply curves of various firms.

3.3 MOVEMENTS ON THE SUPPLY CURVE – INCREASE OR DECREASE IN THE QUANTITY SUPPLIED

When the supply of a good increase as a result of an increase in its price, we say that there is an increase in the quantity supplied and there is an upward movement on the supply curve. The reverse is the case when there is a fall in the price of the good. (See Figure 21)

change in quantity supplied as a result of a price change

Fig. 20: Figure showing change in quantity supplied as a result of a price change

3.4 SHIFTS IN SUPPLY CURVE – INCREASE OR DECREASE IN SUPPLY

When the supply curve bodily shifts towards the right as a result of a change in one of the factors that influence the quantity supplied other than the commodity’s own price, we say there is an increase in supply. When these factors cause the supply curve to shift to the left, we call it a decrease in supply [See Figures 21 (i) and (ii)].

Shifts in supply curves

Fig. 21: Shifts in supply curves

3.5 ELASTICITY OF SUPPLY

The elasticity of supply is defined as the responsiveness of the quantity supplied of a good to a change in its price. The elasticity of supply is measured by dividing the percentage change in quantity supplied of a good by the percentage change in its price i.e.,

E_i =

Or  or  =  =

Where q denotes original quantity supplied.

∆q denotes change in quantity supplied.

p denotes original price.

∆p denotes change in price.

Example:

1. a) Suppose the price of commodity X increases from Rs. 2,000 per unit to Rs. 2,100 per unit and consequently the quantity supplied rises from 2,500 units to 3,000 units. Calculate the elasticity of supply.

Here ∆q =500 units     Δp=Rs.100

p =Rs.2000                 q =2500 units

∴ E_s =  ×  = 4

Elasticity of Supply = 4.

3.5.0 Type of Supply Elasticity

The elasticity of supply can be classified as under:

(i) Perfectly inelastic supply: If as a result of a change in price, the quantity supplied of a good remains unchanged, we say that the elasticity of supply is zero or the good has perfectly inelastic supply. The vertical supply curve in Figure 22 shows that irrespective of price change, the quantity supplied remains unchanged.

Supply curves of zero elasticity

Fig. 22 : Supply curves of zero elasticity

(ii) Relatively less-elastic supply: If as a result of a change in the price of a good its supply changes less than proportionately, we say that the supply of the good is relatively less elastic or elasticity of supply is less than one. Figure 23 shows that the relative change in the quantity supplied (∆q) is less than the relative change in the price (∆p).

relatively less elastic supply

Fig. 23 : Showing relatively less elastic supply

(iii) Relatively greater-elastic supply: If elasticity of supply is greater than one i.e., when the quantity supplied of a good changes substantially in response to a small change in the price of the good we say that supply is relatively elastic. Figure 24, shows that the relative change in the quantity supplied (∆q) is greater than the relative change in the price.

relatively greater elastic supply

Fig. 24: Showing relatively greater elastic supply

(iv) Unit-elastic: If the relative change in the quantity supplied is exactly equal to the relative change in the price, the supply is said to be unitary elastic. Here the coefficient of elasticity of supply is equal to one. In Figure 25, the relative change in the quantity supplied (∆q) is equal to the relative change in the price (∆p).

unitary elasticity

Fig. 25 : Showing unitary elasticity

(v) Perfectly elastic supply: Elasticity of supply said to be infinite when nothing is supplied at a lower price, but a small increase in price causes supply to rise from zero to an infinitely large amount indicating that producers will supply any quantity demanded at that price. Figure 26 shows the infinitely elastic supply.

Supply curve of infinite elasticity

Fig. 26: Supply curve of infinite elasticity

3.5.1 Measurement of supply-elasticity

The elasticity of supply can be considered with reference to a given point on the supply curve or between two points on the supply curve. When elasticity is measured at a given point on the supply curve, it is called point elasticity. Just as in demand, point-elasticity of supply can be measured with the help of the following formula:

E_s =  ×

Qus: The Supply function is given as q = -100 + 10p. Find the elasticity of supply using point method, when price is Rs. 15.

