UNIT -2 : DEMAND ANALYSIS

STRUCTURE
1. INTRODUCTION
2. OBJECTIVES
3. DEMAND FOR A COMMODITY
4. ELASTICITY OF DEMAND
5. THEORY OF CONSUMER CHOICE
6. MARKET EQUILIBRIUM
7. SUMMING UP
8. KEY WORDS
9. KNOW YOUR PROGRESS
10. FURTHER READINGS/REFERENCES
11. MODEL ANSWERS
 1. INTRODUCTION
Demand is the most essential and important aspects of managerial economics, since a
firm would not be established or survive if sufficient demand for its product did not exist. A
firm could have the most efficient production techniques and the most effective management, but
without a demand for its product that is sufficient to cover at least all production and selling
costs over the long run, it simply would not survive. Indeed, many firms go out of business soon
after being set up because their expectations of a sufficient demand for their product fails to
materialize even with a great deal of advertising. Demand, is thus essential for the creation,
survival, and profitability of a firm. In this Unit we examine demand theory, the factors
influencing the demand for firm’s product . We also study elasticity of demand which measures
the responsiveness in quantity demanded of a commodity to changes in each of the forces that
determine demand.
2. OBJECTIVES
After studying this unit, you should be able to:
 Define demand and its determinants which means factors influencing the demand
 Explain the Law of Demand;
 Identify differences between Firm’s Demand Curve and Market Demand Curve.
 Understand the concept of elasticity of demand and its usefulness in decision making

3. DEMAND FOR A COMMODITY

3.1 An Individual’s demand for a commodity
In managerial economics we are primarily interested in the demand for a commodity
faced by the firm. This depends on the size of the total market. The size of the total market is
the sum of the demands of the individual consumers for that commodity in the market. The
demand for a commodity depends on the consumers’ willingness and ability to purchase the
commodity. Consumer demand theory postulates that the quantity demanded of a commodity is
a function of or depends on the price of the commodity in question, the consumer’s income, the
prices of related commodities and the taste and preferences of the consumer. In functional form,
we express this as: Qdx = f (Px, I, Py, T)
Where Qdx = quantity demanded of commodity X
 Px = price of X
Py = price of other related commodities ; y = 1,2,3….n commodities
T = taste and preferences of consumer

When the firm increases the price of a commodity, sales generally decline. The firm
would probably sell more units by lowering the price. Then the firm expects an inverse
relationship between the quantity demanded of its commodity and its price. That is when the
price rises, the quantity purchased declines, and when the price falls, the quantity sold increases.
On the other hand, when a consumers’ income rises, more quantity will be purchased. If the
demand increases with increase in income these commodities are known as normal goods.
There are some goods/services, however, of which the consumer purchases less as income rises.
These goods are called inferior goods. Examples are: jowar, bajra, maize,.
Quantity demanded of a commodity by an individual consumer also depends on the price
of related commodities. The consumer will purchase more of a commodity if the price of a
substitute commodity increases or if the price of a complementary falls. For eg., the consumer
will purchase more of cars if the price of two wheelers increases or if the price of petrol falls.
The quantity of a commodity that an individual buys depends moreover on tastes. However, for
the purpose of analysis it is useful to examine the relationship between the quantity demanded of
a commodity and the price of the commodity. This can be done by assuming the income, price
of the related commodities and tastes and preferences of the consumer constant. This
assumption of keeping all other factors except price of a good is called ceteris paribus.
3.2 Individual demand schedule: Individual demand schedule gives the quantity of demanded
of a commodity by an individual buyer at different prices.
For example, an individual consumer `A’ buys mangoes at various price as shown below
Price of mangoes Quantity demanded of mangoes
(Rs/kg) (kg)
8 0
7 1
6 2
5 3
4 4
3 5
2 6
1 7
0 8
When the above data is plotted in a graph demand curve for mangoes can be obtained (figure
1)

Figure 1 : Demand Curve

The demand curve for mangoes by a single individual consumer is negatively sloped
indicating that the individual purchases more of the commodity per time period at lower
prices. The inverse relationship between the price of the commodity and the quantity
demanded per time period is referred to as the law of demand.
3.3 Shifts in the Individual Demand Curve :If any of the other factors which are held
constant change then the demand curve shifts. It shifts upward or to the right if the income of
the consumer increases, price of substitutes increases or price of complementary good falls or
the consumer’s tastes / preferences for the commodity increases. This is referred to as change
in demand as opposed to a change in quantity demanded, which is movement along the same
demand curve.
Table 2: Shifts in Demand Curve
Price of Original Quantity Increase in Increase in quantity
Mangoes demanded of Mangoes quantity demand demanded due to increase
due to increase in in price of Grapes
income (substitute)
3 5 8 7
4 4 6 5
5 3 5 4
 Figure 2: Shifts in Demand
When an individual’s income rises (while everything else remain constant), the
person’s demand for a commodity usually increases (i.e, the individual demand curve shifts
upwards figure 2) indicating that at the same price that person will purchase more units of the
commodity per unit of time. Thus, if the individual’s income rise, the quantity demand for
the commodity increases such a good is called normal good.
A change in the individual’s tastes for a commodity also causes a shift in that
person’s demand curve for that commodity. For example, a greater desire on the part of an
individual to consume mangoes causes a upward shift in the individual demand curve for
mangoes. A reduced desire is reflected in a downward shift. Similarly, the individual’s
demand curve for a commodity shifts up when the price of a substitute commodity rises, but
shifts down when the price of a complement rises. Thus the demand shifts for mangoes
rightward when the price of grapes increases.

