Economics

Definition: Economics is that branch of social science which is concerned with the study of how
individuals, households, firms, industries and government take decision relating to the allocation
of limited resources to productive uses, so as to derive maximum gain or satisfaction.

Nature of Economics

1. Economics is a science: Science is an organised branch of knowledge, that analyses

cause and effect relationship between economic agents. Further, economics helps in integrating
various sciences such as mathematics, statistics, etc. to identify the relationship between price,
demand, supply and other economic factors.

o Positive Economics: A positive science is one that studies the relationship

between two variables but does not give any value judgment, i.e. it states ‘what is’. It deals
with facts about the entire economy.
o Normative Economics: As a normative science, economics passes value
judgement, i.e. ‘what ought to be’. It is concerned with economic goals and policies to attain
these goals.
 Economics is an art: Art is a discipline that expresses the way things are to be
done, so as to achieve the desired end. Economics has various branches like production,
distribution, consumption and economics, that provide general rules and laws that are capable of
solving different problems of society.

Therefore, economics is considered as science as well as art, i.e. science in terms of its

methodology and arts as in application. Hence, economics is concerned with both theoretical
and practical aspects of the economic problems which we encounter in our day to day life.

Significance Of Economics

 First and foremost, the most important advantage of economics is helping the society decide and
formulate the ways for the optimal allocation of its limited and scarce resources.
 Economics provides us the mechanism and analytical techniques to optimise the utilisation of the
available resources and reduce wastages.

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  The stability of an economy is a must for any country or society to survive in the long run. The
adoption of sound economic practices in a society can only ensure that the economy is stable and
growing at the same time.
 Economics is equally important for the economical growth of individuals. A person may not need
the knowledge and understanding of the theoretical side of economics, but he definitely needs to
understand the basic economic practices that he must follow to save himself from going broke or
bankrupt and to enjoy a healthy and wealthy life. Also, understanding of at least the basic
economics helps maximising the profit.
 Economists can advise governments on how to manage the economy and avoid inflation and
unemployment through well devised economic policies.
 Economists can also be of great help to the society by suggesting certain policies to the
governments to overcome the market failures caused due to various factors such as under or
over-production.

The Nature and Scope of Macroeconomics

Introduction: The term ‘macro’ was first used in economics by Ragner Frisch in 1933. But as a
methodological approach to economic problems, it originated with the Mercantilists in the 16th
and 17th centuries. They were concerned with the economic system as a whole.

1. Nature of Macroeconomics:

Macroeconomics is the study of aggregates or averages covering the entire economy, such as
total employment, national income, national output, total investment, total consumption, total
savings, aggregate supply, aggregate demand, and general price level, wage level, and cost
structure.

In other words, it is aggregative economics which examines the interrelations among the various
aggregates, their determination and causes of fluctuations in them. Thus in the words of
Professor Ackley, “Macroeconomics deals with economic affairs in the large, it concerns the
overall dimensions of economic life. It looks at the total size and shape and functioning of the
“elephant” of economic experience, rather than working of articulation or dimensions of the
individual parts. It studies the character of the forest, independently of the trees which compose
it.”

Macroeconomics is also known as the theory of income and employment, or simply income
analysis. It is concerned with the problems of unemployment, economic fluctuations, inflation or
deflation, international trade and economic growth. It is the study of the causes of
unemployment, and the various determinants of employment.

In the field of business cycles, it concerns itself with the effect of investment on total output,
total income, and aggregate employment. In the monetary sphere, it studies the effect of the total
quantity of money on the general price level.

In international trade, the problems of balance of payments and foreign aid fall within the
purview of macroeconomic analysis. Above all, macroeconomic theory discusses the problems

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of determination of the total income of a country and causes of its fluctuations. Finally, it studies
the factors that retard growth and those which bring the economy on the path of economic
development.

The obverse of macroeconomics is microeconomics. Microeconomics is the study of the

economic actions of individuals and small groups of individuals. The “study of particular firms,
particular households, individual prices, wages, incomes, individual industries, particular
commodities.” But macroeconomics “deals with aggregates of these quantities; not with
individual incomes but with the national income, not with individual prices but with the price
levels, not with individual output but with the national output.”