E_s =  ×

Since  = 10, p = Rs. 15, q = -100 + 10 (15)

q = 50

∴ E_s= 10 ×

or E_s = 3

Where  is differentiation of the supply function with respect to price and p and q refer to price and quantity respectively.

Arc-Elasticity: Arc-elasticity i.e. elasticity of supply between two prices can be found out with the help of the following formula:

or

Where p₁ q₁ are original price and quantity and p₂ q₂ are new price and quantity supplied.

Thus, if we have to find elasticity of supply when p₁ = Rs. 12, p₂ = Rs. 15, q₁ = 20 units and q₂ = 50 units. Then using the above formula, we will get supply elasticity as:

Es =  ×

×  = +3.85

Equilibrium Price

Equilibrium refers to a market situation where quantity demanded is equal to quantity supplied. The intersection of demand and supply determines the equilibrium price. At this price the amount that the buyers want to buy is equal to the amount that sellers want to sell. Only at the equilibrium price, both the buyers and sellers are satisfied. Equilibrium price is also called market clearing price.

The determination of market price is the central theme of micro economic analysis. Hence, micro-economic theory is also called price theory.

The following table explains the equilibrium price

Table 10: Supply and Demand Schedule

The equilibrium between demand and supply is depicted in the diagram below. Demand and supply are in equilibrium at point E where the two curves intersect each other. It means that only at price Rs. 3 the quantity demanded is equal to the quantity supplied. The equilibrium quantity is 19 units and these are exchanged at price Rs. 3. If the price is more than the equilibrium level, excess supply will push the price downwards as there are few takers in the market at this price. For example, in Table 10, if price is say Rs. 5, quantity demanded is 6 units which is quite less than the quantity supplied (31 units). There will be excess supply in the market which will force the sellers to reduce price if they want to sell off their product. Hence the price will fall and continue falling down till the level where quantity demanded becomes equal to the quantity supplied. Opposite will happen when quantity demanded is more than quantity supplied at a particular price.

Equilibrium Price

Fig. 27: Equilibrium Price

The equilibrium price is determined by the intersection between demand and supply. It is also called the market equilibrium.

SUMMARY

♦ “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 given period of time.

♦ The determinants of supply other than its own price are: prices of the related goods, prices of factors of production, state of technology, government policy and other factors.

♦ The law of supply states that when the price of the good rises, the corresponding quantity supplied increases and when the price reduces, the quantity supplied also reduces. There is a direct relationship between price and quantity supplied.

♦ The supply curve establishes the relationship between the amount of supply and the price. It is an upward sloping curve showing a positive relationship between price and quantity supplied.

♦ When the supply of a good increases as a result of an increase in its price we say that there is an increase in the quantity supplied and there is an upward movement on the supply curve. The reverse is the case when there is a fall in the price of the good.

♦ Elasticity of supply means the responsiveness of supply to change in the price of the commodity.

♦ The elasticity of supply can be classified in to perfectly inelastic supply, relatively less-elastic supply, relatively greater-elastic supply, unit-elastic and perfectly elastic supply.

♦ The measurement of supply-elasticity is of two types- point elasticity and arc-elasticity.

♦ Elasticity of supply can be considered with reference to a given point on the supply curve (point elasticity) or between two points on the supply curve (arc elasticity).

♦ Equilibrium price is one at which the wishes of both the buyers and the sellers are satisfied. At this price, the amount that buyers want to buy and sellers want to sell will be equal.

MULTIPLE CHOICE QUESTIONS

1. Demand for a commodity refers to:

(a) desire backed by ability to pay for the commodity.

(b) need for the commodity and willingness to pay for it.

(c) the quantity demanded of that commodity at a certain price.

(d) the quantity of the commodity demanded at a certain price during any particular period of time.

2. Contraction of demand is the result of:

(a) decrease in the number of consumers.

(b) increase in the price of the good concerned.

(c) increase in the prices of other goods.

