U N I T- I I

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CHAPTER

CONSUMER CHOICE AND THE DEMAND CURVE

In Chapter 1 it was stated that, in a marketoriented economy, the central problems of what, how and for whom are solved through forces of demand and supply for various goods and services. Who demands a particular good and who supplies it? This depends on the type of good or service in question. Consider a final product such as alu bhujia.1 As consumers, households are the demanders of alu bhujia and companies like Bikanerwala and Leher are the suppliers. Another example is the service of a computer programmer. This service is demanded by companies or firms. Who are the suppliers of this service? The households, because some members of some households work as computer programmers. In summary, in case of final goods and services, households demand them and firms supply them. In case of services that are required for production, households are the
1

2.1 Consumer's Equilibrium 2.2 Meaning and Determinants of Demand 2.3 Market Demand Curve 2.4 Price Elasticity of Demand

Final goods and services include things that are consumed by households, e.g. a piece of bread, a haircut, a bicycle repair job etc. As opposed to final goods and services, there are intermediate goods (or raw materials) that are consumed (i.e. used up) by businesses. The examples are steel in a bicycle factory, wheat in a flour mill, and various automobile components in a Maruti car workshop.

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suppliers and the fir ms are the demanders. This chapter deals with households as consumers and their demand for final goods and services. How should a consumer decide how much of a product to buy? What factors do affect this decision and how? 2.1 CONSUMERS EQUILIBRIUM: THE BASIS OF THE LAW OF DEMAND Let us ignore for the moment the word equilibrium or the phrase Law of Demand, and focus on the question of how much of any particular good a consumer should demand (or buy) at a given point of time. In order to understand this, we first have to learn a few concepts. 2.1.1 Utility Concepts We begin with the notion that a consumer derives some satisfaction from consuming a product; otherwise, she would not demand it at all. This is captured by a term called total utility, defined as the total psychological satisfaction a consumer obtains from consuming a given amount of a particular good. Consider for example your consumption of gol guppa - the mouth-watering small round-shaped puffed puris, served with tamarind (imli) water and fillings.1 Imagine that you are hungry and have come to your favourite gol guppa vendor. Suppose that if you consume only one gol guppa you derive 20 units of pleasure or utility measured in some units. Let this (psychological)
1

unit be called utils. Thus, the total utility from consuming one gol guppa is 20 utils. Suppose that you like gol guppa so much that eating just one increases your appetite for it. Let the second unit give an additional utility of 22 utils. Then, the total utility from consuming two gol guppas is 20+ 22 = 42 utils. In the same manner we can calculate total utility from consuming three, four or five units and so on. Besides total utility, there is another important concept called marginal utility, defined as the utility from the last unit consumed. Thus the marginal utility from consuming one gol guppa is 20 and that from consuming two gol guppas is 22. You can now notice the relationship that total utility is the sum of marginal utilities. Getting on with our story, your intensity of desire for gol guppa must fall, after consuming a certain amount, regardless of how much you like gol guppa. Suppose that, in your case, such decline in the intensity of desire starts with the third gol guppa you consume. Accordingly, let the third unit give you utility equal to a number less than 22, say, 18 utils. That is, the marginal utility and the total utility obtained from consuming three gol guppas are 18 and 42 +18 = 60 utils respectively. The next (fourth) unit gives you still less utility, say, 14 utils, and so on. This pattern of marginal utility is called the law of diminishing marginal utility. It states that, after consuming a certain amount of a good

Incase gol guppa is not known to the children, the teachers can use other popular eatable as example to explain the concept.

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or service, the marginal utility from it diminishes as more and more is consumed. If you think about it, this law is very natural and should hold for any product one consumes. In fact it is considered as a fundamental psychological law. You will see the critical role of it a little later. Let us resume our story once again. When you have already consumed quite a few gol guppas say 8, and you are very full in your stomach suppose that the next (9th) unit gives zero utility. Imagine what will happen if you keep gulping more. Suppose that eating the 10th unit makes you vomit! This is obviously not a pleasant experience and should give you negative satisfaction. Accordingly, let the utility associated Table 2.1 Units Consumed of Gol guppa 0 1 2 3 4 5 6 7 8 9 10

with the 10th unit be -7 utils. That is, the marginal utility of ten gol guppas is -7 utils. (If you are crazy and still eat more, each additional one can only give you more negative utility.) Table 2.1 summarises your experience with gol guppa in terms of marginal utility and total utility up to 10 units of consumption. Columns (2) and (3) present the marginal and total utility schedules. 2.1.2 How many Gol Guppas will you consume or buy?

From Table 2.1, it is clear that if you are a rational (not crazy) consumer, you will eat less than 10 gol guppas, since consuming 10 or more gives you negative marginal utility. If gol guppas

Marginal and Total Utility Marginal Utility (in utils) 20 22 18 14 11 8 4 2 0 -7 Total Utility (in utils) 0 20 42 60 74 85 93 97 99 99 92