The movement in the same demand curve is called

change in quantity demanded and the shift of
demand curve is called change in demand
(increase/decrease).

3.4 From Individual Demand to Market Demand

The market or aggregate demand for a commodity gives the various amounts of the
commodity demanded per time period, at various prices, by all individuals in the market. The
market demand for a commodity thus depends on all the factors that determine the
individual’s demand and, in addition, on the number of buyers of the commodity in the
market. Geometrically, the Market demand curve for a commodity is the horizontal
summation of demand curves of all the consumers in the market.
Example : If there are three individual consumers in the market buying mangoes, the market
demand for mangoes is as follows:
Price of Qd1 Qd2 Qd3 Market Demand
mangoes Consumer A Consumer B Consumer C Qd1+Qd2+Qd3
Rs/kg)
8 0 1 2 3
7 1 2 3 6
6 2 3 4 9
5 3 4 5 12
4 4 5 6 15
3 5 6 7 18
2 6 7 8 21
1 7 8 9 24
0 8 9 10 27
The quantity demanded of the commodity in the market increases when its price falls and
decreases when its price rises when all other things such as the number of consumers in the
market, consumers’ income, the price of related commodities, and tastes and preferences are
held constant.
The market demand function for mangoes can be written as:
Qdx = F (Px, N, I, Py, T)
Where Qdx = Quantity demanded of commodity X
Px = price of commodity X
N = number of potential consumers in the market
Py= price of a related good (substitute/commentary good)
T = Tastes and preferences
The market demand curve is simply the horizontal summation of the individual
demand curves if the consumption decisions of individual consumers are independent. This is
not always the case. For example, people sometimes demand a commodity because others
are purchasing it and in order to be fashionable. The result is a bangwagon effect to “keep up
with the Joneses”. This tends to make the market demand curve flatter than indicated by the
simple horizontal summation of the individual’s demand curves. At other times, or snob
effect, occurs as many consumers seek to be different and exclusive by demanding less of a
commodity as more people consume it. This tends to make the market demand curve steeper
than indicated by the horizontal summation of the individual’s demand curves.
 Horizontal Summation of Individual Demand Curves

Case Study: The Demand for Big Macs

McDonald’s Company with a nearly 43 per cent share of the 36 billion US fast food
burger market and serving 23 million customers per day. Its closest rival Burger
king hold 22 per cent of the US market. But after nearly three decades of double
digit gains, domestic sales at Mc Donald’s have been growing slowly since the mid
1980s as a result of higher prices, changing tastes, demographic changes and
increased competition from other fast food chains and other forms of delivering fast
foods.
The price of hamburger increased from 15 cents to $4 and this sent customers to
lower pricing competitors Concern over cholesterol and calories also reduced the
growth The proportion of the 15-29 years olds (the primary fast food customers) in
the total population declined from 27.5% to 22%. Competition increased from other
fast food companies such Burger King, Wendys Availability of other fast food
options such as pizza, chicken, tacos and so on Mcdonald identified his loop holes
and adopted the correction measures such as: introduced small hamburgers at price
as little as 59 cents in response to increased public concern about cholesterol and
calories, MCdonald bean publicizing the nutritional content of its menu offerings,
substituted vegetable oils etc. All these measures however failed to stimulate the
growth and Mcdonald abandoned most of them and started expanding its business
abroad where it faces much less competition.
Source: Managerial Economics by Dominick Salvatore

4. Elasticity of Demand
4.1 Price Elasticity of demand
The responsiveness in the quantity demanded of a commodity to a change in its price is
very important to the firm. Sometimes lowering the price of the commodity increases sales
of a firm sufficiently thereby increase in total revenue. At other times, lowering the
commodity price reduces the firm’s total revenues by decrease in total sales. So it is very
important for the manager to examine the relative changes in demand for its commodity with
respect to different variables. This response of the consumer with respect to changes in any
of the independent variables is called elasticity of demand.
1. Price elasticity is the percentage change in quantity demanded of a commodity divided
by percentage change in its price, holding constant all other variables.

Q / Q Q P
EP   
P / P P Q
Where ∆ Q and ∆ P are changes in quantity demanded and price.
The above equation gives elasticity of demand at a given point. So it is called point price
elasticity of demand. At point B quantity demanded is 100 units and the price is Rs 5/-. If
the quantity demanded increases to 200 and price falls to Rs 4/- what is the elasticity at point
B? At point B the price elasticity of demand is = (100/1) X (5 / 100)= -5. This means that the
quantity demanded declines by 5 per cent for each 1 per cent increase in price.
Price