(d) decrease in the income of purchasers.

3. All but one of the following are assumed to remain the same while drawing an individual’s demand curve for a commodity. Which one is it?

(a) The preference of the individual.               (b) His monetary income.

(c) Price of the commodity.                (d) Price of related goods.

4. Which of the following pairs of goods is an example of substitutes?

(a) Tea and sugar.                  (b) Tea and coffee.

(c) Pen and ink.                      (d) Shirt and trousers.

5. In the case of a straight line demand curve meeting the two axes, the price-elasticity of demand at the mid-point of the line would be:

(a) 0                 (b) 1

(c) 1.5              (d) 2

6. The Law of Demand, assuming other things to remain constant, establishes the relationship between:

(a) income of the consumer and the quantity of a good demanded by him.

(b) price of a good and the quantity demanded.

(c) price of a good and the demand for its substitute.

(d) quantity demanded of a good and the relative prices of its complementary goods.

7. Identify the factor which generally keeps the price-elasticity of demand for a good low:

(a) Variety of uses for that good.

(b) very low price of a commodity.

(c) Close substitutes for that good.

(d) High proportion of the consumer’s income spent on it.

8. Identify the coefficient of price-elasticity of demand when the percentage increase in the quantity of a good demanded is smaller than the percentage fall in its price:

(a) Equal to one.                     (b) Greater than one.

(c) Smaller than one.              (d) Zero.

9. In the case of an inferior good, the income elasticity of demand is:

(a) positive.                 (b) zero.

(c) negative.                (d) infinite.

10. If the demand for a good is inelastic, an increase in its price will cause the total expenditure of the consumers of the good to:

(a) remain the same.              (b) increase.

(c) decrease.               (d) any of these.

11. If regardless of changes in its price, the quantity demanded of a good remains unchanged, then the demand curve for the good will be:

(a) horizontal.              (b) vertical.

(c) positively sloped.               (d) negatively sloped.

12. Suppose the price of Pepsi increases, we will expect the demand curve of Coca Cola to:

(a) shift towards left since these are substitutes.

(b) shift towards right since these are substitutes.

(c) remain at the same level.

(d) None of the above.

13. All of the following are determinants of demand except:

(a) tastes and preferences.                (b) quantity supplied.

(c) income of the consumer.               (d) price of related goods.

14. A movement along the demand curve for soft drinks is best described as :

(a) An increase in demand.                (b) A decrease in demand.

(c) A change in quantity demanded.              (d) A change in demand.

15. If the price of Pepsi decreases relative to the price of Coke and 7-UP, the demand for:

(a) Coke will decrease.                       (b) 7-Up will decrease.

(c) Coke and 7-UP will increase.                    (d) Coke and 7-Up will decrease.

16. If a good is a luxury, its income elasticity of demand is:

(a) positive and less than 1.               (b) negative but greater than-1.

(c) positive and greater than 1.                       (d) zero.

17. The price of hot dogs increases by 22% and the quantity of hot dogs demanded falls by 25%. This indicates that demand for hot dogs is:

(a) elastic.                               (b) inelastic.

(c) unitarily elastic.                  (d) perfectly elastic.

18. If the quantity demanded of mutton increases by 5% when the price of chicken increases by 20%, the cross-price elasticity of demand between mutton and chicken is:

(a) -0.25                      (b) 0.25

(c) -4                            (d) 4

19. Given the following four possibilities, which one results in an increase in total consumer expenditure?

(a) demand is unitary elastic and price falls.

(b) demand is elastic and price rises.

(c) demand is inelastic and price falls.

(d) demand is inelastic and prices rises.