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were free, i.e., its price were zero, you would have consumed 8 or 9 units at which your total utility is at its maximum. But as long as you pay something for it, you may not wish to consume so many. You would like to know how much utility you could have obtained if you had spent some amount on other items, e.g., ice cream, chocolate etc. In other words, exactly how many gol guppas you will eat would depend not only on marginal and total utility from consuming gol guppas, but also on the price of gol guppas, and, how much a rupee is worth to you in terms of other goods. We now define marginal utility of one rupee as the extra utility when an additional rupee is spent on other available goods in general. Suppose that, for you, it is 4 utils and let the price of gol guppa be Rs. 2 per piece. Having the information on price and marginal utility of a rupee, we can determine how many gol guppas you will consume. Consider first whether you will buy just one gol guppa. From consuming only one, you obtain utility equal to 20 utils (from Table 2.1). Since the marginal utility of a rupee is 4 utils, we can say that, from consuming one gol guppa, you get utility worth Rs. 20/4 = Rs. 5. On the other hand, you pay and thus sacrifice Rs. 2 for it. Hence you will buy the first unit. Similarly, from the second unit, you get utility worth Rs. 22/4 = Rs. 5.50, while you pay only Rs. 2. Hence you will buy the second gol guppa also. We keep on making such comparisons for successive units. For

example, the 5th gol guppa is worth having it since it gives Rs. 11/4 = Rs. 2.75 worth of utility, which is greater than the price. What happens with the 6 th gol guppa is a bit different. It gives you utility worth Rs. 8/4 = Rs. 2, which is equal to the price. Will you buy it? The answer is that you will be indifferent, that is, whether or not you buy the 6th unit does not make any difference. However, it is clear that you will not buy (consume) more than 6. Because, at any level of consumption beyond 6, the marginal utility in terms of rupees is less than the price (you can check this directly). Hence we have found the answer to our query: you will buy 5 or 6 gol guppas. The above comparisons between how much of marginal utility in terms of money you get and the price you pay implies that, at either of these two levels of consumption, the difference between the total utility in terms of money and your total expenditure on gol guppas (defined as price quantity purchased) is maximised. Table 2.2 illustrates this. Its second column gives total utility in terms of money, defined as total utility divided by the marginal utility of one rupee (equal to 4 utils in this example). Column (3) gives your total expenditure or spending on gol guppas. The last column gives the difference between these two columns; this is like the net gain to a consumer. We see that this difference is maximised (equal to Rs. 11.25) when your gol guppa consumption is either 5 or 6. Having gone through the example, we can now understand why this

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Table 2.2

Difference between Total Utility in Terms of Money and Total Expenditure Total Utility in terms of money (Rs.) 0 5 10.50 15 18.50 21.25 23.25 24.25 24.75 24.75 23 Total Expenditure (Rs.) 0 2 4 6 8 10 12 14 16 18 20 Difference (Rs.) 0 3 6.50 9 10.50 11.25 11.25 10.25 8.75 6.75 3

Amount Consumed of gol guppas 0 1 2 3 4 5 6 7 8 9 10

section is titled Consumers Equilibrium. The word equilibrium, frequently used in economics, means a position of rest. In this example, you will rest, stop or, as economists say, attain consumers equilibrium at 5 or 6 gol guppas. Because you do not want to consume less or more than these quantities. In general, we can then say that consumers equilibrium with respect to the purchase of one good is attained when the difference between total utility in terms of money and the total expenditure on it is maximised. 2.1.3 The General Principle From the example just worked out, we can now derive the general principle of

consumers equilibrium with respect to any particular good. Recall that one of our answers is 6 gol guppas. Ignoring the other answer for the moment, note that, at this level of consumption, the marginal utility in terms of money (Rs. 2) is equal to price (Rs. 2). This is indeed the principle and we can state this in two alternative ways. That is, the consumer s equilibrium is attained when
(A) Marginal Utility of a Product Marginal Utility of a Rupee = Its Price
(B ) Marginal Utility of a Product Its Price

Or

= Marginal Utility of a Rupee.

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In particular, the condition (A) says that the marginal utility of a product in terms of money be equal to its price. Sometimes, this is loosely stated as marginal utility is equal to price. Now go back to the example once again and see that the consumers equilibrium is also attained at 5 gol guppas, where the principle is not satisfied. This possibility exists because gol guppas are not perfectly divisible: they cannot be measured continuously like points on a straight line. If, instead, a product is perfectly divisible and thus can be measured continuously, for example by weight on a weighing scale, there will be just one level of consumption at which the consumers equilibrium is achieved, with condition (A) [or (B)] met. We do implicitly assume from now on that a product is perfectly divisible and thus treat (A) or (B) as the condition of consumers equilibrium.2 2.2 MEANING AND DETERMINANTS OF DEMAND Our analysis of consumers equilibrium implies that the price of a product is an important factor in determining how much of the product a consumer will be willing to buy within a given time period. It is because, as the product price changes, the ratio of marginal utility to price changes so that the consumers equilibrium will occur at a different level of consumption.

This forms the basis of defining demand for a particular good by a consumer: it is the quantity of the good that she is willing to buy at different prices within a given period of time. However, the price of a product is not the only factor that influences how much a consumer should buy of that product. For example, if there is a taste change, it will change the marginal utilities from a product, and, the consumers equilibrium condition will be fulfilled at some other level of consumption even when there is no change in price. Moreover, while our preceding analysis is confined to one good (e.g. gol guppa), in reality, a consumer buys many goods. The consumers equilibrium analysis with respect to many goods (which is outside our scope) suggests two other factors, namely, prices of related goods and income. This is quite natural. If a person consumes, for example, tea and coffee, then a change in the price of tea should affect her consumption of coffee and vice versa. Also, if income changes, different amounts can be bought even when the prices of goods and services she consumes remain unchanged. The last three factors just mentioned are called the determinants of demand. They are namely,

Nothing essential or important is gained by deviating from this assumption. The only modification is that, when a good is not perfectly divisible, the condition (A) or (B) holds either exactly or approximately.