5 B
4 C

Qd
100 200
The price elasticity of demand is different at different points on the demand curve.
If the demand curve is linear :
Q = α 0 – α1 P
The price of elasticity of demand is
P
EP  a1 
Q
Arc Price elasticity of demand
Arc price elasticity of demand means price elasticity of demand between two points on the
demand curve. If we use the above formula as we are using for point elasticity of demand
the price elasticity of demand, for instance from point C to point B and from point B to point
C will yield different values. Arc elasticity of demand from point C to B is
(∆ Q ÷ ∆ P ) × (P ÷ Q) = (100 / -1) X (4 / 200) = -2
from point B to C is
(∆ Q ÷ ∆ P ) × (P ÷ Q) = (100 / -1) X (5 / 100) = -5
To avoid this, we take the average of the two prices and the average of the two quantities in
the calculations. Thus the formulae becomes:
Q2  Q1 P2  P1
EP  
P2  P1 Q2  Q1
Where the subscripts 1 and 2 refer to the original and to the new values respectively or price
and quantity. Using this formulae we obtain the elasticity from C to B or from B to C same
by taking the average price and average quantity.
If Ep = 0 demand is perfectly inelastic
= 1 demand has unitary elastic
= ∞ demand has perfectly elastic
If 0<e<1 = demand is inelastic
If 1<e<∞ = demand is elastic
4.2 Factors Affecting Price Elasticity of Demand
1. Availability of Substitutes. The magnitude of the price elasticity of demand depends on
the availability of substitutes. Larger the magnitude greater is the number of substitutes
for the commodity. For example, the demand for sugar is more price elastic than the
demand for salt because sugar has more number of substitutes (honey and saccharine,
jaggery) than salt. Given percentage increase in prices of sugar and salt there will be a
larger percentage reduction in the quantity demanded of sugar than of salt.
2. The price elasticity of demand is also larger the larger is the time period allowed for
consumers to respond to the change in the commodity price. For eg., during the period
immediately following the sharp increase in gasoline price in 1974, the price elasticity of
demand for gasoline was very low. Over the period of several years, however, the
reduction in the quantity demanded of gasoline was much larger than in the short run as
consumers replaced their gas guzzlers with fuel efficient, compact automobiles.
Case Study:
Estimated Price Elasticity of demand
Commodity Short run elasticity Long run elasticity
Clothing 0.90 2.50
Household natural 1.40 2.10
gas
Tobacco products 0.46 1.89
Electricity 0.13 0.89
gasoline 0.20 0.60
4.3 Income Elasticity of Demand
Consumers income is also one of the important determinants of demand. Income elasticity of
demand measures the responsiveness in the demand for a commodity to a change in
consumers’ income. This is given by percentage change in quantity demanded divided by
percentage change in income. Point income elasticity of demand is given by the formulae:
Q / Q Q I
EI   
I / I I Q

Where ∆ Q and ∆ I are change in quantity demanded and change in income.

For most of the commodities, an increase in income leads to an increase in demand for the
commodity so that income elasticity is positive. If income elasticity is positive these goods
are called normal goods. In the real world, most broadly defined goods such as food,
clothing, housing, health care, education are normal goods.
Necessary goods : income elasticity is positive – lies between 0 and 1.
Luxury goods : income elasticity > 1
Inferior goods : income elasticity < 0 : This type of goods as income increases demand
decreases because consumers can then afford to buy superior ones.

Income elasticity of demand is useful to the firm in estimating and forecasting the over all
demand for the products it sells in a particular market and for a specific range of consumer’s
income.
Case Study: Estimated Income Elasticity of demand in India
Commodity Income Elasticity
Electricity 1.94
Cigaretes 0.50
Chicken 1.50
Cereals 0.36
Pulses 0.75
Clothing 1.75
4.4 Cross Price Elasticity:
The demand for the commodity depends not only on its own price, and income but
also on the prices of related commodities (substitutes or complementary goods). If the price
petrol increases, demand for car declines (both are complementary goods). If the price of
petrol increases, demand for diesel increases (both are substitute goods).
Definition: Cross price elasticity measures the responsiveness of the quantity demanded of
commodity say X to the change in price of say Y. It is defined as the percentage change in
quantity demanded of commodity X divided by percentage change in price of commodity
QX / QX QX P
E XY    Y
PY / PY PY QX