20. Which of the following statements about price elasticity of supply is correct?
21. a) Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.
22. b) Price elasticity of supply is computed as the percentage change in quantity supplied divided by the percentage change in price.
23. c) Price elasticity of supply in the long run would be different from that of the short run.
24. d) All the above.
25. Which of the following is an incorrect statement?
26. a) When goods are substitutes, a fall in the price of one (ceteris paribus) leads to a fall in the quantity demanded of its substitutes.
27. b) When commodities are complements, a fall in the price of one (other things being equal) will cause the demand of the other to rise.
28. c) As the income of the consumer increases, the demand for the commodity increases always and vice versa.
29. d) When a commodity becomes fashionable people prefer to buy it and therefore its demand increases.
30. Suppose the price of movies seen at a theatre rises from Rs. 120 per person to Rs. 200 per person. The theatre manager observes that the rise in price causes attendance at a given movie to fall from 300 persons to 200 persons. What is the price elasticity of demand for movies? (Use Arc Elasticity Method)

(a) .5                (b) .8

(c) 1.0              (d) 1.2

23. Suppose a department store has a sale on its silverware. If the price of a plate-setting is reduced from Rs. 300 to Rs. 200 and the quantity demanded increases from 3,000 plate-settings to 5,000 plate-settings, what is the price elasticity of demand for silverware? (Use Arc Elasticity Method)

(a) .8                            (b) 1.0

(c) 1.25                        (d) 1.50

24. When the numerical value of cross elasticity between two goods is very high, it means
25. a) The goods are perfect complements and therefore have to be used together.
26. b) The goods are perfect substitutes and can be used with ease in place of one another.
27. c) There is a high degree of substitutability between the two goods.
28. d) The goods are neutral and therefore cannot be considered as substitutes.
29. If the local pizzeria raises the price of a medium pizza from Rs. 60 to Rs. 100 and quantity demanded falls from 700 pizzas a night to 100 pizzas a night, the price elasticity of demand for pizzas is: (Use Arc Elasticity Method)

(a) .67              (b) 1.5

(c) 2.0              (d) 3.0

26. If electricity demand is inelastic, and electricity charges increase, which of the following is likely to occur?

(a) Quantity demanded will fall by a relatively large amount.

(b) Quantity demanded will fall by a relatively small amount.

(c) Quantity demanded will rise in the short run, but fall in the long run.

(d) Quantity demanded will fall in the short run, but rise in the long run.

27. Suppose the demand for meals at a medium-priced restaurant is elastic. If the management of the restaurant is considering raising prices, it can expect a relatively:

(a) large fall in quantity demanded.                (b) large fall in demand.

(c) small fall in quantity demanded.                (d) small fall in demand.

28. Point elasticity is useful for which of the following situations?

(a) The bookstore is considering doubling the price of notebooks.

(b) A restaurant is considering lowering the price of its most expensive dishes by 50 percent.

(c) An auto producer is interested in determining the response of consumers to the price of cars being lowered by Rs. 100.

(d) None of the above.

29. A decrease in price will result in an increase in total revenue if:

(a) the percentage change in quantity demanded in less than the percentage change in price.

(b) the percentage change in quantity demanded is greater than the percentage change in price.

(c) demand is inelastic.

(d) the consumer is operating along a linear demand curve at a point at which the price is very low and the quantity demanded is very high.

30. An increase in price will result in an increase in total revenue if:

(a) the percentage change in quantity demanded is less than the percentage change in price.

(b) the percentage change in quantity demanded is greater than the percentage change in price.

(c) demand is elastic.

(d) the consumer is operating along a linear demand curve at a point at which the price is very high and the quantity demanded is very low.

31. Demand for a good will tend to be more elastic if it exhibits which of the following characteristics?

(a) It represents a small part of the consumer’s income.

(b) The good has many substitutes available.

(c) It is a necessity (as opposed to a luxury).

(d) There is little time for the consumer to adjust to the price change.

32. Demand for a good will tend to be more inelastic if it exhibits which of the following characteristics?

(a) The good has many substitutes.

(b) The good is a luxury (as opposed to a necessity).

(c) The good is a small part of the consumer’s income.

(d) There is a great deal of time for the consumer to adjust to the change in prices.