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(a) prices of related goods, (b) income and (c) tastes. 3 The next question is how the own price of a product as well as these three factors affect the quantity demanded of a particular good. 2.2.1 Own Price: The Law of Demand To isolate its effect, hold the other factors constant and ask how the quantity demanded of a product changes as its own price changes. The answer is summarised as what is called the Law of Demand. It states that other things remaining unchanged, as the own price of a commodity increases, the quantity demanded of it by a consumer falls. Other things refer to the prices of related goods, income and tastes. Suppose that, for a particular family, within a month, Table 2.3 lists its quantities demanded of apples at different prices, which are consistent with its consumers equilibrium. The left column lists various prices, while the right column lists the corresponding quantities demanded. It is assumed that the prices of related goods, family income and tastes are kept fixed at some pre-determined levels.
3

The law of demand in tabular form is called a demand schedule. If we graph a demand schedule, we obtain a demand curve. It typically measures own price along the y-axis and quantity demanded on the x-axis. The demand curve corresponding to the demand schedule in Table 2.3 is shown in fig. 2.1. We see that the demand curve is downward sloping. It is because an increase in the own price lowers the Table 2.3 Own Price (in Rs.) 12 13 14 15 16 17 A Demand Schedule Quantity Demanded of Apples 24 17 12 9 7 6

quantity demanded. Each point of the demand curve shows the quantity demanded that is consistent with consumers equilibrium. Why is the Demand Curve Downward Sloping? Isnt it obvious that the demand curve is downward sloping? That is, as

Apart from (a), (b) and (c), there may be other determinants of demand for a good, e.g., future price expectation. Consider an essential product, say, edible oil or sugar. Suppose there is a weather prediction that your village or town will be hit by a severe cyclone in the next three days. You would then anticipate that supply interruptions would occur and prices of these commodities would skyrocket. If you are a rational consumer, you would buy more of these commodities now (and store them) even if prices, income or tastes do not change. Moreover, taste changes can occur not only because of natural changes in a persons liking, but also due to advertising of products.

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Table 2.4 Marginal Utility Schedule and the Demand Schedule Quantity of T-shirts 1 2 3
Fig. 2.1 Demand Curve Corresponding to Table 2.3

Marginal Utility of T-shirts 75 70 65 60 55 50 45

4 5 6 7

the own price increases, the quantity demanded of a product falls. Interestingly, it is not. There is a reason behind it, namely, the law of diminishing marginal utility. Indeed, the demand curve is essentially the marginal utility curve.4 Consider Table 2.4, which lists the marginal utility from consuming T-shirts. Mark that, for simplicity, diminishing marginal utility sets in with the very first unit of consumption. Assume further, again for simplicity of exposition, that the marginal utility of a rupee is equal to 1 util. Then, our consumers equilibrium condition (A) can be stated as Marginal Utility = Price. To begin with, suppose that the price of a T -shirt is Rs. 45. The consumers equilibrium condition holds at 7 T-shirts consumed. This can
4

be restated as follows. The quantity demanded of T-shirts is 7 when the price is Rs. 45. Thus the pair (45, 7) will be on the demand curve. Similarly, suppose that the price of T -shirts increases to Rs. 65. The consumers equilibrium condition now holds at 3 T-shirts consumed, that is, at price Rs. 65, the quantity demanded is 3. Hence the pair (65, 3) will be on the demand curve too. Likewise, we can determine that all other points on the marginal utility schedule are points on the demand schedule. This means that the marginal utility curve itself is the demand curve, and, the demand curve is downward sloping because of the law of diminishing marginal utility.

An intuitive way to see this is that, as a consumer buys more of a good, her marginal utility decreases and therefore she is willing to pay less per unit. This can be turned around to say that if the price of a product falls, a consumer buys more of it.

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2.2.2

Determinants of Demand

Now turn to the remaining factors that affect the quantity demanded of a particular product, or, what we have called the determinants of demand. Change in Price of a Related Good Suppose that Mrs. Das, who lives next door to you, has a weakness for sweets. Burfi and gulab jamun are her favourites. Suppose that burfis become more expensive: from Rs. 5 a piece to Rs. 8 a piece. How will this affect Mrs. Dass demand for gulab jamun? It will increase. Why, because burfi and gulab jamun are substitutes of each other in consumption. Consider another example: that of tea and coffee. The same should happen to the demand for tea if the price of coffee rises or vice versa, because tea and coffee are also substitutes. We say that good A is a substitute of good B if an increase in the price of good B increases the demand for good A. On the other hand, consider tea and sugar. Sugar is complementary to tea Table 2.5

in consumption. Thus, if the price of tea goes up, the quantity demanded of tea should fall, which will reduce the demand for sugar. Another example of a pair of complementary products is petrol and cars. If the price of petrol rises, the quantity demanded of cars should fall. In other words, good A is said to be complementary to good B if an increase in the price of good B decreases the demand for good A. These examples illustrate cross price effects: how the demand for one particular product is affected by a change in the price of another. Numerical examples of cross price effects are given in Tables 2.5 and 2.6. In Table 2.5, note that as the price of coffee rises from Rs. 200 to Rs. 250, the quantity demanded of tea increases for any given price of tea. For example, given price of coffee = Rs. 200, at tea price equal to Rs. 170, the quantity demanded of tea is 11, whereas, given coffee price = Rs. 250, at the same tea price (Rs. 170), the quantity demanded of tea is 18. The demand schedules of

Effect of an Increase in the Price of Coffee on Demand for Tea Quantity Demanded of Tea when Price of Coffee (per kg) = Rs. 200 20 11 5 2 1 Quantity Demanded of Tea when Price of Coffee (per kg) = Rs. 250 28 18 10 7 4

Price of Tea (per kg) Rs. 150 170 190 210 230

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Table 2.6

Effect of an Increase in the Price of Tea on Demand for Sugar Quantity Demanded of Sugar when Price of Tea (per kg) = Rs. 170 20 14 9 6 5 Quantity Demanded of Sugar when Price of Tea (per kg)= Rs. 200 12 7 4 2 1