1. If the value of Exy is positive, commodities X and Y are substitutes because an increase
in price of Y leads to an increase in quantity demanded of X as X is substituted for Y
2. If the value of Exy is negative, commodities X and Y are complementary because an
increase in price of Y leads to decrease in quantity demand of X as X is complementary
goods
3. The magnitude of the elasticity will indicate the degree of substitution or
complementarity between the two commodities. For example if the cross price elasticity
value is greater in case of coffee and tea than in case of coffee and cocoa, shows that
there is a greater substitutability between coffee and tea than coffee and cocoa.
4. If the value of cross price elasticity is zero then both the commodities are unrelated.
Utility of the Concept:
It is very important in managerial decision making . For example, a manufacturer of both
razors and razor blades can use cross price elasticity of demand to measure the increase in the
demand for razor blades that would result if the firm reduced the price of razore
Case Study:
Commodity Cross Price Elasticity Cross Price Elasticity
with respect to Price of:
cereals Fish -0.87
Clothing Food -0.18
Entertainment Food -0.72
Natural Gas Electricity 0.80
4.5 Use of Elasticities in Managerial Decision Making
The firm should identify first all the important variables that affect the demand for the product it
sells. The elasticity of the firm’s sales with respect to the variables outside the firm’s control is
also crucial to the firm in responding most effectively to competitor’s policies and in planning
the best growth strategy.
5. Theory of Consumer Choice
5.1 Utility Analysis
In order to examine whether the consumer would purchase any finite quantity at the
going price, we must know the consumer’s motive or objective and his constraints. The basic
postulate in economics is that the motive of the consumer is to maximize the satisfaction or
utility he derives from consumption of the goods. How much of the good, say X, the consumer
would purchase depends on what utility he derives from its consumption in comparison to the
demand for consumer goods. Thus, utility provides the basis for the demand for consumer
goods. As far as utility analysis is concerned, there are two approaches for utility analysis –
cardinal utility theory and ordinal utility theory. T
5.1.1.Cardinal utility theory
The cardinal utility theory says that utility is measured in some well defined units called
“utils”. If commodity X gives him 2 utils and commodity Y gives him 6 utils then it can be said
utility derived from the consumption of commodity is greater than commodity X. It can also say
that a consumer with 6 utils of satisfaction derives 3 times the utility in comparison to one in
which the one he has only 2 utils of satisfaction.
5.1.2 Ordinal Utility Theory
According to the ordinal utility theory utility can not be measured and it can be ordinally
measured, we can compare two or more situations for the same individual in terms of the utility
he derives in each of them. If the consumer has two consumption bundles he ordered his
preferences which commodity bundle is preferred.
Cardinal utility theory
As per the Cardinal Utility theory, a consumer derives total utility (TU) from the
consumption of several commodities like X, Y, Z. The total utility of a consumer is considered
to be a function of his consumption of various commodities.
TU = f (X, Y, Z)
The cardinal utility theory assumes that the utility derived from different commodities are
independent and that the utility function is additive in X, Y, Z etc.
TU = TUx + TUy + TUz+………….+ TUn
Marginal Utility (MU)
MU is the addition to the consumer’s total satisfaction when he consumes on more unit of
the good, other things remaining the same. These other things are the tastes and preferences of
the consumer and consumption of all other goods. Since the MU is the rate of change in the total
utility, it is geometrically measured as the slope of the total utility curve. More formally, it can
be defined as: MUx = ∆ TUx / ∆ X or MUn = ∆ TUn = TUn – TU(n-1).
Relationship between TU and MU and the Law of Diminishing Marginal Utility
Let us assume that the consumer consumes two commodities X and Y over a given period of time. The
utility he derives by consuming different units of X and Y is given in the table below.
Units TUx TUy MUx MUy
consumed
1 150 7200 150 7200
2 250 12600 100 5400
3 325 16200 75 3600
4 375 18900 50 2700
5 415 20700 40 1800
From the above table it is clear that total utility increases as the consumption of X and Y
increases. This implies that as the consumer consumes more of the goods, his total satisfaction
increases. The consumption of the commodity reaches saturation point when satiated with the
good X, and this is the point of maximum utility. Thus, if the entire utility curve has a point of
maxima at some level of the consumption of the good X, it must be concave from below near
that point. The concavity of the total utility curve implies a fall in the rate of change. At the
point of maximum utility, the rate of change in the total utility, i.e marginal utility, should be by
definition zero. Thus, even for a positively desired commodity, as consumption per unit of time
increases, the MU will start declining; reach zero at some point; and then become negative.
Every commodity can potentially turn into a discommodity at a very high consumption rate per
unit of time. This is what is known as diminishing marginal utility. This law states that
other things being the same, as a consumer increase his consumption of a good, the
additions made to his total utility would eventually start declining.
 From the above figure it is clear that total utility is an upward sloping concave curve and
marginal utility a downward slopping curve with respect to X. The slope of the TU curve is
MU. The TU curve rises up to OM and then declines as X increases per unit of time. The
MU curve slopes downward but remains positive up to OM units of X. After OM, then MU
becomes negative. Thus, when TU is at its maximum. MU falls to zero. Up to OM units, X
is a positively desired good, and thereafter a discommodity.
The diminishing marginal utility is based on the assumption or condition that
1. the consumption of other goods do not change
2. the preference function of the consumer does not change
3. the units of good X are homogeneous in all respects
4. the time duration does not change.
Law of Equi- Marginal Utility
A consumer is faced with a choice of consuming various goods available in the
market. He has therefore to decide how he should spend his limited income on different goods
so as to get maximum possible satisfaction. This is a problem of constrained maximization.
For eg., a consumer has a money income of Rs 5500/-. For simplicity, we assume that there
are only two goods x and y which he can consume. His utilities from the consumption of these
goods are given in the table below. Let us assume that price of x is Rs 25 and price of Y is Rs
1800 per unit. In order to maximize the satisfaction or utility from the consumption of both
these goods, the consumer should closely monitor the satisfaction he derives from each
commodity per rupee spent on it. In order to arrive at the MU of per rupee spent on the
commodity, we have to consider the cost of obtaining one unit of the commodity or the price of
the commodity. For instance, one unit of X adds 150 utils to the consumers’ satisfaction when
he is consuming only one unit of X. Therefore, per rupee spent on X, his satisfaction would
increase by 6 utils (=150/25). In the same way we can work out the additional utility per rupee
spent on X and Y when the consumer consumes different units of the commodity. Thus the
marginal utility of rupee spent on X and Y are given by MUx / Px and MUy / Py respectively.
Marginal Utility of Money Spent on Goods X and Y (in Utils)
Units consumed MUx MUy
1 150/25 = 6 7200/1800= 4
2 100/25 = 4 5400/1800 = 3
3 75/25 = 3 3600/1800 = 2
4 50/25 = 2 2700/1800= 1.5
5 40/25= 1.6 1800/1800 = 1
The utility maximizing consumer should so choose to spend his limited income on
consuming different goods that he gets the same satisfaction per rupee spent on these goods.
If the marginal utility per rupee spent on different goods is not the same, the consumer can
always increase his utility by reallocating his purchases. Therefore, the condition of
consumer’s equilibrium is:
MUx / Px = MUy/Py = MUz/Pz=……………………….MUn/Pn
This condition of consumer’s equilibrium is known as the law of equi-marginal
utility. This is a necessary condition for the consumer’s equilibrium. When it combines
with the law of diminishing MU for every commodity consumed, together they represent a
sufficient condition for the consumer’s equilibrium. The law of demand then follows directly.
In the earlier example, the consumer will be in equilibrium when he consumes 4 units of X
and 3 units of Y. This is because at this point he derives equal marginal utility per rupee
spent on both X and Y in this case 2 utils. At this point he has to exhaust his entire income
which means total expenditure is equal to total income.
Derivation of Demand Curve from Equi-Marginal utility:
By assuming cardinal utility, it is able to derive the consumer’s equilibrium when the
prices of the goods, the consumer’s money income and his preference function are given. In
the example cited above the consumer with the income of Rs 5500 and the prices of X and Y
at Rs 25 and Rs 1800 respectively. The consumer will be in equilibrium when he purchases
4 units of X and 3 units of Y. Thus, in the below fig one point (point A) can be located. At
price Rs 25, the consumer’s demand of 4 units of X represents the consumer’s optimal
behaviour which maximizes his total satisfaction. Let us assume that the price of X falls to
Rs 20, then there will be a change in marginal utility of money spent on Good X. Since price
has fallen, the marginal utility per rupee spent on X would rise for all units of X.
Marginal Utility of Money Spent on Goods X and Y (in Utils)
Units consumed MUx MUy
1 150/20 = 7.5 7200/1800= 4
2 100/20 = 5 5400/1800 = 3
3 75/20 = 3.75 3600/1800 = 2
4 50/20 = 2.5 2700/1800= 1.5
5 40/20= 2.0 1800/1800 = 1
The above table shows new calculations. At the old equilibrium level of consumption of the
good X, the consumer now finds higher marginal utility per rupee spent on X in comparison
to good Y. Now, he will be in equilibrium if he consumes 5 units of X and 3 units of Y. At
this new equilibrium, he spend all his income of 5500 as he would have done in the earlier
situation. But now the price of good X has fallen, his total satisfaction has gone up. Another
point on the demand curve for good X is at B at which the consumer is consuming 5 units of
X at price 20.
5.2 INDIFFERENCE CURVE ANALYSIS
The curve showing different combinations of goods yielding the same level of utility is
known as the indifference curve (IC curve) or Equal Utility Curve. The IC curve shows the
possibility of substitution in consumption without losing utility. The whole utility or
preference function of a consumer can be represented by the set of indifference curves which
are known indifference map. In other words a group of Indifference curves are called
indifference map.

