Demand and supply functions

Concept of utility

Utility

is a property common to all commodities

and services desired by a person. It has no
physical or material existence and so it is
inherent in a commodity.
Any commodity which has a capacity to satisfy
consumer want, it has utility.
Utility is subjective in nature. Utility has
nothing to do with usefulness. Hence in
economics, the concept of utility is legally,
morally, socially and ethically neutral.

Approaches to utility
It argues that a
consumer has
the capacity to
measure the
level of
satisfaction that
she derives
from
Cardin
consumption
of
al
a given quantity
of a commodity.

Utility

It argues that
a consumer
cannot
measure
satisfaction
numerically or
subjectively
instead
consumer can
rank the
Ordina
different
baskets or l

Marginal Utility& Total Utility

Marginal

utility is the utility of last unit or

addition to total utility by the consumption
of one additional unit of commodity.
MU10 = TU10 TU9
Total Utility- It is the sum of marginal
utilities obtained from consumption of each
successive unit of a commodity or service.
If continuous units of a commodity 'X' are
consumed, then
TUx = MUx

Terms related to Utility

Initial

Utility:
The amount of satisfaction to be obtained from the consumption
of very first unit of a commodity or service is called the initial
utility e.g. the amount of satisfaction to be obtained from
consumption of the first apple is units. It is called initial utility of
the consumer.
Positive Utility:
When a consumer consumes successive units of a commodity or
service, its marginal utility decreases. The utility obtained from
the consumption of all the units of a commodity or service before
reaching the marginal utility equal to zero, is called positive
utility.
Saturation Point:
By the consumption of that unit of a commodity where the
marginal utility drops down to zero, is called the saturation point.

Terms related to Utility

Negative

Utility:
By using the next unit of a commodity after
saturation point, that unit gives negative satisfaction
to the consumer and marginal utility becomes
negative, it is known as negative utility.
Util:
Although utility cannot be measured but in cardinal
approach of consumer behavior, the term which is
used as a unit of utility is known as Util and
arithmetic numbers (1, 2, 3, .......) are used. For
example X ate an apple and got 10 Util of utility.

Law of diminishing marginal

utility

law of diminishing marginal utility describes a

familiar and fundamental tendency of human behavior. The
law of diminishing marginal utility states that:
As a consumer consumes more and more units of a
specific commodity, the utility from the successive units
goes on diminishing.
Mr. H. Gossen, a German economist, was first to explain
this law in 1854. Alfred Marshal later on restated this law
in the following words:
The additional benefit which a person derives from an
increase of his stock of a thing diminishes with every
increase in the stock that already has.
The

Schedule to law
Unit

Total

Marginal

Utility

utility

1 glass of 20

20

water
2 glass of 32

12

Marginal utility curve

The

Assumption of law

law of diminishing marginal utility is true under certain assumptions.

These assumptions are as under:
(i) Rationality: In the cardinal utility analysis, it is assumed that the consumer
is rational. He aims at maximization of utility subject to availability of his
income.
(ii) Constant marginal utility of money: It is assumed in the theory that the
marginal utility of money based for purchasing goods remains constant. If the
marginal utility of money changes with the increase or decrease in income, it
then cannot yield correct measurement of the marginal utility of the good.
(iii) Diminishing marginal utility: Another important assumption of utility
analysis is that the utility gained from the successive units of a commodity
diminishes in a given time period.
(iv) Utility is additive: In the early versions of the theory of consumer
behavior, it was assumed that the utilities of different commodities are
independent. The total utility of each commodity is additive.
U = U1 (X1) + U2 (X2) + U3 (X3). Un (Xn)

Assumption of law Conti

v) Consumption to be continuous: It is assumed in this law that the

consumption of a commodity should be continuous. If there is interval

between the consumption of the same units of the commodity, the law
may not hold good. For instance, if you take one glass of water in the
morning and the 2nd at noon, the marginal utility of the 2nd glass of
water may increase.
(vi) Suitable quantity: It is also assumed that the commodity consumed is
taken in suitable and reasonable units. If the units are too small, then the
marginal utility instead of falling may increase up to a few units.
(vii) Character of the consumer does not change: The law holds true if
there is no change in the character of the consumer. For example, if a
consumer develops a taste for wine, the additional units of wine may
increase the marginal utility to a drunkard.
(viii) No change to fashion: Customs and tastes: If there is a sudden
change in fashion or customs or taste of a consumer, it can than make
the law inoperative.
(ix) No change in the price of the commodity: there should be any
change in the price of that commodity as more units are consumed.