Price of Sugar (per kg) Rs. 5 8 11 14 17

tea given in column (2) and (3) of Table 2.5 are graphed in Figure 2.2. We see that demand curve for tea when the price of coffee is Rs. 250 lies to the right of that when the price of coffee is Rs. 200. Hence, an increase (a decrease) in the price of a substitute good shifts the demand curve for a product to the right (left). Similarly, in Table 2.6, notice that, as the tea price increases from Rs. 170 to Rs. 200, the quantity demanded of sugar decreases for any given price of sugar. Figure 2.3 graphs Table 2.6. The demand curve for sugar when tea price is Rs. 200 lies to the left of that when the sugar price is Rs. 170. Thus, an increase (a decrease) in the price of a complementary good shifts the demand curve for a product to the left (right). A Change in Income Suppose that you only buy peanuts and ice cream from your pocket money. Ice cream is your favourite but it is costly. You like peanuts much less, but

Fig. 2.2

Change in demand due to increase in the price of a substitute good

they are cheap. Suppose that your pocket money increases. Will you buy more of ice cream, more of peanuts or both? We bet that you will buy more ice cream. Whether you will buy more peanuts is not clear. Very likely, you will buy less of peanuts, not because your taste changes but because you can afford more ice cream, which is your favourite. Hence, generally, we can say that, as income increases, a consumer may

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buy more or less of a product. If she buys more (e.g. ice cream), then we say that the product in question is a normal

those, for which demand falls as income rises. Table 2.7 presents numerical examples of both normal and inferior goods. Observe that, at any given price, as income increases, quantity demanded of the normal good increases (by comparing columns (2)-(3)) and that of the inferior good decreases (by comparing columns (5)-(6)). These are graphed in figs. 2.4 and 2.5. The original demand curve for the normal good, when income is Rs. 300, is indicated by the line NN0 in fig. 2.4. This represents the column pair (1)-(2). The new demand curve, when income of Rs. 400, is marked by NN 1 that represents the column pair (1)-(3). Hence an increase in income shifts the demand curve to the right if the good is nor mal. For the inferior good, the demand curves are indicated by FF 0 (original) and FF 1 (new) in

Fig. 2.3 Change in demand due to increase in the price of a complementary good

good. If she buys less (e.g. peanuts), then we say that it is an inferior good. Put differently, nor mal goods are those, for which demand increases as income increases. Inferior goods are Table 2.7 Own Price

Normal and Inferior Goods An Inferior Good Own Price Quantity Quantity Demanded: Demanded: Income = Income = Rs. 300 Rs. 400 3 4 5 6 7 8 20 17 14 11 8 5 15 12 9 6 3 0

A Normal Good (Quantity (Quantity Demanded: Demanded: Income = Income = Rs. 300 Rs. 400 15 12 9 7 5 3 19 16 13 11 9 7

1 2 3 4 5 6

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fig. 2.5. Thus an increase in income shifts the demand curve to the left if the good is inferior. In the real world, there are much fewer examples of inferior goods than normal goods. Yet there are important examples. In India, cereals as a single category of goods (that includes rice, wheat, bajra, jowar etc.) constitute an inferior good. Within this category, the inferior-good characteristic applies to bajra, jowar, maize and related cereals. A Change in Tastes Finally, consider a taste change. Suppose you are impressed by an advertisement in TV, in which your favourite actor drinks Coca Cola, and, as a result, your liking for Coca Cola increases. This will shift your demand curve for Coca Cola to the right. This is an example of a favourable change in tastes. An unfavourable change in taste will imply the opposite. We can then say
Fig. 2.5 Change in demand due to increase in income (Inferior Good)

that a favourable (an unfavourable) change in tastes shifts the demand curve to the right (left). A taste change may result from a change in a persons liking, or, from some other source. If, for instance, for health reasons, you have to consume more of a product although you dont like it, this is also considered a taste change. 2.2.3 Change in Quantity Demanded Versus Change/ Shift in Demand We have seen that the quantity demanded of a product depends on own price and other factors like prices of related goods, income and tastes. The law of demand refers to the effect of a change in the own price. A graphical representation of this is the demand curve, which is downward sloping. A change in the own price causes a movement along a given demand curve: higher (lower) the price, less (more) is the quantity demanded.

Fig. 2.4 Change in demand due to increase in income (Normal Good)

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Such a movement is called a change in the quantity demanded. In contrast, when a change in any other factor causes a (left or rightward) shift of a demand curve, we call this a change in demand. The distinction between the two concepts is illustrated in fig. 2.6. Fig. 2.6(a) illustrates a change in the quantity demanded. There is a price change from P0 to P1. As a result, there is a movement along the same demand curve from A to B. The quantity demanded changes from Q0 to Q1. In contrast, fig. 2.6(b) shows a change in demand, meaning a shift of a demand curve from DD0 to DD1 due to a change in the prices of related goods, income or tastes. 2.3 MARKET DEMAND CURVE We have studied consumers equilibrium and the determinants of demand for a good from the perspective of a single individual. How do we get the demand curve of a product by all individuals together in an economy, e.g., the economy of a region or a country? The economy-wide demand curve for a particular product is called the market demand curve. It is obtained by summing up the demand curves across consumers or households. Consider the market for, say, gulab jamun. Suppose that there are three consumers in the market: Amar, Akbar and Anthony. If at the price equal to Rs. 3 a piece, Amar demands 5, Akbar 6 and Anthony 8 per week, then the total quantity demanded is 19. Hence

(a) Change in Quantity Demanded

(b) Change in Demand Fig. 2.6 Change in Quantity Demanded Versus Change in Demand