Properties of IC Curves:
1. The level of satisfaction remain the same as the consumer moves along the same IC
curve.
2. Higher the indifference curve higher be the satisfaction. The greater the distance of an
indifference curve from the origin, the higher is the level of utility attached to it.
3. IC curve is negatively sloped because by consuming more of x, the consumer has to
consume less y in order to remain on the same IC Curve.
4. IC curves are convex to the origin because of diminishing Marginal rate of substitution
(MRS - the amount of y that the consumer would be willing to give up for an additional
unit of X).
5. Consistency of preferences or transitivity axiom: IC curves do not cut each other. If they
cut each other the property of higher the indifference curve higher will be the satisfaction
would be violated. The transitivity of ordering is necessary to ensure consistency. If
A>B and B> C, then A must be greater than C. The consistency of the preference
ordering implies that the IC curves cannot intersect one another.
The Budget Line or Budget constraint
The consumer would like to be on the higher indifference curve as higher IC curve
represent higher level of satisfaction. However he is constrained by the given Budget. His
budget depends on his income level and the prevailing commodity prices. The budget line
shows various combinations of goods that the consumer can purchase given his money
income and prices. Let us assume that the consumer has an income of Rs 6/-. Let us assume
that there are only two commodities in his consumption basket. The price of commodities X
and Y are Rs 2 and Rs 1 respectively. If the consumer spents his entire income on
commodity X he can buy 3 units of X or if he spent his entire income on commodity Y he
can buy 6 units of Y. By joining these two points budget line can be obtained (AB in the
fig). Different points on this line shows various combinations of these two commodities that
the consumer can purchase within the given budget.
Consumer’s Equilibrium
The consumer will be in equilibrium or maximizes the utility or satisfaction when he reaches
the highest IC curve possible with his budget line. In other words, he will be in equilibrium
at the point of tangency of IC curve to the budget line .
For example, if income is 6, prices of X and Y are 1 and 1 respectively, the consumer will be
in equilibrium when he consumes 3X and 3 Y point (point C in the above fig) where the
budget line PT is tangent to the IC2 curve (the highest indifference curve that the consumer
can reach with his income or her budget line).
Price Consumption Curve (PCC) and Price Effect
The demand curve can be derived given the consumer’s money income and price of
commodity Y from consumer’s equilibrium points that result from different prices of
commodity X. The figure below shows that with income M and the Px and Py the
individual will be in equilibrium at point T1 where the budget line AB is tangent to the
indifference curve IC1. At this point consumer is demanding X1 quantity of X and Y1
quantity of Y. If Px falls then the consumer budget line shifts towards x axis as commodity
X is measured in X axis. Now the new budget line is AC, This new budget line is tangent
to another indifference curve and the consumer would be in new equilibrium point at T2. At
this new equilibrium point consumer is demanding more of X. Like this as the price of X
changes keeping the price of y and income constant new equilibrium quantities can be
obtained. The locus of different equilibrium points gives us the Price Consumption Curve
(PCC). The PCC gives us the price effect. The various equilibrium quantities of X
purchased can be plotted against various prices of X in a separate graph we obtain the
demand curve.
Income Consumption Curve (ICC) and Income Effect
When there is change in the consumer’s money income with all other things
remaining the same, it amounts to a change in the real income by the same amount and in the
same direction. A change in consumer’s money income shifts the budget line upward or
downward, depending upon whether the consumer’s money income has increased or
decreased.
The figure below shows the consumer’s budget line AB and the consumer will be in
equilibrium at point a where the budget line is tangent to the IC curve. If consumer’s money
income rises given the prices of X and Y the budget line shifts parallel towards right. The
new budget line (20,20) is tangent to the higher IC curve let us say at b. If the consumer’s
money income falls, given the prices, the budget line shift downward parallel. Income
consumption curve (ICC curve) can be obtained by joining the locus of all equilibrium
points such as a,b,c,d the below figure. The ICC curve measures the income effect. The
Income Effect (IE) is thus defined as change in the equilibrium quantity of a good in
response to a change in the consumer’s money income when prices of goods and tastes and
preferences of the consumer remain the same. If the IE is positive for a good, it is known as
a normal good. Positive IE means a direct relationship between income and the quantity
demanded of the good. When the IE is negative for a good, it is called an inferior good.
Thus, the demand for inferior good would tend to rise when the income of a consumer falls.
1 ICC is upward sloping when both the goods are normal goods.
2. ICC is backward bending when good X becomes an inferior good and good Y is a normal
good.
3. The ICC is forward falling when good Y becomes an inferior good and good X is a normal
good
4. If ICC is vertical the income effect for good X is zero, which means that the consumer
spends the same amount of money on good X irrespective of changes in income
5. If ICC is horizontal, the same amount of Y is consumes irrespective of income changes.