Microeconomics, according to Ackley, “deals with the division of total output among industries,
products, and firms, and the allocation of resources among competing uses. It considers problems
of income distribution. Its interest is in relative prices of particular goods and services.”

Macroeconomics, on the other hand, “concerns itself with such variables as the aggregate
volume of the output of an economy, with the extent to which its resources are employed, with
the size of the national income, with the ‘general price level’.”

Both microeconomics and macroeconomics involve the study of aggregates. But aggregation in
microeconomics is different from that in macroeconomics. In microeconomics the
interrelationships of individual households, individual firms and individual industries to each
other deal with aggregation.

“The concept of ‘industry’, for example, aggregates numerous firms or even products. Consumer
demand for shoes is an aggregate of the demands of many households, and the supply of shoes is
an aggregate of the production of many firms.

The demand and supply of labour in a locality are clearly aggregate concepts.” “However, the
aggregates of microeconomic theory,” according to Professor Bilas, “do not deal with the
behaviour of the billions of dollars of consumer expenditures, business investments, and
government expenditures. These are in the realm of microeconomics.”

Thus the scope of microeconomics to aggregates relates to the economy as a whole, “together
with sub-aggregates which (a) cross product and industry lines (such as the total production of
consumer goods, or total production of capital goods), and which (b) add up to an aggregate for
the whole economy (as total production of consumer goods and of capital goods add up to total
production of the economy; or as total wage income and property income add up to national
income).” Thus microeconomics uses aggregates relating to individual households, firms and
industries, while macroeconomics uses aggregates which relate them to the “economy wide
total”.

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Scope and Importance of Macroeconomics:As a method of economic analysis macroeconomics
is of much theoretical and practical importance.

(1) To Understand the Working of the Economy:The study of macroeconomic variables is

indispensable for understanding the working of the economy. Our main economic problems are
related to the behaviour of total income, output, employment and the general price level in the
economy.

These variables are statistically measurable, thereby facilitating the possibilities of analysing the
effects on the functioning of the economy. As Tinbergen observes, macroeconomic concepts
help in “making the elimination process understandable and transparent”. For instance, one may
not agree on the best method of measuring different prices, but the general price level is helpful
in understanding the nature of the economy.

(2) In Economic Policies:Macroeconomics is extremely useful from the point of view of

economic policy. Modern governments, especially of the underdeveloped economies, are
confronted with innumerable national problems. They are the problems of overpopulation,
inflation, balance of payments, general underproduction, etc.

The main responsibility of these governments rests in the regulation and control of
overpopulation, general prices, general volume of trade, general outputs, etc. Tinbergen says:
“Working with macroeconomic concepts is a bare necessity in order to contribute to the solutions
of the great problems of our times.” No government can solve these problems in terms of
individual behaviour. Let us analyse the use of macroeconomic study in the solution of certain
complex economic problems.

(i) In General Unemployment:The Keynesian theory of employment is an exercise in

macroeconomics. The general level of employment in an economy depends upon effective
demand which in turn depends on aggregate demand and aggregate supply functions.

Unemployment is thus caused by deficiency of effective demand. In order to eliminate it,

effective demand should be raised by increasing total investment, total output, total income and
total consumption. Thus, macroeconomics has special significance in studying the causes, effects
and remedies of general unemployment.

(ii) In National Income:The study of macroeconomics is very important for evaluating the
overall performance of the economy in terms of national income. With the advent of the Great
Depression of the 1930s, it became necessary to analyse the causes of general overproduction
and general unemployment.

This led to the construction of the data on national income. National income data help in
forecasting the level of economic activity and to understand the distribution of income among
different groups of people in the economy.

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(iii) In Economic Growth:The economics of growth is also a study in macroeconomics. It is on
the basis of macroeconomics that the resources and capabilities of an economy are evaluated.
Plans for the overall increase in national income, output, and employment are framed and
implemented so as to raise the level of economic development of the economy as a whole.