(3, 19) is a point on the market demand curve. Repeat the same exercise for other possible prices and obtain the corresponding points. Plot the points, join them and you get the market demand curve. A numerical example is given in Table 2.8. Individual demand schedules are given by column pairs (1)-(2), (1)-(3) and (1)-(4). The column

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pair (1)-(5) gives the market demand schedule. Note that for each row (price), the entry in column (5) is the sum of corresponding entries in columns (2), (3) and (4). These individual demand schedules and the market demand schedule are graphed in fig. 2.7. Amars, Akbars and Anthonys demand curves are respectively marked by their names. The right most line is the market demand curve. This is obtained by horizontally summing the individual demand curves. What are the determinants of the market demand curve? They are the determinants of the individual demand curve described earlier plus how many consumers buy the product, that is, (a) prices of related goods; (b) income levels across individuals, or Table 2.8

what we can call, the distribution of income; (c) consumers tastes (d) the number of consumers who buy the product, or what we can call, the market size.5 2.4 PRICE ELASTICITY DEMAND OF

We have seen how various factors like own price and income affect the demand for a commodity. The direction of change was our focus - whether the quantity demanded increases or decreases as price, income or other factors change. The concept of elasticity captures the magnitude of change or the degree of responsiveness. For example, the price elasticity of demand quantifies the effect of a change in own price on the quantity demanded.

Individual and Market Demand Schedules for Gulab Jamun Amars Demand 7 6 5 4 3 2 Akbars Demand 15 10 6 3 1 0 Anthonys Demand 13 10 8 7 6 5 Market Demand 35 26 19 14 10 7

Price of Gulab Jamun in Rs. 1 2 3 4 5 6

5

Many multinational firms today look at the Indian or the Chinese market as very lucrative, because of their market sizes, which refer to the huge number of consumers in these countries.

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Fig. 2.7 Individual and Market Demand Curves

2.4.1 Definition and Formulas Formally, Elasticity of demand is defined as

(C ) Price elasticity of demand = e D % change in the quantity demanded = % change in the own price

Since the changes in price and quantity along a demand curve occur in opposite directions, the ratio of % change in quantity demanded and that in the own price is negative in sign. Hence attaching a negative sign in front of the ratio makes the sign of eD positive. Some other textbooks define the price elasticity the same way as above, except for the minus sign. But there is no reason to get confused. Strictly speaking, our definition gives the absolute value of the elasticity, which is, often, referred to as elasticity.

Along a given demand curve, let the original price be P0 and the original quantity be Q0. Suppose that the price increases to P 1 and the quantity demanded falls to Q1. Then the % changes in price and quantity demanded are respectively equal to [(P1P0)/P0]100 and [(Q1Q0)/Q0]100. Thus (C) can be written as

(D ) e D =

(Q1 Q0 ) / Q0 . (P1 P0 ) / P0

If we further denote a change in quantity as Q and a change in price as P, we can also write
(E ) eD = Q/Q0 . P / P0

Consider the following numerical example. Suppose that in your home town, rasgoolas were being available at Rs. 5.00 per piece and the residents of

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the town were buying 1200 rasgoolas per day. Now they become more expensive for some reason, at Rs. 5.50 per piece. Fewer people are eating rasgoolas and many who eat, are eating less. Suppose that the people in the town are now buying 960 rasgoolas per day. What is the price elasticity of demand? We have to do some arithmetic. The % change in the price is equal to [(5.50 5.00)/5.00] 100 =10. The % change in quantity is equal to [(960 1200)/1200] 100 = 20. Hence, eD, the price elasticity, is equal to 20/10 = 2. Properties 1. A very desirable property of the elasticity formula in measuring the degree of responsiveness is that it is independent of the choice of units. It is because any percentage change of a variable is independent of units. 2. If two demand curves intersect, at their point of intersection, the elasticity associated with the flatter demand curve is higher. This is exhibited in fig. 2.8. The demand curves DD and DD intersect at the point C. At this point, P0 is the price of the product. The claim is that, at price P0, the elasticity is greater along the flatter demand curve DD. Why? Because the original quantity demanded is the same, equal to D0, along both demand curves, and, if there is an increase in price, say to P1, the quantity demanded falls more along the flatter demand curve (by amount D2D0 as compared to

D1D0 along DD). This implies that, while the % change in price is the same along both demand curves, the % change in quantity demanded is greater along DD. Therefore, price elasticity associated with DD is higher. 3. Higher the value of the price elasticity, greater is the degree of responsiveness of quantity demanded to price. In particular, if eD>1, then the % change in quantity demanded must exceed the % change in price. We then say that the product demand is elastic (e.g. jewellery). If eD<1, the % change in quantity demanded is less than that of the price, and, we say that the product demand is inelastic. Typically, the demand for luxury goods is elastic and that for necessary goods (e.g. basic food items) is inelastic. Finally, if eD =1, it is said that the demand is unitarily elastic. In this special case, the demand curve takes a particular

Fig. 2.8

Elasticity Comparison

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shape, called rectangular hyperbola in geometry. It is a curve, which extends towards the x-axis and y-axis in a uniform manner without touching them. Fig. 2.9 exhibits this. 4. There are two other special cases. If the product is absolutely essential, like demand for a rare medicine or some very bad case of addiction to undesirable products like opium, the demand curve is vertical. In this case, the price elasticity is zero, i.e., the product demand is totally or perfectly inelastic. This is evident, because, along a vertical demand curve, the quantity demanded is totally insensitive to any change in price. This case is exhibited in fig. 2.10(a). The last special case is the one, where demand curve is horizontal and thus the demand is perfectly elastic, i.e., the price

2.4.2 Factors Affecting the Magnitude of Price Elasticity In general, the magnitude of price elasticity depends on the following factors. Availability of Close Substitutes: If close substitutes of a product are readily available, its price elasticity of demand is likely to be high, because even a very small increase in price will make consumers switch to other

(a) Perfectly Inelastic Demand

Fig. 2.9

Unitarily Elastic Demand

elasticity is equal to infinity. Fig. 2.10(b) shows this. An economic example of this demand curve will be given in Chapter 4.