From ICC curve it is possible to derive the income demand curve which is Engel Curve. The
Engel curve shows relationship between the consumer’s demand for and his income.
Substitution Effect

An effect caused by a rise in price that induces a consumer (whose income has remained the
same) to buy more of a relatively lower-priced good and less of a higher-priced one.
Substitution effect is always negative for the seller: consumers always switch from spending
on higher-priced goods to lower-priced ones as they attempt to maintain their living standard
in case of rising prices.

6. MARKET EQUILIBRIUM

1. The demand side of the market

Every market has a demand and supply side. The demand side can be represented by a
market demand curve, which shows the amount of a commodity the buyers would like to
purchase at different prices.

For example :
 Price of mangoes (Rs per kg) Demand for mangoes (tones)
20 4
15 5
10 7
5 11

For example, the market demand curve for mangoes in the above figures shows that 4 tones
of mangoes are demanded at price Rs 20 per kg (point A in the figure), 5 tones are demanded
at price Rs 15 (point B), 7 tonnes at price (point C) Rs 10 and 11 tones at price Rs 5 (point
D). From this it can inferred that more of mangoes are demanded at lower prices and vice
verse. This that the demand for mangoes or for any other commodity is inversely related to
price which also means the demand curve is down ward sloping. This is refered to as law of
demand. This law is derived based on the assumption that other things such as tastes /
preferences, incomes and prices of other related commodities, the number of buyers in the
market remained constant (ceteris paribus).

The supply side of the market:

The supply side of the market is represented by supply curve. This curve shows the amount
of commodity that sellers would offer for sale at different prices. For example, the market
supply curve for mangoes

Price of mangoes (Rs per kg) Supply of mangoes (tones)

20 10
15 8
10 7
5 5

The above figure shows that at Rs 20 per kg 10 tonnes of mangoes are offered for sale (point
E in the figure); at Rs 15/- 8 tonnes of mangoes (point F); at Rs 10/- 7 tonnes (point C) and at
Rs 5/- 5 tonnes of mangoes are offered for sale. This shows that the higher mango prices
induce the seller to sell higher quantity of mangoes. The meaning of this is that there is a
positive or direct relationship between price of a commodity and the quantity supplied. The
supply curve is up ward slopping curve. This is the law of supply. The law of supply is
based on the assumption of constant technology, input or resource prices.
The Equilibrium Price:

