Unit 2B

Theory of Supply: Meaning of supply, Determinants of

supply, Law of supply and its determinants, Expansion and
Contraction of Supply, Increase and decrease in supply.
Theory of Consumer Behavior: Consumer Surplus Law of
Diminishing Marginal Utility
 Supply
• The quantity supplied is the number of units
that sellers want to sell over a specified period
of time at a particular price.
• The amount of a good producers would want
to produce and sell at a specific price
• “ The amounts of a product that producers are
willing and able to make available for sale at
each of a series of prices during a specific
period”
The Difference Between Supply and Stock

Stock is the quantity of output which a seller

has with him and has not yet brought for sale;
whereas supply is the quantity of output
brought from existing stock for sale at a
certain price in the market
 Law of Supply
Law of Supply states that
all other factors remaining unchanged
the supply of a good increases as its price
increases.
This can be shown by a supply schedule, a
supply curve or a supply function.
 The Law of Supply
• Explains the fundamental characteristic of
supply
“All else equal, as price rises, the quantity
supplied rises, as price fall the quantity
supplied falls”
• Positive or direct relationship between the
quantity supplied and the price Law of
Supply
 Supply Schedule and Supply Curve
• Supply Schedule:
- A list showing the amount of a product that
producers would produce and sell at a series of
varying prices, during a certain time, with all the
other factors held constant
• Supply Curve:
-The graphical representation of the relation between
the quantity supplied of a good that producers are
willing and able to sell and the price of the good
• Supply schedule price quantity

1 2
• There exists a positive
relation between quantity 5 10
and price
8 15

13 25

20 35
• Supply Curve: price

qty

• Supply function shows the relation between quantity

and price.
It is a positive relation. Example : q= 4+3p
Assumptions of the Law

• Constant cost of production

• Constant price of capital goods
• Constant technology
 Determinants of Supply
• Price of the good
• Resource Prices
• Technology
• Taxes and subsidies
• Price of Other Goods
• Expectations
• Number of Sellers
 Determinants Of Supply
• Price
• Cost of production
• Technological progress
• Prices of related outputs
• Govt policy

All factors other than price cause a shift of the

supply curve and is called a change in supply
 EQUILIBRIUM
• Equilibrium - perfect balance in supply and
demand
• Determines market output and price

p
p s

eqm

dem
q
Market forces drive market to equilibrium

• at prices < equilibrium level: excess demand

(amount by which quantity demanded
exceeds quantity supplied at the specified
price)
• at price > equilibrium level: excess supply
• equilibrium price is market clearing price: no
excess demand or excess supply
 Equilibrium in a Market

Demand Price Supply

800 $3,000 2,900
1,150 $2,500 2,550
1,500 $2,000 2,200
1,850 $1,500 1,850
2,200 $1,000 1,500
2,550 $500 1,150
2,900 $0 0
 Surplus and Shortage
• Any price above the equilibrium causes an excess supply
and any price below the equilibrium causes a shortage.
• The market if uncontrolled will automatically arrive at
the equilibrium price at which supply equals demand.
• Any shift in demand and supply curves will result in a
new equilibrium
• Comparison of equilibrium is called comparative -statics
 Elasticity
• Elasticity: A measure of the responsiveness
of one variable to changes in another
variable; the percentage change in one
variable that arises due to a given
percentage change in another variable.
• By converting each of these changes into
percentages, the elasticity measure does
not depend on the units in which we
measure the variables.
 Elasticity of Supply
• Price Elasticity of Supply:
– The responsiveness of supply to changes
in price
– If es is inelastic (<1)- it will be difficult for suppliers to react
swiftly to changes in price
– If es is elastic(>1) – supply can react quickly to changes in price

% Δ Quantity Supplied
____________________
es =
% Δ Price
Shifts and Movement along Supply Curve

