Lesson 2  Theory of Demand and Supply 29

Lesson 2
Theory of Demand and Supply

LESSON OUTLINE
LEARNING OBJECTIVES

– Introduction The theory of demand and supply is a theory of

– Utility price and output determination. In a market
economy, individual consumers make plans of
– Cardinal and Ordinal Utility
consumption and individual firms make plans
– Concepts of Total, Average & Marginal
of production based on the changes in market
Utility
prices.
– Law of Diminishing Marginal Utility
– Law of Equi-Marginal Utility Economists use the term invisible hand to
describe the frequent exchanges in the market
– Demand
because everyone (no matter consumer or
– Law of Demand
producer) takes the market price as a signal on
– Change in Demand trade and makes exchanges with private
– Determinants of Demand property rights (defined and protected by laws).
– Supply
The price system works efficiently in a market
– Law of Supply economy only if there is free choice within the
– Change in Supply market.
– Determinants of Supply
The following section explains how the market
– Determination of Equilibrium Price and price is determined by the interaction of
Quantity
consumers (demand) and producers (supply).
– Elasticity of Demand and Supply
In the latter parts, the factors causing a change
– Price Elasticity, Cross Price Elasticity and
Income Elasticity of Demand in price are explained, In this chapter; you’ll find
the basics of demand and supply analysis. You
– Price Elasticity of Supply
will learn about the various factors that can shift
– Theory of Consumer Behavior
a supply or demand curve up or down, the
– Indifference Curve Approach concepts of equilibrium and market adjustment,
– Lesson Round Up and the signaling and rationing functions of
– Glossary prices.
– Self-Test Questions

An old story says that if you want an “educated economist,” all you have to do is get a parrot and train the
bird to squawk “demand and supply” in response to every question about the economy! Not smart enough,
but ... It’s true that the theory of demand and supply is a central part of economics. It is widely applicable,
and also is a model of the way economists try to think most problems through...
30 FP-BE

INTRODUCTION

Demand and Supply is perhaps one of the most fundamental concepts of economics. Analysis of the
determination of prices of goods and services in the market is an indispensable part of the subject matter of
economic theory. When an economy is guided by market mechanism, prices are determined by interaction
between demand and supply forces, that is, they are the result of decisions taken by buyers and sellers in
market place to buy and sell.
The market of an economy comprises of two different groups of participants: Consumers and Producers. Demand
analysis focuses on the behavior of consumers, while supply analysis examines the behavior of producers. The
consumer indirectly tells the producer what she is willing to buy and how much she is willing to pay based on her
actual spending patterns. The producer supplies the product if she can make a profit by doing so. The forces of
demand and supply coordinate to arrive at an equilibrium price and quantity of output which best satisfies the
consumers and reaps maximum profits to producers.
But before understanding Demand & Supply, there is a need to discuss the concept of utility.

UTILITY

Meaning of Utility
Human wants are unlimited and they are of different intensity. The means at the disposal of a man are not only
scarce but they have alternative uses. As a result of scarcity of resources, the consumer cannot satisfy all his
wants. He has to choose as to which want is to be satisfied first and which afterward if the resources permit. The
consumer is confronted with making a choice.
For example, a man is thirsty. He goes to the market and satisfies his thirst by purchasing coca cola instead of
tea. We are here to examine the economic forces which make him purchase a particular commodity. The answer
is simple. The consumer buys a commodity because it gives him satisfaction. In technical term, a consumer
purchases a commodity because it has utility for him.
Utility of a good is its expected capacity to satisfy a human want. To a consumer, the utility of a good is the satisfaction
which he expects from its consumption. It is the extent to which it is expected to satisfy his want(s).
The fact that utility of a good is the satisfaction which the consumer expects from its consumption implies that it
is a subjective thing. It depends upon the mental assessment of the consumer and is determined by several
factors which influence the consumer’s judgment. These factors include, for example, the intensity of the want(s)
to be satisfied. Utility of a good varies with the intensity of the want to be satisfied by its consumption. This fact
leads to a few important inferences.
– Utility of a good differs from consumer to consumer. This is because a given want can be felt in different
intensities by different consumers.
– The utility of a good keeps changing even for the same consumer on account of changes in the intensity
of the want(s) to be satisfied by its use. This change may be the result of a shift in the circumstances
faced by the consumer, or it may take place in the process of the satisfaction of the want itself.
– The utility of a good is not to be equated with its usefulness. Satisfaction of a want need not add to the
welfare of the consumer. For example, smoking, drug taking or consumption of similar other things is
believed to be harmful for the health of the consumer. But the consumer believes that they have utility for
him because he can use these to satisfy his wants.
In economics, we are not concerned with the ‘normative’ aspect of utility. It does not matter whether its consumption
adds to their well-being or not. So long as the consumers expect to derive some ‘satisfaction’ from a good (that is, so
long the good has a ‘utility’ for them), they will be ready to buy it at some price and create a demand for it in the market.
 Lesson 2  Theory of Demand and Supply 31