Limitation to law

(i)

Case of intoxicants: Consumption of liquor defies the

low for a short period. The more a person drinks, the more
likes it. However, this is truer only initially. A stage comes
when a drunkard too starts taking less and less liquor and
eventually stops it.
(ii) Rare collection: If there are only two diamonds in the
world, the possession of 2nd diamond will push up the
marginal utility.
(iii) Application to money: The law equally holds good for
money. It is true that more money the man has, the
greedier he is to get additional units of it. However, the
truth is that the marginal utility of money declines with
richness but never falls to zero.

Law of equi-marginal utility

The

law of equi marginal utility was presented in

19th century by an Australian economists H. H.
Gossen. It is also known as law of maximum
satisfaction or law of substitution or Gossens second
law. A consumer has number of wants. He tries to
spend limited income on different things in such a
way that marginal utility of all things is equal. When
he buys several things with given money income he
equalizes marginal utilities of all such things. The law
of equi marginal utility is an extension of the law of
diminishing marginal utility. The consumer can get
maximum utility by allocating income among
commodities in such a way that last dollar spent on
each item provides the same marginal utility.

Statement of law

person can get maximum utility with his

given income when it is spent on different
commodities in such a way that the marginal
utility of money spent on each item is
equal".
It is clear that consumer can get maximum
utility from the expenditure of his limited
income. He should purchase such amount of
each commodity that the last unit of money
spend on each item provides same marginal
utility.

Assumption of law
There

is no change in the prices of the goods.

The income of consumer is fixed.
The marginal utility of money is constant.
Consumer has perfect knowledge of utility
obtained from goods.
Consumer is normal person so he tries to seek
maximum satisfaction.
The utility is measurable in cardinal terms.
Consumer has many wants.
The goods have substitutes.

Schedule and explanation

The

law of substitution can be explained

with the help of an example. Suppose
consumer has six dollars that he wants to
spend on apples and bananas in order to
obtain maximum total utility. The
Money ($)
M.U. of apples
M.U. of Bananas
following
table
shows
marginal
utility
1
10
8
additional7 dollars of
2(MU) of spending
9
and bananas:
3income on apples
8
6
4

The

above schedule shows that consumer can spend six

dollars in different ways:
$1 on apples and $5 on bananas. The total utility he
can get is:
[(10) + (8+7+6+5+4)] = 40.
$2 on apples and $4 on bananas. The total utility he
can get is:
[(10+9) + (8+7+6+5)] = 45.
$3 on apples and $3 on bananas. The total utility he
can get is:
[(10+9+8) + (8+7+6)] = 48.
$4 on apples and $2 on bananas. This way the total
utility is:
[(10+9+8+7) + (8+7)] = 49.
$5 on apples and $1 on bananas. The total utility he

Limitations

The

law is not applicable in case of indivisible

goods. The consumer is unable to divide the
goods to adjust units of utility derived from
consumption of goods. The law is not applicable
in case of indivisible goods. The consumer is
unable to divide the goods to adjust units of
utility derived from consumption of goods.
There is no measurement of utility. It is
psychological concept. It is not possible to
express it into quantitative form.
The law does not hold well in case fashion and
customs. The people like to spend money on
birthdays, marriages and deaths.