• In economics, like demand, change in quantity

supplied and change in supply are two
different concepts.
• Expansion and Contraction of Supply
• Increase and Decrease In Supply
 Expansion and Contraction of Supply
Expansion or extension
of Supply: When there
are large quantities of a
good supplied at higher
prices, it is known as
expansion or extension of
supply.
Contraction of
supply: occurs when
smaller quantities of
goods are supplied even
at reduced prices.
In Figure, quantity supplied at price OP1 is OQ1. When
the price rises to OP2, the quantity supplied also
increases to OQ2, which is shown by the upward
movement from A1 to A2 (it is pointed by the direction
of the arrow between A1 to A2). This upward
movement is known as the expansion of supply.
On the contrary, a fall in price from OP1 to OP3 results
in a decrease in supply from OQ1 to OQ2. This
movement from A1 to A3 shown by the arrow pointed
downwards is known as the contraction of supply.
Thus, the movement from A1 to A3 is the
representation of the expansion and contraction of the
quantity supplied.
 Increase and Decrease In Supply
• An increase in supply takes place when a supplier is willing
to offer large quantities of products in the market at the
same price due to various reasons, such as improvement
in production techniques, fall in prices of factors of
production, and reduction in taxes.

• A decrease in supply occurs when a supplier is willing to

offer small quantities of products in the market at the
same price due to increase in taxes, low agricultural
production, high costs of labour, unfavourable weather
conditions, etc.
• A shift takes place in supply curve due to
the increase or decrease in supply.
• increase in supply in indicated by the shift
of the supply curve from S1 to S2. Because
of an increase in supply, there is a shift at
the given price OP, from A1 on supply
curve S1 to A2 on supply curve S2. At this
point, large quantities (i.e. Q2 instead of
Q1) are offered at the given price OP.
• On the contrary, there is a shift in supply
curve from S1 to S3 when there is a
decrease in supply. The amount supplied
at OP is decreased from OQ1 to OQ3 due
to a shift from A1 on supply curve S1 to A3
on supply curve S3.
• However, a decrease in supply also occurs
when producers sell the same quantity at a
higher price (which is shown in Figure) as
OQ1 is supplied at a higher price OP2.
 Theory of Consumer Behavior: Consumer
Surplus Law of Diminishing Marginal Utility
• The consumer has to decide how to spend her income on
different goods.
• Economists call this the problem of choice. Most naturally, any
consumer will want to get a combination of goods that gives her
maximum satisfaction. What will be this ‘best’ combination?
• This depends on the likes of the consumer and what the
consumer can afford to buy.
• The ‘likes’ of the consumer are also called ‘preferences’. And
what the consumer can afford to buy, depends on prices of the
goods and the income of the consumer.
• This section presents two different approaches that explain
consumer behaviour (i) Cardinal Utility Analysis and (ii) Ordinal
Utility Analysis.
Preliminary Notations and Assumptions

• A consumer, in general, consumes many

goods; but for simplicity, we shall consider the
consumer’s choice problem in a situation
where there are only two goods
 UTILITY
The want satisfying power contained in a good is
said to be its utility. In economics the term
utility is used to denote the satisfaction or
welfare.
Utility derived from a good are of different form
such as 1) Form utility, 2) Place utility, 3) Time
utility, and 4) possession utility.
 Utility
• A consumer usually decides his demand for a commodity on the basis of utility (or
satisfaction) that he derives from it.
• Utility of a commodity is its want-satisfying capacity. The more the need of a commodity
or the stronger the desire to have it, the greater is the utility derived from the
commodity.
• Utility is subjective. Different individuals can get different levels of utility from the same
commodity. For example, some one who likes chocolates will get much higher utility
from a chocolate than some one who is not so fond of chocolates
1We shall use the term goods to mean goods as well as services.
2The assumption that there are only two goods simplifies the analysis considerably and allows us to
understand some important concepts by using simple diagrams.