(b) Perfectly Elastic Demand

Fig. 2.10

Elasticitiy = 0,

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products in a big way. Otherwise, in the absence of close substitutes, the elasticity is likely to be small. For example, if it is a staple food item of a particular region, say, rice in Orissa or West Bengal, by definition, there are no (very) close substitutes available. It is indispensable. Hence the demand for rice is likely to be inelastic. More generally, the demand for essential products is likely to be inelastic. On the other hand, luxury items like eating in a restaurant, buying a big-size colour TV etc. are relatively dispensable. Hence the demand for these items is likely to be relatively elastic. Proportion of Total Expenditure Spent on the Product: If the amount spent on a product constitutes a very small fraction of the total expenditure on all goods and services you consume, then the price elasticity is likely to be small. The demand for salt is an example. On the other hand, if it is a high-price item and takes a major portion of your total expenditure, your demand for it is more sensitive to a price change; that is, the elasticity of demand is likely to be high. Habits: Some products which are not essential for some individuals are essential for others. A form of consumption such as eating out in fivestar restaurants is a luxury for many people; therefore, their demand for it is very elastic. But, for someone who is very rich, it may be an essential demand, because he is already habituated. Hence his demand for five-

star restaurant food is inelastic. Similarly, for an opium addict, the demand for opium is very inelastic, whereas for other casual opium takers, the demand is likely to be elastic. Time Period: All other things remaining the same, the longer the time period, more elastic is the demand for any product. The consumption of petrol is a prime example. In the 1970s, when OPEC (Organisation of Petroleum Exporting Countries) dramatically increased the price of oil for the first time in history, the whole world was shocked. Countries could not immediately find and adopt any other forms of energy for their needs. In other words, substitutes of oil could not be available and the demand for oil was very inelastic. But over years alternative types of energy were developed, and, substitutes became more readily available. The demand for oil is more elastic today than it was 30 years ago. Clip 2-1 reports price elasticities for various products that have been estimated by various authors. 2.4.3 Measurement of Elasticity

Finding price elasticity of demand using its definition as such is called the percentage method of measuring elasticity. In particular, when the price change is very small, a graphical formula or a geometric method can also be used to measure elasticity. Suppose that it is a straight-line demand curve, as shown in fig. 2.11, having intercepts A and B respectively on the price axis and quantity axis

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Clip 2-1
Price Elasticity Estimates
Price elasticities have been estimated for various products and services and in the context of different countries. Five examples are reported below, four of which are for India and one for America. As you see, the price elasticities for food items and clothing are less than one, as these are essential items. Note that item No. 4 is an example of a service: long distance phone calls from PCOs. The elasticity for this item is also less than one. It indicates that long-distance telephone calls are not a luxury demand anymore; they have become a necessity in a country like India. The item no. 5 shows that the demand for residential land in America is elastic, equal to 1.64. Product/Service 1. Cereals & cereal substitutes (India) Other foods (India) Clothing (India) Long distance phone calls from Public Call Offices (India) Residential Land in Philadelphia (U.S.A.) Price Elasticity Estimate 0.544 Source Meenakshi and Ray (1999) Meenakshi and Ray (1999) Meenakshi and Ray (1999) Das and Srinivasan (1999)

2. 3. 4.

0.804 0.560 0.580

5.

1.640

Gyourko and Voith (2001)

Das, P. and P.V. Srinivasan, Demand for Telephone Usage in India, Information Economics and Policy, 11, 1999, pages 177-194. Meenakshi, J. V. and Ranjan Ray, Regional Differences in Indias Food Expenditure Pattern: A Complete Demand Systems Approach, Journal of International Development, 11, 1999, pages 47-74. Gyourko, J. and R. Voith, The Price Elasticity of Demand for Residential Land: Estimation and Some Implications for Urban Reform, mimeo, Wharton School of Management, 2001.

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respectively. Suppose that initially the price is P0, and the quantity consumed is Q0, that is, the consumer is at point C on the demand curve. Then, for small price changes, the price elasticity turns out to be equal to BC/AC. This graphical formula is called point elasticity. In other words, point elasticity, at a certain point along a straight-line demand curve, is equal to the lower segment divided by the upper segment of the demand curve at that point. A proof of it is given in Appendix 2. The point elasticity formula implies that, as price increases, the ratio of the lower segment to the upper segment increases (as we are looking at points higher up on the demand curve) and therefore the product becomes more elastic.6,7,8 2.4.2 Total Expenditure and Price Elasticity The concept of price elasticity does not just quantify the relationship between price and quantity demanded, it also indicates the direction in which the total expenditure on a product changes, as there is a change in price. Return to the rasgoola example and ask the following simple question. Because of the increase in the price of

Fig. 2.11 Point Elasticity along a Straight Line Demand Curve

rasgoolas, does consumer spending or total expenditure on rasgoolas increase or decrease? By definition, the total expenditure on a particular good = price quantity. If we denote total expenditure by TE, price by P and quantity by Q, then TE = PQ. Let us now calculate TE. Originally, P and Q were respectively Rs. 5.00 and 1,200; hence TE was equal to Rs. 6,000. At the new price Rs. 5.50 and quantity = 960, TE = Rs. 5,280. Thus the total expenditure has fallen. Note also that the elasticity is equal to 2. That is, in the example, the demand for rasgoola is elastic, and, as there is a price increase, the total expenditure falls.