(iv) In Monetary Problems:It is in terms of macroeconomics that monetary problems can be

analysed and understood properly. Frequent changes in the value of money, inflation or
deflation, affect the economy adversely. They can be counteracted by adopting monetary, fiscal
and direct control measures for the economy as a whole.

(v) In Business Cycles:Further macroeconomics as an approach to economic problems started

after the Great Depression. Thus its importance lies in analysing the causes of economic
fluctuations and in providing remedies.

(3) For Understanding the Behaviour of Individual Units:For understanding the behaviour of
individual units, the study of macroeconomics is imperative. Demand for individual products
depends upon aggregate demand in the economy. Unless the causes of deficiency in aggregate
demand are analysed, it is not possible to understand fully the reasons for a fall in the demand of
individual products.

The reasons for increase in costs of a particular firm or industry cannot be analysed without
knowing the average cost conditions of the whole economy. Thus, the study of individual units is
not possible without macroeconomics.

Microeconomics Definition Features Scope Importance

Whereas in macroeconomics, whole economy or its large groups are studied like total
production, total consumption, total investment, total savings, total demand, total employment.
Are you studied?

“microeconomics is the study of particular firms, particular households, individual wages,

incomes, individual industries, and particular commodities”. – Professor Boulding

“Microeconomic is the study of economic actions of individuals and well-defined groups of

individuals.” – Handerson and Cfoant

“The micro model is built slowly on the individuals and deals with interpersonal relations only”
– Chamberlin

Features of Microeconomics

Following are the Characteristics:

1. Study of specific units

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Under it, the study of particular units and economic behavior of the group is done.

2. No effect on the Economy

Under its size of an individual unit is so small that any change arises due to it has no effect on
the whole economy. 12 Methods to Correct Disequilibrium in Balance of Payments (Step-by-
Step).

3. Price theory

Microeconomics is also called as price theory because under it with the equilibrium of demand
and supply curve individual price of different commodities is determined.

4. Study of individual price instant of the general price level

Microeconomics studies only individual prices of any commodity. So, general prices are not
studied under it.

Scope of Microeconomics

Fall points are studied under microeconomics:

1. Consumption

Under it principles of consumption like the law of diminishing marginal utility, the law of equal
marginal utility, the law of demand, the elasticity of demand, consumer surplus, indifference
curve and studied.

2. Production

Under its principles of production like the law of returns to scale, cost of production and the
optimum combination of factors are studied.

3. Distribution

Under it returns of factors of production like interest, wages, salary and determination of profit
and study.

Demand Forecasting: Meaning, Objectives, Features, Need & Limitations

4. Exchange

Under different conditions of the market, determination of price and output is also the main
subject matter of microeconomics.

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 BASIS FOR
MICROECONOMICS
COMPARISON
Meaning The branch of economics that
studies the behavior of an
individual consumer, firm,
family is known as
Microeconomics.
Deals with Individual economic
variables
Business Applied to operational or
Application internal issues
Tools Demand and Supply
Assumption It assumes that all macro-
economic variables are
constant.
Concerned with Theory of Product Pricing,
Theory of Factor Pricing,
Theory of Economic Welfare.
Scope Covers various issues like
demand, supply, product
pricing, factor pricing,
production, consumption,
economic welfare, etc.
Importance Helpful in determining the
prices of a product along with
the prices of factors of
production (land, labor,
capital, entrepreneur etc.)
within the economy.
Limitations It is based on unrealistic
assumptions, i.e. In
microeconomics it is
assumed that there is a full
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employment in the society
which is not at all possible.
MACROECONOMICS
The branch of economics that
studies the behavior of the
whole economy, (both national
and international) is known as
Macroeconomics.
Aggregate economic variables
Environment and external
issues
Aggregate Demand and
Aggregate Supply
It assumes that all micro-
economic variables are
constant.
Theory of National Income,
Aggregate Consumption,
Theory of General Price Level,
Economic Growth.
Covers various issues like,
national income, general price
level, distribution, employment,
money etc.
Maintains stability in the
general price level and resolves
the major problems of the
economy like inflation,
deflation, reflation,
unemployment and poverty as a
whole.
It has been analyzed that
'Fallacy of Composition'
involves, which sometimes
doesn't proves true because it is
possible that what is true for
aggregate may not be true for
individuals too.
What Is Opportunity Cost?