Limitations continues..
The

law is not applicable in case of durable goods. The

calculation of marginal utility of durable goods is
impossible.
The law fails when goods of choice are not available.
The consumer is bound to use commodity, which
provides low utility due to non availability of goods
having high utility.
There are certain lazy consumers. They do not care for
maximum utility. The law fails to operate in case of
laziness of consumers. They go on consuming goods with
comparing utility. There is no measurement of utility. It
is psychological concept. It is not possible to express it
into quantitative form. The law does not hold well in

Practical implications-

The

law of equi marginal utility is helpful in

the field of production. The producer has limited
resources. He uses limited resources to purchase
production factors. He tries to equalize marginal
utility of all factors. He wishes to get maximum
output and profit.
National income is distributed among factors of
production according to this law. An
entrepreneur can pay factors of production equal
to marginal product measured in money terms.
He will substitute one factor for another until
marginal productivity of all factors is equal to
prices of their services.

Practical implication continues.

The

law is applicable in consumption. A

rational consumer tries to get maximum
satisfaction when he spends his limited
resources on various things. He tries to
equalize weighted marginal utility of all
the things.
The law is applicable in public finance.
The government can spend its revenue to
get maximum social advantage. The
marginal utility of each dollar spent in one
sector must be equal to marginal utility

Law of demand

In

economic terminology the term demand conveys a

wider and definite meaning than in the ordinary
usage. Ordinarily demand means a desire, whereas in
economic sense it is something more than a mere
desire.
It is interpreted as a want backed up by the purchasing power.
Further demand is per unit of time such as per day,
per week etc. moreover it is meaningless to mention
demand without reference to price.
Demand for anything means the quantity of that
commodity, which is bought, at a given price, per
unit of time.

Demand price relationship

This

law explains the functional

relationship between price of a commodity
and the quantity demanded of the same.
It is observed that the price and the
demand are inversely related which means
that the two move in the opposite direction.
An increase in the price leads to a fall in
the demand and vice versa.
Other things being equal, the demand for
a commodity varies inversely as the price

Demand Schedule

Demand Curve

Assumptions of law
The

law of demand in order to establish the

price-demand relationship makes a number of
assumptions as follows:
Income of the consumer is given and constant.
No change in tastes, preference, habits etc.
Constancy of the price of other goods.
No change in the size and composition of
population.
These Assumptions are expressed in the phrase
other things remaining equal.

Exceptions to law

Continuous

changes in the price lead to the exceptional behavior.

If the price shows a rising trend a buyer is likely to buy more at a
high price for protecting himself against a further rise. As against
it when the price starts falling continuously, a consumer buys less
at a low price and awaits a further in price.
Giffen's Paradox describes a peculiar experience in case of inferior
goods. When the price of an inferior commodity declines, the
consumer, instead of purchasing more, buys less of that
commodity and switches on to a superior commodity. Hence the
exception.
Conspicuous Consumption refers to the consumption of those
commodities which are bought as a matter of prestige. Naturally
with a fall in the price of such goods, there is no distinction in
buying the same. As a result the demand declines with a fall in
the price of such prestige goods.
Ignorance Effect implies a situation in which a consumer buys
more of a commodity at a higher price only due to ignorance.

Factors affecting demand

The

law of demand, while explaining the price-demand relationship

assumes other factors to be constant. In reality however, these factors
such as income, population, tastes, habits, preferences etc., do not remain
constant and keep on affecting the demand. As a result the demand
changes i.e. rises or falls, without any change in price.
Income: The relationship between income and the demand is a direct one.
It means the demand changes in the same direction as the income. An
increase in income leads to rise in demand and vice versa.
Population: The size of population also affects the demand. The
relationship is a direct one. The higher the size of population, the higher
is the demand and vice versa.
Tastes and Habits: The tastes, habits, likes, dislikes, prejudices and
preference etc. of the consumer have a profound effect on the demand for
a commodity. If a consumers dislikes a commodity, he will not buy it
despite a fall in price. On the other hand a very high price also may not
stop him from buying a good if he likes it very much.