• Also, utility that one individual gets from the commodity can change with change in
place and time. For example, utility from the use of a room heater will depend upon
whether the individual is in Ladakh or Chennai (place) or whether it is summer or winter
(time)
•The utility of form refers to the specific product or service that a company offers to its potential
customers. For example, a manufacturing firm might offer the raw material of rubber in the form
of automobile tires.

•The utility of place refers primarily to making goods or services readily and conveniently available
to potential customers. Examples of place utility range from a retail store's location to how easy a
company's website or services are to find on the Internet.

•The utility of time refers to easy availability of products or services at the time when customers
need or want to purchase them. Addressing the utility of time involves a company's business plan
and the logistical planning of manufacturing and delivery issues.

•The utility of possession refers to the benefit customers derive from ownership of a company's
product once they have purchased it. For example, if a company sells headphones, then it offers
customers an added value in listening to music available through using the headphones to
improve the functionality of a stereo system. Offering favorable financing terms toward ownership
is another way a company might choose to improve the value of possessing its products.
 CARDINAL UTILITY
• Cardinal Utility : The numbers 1, 2, 3, 4 are
cardinal numbers. For example the number 2
is twice the size of 1. In the same way, the
number 4 is four times the size of number 1
• Alfred Marshall developed cardinal utility
analysis.
• According to cardinal approach, utility can be
measured.
 ORDINAL UTILITY
• Ordinal utility : The numbers 1st, 2nd, 3rd, and
4th, are ordinal numbers. These ordinal
numbers are ranked or ordered. This ranking
does not explain the actual size relation of the
numbers. The second one might or might not
be twice as big as the first one.
• Hicks and Allen used ordinal utility approach
for analyzing the consumer behavior. This
analysis is known as indifference curve analysis.
 Measures of Utility
Total Utility: Total utility of a fixed quantity of a
commodity (TU) is the total satisfaction derived
from consuming the given amount of some
commodity x.
More of commodity x provides more satisfaction
to the consumer.
TU depends on the quantity of the commodity
consumed. Therefore, TUn refers to total utility
derived from consuming n units of a commodity x.
Marginal Utility: Marginal utility (MU) is the change in total utility
due to consumption of one additional unit of a commodity. For
example, suppose 4 bananas give us 28 units of total utility and 5
bananas give us 30 units of total utility.
Clearly, consumption of the 5th banana has caused total utility to
increase by 2 units (30 units minus 28 units). Therefore, marginal
utility of the 5th banana is 2 units.
MU5 = TU5 – TU4 = 30 – 28 = 2
In general, MUn = TUn – TUn-1, where subscript n refers to the nth
unit of the commodity
Total utility and marginal utility can also be related in the following
way.
TUn = MU1 + MU2 + … + MUn-1 + MUn
This simply means that TU derived from consuming n units of
bananas is the sum total of marginal utility of first banana (MU1),
marginal utility of second banana (MU2), and so on, till the marginal
utility of the nth unit.
Let us see the example of the values of marginal and total utility derived
from consumption of various amounts of a commodity. Usually, it is
seen that the marginal utility diminishes with increase in consumption
of the commodity. This happens because having obtained some amount
of the commodity, the desire of the consumer to have still more of it
becomes weaker. The same is also shown in the table and graph.
Values of marginal and total utility derived from consumption of various
amounts of a commodity
Unit Total Utility Marginal Utility
1 12 12
2 18 6
3 22 4
4 24 2
5 24 0
6 22 -2
Notice that MU3 is less than MU2. You may also notice that total utility increases
but at a diminishing rate: The rate of change in total utility due to change in
quantity of commodity consumed is a measure of marginal utility. This marginal
utility diminishes with increase in consumption of the commodity from 12 to 6, 6
to 4 and so on. This follows from the law of diminishing marginal utility.
 Law of Diminishing
Marginal Utility
states that marginal utility from consuming each
additional unit of a commodity declines as its
consumption increases, while keeping
consumption of other commodities constant.
• MU becomes zero at a level when TU remains
constant. In the example, TU does not change
at 5th unit of consumption and therefore
MU5= 0. Thereafter, TU starts falling and MU
becomes negative.
• The technique of indifference curves was originated by
Francis Y. Edgeworth in England in 1881. It was then refined
by Vilfredo Pareto, an Italian economist in 1906. This
technique attained perfection and systematic application in
demand analysis at the hands of Prof. John Richard Hicks
and R.G.D. Allen in 1934.