Opportunity costs represent the benefits an individual, investor or business misses out on when
choosing one alternative over another. While financial reports do not show opportunity cost,
business owners can use it to make educated decisions when they have multiple options before
them.

Because by definition they are unseen, opportunity costs can be easily overlooked if one is not
careful. Understanding the potential missed opportunities foregone by choosing one investment
over another allows for better decision-making.

Managerial Economics: 6 Basic Principles of Managerial Economics –

Explained!

Managerial Economics: 6 Basic Principles of Managerial Economics –

Explained!
Introduction:Managerial Economics is both conceptual and metrical. Before the substantive
decision problems which fall within the purview of managerial economics are discussed, it is
useful to identify and understand some of the basic concepts underlying the subject.
Economic theory provides a number of concepts and analytical tools which can be of
considerable and immense help to a manager in taking many decisions and business planning.
This is not to say that economics has all the solutions. In fact, actual problem solving in business
has found that there exists a wide disparity between economic theory of the firm and actual
observed practice.

Therefore, it would be useful to examine the basic tools of managerial economics and the nature
and extent of gap between the economic theory of the firm and the managerial theory of the firm.
The contribution of economics to managerial economics lies in certain principles which are basic
to managerial economics. There are six basic principles of managerial economics.

Content:

1. The Incremental Concept

2. The Concept of Time Perspective

3. The Opportunity Cost Concept

4. The Discounting Concept

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5. The Equi-marginal Concept

6. Risk and Uncertainty

1. The Incremental Concept:The incremental concept is probably the most important concept
in economics and is certainly the most frequently used in Managerial Economics. Incremental
concept is closely related to the marginal cost and marginal revenues of economic theory.

The two major concepts in this analysis are incremental cost and incremental revenue.
Incremental cost denotes change in total cost, whereas incremental revenue means change in
total revenue resulting from a decision of the firm.

The incremental principle may be stated as follows:

A decision is clearly a profitable one if

(i) It increases revenue more than costs.

(ii) It decreases some cost to a greater extent than it increases others.

(iii) It increases some revenues more than it decreases others.

(iv) It reduces costs more than revenues.

Illustration:Some businessmen hold the view that to make an overall profit, they must make a
profit on every job. The result is that they refuse orders that do not cover full costs plus a
provision of profit. This will lead to rejection of an order which prevents short run profit. A
simple problem will illustrate this point. Suppose a new order is estimated to bring in an
additional revenue of Rs. 10,000. The costs are estimated as under:

Labour Rs. 3,000

Materials Rs. 4,000

Overhead charges Rs. 3,600

Selling and administrative expenses Rs. 1,400

Full Cost Rs.12, 000

The order appears to be unprofitable. For it results in a loss of Rs. 2,000. However, suppose there
is idle capacity which can be utilised to execute this order. If order adds only Rs. 1,000 to
overhead charges, and Rs. 2000 by way of labour cost because some of the idle workers already
on the pay roll will be deployed without added pay and no extra selling and administrative costs,
then the actual incremental cost is as follows:

Labour Rs. 2,000

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Materials’ Rs. 4,000

Overhead charges Rs. 1,000

Total Incremental Cost Rs. 7,000

Thus there is a profit of Rs. 3,000. The order can be accepted on the basis of incremental
reasoning. Incremental reasoning does not mean that the firm should accept all orders at prices
which cover merely their incremental costs.

The concept is mainly used by the progressive concerns. Even though it is a widely followed
concept, it has certain limitations:

(a) The concept cannot be generalised because observed behaviour of the firm is always variable.

(b) The concept can be applied only when there is excess capacity in the concern.

(c) The concept is applicable only during the short period.

2. Concept of Time Perspective:The time perspective concept states that the decision maker
must give due consideration both to the short run and long run effects of his decisions. He must
give due emphasis to the various time periods. It was Marshall who introduced time element in
economic theory.