6 7 8

This is not a general property of price elasticity. It may not hold when the demand curve is not a straight line. At point B the elasticity is zero and at point A it is infinity. If it is not a straight-line demand curve, then the point elasticity measure at a point on it is based on the tangent to the curve at that point. You will find a treatment of this in a higher-level micro economics textbook.

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It turns out that such opposite movements in the directions of price and total expenditure changes hold, not just in this example, but always, when the product demand is elastic. Similarly, if the product demand is inelastic, the total expenditure always increases as price increases. Moreover, as a special case, if the product demand is unitarily elastic, then the total expenditure does not change with any price change. You can relate the last case to fig. 2.9, which depicts the unitarily-elastic case. That is, the total expenditures at all points on that demand curve are the same. There is thus a general relationship between the direction of price change and the direction of change in total expenditure, depending on the magnitude of price elasticity. If the product demand is elastic, unitarily elastic or inelastic, an increase in price leads respectively to a decrease, no change or an increase in the total expenditure on the product. Table 2.9 presents this result in a tabular form. This result can be proven algebraically, but it is beyond our Table 2.9

scope. However, it is quite intuitive. If the demand for a product is elastic, it means that a small price change invites a relatively large adjustment in the quantity. Hence the total expenditure must change in the same direction in which the quantity changes. Now you see that, as price increases, quantity falls and the fall in quantity is associated with a fall in the total expenditure. Just the opposite holds when the product demand is inelastic. In this case a large price change leads only to a relatively small adjustment in quantity. Hence the total expenditure must change in the same direction as the price change, i.e., a price increase leads to an increase in total expenditure. So far we have discussed how we can determine the direction of change in total expenditure, given the direction of change in the price and given whether the product is elastic or inelastic. Alternatively, if we know the direction of change in price and the direction of change in total expenditure, we can infer whether the product demand is elastic or inelastic. For

Price Change and Its Effect on Total Expenditure Elasticity Total Expenditure

Price Change

eD > 1

No Change

eD > 1
eD < 1 eD < 1

eD = 1

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instance, if because of a price increase, the total expenditure increases, then the product demand must be inelastic. You can readily verify that from Table 2.9. This link, via price elasticity, between changes in price and total expenditure has important practical implications. Return once again to the rasgoola example. Suppose that there is only one (giant) halwai shop in town, who sells rasgoolas. If you are the halwai shop owner and are

thinking about increasing the price of rasgoola, wouldnt you want to know if a price increase would increase or decrease your total sales in rupees? From a sellers perspective, the total value of sales is usually called total revenue and note that total revenue is equal to the total expenditure by the consumers.9 Hence the relationships between elasticity, price change and total expenditure are important from the viewpoint of decision making by a producer or a firm.

SUMMARY
l l l l l l l l l

Total utility is equal to the sum of marginal utilities. A rational consumer will never consume that much of a product such that the marginal utility from it is negative. At the consumers equilibrium, the difference between total utility in terms of money and the total expenditure on a good is maximised. Consumers equilibrium is attained when the condition that the marginal utility in terms of money is equal to the price is met. The law of demand defines demand curve, which is downward sloping. The demand curve is downward sloping because of the law of diminishing marginal utility. The demand curve is essentially same as the downward sloping portion of the marginal utility curve. A shift of the demand curve is caused by a change in the prices of related goods, a change in income or a change in tastes. An increase in the price of a substitute good causes an increase in demand or a rightward shift of the demand curve, while an increase in the price of a complementary good causes a decrease in demand or a leftward shift of the demand curve. As income increases, the demand for a product increases or decreases, i.e., the demand curve shifts to the right or left, depending on whether the good is normal or inferior.

We will see the use of the term total revenue in Chapters 4, 6 and 7.

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A favourable taste change increases the demand for a good, i.e., shifts the demand curve to the right; an unfavourable change does the opposite. Market demand curve is obtained by horizontally summing up the individual demand curves. The determinants of market demand curve are prices of related goods, distribution of income, tastes and the market size. The price elasticity of demand is independent of the choice of units. When two demand curves intersect, the elasticity associated with the flatter demand curve is greater. Greater the availability of close substitutes of a product, the higher is the price elasticity of demand for a product. Typically, the demand for luxury products is elastic and that for necessary goods is inelastic. Greater is the share of the total budget spent on a particular good, the more elastic is the demand for it. Longer the time horizon, the more elastic is the demand for a product. If the demand curve is vertical (horizontal), the price elasticity is zero (infinity). In case of elasticity equal to one, the demand curve is a rectangular hyperbola. Given that the demand is a straight line, the point elasticity is equal to the lower segment divided by upper segment of the demand curve at that point. If demand is elastic (inelastic), an increase in the price of the product leads to a decrease (an increase) in the total expenditure on the product. In case of a unitarily elastic demand, a change in price leaves the total expenditure on the product unchanged.

l l l l l l l l l

EXERCISES

Section I
2.1 2.2 Define total utility. Define marginal utility.

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2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 2.14

How is total utility derived from marginal utilities? State the law of diminishing marginal utility. Give the meaning of demand. Name two determinants of the demand. List the factors that cause changes in demand. What is the law of demand? What is a demand schedule? Give an example of a pair of commodities that are substitutes of each other. Give an example of a pair of commodities such that one of them is complementary in consumption to the other. If the price of good X rises and it leads to an increase in demand for good Y, how are the two goods related? If the price of good X rises and this leads to a decrease in demand for good Y, how are the two goods related? Define price elasticity of demand.