The equilibrium price for a commodity is obtained or determined at the intersection of

market demand curve and market supply curve of the commodity. For instance the
equilibrium price of mangoes in the earlier example is determined at point C where market
demand curve and market supply curve for mangoes intersect i.e at price Rs 10/- and the
equilibrium quantity demanded and supplied is 7 tonnes. At any price of mangoes above this
price supply exceeds the demand (excess supply or glut) and any price below this price
demand exceeds supply (excess demand or shortage). At price Rs 10/- the entire market is
cleared (market supply=market demand) where there is no excess supply nor excess demand
for mangoes in the market. This price is called market clearing price.
At a particular point in time, the actual or observed market price may or may not be the
equilibrium price. However, it is always clear that market forces (demand and supply)
always push the market price toward the equilibrium level. This may occur rapidly or
slowly. Before a market price reaches a particular equilibrium llevel, the demand curve/or
the supply curve may shift, defining a new equilibrium price.
Shift in demand curve and equilibrium:
If the demand for mangoes increases due to increase in incomes, then the demand curve for
mangoes shifts to the right. As a result the equilibrium price will rise. For example, at the
existing prices if the demand for mangoes increases due to increase in incomes then:
Price of Original Increase in Demand
mangoes (Rs Demand for for mangoes (tones)
per kg) mangoes (tones)
20 4 6
15 5 8
10 7 10
5 11 12

As a result of increase in demand for mangoes demand curve shifts outward (right). The
equilibrium price will rise and the new equilibrium price is determined at Rs 15/- where
demand and supply is equal to 8 tonnes of mangoes. At the original equilibrium price, with
the changed demand, demand exceeds supply (excess demand) by 3 tonnes (demand is for 10
tonnes and supply is 7 tonnes). If incomes decrease or peoples tastes towards this
commodity changes then the demand curve shift downwards and the equilibrium price would
be reduced and the new equilibrium price would be established until demand is equal to
supply.
Shift in the supply curve and equilirbrium:
As a result of improvements in the existing technology or the decline in input prices, the
supply curve shifts to the right. This will result in fall in equilibrium price. For eg:
 Price of Original Supply of Change in supply
mangoes mangoes (tones) of mangoes (tones)
(Rs per
kg)
20 10 15
15 8 13
10 7 12
5 5 11

As a result of increase in supply of mangoes supply curve shifts right. The equilibrium price
will fall and the new equilibrium price is determined at Rs 5/- where demand and supply is
equal to 11 tonnes of mangoes. At the original equilibrium price, with the changed supply,
supply exceeds supply (glut) by 5 tonnes (demand is for 7 tonnes and supply is 12 tonnes).
The opposite occurs if the supply falls.

If both demand and supply changes:

If both demand and supply curve shifts to the right with the same slopes, then the same
equilibrium price is established at Rs 10/-, but the equilibrium quanity increases. For eg:
 7. SUMMING UP

The demand for a commodity faced by a firm depends on the market or industry demand
for the commodity, which, in turn, is the sum of the demands for the commodity of the
individual consumers in the market. The demand for a commodity that the firm faces
depends on the price of the commodity, number of potential buyers (size of the market),
consumer income, the prices of related commodities and so on. The responsiveness of the
consumer’s demand for various commodities in respect of to different independent variables
is measure demanded with the help of elasticity of demand. The price elasticity of demand
measures the percentage change in quantity demanded of a commodity divided by a price of a
commodity keeping all other factors constant. With the help of Point and ARC method price
elasticity of demand can be estimated. Price elasticity of demand is highly useful to the
manager in making price decisions. The income elasticity of demand measures the ratio of
percentage change in quantity demanded to percentage change in income keeping all other
factors constant. The cross price elasticity is the ratio of percentage change in quantity of
commodity to percentage change in the price of a related good keeping all other factors such
as income, its own price and taste and preferences constant. The underlying theory behind the
consumer demand is the theory of consumer choice. The theory of consumer choice is
explained with the help of cardinal utility and ordinal utility theory. The theory of equi
marginal utility and the indifference curve analysis are in explaining the consumer behaviour
in respect to changes in price, income and taste and preferences.

8. KEY WORDS
1. Demand Curve: Amount of a good consumers are willing purchase as a function of its
price.
2. Utility: Satisfaction derived by a consumer from consumption of a good.
3. Indifference Curve: A graphical representation of different combinations of goods yielding
the same level of satisfactions.
4. Income Effect: Increased consumption brought about by an increased income when the
prices of goods are held constant.
5. Substitution Effect: Reflection of a situation when consumption changes due to a change in
price while the level of satisfaction is held constant.

9. KNOW YOUR PROGRESS:

1. Name any five variables which may be included in the demand function and explain its
impact on demand.

2. Given that an individual consumer’s demand curve is P = 200 – 4Q.

a) Find the quantity this consumer would purchase at a price of Rs. 20.
b) Suppose that the price increases to Rs. 60. How much would the consumer now
purchase?
c) Would this represent a change in demand or a change in quantity demanded? Why?

3. Suppose demand for a product in each of the three consumers is shown below:
Consumer 1 Demand: Q1 = 307 – 5P
Consumer 2 Demand: Q2= 204 – 3P
Consumer 3 Demand: Q3 = 500 – 9P
Find the total demand in the market

4. Suppose you read in today’s newspaper that carrot prices have soared because more
carrots are being demanded. Then tomorrow you read that the rising price of carrots has
greatly reduced the typical consumers demand for carrots as consumers have switched to
potatoes and peas. The two statements appear to contradict each other. The first
associates a rising price with rising demand; while the second associates a rising price
with a declining demand. Comment.