The economic concepts of the long run and the short run have become part of everyday
language. Managerial economists are also concerned with the short run and long run effects of
decisions on revenues as well as costs. The main problem in decision making is to establish the
right balance between long run and short run.

In the short period, the firm can change its output without changing its size. In the long period,
the firm can change its output by changing its size. In the short period, the output of the industry
is fixed because the firms cannot change their size of operation and they can vary only variable
factors. In the long period, the output of the industry is likely to be more because the firms have
enough time to increase their sizes and also use both variable and fixed factors.

In the short period, the average cost of a firm may be either more or less than its average
revenue. In the long period, the average cost of the firm will be equal to its average revenue. A
decision may be made on the basis of short run considerations, but may as time elapses have long
run repercussions which make it more or less profitable than it at first appeared.

Illustration:The firm which ignores the short run and long run considerations will meet with
failure can be explained with the help of the following illustration. Suppose, a firm having a
temporary idle capacity, received an order for 10,000 units of its product. The customer is
willing to pay only Rs. 4.00 per unit or Rs. 40,000 for the whole lot but no more.

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The short run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the
contribution to overhead and profit is Rs. 1.00 per unit (or Rs. 10, 000 for the lot). If the firm
executes this order, it will have to face the following repercussion in the long run:

(a) It may not be able to take up business with higher contributions in the long run.

(b) The other customers may also demand a similar low price.

(c) The image of the firm may be spoilt in the business community.

(d) The long run effects of pricing below full cost may be more than offset any short run gain.

Haynes, Mote and Paul refer to the example of a printing company which never quotes prices
below full cost due to the following reasons:

(1) The management realized that the long run repercussions of pricing below full cost would
more than offset any short run gain.

(2) Reduction in rates for some customers will bring undesirable effect on customer goodwill.
Therefore, the managerial economist should take into account both the short run and long run
effects as revenues and costs, giving appropriate weight to most relevant time periods.

3. The Opportunity Cost Concept:Both micro and macro economics make abundant use of the
fundamental concept of opportunity cost. In everyday life, we apply the notion of opportunity
cost even if we are unable to articulate its significance. In Managerial Economics, the
opportunity cost concept is useful in decision involving a choice between different alternative
courses of action.

Resources are scarce, we cannot produce all the commodities. For the production of one com-
modity, we have to forego the production of another commodity. We cannot have everything we
want. We are, therefore, forced to make a choice.

Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice
of alternatives is involved when carrying out a decision requires using a resource that is limited
in supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone
by pursuing one course of action rather than another.

The concept of opportunity cost implies three things:

1. The calculation of opportunity cost involves the measurement of sacrifices.

2. Sacrifices may be monetary or real.

3. The opportunity cost is termed as the cost of sacrificed alternatives.

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Opportunity cost is just a notional idea which does not appear in the books of account of the
company. If resource has no alternative use, then its opportunity cost is nil.

In managerial decision making, the concept of opportunity cost occupies an important place. The
economic significance of opportunity cost is as follows:

1. It helps in determining relative prices of different goods.

2. It helps in determining normal remuneration to a factor of production.

3. It helps in proper allocation of factor resources.

4. Equi-Marginal Concept:One of the widest known principles of economics is the equi-

marginal principle. The principle states that an input should be allocated so that value added by
the last unit is the same in all cases. This generalisation is popularly called the equi-marginal.

Let us assume a case in which the firm has 100 unit of labour at its disposal. And the firm is
involved in five activities viz., А, В, C, D and E. The firm can increase any one of these
activities by employing more labour but only at the cost i.e., sacrifice of other activities.

An optimum allocation cannot be achieved if the value of the marginal product is greater in one
activity than in another. It would be, therefore, profitable to shift labour from low marginal value
activity to high marginal value activity, thus increasing the total value of all products taken
together.