Section II
2.15 A persons total utility schedule is given below. Derive her marginal utility schedule. Amount Consumed 0 1 2 3 4 5 2.16 Total Utility 0 10 25 38 48 55

A persons marginal utility schedule is given below. Derive her total utility schedule. (Assume that the total utility of consuming zero is zero.)

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Amount Consumed 1 2 3 4 5 6 2.17 2.18 2.19

Marginal Utility 7 10 8 6 3 0

2.20

2.21 2.22 2.23 2.24 2.25 2.26 2.27 2.28 2.29

2.30 2.31

What is consumers equilibrium. State the condition of consumers equilibrium. Starting from an initial situation of consumers equilibrium, suppose that the marginal utility of a rupee increases. Will it increase or decrease the quantity demanded of the product? Ice creams sell for Rs. 30. Lakhmi, who loves ice cream, has already eaten 3. Her marginal utility from eating 3 ice creams is 90. Suppose further that, for her, the marginal utility of one rupee is 3. Should she eat more ice cream or should she stop? Explain the determinants of demand. What is meant by cross price effects? Give two numerical examples to illustrate this. What is meant by one good being a substitute of another? What is meant by one good being complementary to another? Differentiate between substitute and complementary goods. How will an increase in the price of coffee affect the demand for tea? How will an increase in the price of tea affect the demand for sugar? Suppose that good A is a substitute of good B. How will an increase in the price of good B affect the demand curve for good A? Suppose that good A complementary to good B in consumption. How will an increase in the price of good B affect the demand curve for good A? Give two examples of normal goods and two examples of inferior goods. How does an increase in income affect the demand curve for a normal good?

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2.32 2.33 2.34 2.35 2.36

How does an increase in income affect the demand curve for an inferior good? Define (a) complementary goods, (b) substitute goods, (c) inferior good and (d) normal good. Distinguish between a change in quantity demanded and a change in demand. How is the market demand curve derived from the individual demand curves? There are four consumers of a fruit called Smile. They are Isha, Ifraah, Ila and Ibema. Their demand curves for Smile are given below. Derive the market demand curve. Quantity Quantity Quantity Demanded by Demanded by Demanded by Ifraah Ila Ibema 7 6 5 4 3 2 15 12 9 6 3 0 8 6 4 2 0 0

Price Quantity (Rs.) Demanded by Isha 1 2 3 4 5 6 16 11 7 4 2 1

2.37 2.38 2.39

2.40

2.41

Explain the determinants of the market demand curve. Distinguish between individual and market demand curves. Originally, a product was selling for Rs. 10 and the quantity demanded was 1000 units. The product price changes to Rs. 14 and as a result the quantity demanded changes to 500 units. Calculate the price elasticity. Which of the following commodities have inelastic demand? Salt, a particular brand of lipstick, medicine, mobile phone and school uniform. Draw diagrams showing elasticity equal to (a) zero, (b) one and (c) infinity.

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2.42 2.43 2.44 2.45 2.46

2.47

2.48

2.49 2.50

Draw a straight line demand curve. Choose any three points on it and compare the point elasticities at these three points. Consider the above straight line demand curve. Compare the point elasticities between the points A, B and C. The price elasticity is 2. The % change in price is equal to 5. Find the % change in quantity. The price elasticity is 0.5. The % change in quantity is 4. What is the % change in price? As the price of peanut packets increases by 5%, the number of peanut packets demanded falls by 8%. What is the elasticity of demand for peanut packets? As the price of a product decreases by 7%, the total expenditure on it has gone up by 3.5%. What can we say about the elasticity of demand for this product? The price of cauliflower goes up by 8% and the total expenditure by a family on cauliflower goes up by 8%. What can we say about the elasticity of demand for cauliflower by this family? Show the effect of an increase in price on total expenditure depending on the values of price elasticity. A dentist was charging Rs. 300 for a standard cleaning job and per month it used to generate total revenue equal to Rs. 30,000. She has since last month increased the price of dental cleaning to Rs. 350. As a result, fewer customers are now coming for dental cleaning, but the total revenue is now Rs. 33,250. From this, what can we conclude about the elasticity of demand for such a dental service?

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2.51 2.52

If a product price increases, a familys spending on the product has to increase. Defend or refute. Determine how the following changes (or shifts) will affect market demand curve for a product. (a) A new steel plant comes up in Jharkhand. Many people who were previously unemployed in the area are now employed. How will this affect the demand curve for colour TVs and Black and White TVs in the region? (b) In order to encourage tourism to Goa, the Government of India suggests Indian Airlines to reduce air fare to Goa from the four major cities, Chennai, Kolkata, Mumbai and New Delhi. If the Indian Airlines reduces the air fare to Goa, how will this affect the market demand curve for air travel to Goa? (c) There are train and bus services between New Delhi and Jaipur. Suppose that the train fare between the two cities comes down. How will this affect the demand curve for bus travel between the two cities?

Section III
2.53 Discuss how the market demand curve is derived from the individual demand curves and the determinants of market demand. Explain why consumers equilibrium is attained when the marginal utility of a product in terms of money is equal to its price. Suppose there are three consumers in a particular market: Leander, Andre and Tim. Their demand schedules are given in the following table.

2.54

2.55

Price Quantity Demanded Quantity Demanded Quantity Demanded by Leander by Andre by Tim 1 2 3 4 5 60 50 40 30 20 55 40 25 10 0 24 13 5 0 0

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2.56 2.57

(a) Derive the market demand schedule and plot the market demand curve. (b) Suppose Andre drops out of the market. Derive the new market demand curve. (c) Suppose Andre stays in the market and another person, Marat, joins the market, whose quantity demanded at any given price is half of that of Leander. Derive the new market demand curve. Why does the demand curve slope downwards? Explain the factors affecting the magnitude of price elasticity of demand.