Measurement of Utility

The need for measuring utility arises so that it can be used in the analysis of demand behaviour of individual
consumers, and therefore, of the market as a whole. The basis of the reasoning is that a consumer compares
utility of a good with the price he has to pay for it. He keeps buying its additional units so long as the utility from
them is at least equal to the price to be paid for them. In economic theory, utility can be measured in two ways:
– Cardinal Approach
– Ordinal Approach

Cardinal Utility Approach

Cardinal utility approach assumes that utility can be measured in cardinal numbers such as 1, 3, 10, 15, etc. The
utility expressed in imaginary cardinal numbers tells us a great deal about the preference of the consumer for a
good. In cardinal measurement, utility is expressed in absolute standard units, such as there being 20 units of
utility from the first loaf of bread and 15 units from the second.
Pareto, an Italian Economist, severely criticized the concept of cardinal utility. He stated that utility is neither quantifiable nor
addible. It can, however be compared. He suggested that the concept of utility should be replaced by the scale of preference.

Ordinal Utility Approach

Ordinal utility approach is purely subjective and is immeasurable. Ordinal measurement of utility is the one in
which utility can not be expressed in absolute units. Utility from two or more sources is only ‘ranked’ or ‘ordered’
in relation to each other. Utility from one source may be ‘equal to’, ‘more than’ or ‘less than’ utility from another
source. But it is not possible to state the difference in absolute or numerical units.
The fact is that utility is a subjective thing and varies from person to person and from one situation to another.
For this reason, it is neither possible to measure it in absolute terms, nor compare utility of a good for two
individuals. This implies that cardinal measurement of utility is only a theoretical phenomenon, and has less
validity in practice. Utility is best measured in ordinal terms.
However, in a number of cases, analysis of demand decisions requires the use of a cardinal measurement of
utility. For this reason, economists adopted a standard unit of measuring utility and called it ‘util’ (also frequently
used in plural as ‘utils’). But ‘utils’ itself happens to a subjective, discretionary and imprecise measure and,
therefore, does not determine the demand behaviour of consumers.
To overcome this limitation, Marshall advocated that utility of a good to the consumer should be measured in
units of money which the consumer is willing to pay for buying the commodity. For example, if a consumer is
willing to pay, at the most, five rupees for the first bottle of a cold drink and only four rupees for the second one,
then according to this approach, the utility of the first bottle to the consumer equals five rupees and that of the
second equals four rupees. This approach was widely accepted and seemed to be useful in analyzing demand
decisions of the consumers because, in practice, the consumers pay for their purchases in monetary terms.

Concepts of Total, Average and Marginal Utility

When a consumer consumes a good, the utility derived from it varies with its quantity, and generates three
concepts; namely
– Total Utility(TU)
– Average Utility(AU)
– Marginal Utility(MU)
If a consumer buys n units of a good X then, for him, Total utility (TU) from it is the summation of utilities derived
32 FP-BE

from all the n units. By dividing this total utility (TU) by the number of units of X, that is n, the resultant is Average
utility (AU) of these units of X to the consumer. The additional satisfaction a consumer gains from consuming
one more unit of ‘X’ is Marginal utility (MU) of that unit of X.
Symbolically, if Ui stands for the utility of ith unit of good X, then
– TUn = Ui, i = 1, 2, 3, ............. n
– AUn=TUn/n
– MUn = TUn – TUn-1
In the case of a ‘perfectly divisible’ good, MU equals the first derivative of TU with respect to X, i.e.
Marginal utility of nth unit of consumption, MUn = dTU/dX
It is clear that utility of good X to the consumer is directly related to the intensity of the want to be satisfied
through its consumption which is explained as follows:
– For a given consumer, the three measures of utility depend upon the intensity of the want, which he
expects to satisfy.
– When a consumer consumes a good to satisfy his want, its intensity also undergoes a change. Therefore,
the three measures of utility are also affected by the stock of X with the consumer.
– The intensity of a want being satisfied tends to change over time. The capacity of different goods to
satisfy wants also differs. These factors also cause a shift in the three measures of utility.
– Generally speaking, wants are not felt with equal intensity by all consumers. Therefore, the measures of
utility tend to vary from consumer to consumer.