If, for example, the value of the marginal product of labour in activity A is Rs. 50 while that in
activity В is Rs. 70 then it is possible and profitable to shift labour from activity A to activity B.
The optimum is reached when the values of the marginal product is equal to all activities. This
can be expressed symbolically as follows:

VMPLA = VMPLB = VMPLC = VMPLD = VMPLE

Where VMP = Value of Marginal Product.

L = Labour

ABCDE = Activities i.e., the value of the marginal product of labour employed in A is equal to
the value of the marginal product of the labour employed in В and so on. The equimarginal
principle is an extremely practical notion.

It is behind any rational budgetary procedure. The principle is also applied in investment
decisions and allocation of research expenditures. For a consumer, this concept implies that
money may be allocated over various commodities such that marginal utility derived from the
use of each commodity is the same. Similarly, for a producer this concept implies that resources
be allocated in such a manner that the marginal product of the inputs is the same in all uses.

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5. Discounting Concept:This concept is an extension of the concept of time perspective. Since
future is unknown and incalculable, there is lot of risk and uncertainty in future. Everyone knows
that a rupee today is worth more than a rupee will be two years from now. This appears similar to
the saying that “a bird in hand is more worth than two in the bush.” This judgment is made not
on account of the uncertainty surrounding the future or the risk of inflation.

It is simply that in the intervening period a sum of money can earn a return which is ruled out if
the same sum is available only at the end of the period. In technical parlance, it is said that the
present value of one rupee available at the end of two years is the present value of one rupee
available today. The mathematical technique for adjusting for the time value of money and
computing present value is called ‘discounting’.

The following example would make this point clear. Suppose, you are offered a choice of Rs.
1,000 today or Rs. 1,000 next year. Naturally, you will select Rs. 1,000 today. That is true
because future is uncertain. Let us assume you can earn 10 per cent interest during a year.

You may say that I would be indifferent between Rs. 1,000 today and Rs. 1,100 next year i.e.,
Rs. 1,100 has the present worth of Rs. 1,000. Therefore, for making a decision in regard to any
investment which will yield a return over a period of time, it is advisable to find out its ‘net
present worth’. Unless these returns are discounted and the present value of returns calculated, it
is not possible to judge whether or not the cost of undertaking the investment today is worth.

The concept of discounting is found most useful in managerial economics in decision problems
pertaining to investment planning or capital budgeting.

The formula of computing the present value is given below:

V = A/1+i

where:

V = Present value

A = Amount invested Rs. 100

The Law of Demand

There is an inverse relationship between quantity demanded and its price. The people know that
when price of a commodity goes up its demand comes down. When there is decrease in price the
demand for a commodity goes up. There is inverse relation between price and demand . The law
refers to the direction in which quantity demanded changes due to change in price.

A consumer may demand one dozen oranges at $5 per dozen . He may demand two dozens when
the price is $4 per dozen. A person generally buys more at a lower price. He buys less at  higher

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price. It is not the case with one person but all people liken to buy more due to fall in price and
vice versa. This is true for all commodities and under all conditions. The economists call it
as law of demand. In simple words the law of demand states that other things being equal more
will be demanded at lower price and lower will be demanded  at higher price.

Definition

1. Alfred Marshal says that the amount demanded increase with a fall in price, diminishes
with a rise in price.

2. C.E. Ferguson says that according to law of demand, the quantity demanded varies
inversely with price.

3. Paul A. Samuelson says that law of demand states that people will buy more at a lower
prices and buy less at higher prices, other things remaining the same.

Assumptions of the law

1. There is no change in income of consumers.

2. There is no change in the price of product.

3. There is no change in quality of product.

4. There is no substitute of the commodity.

5. The prices of related commodities remain the same.

6. There is no change in customs.

7. There is no change in taste and preference of consumers.

8. The size of population remains the same.

9. The climate and weather conditions are same.

10. The tax rates and other fiscal measures remain the same.

Explanation of the law

The relationship between price of a commodity and its demand depends upon many factors. The
most important factor is nature of commodity. The demand schedule shows response of quantity
demanded to change in price of that commodity. This is the table that shows prices per unit of
commodity ands amount demanded per period of time. The demand of one person is called
individual demand. The demand of many persons is known as market demand. The experts are
concerned with market demand schedule. The market demand schedule means 'quantities of
given commodity which all consumers want to buy at all possible prices at a given moment of

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time'. The demand schedules of all individuals can be added up to find out market demand
schedule.