Other

Prices: This is another important determinant of demand for

a commodity. The effects depends upon the relationship between
the commodities in question. If the price of a complimentary
commodity rises, the demand for the commodity in reference
falls.
Advertisement: This factor has gained tremendous importance in
the modern days. When a product is aggressively advertised
through all the possible media, the consumers buy the advertised
commodity even at a high price and many times even if they
dont need it.
Fashions: Hardly anyone has the courage and the desire to go
against the prevailing fashions as well as social customs and the
traditions. This factor has a great impact on the demand.
Imitation: This tendency is commonly experienced everywhere.
This is known as the demonstration effects, due to which the low
income groups imitate the consumption patterns of the rich ones.
This operates even at international levels when the poor countries
try to copy the consumption patterns of rich countries.

Variation and changes in

demand
The
law of demand explains the effect of only-one factor

viz., price, on the demand for a commodity, under the

assumption of constancy of other determinants.
In practice, other factors such as, income, population etc.
cause the rise or fall in demand without any change in the
price. These effects are different from the law of demand.
They are termed as changes in demand in contrast to
variations in demand which occur due to changes in the price
of a commodity.
In economic theory a distinction is made between
(a) Variations i.e. extension and contraction in demand due
to price and
(b) Changes i.e. increase and decrease in demand due to
other factors.

Variations

in demand refer to those which

occur due to changes in the price of a
commodity.
These are two types.
Extension of Demand: This refers to rise in
demand due to a fall in price of the
commodity. It is shown by a downwards
movement on a given demand curve.
Contraction of Demand: This means fall in
demand due to increase in price and can be
shown by an upwards movement on a given
demand curve.

Changes

in demand imply the rise and fall due

to factors other than price.
It means they occur without any change in
price. They are of two types.
Increase in Demand: This refers to higher
demand at the same price and results from rise
in income, population etc., this is shown on a
new demand curve lying above the original one.
Decrease in demand: It means less quantity
demanded at the same price. This is the result
of factors like fall in income, population etc.
this is shown on a new demand lying below the
original one.

Concluding Remarks
The

law of demand explains the functional

relationship between price and demand.
In fact, the demand for a commodity depends not
only on the price of a commodity but also on
other factors such as income, population, tastes and
preferences of the consumer.
The law of demand assumes these factors to be
constant and states the inverse price-demand
relationship. Barring certain exceptions, the inverse
price- demand relationship holds good in case of
the goods that are bought and sold in the market.

Concluding Remarks..
The

law of demand explains the direction of a

change as it states that with a rise in price the
demand contracts and with a fall in price it expands.
However, it fails to explain the extent or magnitude
of a change in demand with a given change in price.
In other words, the law of demand merely shows the
direction in which the demand changes as a result of
a change in price, but does not throw any light on
the amount by which the demand will change in
response to a given change in price.
Thus, the law of demand explains the qualitative but
not the quantitative aspect of price- demand
relationship.

Base for elasticity of demand

Although

it is true that demand responds to change

in price of a commodity, such response varies from
commodity to commodity.
Some commodities are more responsive or sensitive
to change in price while some others are less. The
concept of the elasticity of demand has great
significance as it explains the degree of
responsiveness of demand to a change in price.
It thus elaborates the price-demand relationship. The
elasticity of demand thus means the sensitiveness or
responsiveness of demand to a change in price.

Elasticity of demand-

According

to Marshall, the elasticity (or responsiveness)

of demand in a market is great or small accordingly as the
demand changes (rises or falls) much or little for a given
change (rise or fall) in price.
Elasticity of demand is a measure of relative changes in
the amount demanded in response to a small change in
price.
The demand is said to be elastic when a small change in
price brings about considerable change in demand.
On the other hand, the demand for a good is said to be
inelastic when a change in price fails to bring about
significant change in demand.
Ep = [Percentage change in quantity demanded /
Percentage change in the price]

Price elasticity
The

concept of price elasticity reveals that the

degree of responsiveness of demand to the
change in price differs from commodity to
commodity.
Demand for some commodities is more elastic
while that for certain others is less elastic.
Perfectly inelastic demand (ep = 0)
Relatively less elastic demand (e < 1)
Unitary elasticity (e = 1)
Relatively more elastic demand (e > 1)
Perfectly elastic demand (e = )

Perfectly

inelastic demand (ep = 0)

This describes a situation in which demand shows no response to a
change in price. In other words, whatever be the price the quantity
demanded remains the same.
Relatively less elastic demand (e < 1)
In this case the proportionate change in demand is smaller than in price
Unitary elasticity demand (e = 1)
When the percentage change in price produces equivalent percentage
change in demand.
Relatively more elastic demand (e > 1)
In case of certain commodities the demand is relatively more
responsive to the change in price. It means a small change in price
induces a significant change in, demand.
Perfectly elastic demand (e = )
This is experienced when the demand is extremely sensitive to the
changes in price. In this case an insignificant change in price produces
tremendous change in demand.