• Hicks discarded the Marshallian assumption of cardinal

measurement of utility and suggested ordinal measurement
which implies comparison and ranking without
quantification of the magnitude of satisfaction enjoyed by
the consumer .

• Professor Hicks introduced the concept of scale of

preferences of a consumer as the base of indifference curve
technique. The conceptual arrangement of different goods
and their combinations in a set order of preferences is called
the scale of preferences.
 Assumptions of Indifference Curve Analysis

• Rationality: The consumer is assumed to be rational he aims at the

maximization of his utility, given his income and market prices. It is assumed he
has full knowledge (certainty) of all relevant information.

• Utility is ordinal: It is taken as axiomatically true that the consumer can rank his
preferences (order the various ‘baskets of goods’) according to the satisfaction
of each basket. He need not know precisely the amount of satisfaction. It
suffices that he ex­presses his preference for the various bundles of
commodities. It is not necessary to assume that utility is cardinally measurable.
Only ordinal measurement is required.

• Diminishing marginal rate of substitution: Preferences are ranked in terms of

in­difference curves, which are assumed to be convex to the origin. This implies
that the slope of the indifference curves increases. The slope of the indifference
curve is called the marginal rate of substitution of the commodities. The
indifference-curve theory is based, thus, on the axiom of diminishing marginal
rate of substitution.
• The total utility of the consumer depends on the quantities
of the commodities consumed
U = f (q1, q2,…, qx, qy,………….. qn)

• Consistency and transitivity of choice: It is assumed that the

consumer is consistent in his choice, that is, if in one period
he chooses bundle A over B, he will not choose B over A in
another period if both bundles are available to him.

Similarly, it is assumed that consumer’s choices are

characterised by transitivity: if bundle A is preferred to B,
and B is preferred to C, then bundle A, is preferred to C.
Symbolically we may write the transitivity assumption as
follows:
If A > B, and B > C, then A > C
Definition :

• An indifference curve is the locus of points representing all the different

combinations of two goods which yield equal level of utility to the
consumer.

Indifference Schedule :

• Indifference schedule is a list of various combinations of commodities

which are equally satisfactory to the consumer concerned.
 Indifference Schedule:
     
Combinations Apples Mangoes
     
A 15 1
     
B 11 2
     
C 8 3
     
D 6 4
     
E 5 5
Indifference curve IC shows all possible combinations of apples and mangoes between
which a person is indifferent. Point A shows consumption bundle consisting of 15
apples and one mango. Moving from point A to Point B, we are willing to give up 4
apples to get a second mango (total utility is the same at points A and B).

16
A
14
12
B
10
Apples

C
8
D
6 E
IC
4
2
0
0 1 2 3 4 5 6
Mangoes
 Indifference Map :
A graph showing a whole set of indifference curves is called an indifference map. All
points on the same curve give equal level of satisfaction, but each point on higher curve
gives higher level of satisfaction.

25

20

15
Apples

10
IC3
5
IC2
IC1
0
0 1 2 3 4 5
Mangoes
Properties of indifference curves :

• Indifference curves are negatively sloped

Given a combination of commodity X and commodity Y, with every increase in
X, the amount in Y should fall in order that the level of satisfaction from every
combination should remain the same.

• Indifference curves are convex to the origin

Convexity illustrates the law of diminishing marginal rate of substitution.

• Indifference curves can never intersect each other

Indifference curves can never intersect each other because each indifference
curve represents a specific level of satisfaction. If two indifference curves
intersect each other, then at the point of intersection, the consumer is
experiencing two different levels of utility.
Consumer Equilibrium
A consumer seeks a market basket that generates the maximum level of
happiness. However, one’s money income and prices of goods imposes a
limit on the level of satisfaction that one may attain. Thus, the income at
the disposal of the consumer in conjunction with prices of the
commodities will determine the budgetary constraint or the price line.