33. Suppose a consumer’s income increases from Rs. 30,000 to Rs. 36,000. As a result, the consumer increases her purchases of compact discs (CDs) from 25 CDs to 30 CDs. What is the consumer’s income elasticity of demand for CDs? (Use Arc Elasticity Method)

(a) 0.5              (b) 1.0

(c) 1.5              (d) 2.0

34. Total utility is maximum when:

(a) marginal utility is zero.                               (b) marginal utility is at its highest point.

(c) marginal utility is negative.                        (d) none of the above.

35. Which one is not an assumption of the theory of demand based on analysis of indifference curves?

(a) Given scale of preferences as between different combinations of two goods.

(b) Diminishing marginal rate of substitution.

(c) Constant marginal utility of money.

(d) Consumers would always prefer more of a particular good to less of it, other things remaining the same.

36. The consumer is in equilibrium at a point where the budget line:

(a) is above an indifference curve.                             (b) is below an indifference curve.

(c) is tangent to an indifference curve.                       (d) cuts an indifference curve.

37. An indifference curve slopes down towards right since more of one commodity and less of another result in:

(a) same level of satisfaction.             (b) greater satisfaction.

(c) maximum satisfaction.                  (d) any of the above.

38. Which of the following statements is incorrect?

(a) An indifference curve must be downward-sloping to the right.

(b) Convexity of a curve implies that the slope of the curve diminishes as one moves from left to right.

(c) The income elasticity for inferior goods to a consumer is positive.

(d) The total effect of a change in the price of a good on its quantity demanded is called the price effect.

39. The second glass of lemonade gives lesser satisfaction to a thirsty boy. This is a clear case of

(a) Law of demand.                             (b) Law of diminishing returns.

(c) Law of diminishing utility.              (d) Law of supply.

40. What will happen in the rice market if buyers are expecting higher rice prices in the near future?

(a) The demand for rice will increase.                        (b) The demand for rice will decrease.

(c) The demand for rice will be unaffected.               (d) None of the above.

41. In the case of a Giffen good, the demand curve will be:

(a) horizontal.              (b) downward-sloping to the right.

(c) vertical.                  (d) upward-sloping to the right.

42. By consumer surplus, economists mean

(a) the area inside the budget line.

(b) the area between the average revenue and marginal revenue curves.

(c) the difference between the maximum amount a person is willing to pay for a good and its market price.

(d) none of the above.

43. Which of the following is a property of an indifference curve?

(a) it is convex to the origin.

(b) the marginal rate of substitution is constant as you move along an indifference curve.

(c) marginal utility is constant as you move along an indifference curve.

(d) total utility is greatest where the 45 degree line cuts the indifference curve.

44. When economists speak of the utility of a certain good, they are referring to

(a) the demand for the good.

(b) the usefulness of the good in consumption.

(c) the expected satisfaction derived from consuming the good.

(d) the rate at which consumers are willing to exchange one good for another.

45. A vertical supply curve parallel to Y axis implies that the elasticity of supply is:

(a) Zero.                                  (b) Infinity.

(c) Equal to one.                     (d) Greater than zero but less than infinity.

46. The supply of a good refers to:

(a) actual production of the good.                               (b) total existing stock of the good.

(c) stock available for sale.

(d) amount of the good offered for sale at a particular price per unit of time.

47. An increase in the supply of a good is caused by:

(a) improvements in its technology.                           (b) fall in the prices of other goods.

(c) fall in the prices of factors of production.              (d) all of the above.

48. Elasticity of supply refers to the degree of responsiveness of supply of a good to changes in its:

(a) demand.                            (b) price.

(c) cost of production.             (d) state of technology.

49. A horizontal supply curve parallel to the quantity axis implies that the elasticity of supply is:

(a) zero.                                   (b) infinite.

(c) equal to one.                      (d) greater than zero but less than one.

50. Contraction of supply is the result of:

(a) decrease in the number of producers.                  (b) decrease in the price of the good concerned,

(c) increase in the prices of other goods.                   (d) decrease in the outlay of sellers.

51. Conspicuous goods are also known as:

(a) prestige goods.                  (b) snob goods.