5. the demand function for a cola soft drink is Q = 20 – 2 P where Q = quantity demanded
and P for price
a) calculate point elasticiities at prices 5 and 9, what is the nature of elasticity, interpret the
magnitude
b) calculate the arc elasticity at the interval between P = 5 and P =6

6. Let the demand curve be Q = 100 – 10 P + .5 Y

where Q = quantity demanded, P = Price and Y = income. Let P = 7 and Y = 50
a) interpret the equation
b) at a price 7 what is the price elasticity
c) at an income level of 50, what is income elasticity
d) if income is 70, what is the income elasticity

7 Let the demand curve be Q x= 100 – 10 Px + 5 Py

a) estimate the cross price elasticity of x with respect y when Px = 10 Py =5
b) interpret the results
c) find out whether x and y are substitutes or complementary goods

7. Why do we study consumer demand theory managerial economics?

8. Distinguish between the inferior goods and normal goods
9. Name the different types of demand functions? Which are the most interested in
managerial economics? Why? Why then study the other types of demand?
10. What happens to demand when the following changes occur?
a) The price of a normal commodity falls
b) Income increases and the commodity is normal
c) Income increase and the commodity is inferior
d) The price of a substitute good increases
e) The price of a complement good decreases.

11. How do you measure the elasticity of demand? Explain the limitations of the point
method?

12. Explain the properties of indifference curves and the consumer’s equilibrium

13. What is Equi marginal utility? Explain with the help of tables and diagrams

14. Explain price consumption and income consumption curve diagrammatically?

15. Consider the following supply and demand equations for a certain product:
Qs = 25000 P; Qd = 50000 – 10000 P
a) plot the demand and supply curves
b) what the equilibrium quantities and price for the industry?
16. The demand for caps is Q = 2000 – 100 P
a) At price Rs 12 how many caps can be purchased
b) in order to sell 1000 caps what could be the price
c) at what price would cap sales becomes zero
17. The following relations describe monthly demand and supply for a computer support
service catering to small business
Qd = 3000 – 10 P; Qs = -1000 + 10 P
Where Q is the number of businesses that need services and P is monthly fee in Rs
a) at what average monthly fee would demand equal zero
b) at what average monthly fee would supply equal to zero
c) what is the equilibrium price and output
d) suppose demand increases to Qd1 = 3500 – 10 P what is the effect on supply
what are the new equilibrium price and output
e) suppose new suppliers enter the market due to increase in demand, so that the
new supply curve is Qs1 = - 500 + 10 P what are the new equilibrium price and output
18. A travel company has hired a management consulting company to analyse demand in 26
regional markets for one of its major products: a guided tour to a particular country: the
consultant uses data to estimate the following equation:
Qd = 1500 – 4P + 5A + 10 l + 3Px
Where Qd = quantity demanded; P = Price of the product; A = advertising expenditure
I = Income; Px = price of some other travel products; Calculate the amount demanded
using the following information P = 400 ; A = 20000; I = 15000 ; Px = 500
9. FURTHER READINGS/REFERENCES
1. Mansfield, Edwin, 2003 “Managerial Economics: Theory, Applications and Cases”, Fifth
edition WW. Norton.
2. Petersen, H. Craig and W. Cris Lewis, 2001 “Managerial Economics”, Fourth Edition,
Pearson Education Asia
3. Dominick Salvatore and Ravikesh Srivastava “Managerial Economics: Principles and
World Wide Apllications” Sixth Edition, Oxford University Press.
4. Ravindra H Dholakia, Ajay N Oza (1996). Microeconomics for Management Students,Oxford
University Press

10. MODEL ANSWERS

Answers to the above know your progress questions

1. The variables in the demand function are own price of the commodity, income of the
consumer, prices of related commodities, tastes and preferences of the consumer and
expectations of the consumer. When other things remain same, the price of the product
decreases the quantity demanded of the product increases and vice versa. When other
things remain same, the income of the consumer increases the quantity demanded of the
commodity increases. When other things remain same, when the price of related goods
changes the change in quantity demanded depends on the nature of the good that is if the
commodity is a substitute then the increase in the price of substitute increases the demand
for the commodity and vice versa. If it is a complementary they move in opposite
direction. Read more in the Material.
2. Express the given equation in terms of quantity and substitute the value of P. Substitute
the increased price and see how much of quantity demanded has increased. This
represents a change in quantity demanded and not change in demand because all other
things remain the same. When all other things remain same, the consumer moves on the
same demand up and down when there the price changes.
3. Total demand in the market can be obtained by simple adding Q1, Q2 and Q3.
15. Qs = 25000 & Qd = 50000-10000 P – for getting equilibrium quantity and price equate Qs with
Qd solve the equation for P; Qs = Qd
25000 = 50000-10000P
P = 2.5
Substitute the value of P either in the demand function to get the equilibrium quantity
Qd = 50000-10000 * 2.5
Qd = 50000- 25000 = 25000

16. Demand for Caps Q = 2000 – 100 P

a) at price 12 the demand for caps will be: substitute the value of P =12 in the demand equation and
solve for the equation for Q as:

Q = 2000 – 100 * 12
= 2000 – 1200 = 800

Q = 800 at P = 12
b)in order to sell 1000 caps what could be the price
1000 = 2000 – 100 P
Solve for P
P = 10
c) Caps sales will zero at what price:
0 = 2000 – 100 P
100 P = 2000
P = 20

At price 20 the caps sales will be zero.

19. For getting the demand substitute the values of P, A, I and Px in the demand equation.