14

12

10

8
Apples

E
6 IC
4
Price Line
2

0
0 5 10 15 20
Mangoes
• Consumer equilibrium is attained when, given his budget constraint, the
consumer reaches the highest possible point on the indifference curve.
The maximum satisfaction is yielded when the consumer reaches
equilibrium at the point of tangency between an indifference curve and
the price line. At point E, the price line is tangent to the indifference curve.

• At the equilibrium point, slope of indifference curve = slope of price line

• slope of indifference curve = MRS

• slope of price line = PX / PY

• Thus, at point E, MRS = PX / PY

• Thus, satisfaction is maximized when the marginal rate of substitution of

X for Y is just equal to the price of X to the price of Y.
If the commodities are perfect substitutes the
indifference curve becomes a straight line with
negative slope (figure 2.7). If the commodities
are complements the indifference curve takes
the shape of a right angle (figure 2.8)
.
• In the first case the equilibrium of the consumer
may be a corner solution, that is, a situation in
which the consumer spends all his income on one
commodity. This is sometimes called ‘monomania’.
Situations of ‘monomania’ are not observed in the
real world and are usually ruled out from the
analysis of the behaviour of the consumer.
• In the case of complementary goods, indifference-
curves analysis breaks down, since there is no
possibility of substitution between the
commodities
• The negative of the slope of an indifference curve
at any one point is called the marginal rate of
substitu­tion of the two commodities, x and y,
and is given by the slope of the tangent at that
point
• [Slope of indifference curve] = – dy/dx = MRSx,y
• The marginal rate of substitution of x for y is
defined as the number of units of commodity y
that must be given up in exchange for an extra
unit of commodity x so that the con­sumer
maintains the same level of satisfaction
 The budget constraint of the consumer
The consumer has a given income which sets
limits to his maximizing behaviour. Income
acts as a constraint in the attempt for
maximizing utility. The income constraint, in
the case of two commodities, may be written
Y=Pxqx + Pyqy 
We may present the income constraint
graphically by the budget line
Budget line
 Graphical presentation of the equilibrium of the consumer
• Given the indifference map of the consumer and his budget
line, the equilibrium is defined by the point of tangency of
the budget line with the highest possible indifference curve
(point e in figure 2.11).
At the point of tangency the slopes of the budget line (P x/Py)
and of the indifference curve (MRSx, y = MUx/MUy) are equal:
MUX = MUy = PX / Py
Thus the first-order condition is denoted graphically by the
point of tangency of the two relevant curves. The second-
order condition is implied by the convex shape of the
indifference curves. The consumer maximizes his utility by
buying x and y of the two commodities.
Equilibrium of the consumer
 Sources of Information
• http://www.economicsdiscussion.net
• http://
www.economicsdiscussion.net/demand/demand-function/mathematical-expressi
on-of-demand-function-economics/25180
• http://
www.economicsdiscussion.net/law-of-demand/law-of-demand-schedule-curve-fu
nction-assumptions-and-exception/3429
• http://www.investopedia.com/ask/answers/032615/what-are-four-types-econom
ic-utility.asp
• http://www.economicsdiscussion.net/theory-of-demand/theory-of-consumer-be
haviour-indifference-curves/4848
• https://www.slideshare.net/harshalvyas/elasticity-of-demandppt-2932407
• https://
www.economicsdiscussion.net/demand/changes-in-demand-and-quantity-deman
ded-with-diagram/3393
• https://www.slideshare.net/kinnar32/demand-and-supply-10239895?qid=cd4f6a
82-2b6f-42b8-b6da-8f15bc3d2d5d&v=&b=&from_search=2
• https://economicsconcepts.com/law_of_demand.htm