Determinants of elasticity
Nature

of the Commodity
Number of Substitutes Available
Number Of Uses
Possibility of Postponement of
Consumption
Range of prices
Proportion of Income Spent

Identify

Quiz

the elasticity of demandFood grains

Salt
Luxuries or comforts
Tea/coffee
Electricity
Milk
Coal in railways
Coal in household
Umbrella
Woolen clothes in rainy season
Consumer durables
Clothes for occassions

Income elasticity of demand

Demand

for a commodity changes in response to a

change in income of the consumer.
The income effect suggests the effect of change in
income on demand. The income elasticity of demand
explains the extent of change in demand as a result
of change in income.
In other words, income elasticity of demand means
the responsiveness of demand to changes in income.
Thus, income elasticity of demand can be expressed
asEY = [Percentage change in demand / Percentage
change in income]

Income

Elasticity of Demand Greater than One: When the percentage

change in demand is greater than the percentage change in income, a
greater portion of income is being spent on a commodity with an
increase in income- income elasticity is said to be greater than one.
Income Elasticity is unitary: When the proportion of income spent on a
commodity remains the same or when the percentage change in income is
equal to the percentage change in demand, EY = 1 or the income
elasticity is unitary.
Income Elasticity Less Than One (EY< 1): This occurs when the
percentage change in demand is less than the percentage change in
income.
Zero Income Elasticity of Demand (EY=o): This is the case when
change in income of the consumer does not bring about any change in
the demand for a commodity.
Negative Income Elasticity of Demand (EY< o): It is well known that
income effect for most of the commodities is positive. But in case of
inferior goods, the income effect beyond a certain level of income
becomes negative. This implies that as the income increases the
consumer, instead of buying more of a commodity, buys less and
switches on to a superior commodity. The income elasticity of demand in
such cases will be negative.

Cross Elasticity of Demand

The

concept of cross elasticity explains the degree of change in demand

for X as, a result of change in price of Y. This can be expressed as:
EC = [Percentage Change in demand for X / Percentage change in price
of Y]
The relationship between any two goods is of two types.
The goods X and Y can be complementary goods (such as pen and ink)
or substitutes (such as pen and ball pen). In case of complementary
commodities, the cross elasticity will be negative. This means that fall in
price of X (pen) leads to rise in its demand so also rise in t) demand
for Y (ink).
On the other hand, the cross elasticity for substitutes is positive which
means a fall in price of X (pen) results in rise in demand for X and fall
in demand for Y (ball pen)
If two commodities, say X and Y, are unrelated there will be no change
i. Demand for X as a result of change in price of Y. Cross elasticity in
cad of such unrelated goods will then be zero.

Importance of Elasticity

The

law of demand merely explains the qualitative

relationship while the concept of elasticity of demand
analyses the quantitative price-demand relationship.
The Pricing policy of the producer is greatly influenced by
the nature of demand for his product. If the demand is
inelastic, he will be benefited by charging a high price. If on
the other hand, the demand is elastic, low price will be
advantageous to the producer. The concept of elasticity helps
the monopolist while practicing the price discrimination.
The price of joint products can be fixed on the basis of
elasticity of demand. In case of such joint products, such as
wool and mutton, cotton and cotton seeds, separate costs of
production are not known. High price is charged for a
product having inelastic demand (say cotton) and low price
for its joint product having elastic demand (say cotton seeds).