(c) veblen goods.                    (d) all of the above.

52. The quantity purchased remains constant irrespective of the change in income. This is known as

(a) negative income elasticity of demand.

(b) income elasticity of demand less than one.

(c) zero income elasticity of demand.

(d) income elasticity of demand is greater than one.

53. As income increases, the consumer will go in for superior goods and consequently the demand for inferior goods will fall. This means:

(a) income elasticity of demand less than one.

(b) negative income elasticity of demand.

(c) zero income elasticity of demand.

(d) unitary income elasticity of demand.

54. When income increases the money spent on necessaries of life may not increase in the same proportion, This means:

(a) income elasticity of demand is zero.

(b) income elasticity of demand is one.

(c) income elasticity of demand is greater than one.

(d) income elasticity of demand is less than one.

55. The luxury goods like jewellery and fancy articles will have

(a) low income elasticity of demand               (b) high income elasticity of demand

(c) zero income elasticity of demand              (d) none of the above

56. A good which cannot be consumed more than once is known as

(a) durable good                     (b) non-durable good

(c) producer good                   (d) none of the above

57. A relative price is

(a) price expressed in terms of money          (b) what you get paid for babysitting your cousin

(c) the ratio of one money price to another    (d) equal to a money price

58. A point below the budget line of a consumer

(a) Represents a combination of goods which costs the whole of consumer’s income.

(b) Represents a combination of goods which costs less than the consumer’s income.

(c) Represents a combination of goods which is unattainable to the consumer given his/her money income.

(d) Represents a combination of goods which costs more than the consumers’ income.

59. Demand is the

(a) the desire for a commodity given its price and those of related commodities.

(b) the entire relationship between the quantity demanded and the price of a good other things remaining the same.

(c) willingness to pay for a good if income is larger enough.

(d) ability to pay for a good.

60. If, as people’s income increases, the quantity demanded of a good decreases, the good is called

(a) a substitute.                       (b) a normal good.

(c) an inferior good.                 (d) a complement.

61. The price of tomatoes increases and people buy tomato puree. You infer that tomato puree and tomatoes are

(a) normal goods.                    (b) complements.

(c) substitutes.                         (d) inferior goods.

62. Chicken and fish are substitutes. If the price of chicken increases, the demand for fish will

(a) increase or decrease but the demand curve for chicken will not change.

(b) increase and the demand curve for fish will shift rightwards.

(c) not change but there will be a movement along the demand curve for fish.

(d) decrease and the demand curve for fish will shift leftwards.

63. Potato chips and popcorn are substitutes. A rise in the price of potato chips will __________ the demand for popcorn and the quantity of popcorn will __________

(a) increase; increase                         (b) increase; decrease

(c) decrease; decrease                       (d) decrease; increase

64. If the price of Orange Juice increases, the demand for Apple Juice will __________.

(a) increase                             (b) decrease

(c) remain the same.               (d) become negative.

65. An increase in the demand for computers, other things remaining same, will:

(a) Increase the number of computers bought.

(b) Decrease the price but increase the number of computers bought.

(c) Increase the price of computers.

(d) Increase the price and number of computers bought.

66. When total demand for a commodity whose price has fallen increases, it is due to:

(a) income effect.                               (b) substitution effect.

(c) complementary effect.                  (d) price effect.

67. With a fall in the price of a commodity:

(a) consumer’s real income increases.

(b) consumer’s real income decreases.

(c) there is no change in the real income of the consumer.

(d) none of the above.

68. With an increase in the price of diamond, the quantity demanded also increases. This is because it is a:

(a) substitute good.                 (b) complementary good.

(c) conspicuous good.            (d) none of the above.

69. An example of a good that exhibit direct price-demand relationship is

(a) Giffen goods.                     (b) Complementary goods.

(c) Substitute goods.               (d) None of the above.

70. In Economics, when demand for a commodity increases with a fall in its price it is known as:

(a) contraction of demand.                 (b) expansion of demand.