Demand schedule

Price in dollars. Demand in Kg.

5 100

4 200

3 300

2 400

The table shows the demand of all the consumers in a market. When the price decreases there is
increase in demand for goods and vice versa. When price is $5 demand is 100 kilograms. When
the price is $4 demand is 200 kilograms. Thus the table shows the total amount demanded by all
consumers various price levels.

Diagram

There is same price in the market. All consumers purchase commodity according to their needs.
The market demand curve is the total amount demanded by all consumers at different prices. The
market demand curve slopes from left down to the right.

Why demand curve falls

Marginal utility decreases:

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When a consumer buys more units of a commodity, the marginal utility of such commodity
continue to decline. The consumer can buy more units of commodity when its price falls and
vice versa. The demand curve falls because demand is more at lower price.

Price effect:

When there is increase in price of commodity, the consumers reduce the consumption of such
commodity. The result is that there is decrease in demand for that commodity. The consumers
consume mo0re or less of a commodity due to price effect. The demand curve slopes downward.

Income effect

Real income of consumer rises due to fall in prices. The consumer can buy more quantity of
same commodity. When there is increase in price, real income of consumer falls. This is income
effect that the consumer can spend increased income on other commodities. The demand curve
slopes downward due to positive income effect.

Same price of substitutes

When the price of a commodity falls, the prices of substitutes remaining the same, consumer can
buy more of the commodity and vice versa. The demand curve slopes downward due to
substitution effect.

Demand of poor people

The income of people is not the same, The rich people have money to buy same commodity at
high prices. Large majority of people are poor, They buy more when price fall and vice versa.
The demand curve slopes due to poor people.

Different uses of goods

There are different uses of many goods. When prices of such goods increase these goods are put
into uses that are more important and their demand falls. The demand curve slopes downward
due to such goods.

Exceptions to the law

Inferior goods

The law of demand does not apply in case of inferior goods. When price of inferior commodity
decreases and its demand also decrease and amount so saved in spent on superior commodity.
The wheat and rice are superior food grains while maize is inferior food grain.

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Demonstration effect

The law of demand does not apply in case of diamond and jewelry. There is more demand when
prices are high. There is less demand due to low prices. The rich people like to demonstrate such
items that only they have such commodities.

Ignorance of consumers 

The consumer usually judge the quality of a commodity from its price. A low priced commodity
is considered as inferior and less quantity is purchased. A high priced commodity is treated as
superior and more quantity is purchased. The law of demand does not apply in this case.

Less supply

The law of demand does not work when there is less supply of commodity. The people buy more
for stock purpose even at high price. They think that commodity will become short.

Depression

The law of demand does not work during period of depression. The prices of commodities are
low but there is increase in demand. it is due to low purchasing power of people.

Speculation

The law does not apply in case of speculation. The speculators start buying share just to raise the
price. Then they start selling large quantity of shares to avoid losses.

Out of fashion  

The law of demand is not applicable in case of goods out of fashion. The decrease in prices
cannot raise the demand of such goods. The quantity purchased is less even though there is falls
in prices.

Importance of the law

Price determination

A monopolist can determine price of a commodity on the basis of such law. He can know the
effect on demand due to increase or decrease in price. The demand schedule can help him to
determine the most suitable price level.

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Tax on commodities

The law of demand is important for tax authorities. The effect of tax on different commodities is
checked. The commodity must be taxed if its demand is relatively inelastic. A commodity cannot
be taxed if its sales fall to great extent.

Agricultural prices 

The law of demand is useful to determine agricultural prices. When there are good crops, the
prices come down due to change in demand. In case of bad crops, the prices go up if demand
remains the same. The poverty of farmers can be determined.

Planning

Individual demand schedule is used in planning for individual goods and industries. There is
need to know the effect of change in price on the demand of commodity at national and world
level. The nature of demand schedule helps to know such effect.

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