Importance of Elasticity
The

concept of elasticity of demand is helpful to the Government in fixing

the prices of public utilities.
The Elasticity of demand is important not only in pricing the commodities
but also in fixing the price of labour viz., wages.
The concept of elasticity of demand is very important in the field
international trade. It helps in solving some of the problems of international
trade such as gains from trade, balance of payments etc. policy of tariff also
depends upon the nature of demand for a commodity.
The concept of elasticity of demand is useful to Government in formulation
of economic policy in various fields such as taxation, international trade etc.
(a) The concept of elasticity of demand guides the finance minister in
imposing the commodity taxes. He should tax such commodities which have
inelastic demand so that the Government can raise handsome revenue.
(b) The concept of elasticity of demand helps the Government in formulating
commercial policy. Protection and subsidy is granted to the industries which
face an elastic demand.

Supply- Conceptual framework

Supply

during a given period of time

means the quantities of goods which are
offered for sale at particular price.
Supply is a relative term. It is always
referred to in relation to price and time.
Supply is what the seller is able and
willing to offer for sale.
The law, reflects the general tendency of
the sellers in offering their stock of a
commodity for sale in relation to the
varying price.

Statement of law-

Ceteris

Paribus, the supply of a

commodity expands(I.e. rises) with a rise
in its price, and contracts (I.e. falls) with
a fall in its price.
The law, thus, suggests that the supply
varies directly with the changes in price.
So, a larger amount is supplied at a
higher price than at lower price in the
market.

Schedule to lawPrice

Supply of
Coffee

12

15

18

Assumptions underlying the law

Cost

of production in unchanged
No change in technique of production
Fixed scale of production
Government policies are unchanged
No change in transport costs
No speculation
The prices of other goods are held
constant.

Extension/Contraction of supply

Supply shifters
RATNEST

RESOURCE COST :
RESOURCE COST If resource cost decreases supply Increases
[making more $] If resource cost increases supply Decreases [making
less $]
ALTERNATIVE OUTPUT PRICE CHANGE :
ALTERNATIVE OUTPUT PRICE CHANGE One opportunity cost
of producing eggs is not selling chickens. An increase in the price
people are willing to pay for fresh chicken would make it more
profitable to sell chickens and would thus increase the opportunity
cost of producing eggs. It would shift the supply curve for eggs to
the left, reflecting a decrease in supply.
TECHNOLOGICAL IMPROVEMENT :
TECHNOLOGICAL IMPROVEMENT An improvement in
technology usually means that fewer and/or less costly inputs are
needed. If the cost of production is lower, the profits available at a
given price will increase, and producers will produce more. With
more produced at every price, the supply curve will shift to the
right, meaning an increase in supply

NUMBER

OF SUPPLIERS :
NUMBER OF SUPPLIERS A change in the number of sellers in an industry
changes the quantity available at each price and thus changes supply. An
increase in the number of sellers supplying a good or service shifts the
supply curve to the right; a reduction in the number of sellers shifts the
supply curve to the left
EXPECTATIONS :
EXPECTATIONS . If a change in the international political climate leads
many owners to expect that oil prices will rise in the future, they may
decide to leave their oil in the ground, planning to sell it later when the
price is higher. Thus, there will be a decrease in supply; the supply curve for
oil will shift to the left.
SUBSIDIES :
SUBSIDIES Free money from the government (subsidies) induces suppliers
to supply more.
TAXES :
TAXES If business have their taxes decreased, it moves the supply curve to
the right. If business have their taxes increased, it moves the supply curve to
the left.

Demand forecasting

Demand

forecasting is predicting the future

demand for the firms product.
The knowledge about the future demand for
the product helps a great deal in the
following areas of business decision making.
Planning and scheduling production
Acquiring inputs
Making provisions for finances
Formulation of pricing strategy
Planning advertisement.

Steps involvedSpecifying

the objective
Determining time perspective
Making choice of method for demand
forecasting
Collection of data and data adjustment
Estimation and interpretation of result

Techniques

Survey
method
s

Statistic
al
Methods

Forecasti
ng
techniqu
e

Survey Methods

Consumer
survey
Opinion
Poll

Complete
enumeration
Sample survey
End-use method

Expert opinion
Market studies
and
experimentation.