(c) no change in demand.                   (d) none of the above.

71. The quantity supplied of a good or service is the amount that

(a) is actually bought during a given time period at a given price.

(b) producers wish they could sell at a higher price.

(c) producers plan to sell during a given time period at a given price.

(d) people are willing to buy during a given time period at a given price.

72. Supply is the

(a) limited resources that are available with the seller.

(b) cost of producing a good.

(c) entire relationship between the quantity supplied and the price of good.

(d) Willingness to produce a good if the technology to produce it becomes available.

73. In the book market, the supply of books will decrease if any of the following occurs except

(a) a decrease in the number of book publishers.

(b) a decrease in the price of the book.

(c) an increase in the future expected price of the book.

(d) an increase in the price of paper used.

74. If price of computers increases by 10% and supply increases by 25%. The elasticity of supply is :

(a) 2.5                          (b) 0.4

(c) (-) 2.5                     (d) (-) 0.4

75. An increase in the number of sellers of bikes will increase the

(a) the price of a bike.                         (b) demand for bikes.

(c) the supply of bikes.                        (d) demand for helmets.

76. If the supply of bottled water decreases, other things remaining the same, the equilibrium price __________ and the equilibrium quantity __________

(a) increases; decreases.                   (b) decreases; increases.

(c) decreases; decreases.                  (d) increases; increases.

77. A decrease in the demand for cameras, other things remaining the same will.

(a) increase the number of cameras bought.

(b) decrease the price but increase the number of cameras bought.

(c) increase the price of cameras.

(d) decrease the price and decrease in the number of cameras bought.

78. If good growing conditions increases the supply of strawberries and hot weather increases the demand for strawberries, the quantity of strawberries bought

(a) increases and the price might rise, fall or not change.

(b) does not change but the price rises.

(c) does not change but the price falls.

(d) increases and the price rises.

79. Comforts lies between

(a) inferior goods and necessaries.                (b) luxuries and inferior goods.

(c) necessaries and luxuries.                          (d) none of the above.

80. In a very short period, the supply

(a) can be changed.                (b) can not be changed.

(c) can be increased.              (d) none of the above.

81. When supply curve moves to the left, it means

(a) Smaller supply at a given price.                (b) larger supply at a given price.

(c) constant supply at a lower price.               (d) none of the above.

82. When supply curve moves to right, it means

(a) supply increases.                           (b) supply decreases.

(c) supply remains constant.              (d) none of the above.

83. The elasticity of supply is defined as the

(a) responsiveness of the quantity supplied of a good to a change in its price.

(b) responsiveness of the quantity supplied of a good without change in its price.

(c) responsiveness of the quantity demanded of a good to a change in its price.

(d) responsiveness of the quantity demanded of a good without change in its price.

84. Elasticity of supply is measured by dividing the percentage change in quantity supplied of a good by __________

(a) Percentage change in income.

(b) Percentage change in quantity demanded of goods.

(c) Percentage change in price.

(d) Percentage change in taste and preference.

85. Elasticity of supply is zero means

(a) perfectly inelastic supply.              (b) perfectly elastic supply.

(c) imperfectly elastic supply.             (d) none of the above.

86. Elasticity of supply is greater than one when

(a) proportionate change in quantity supplied is more than the proportionate change in price.

(b) proportionate change in price is greater than the proportionate change in quantity supplied.

(c) change in price and quantity supplied are equal.

(d) None of the above.

87. If the quantity supplied is exactly equal to the relative change in price then the elasticity of supply is

(a) less than one.                    (b) greater than one.

(c) one.                                    (d) none of the above.

88. The price of a commodity decreases from Rs. 6 to Rs. 4 and the quantity demanded of the good increases from 10 units to 15 units, find the coefficient of price elasticity. (Use Point Elasticity Method)

(a) 1.5              (b) 2.5

(c) -1.5             (d) 0.5

89. The supply function is given as Q= -100 + 1 OP. Find the elasticity using point method, when price is Rs. 15.

(a) 4                 (b) -3

(c) -5                (d) 3

90. The figure below shows the budget constraint of a consumer with an income of Rs. 900/-to spend on two commodities, namely ice cream and chocolates.

The prices of these two commodities respectively are:

(a) Rs.10andRs.20

(b) Rs.20andRs.10

(c) Rs.10andRs.5

(d) Any of the above.

91. Which of the following statements about price elasticity of demand is correct?

(a) Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

(b) Price elasticity of demand is computed as the percentage change in quantity demanded divided by the percentage change in price.

(c) Price elasticity of demand in the long run would be different from that of the short run.

(d) All the above.

92. The aim of the consumer in allocating his income is to __________.

(a) maximize his total utility.

(b) maximize his marginal utility.

(c) to buy the goods he wants most whatever the price.

1. to buy the goods which he expects to be short in supply.
2. At higher prices people demand more of certain goods not for their worth but for their prestige value -This is called

(a) veblen effect.                    (b) giffens paradox.

(c) speculative effect.             (d) none of the above.

94. If the price of air-conditioner increases from Rs. 30,000 to Rs. 30,010 and resultant change in demand is negligible, we use the measure of __________ to measure elasticity.

(a) point elasticity.                   (b) perfect elasticity.

(c) perfect inelasticity.             (d) price elasticity.

95. If the percentage change in supply is less than the percentage change in price it is called

(a) unit elasticity of supply.                 (b) perfectly elastic.

(c) more elastic supply.                       (d) inelastic supply.

96. The supply curve shifts to the right because of __________

(a) improved technology.                    (b) increased price of factors of production.

(c) increased excise duty.                   (d) all of the above.

97. Which of the following statements is correct?

(a) When the price falls the quantity demanded falls.

(b) Seasonal changes do not affect the supply of a commodity.

(c) Taxes and subsidies do not influence the supply of the commodity.

(d) With lower cost, it is profitable to supply more of the commodity.

98. If the demand is more than supply, then the pressure on price will be

(a) upward                   (b) downward

(c) constant                 (d) none of the above

99. The supply curve for perishable commodities is __________.

(a) elastic                    (b) inelastic

(c) perfectly elastic      (d) perfectly inelastic

100. Supply is a __________ concept.

(a) stock                      (b) flow and stock

(c) flow                        (d) none of the above

101. The cross elasticity between Rye bread and Whole wheat bread is expected to be:

(a) positive                  (b) negative

(c) zero                        (d) can’t say

102. In the diagram given below, the shaded portion represents.

(a) Price above which there is no demand for the commodity.

(b) Monopoly price of the commodity.

(c) Consumer surplus.

(d) None of the above.

103. The income elasticity of tomatoes is 0.25, it means tomatoes are:

(a) inferior goods.        (b) luxury goods,

(c) normal goods.        (d) can’t say.

104. The cross elasticity between personal computers and soft wares is:

(a) positive.                 (b) negative.

(c) zero.                       (d) one.

105. The cross elasticity between Bread and DVDs is:

(a) positive.                 (b) negative.

(c) zero.                       (d) one.

106. Which of the following statements is correct?

(a) With the help of statistical tools, the demand can be forecasted accurately.

(b) The more the number of substitutes of a commodity, more elastic is the demand.

(c) Demand for butter is perfectly elastic.

(d) Gold jewellery will have negative income elasticity.

107. Suppose the income elasticity of education in private school in India is 1.6. What does this indicate:

(a) Private school education is a luxury.

(b) Private school education is a necessity.

(c) Private school education is an inferior commodity.

(d) We should have more private schools.

108. Suppose potatoes have (-).0.4 as income elasticity. We can say from the data given that:

(a) Potatoes are inferior goods.

(b) Potatoes are superior goods.

(c) Potatoes are necessities.

(d) There is a need to increase the income of consumers so that they can purchase potatoes.

ANSWERS

*This article contains all topics about THEORY OF DEMAND AND SUPPLY – Business Economics and Business commercial knowledge.

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