Table:2.3 Total, Average and Marginal Utility of Slices of Bread

Slices of Bread Total Utility Average Utility Marginal Utility

1st 40 40 40
2nd 78 39 38
3rd 113 37.7 35
4th 144 36 31
5th 170 34 26
6th 190 31.7 20
7th 203 29 13
8th 208 26 5
9th 204 22.7 -4

Table 2.3 illustrates interrelationship between three concepts of utility by considering a hypothetical example of
a consumer who consumes slices of bread to satisfy his hunger. It should be specifically noted that the consumer
is to consume bread without allowing any unreasonable time gap between the intakes of successive slices. This
assumption is essential to ensures that the intensity of hunger of the consumer decreases as he consumes
additional slices. By implication, the marginal utility of slices also falls, and depending upon the number of slices
consumed, it can even become zero or negative. In Table 2.3, units of MU are shown in column 4. It becomes
negative when the consumer consumes 9th slice. Figures of TU are shown in column 2. At each stage, TU is the
 Lesson 2  Theory of Demand and Supply 33

cumulative total of the MU in column 4. Thus, for example, for four slices, TU equals 144, that is, (40 + 38 + 35
+ 31). Average utility is shown in column 3. Its entries are obtained by dividing the figures in column 2 with their
corresponding figures in column 1.
It should be noted that, for the first slice, all the three measures of utility are equal to each other. Moreover, since
MU falls with successive slices of bread, therefore, TU increases at a decreasing rate. It reaches its maximum
when MU falls to zero and actually declines when MU becomes negative. In our example, TU reaches its
maximum with 8th slice and decreases with the consumption of 9th slice because its MU becomes negative (-4).
It should also be noted that when MU is falling, AU also falls but at a slower rate. This fact can be verified by
comparing figures in column 3 with those in column 4.

Fig. 2.2: Total Utility, Average Utility and Marginal Utility of Slices of Bread

In Fig. 2.2, information contained in Table 2. 3 is

expressed in the form of a bar diagram. Each step along
X-axis represents one slice of bread. Total height of a
bar represents total utility corresponding to the number
of slices consumed. The upper portion of a bar shaded
by dots represents the MU of the corresponding number
of slice. Similarly, the portion of a bar shaded diagonally
represents the AU of the slices consumed. It should be
noted that MU of 9th slice is negative. As a result, the
height of the bar also decreases. And so is the case
with the shaded portion representing AU.
In the figure, Total Utility is Height of the bar, Average
Utility is dark-shaded area and Marginal Utility is light-
shaded area.

Fig. 2.3: Total, Average and Marginal Utility

Fig. 2.3: Total, Average and Marginal Utility

A generalized way of showing the relationship between
three measures of utility is to take good X and assume
that it is perfectly divisible, that is, it can be divided
into infinitesimally small units. In this case, TU, AU and
MU of X can be expressed in the form of curves. The
three curves of utility become smooth with a type of
interrelationship shown in Fig. 2.3.
The figure shows that initially the total utility curve
slopes upwards to the right. This indicates that the
total utility will rise with consumption of additional units
of the commodity. However, the increase in total utility
is not constant, but falls steadily.
34 FP-BE

In other words, the total utility rises at a falling rate. This is shown by corresponding downward or negative slope of
the marginal utility curve. When the total utility reaches its maximum value, marginal utility becomes zero. Before
this point, though marginal utility falls, it always remains positive. The total utility stops rising at this stage. When
consumption is expanded beyond this, the total utility starts to fall because marginal utility becomes negative.
It is conventionally assumed that MU diminishes with successive units of good X. This show:
– Marginal Utility Curve slope downwards.
– Average Utility Curve falls slower than Marginal Utility Curve. Therefore, AU curve has a flatter slope and
lies above MU curve.
– Total Utility Curve rises at a diminishing rate. It reaches its maximum distance from X-axis when MU is
zero. Thereafter, it also slopes downwards, when MU is negative.
Geometrically, TU curve itself provides complete information regarding total, average and marginal utility as follows.
Given the quantity of good X (say, OX’), we consider the corresponding point (P’) on TU curve. Then, the perpendicular
distance P’X’ measures total utility of the quantity OX’. The slope of the ray from the origin to P’ (OP’) measures its
average utility. The slope of the tangent to total utility curve at point P’ measures marginal utility. Recall that
marginal utility is also the first derivative of total utility with respect to quantity of the good that is dTU / dX.

REVIEW QUESTIONS

1. What is demand?
2. What is demand function?
3. Explain concept of demand with the help of schedule and curve?
4. What do you understand by utility?
5. Explain the relationship between TP, AP and MP.

LAW OF DIMINISHING MARGINAL UTILITY (DMU)

The law of diminishing marginal utility states that as the stock of a commodity increases with the consumer, its
marginal utility to the consumer decreases. It eventually falls to zero and become even negative. The law
describes a familiar psychological tendency of the human beings.
Marshall says that “the additional benefit which a person derives from a given increase in his stock of a thing
diminishes with every increase in the stock that he already has.”
The specific behaviour of marginal utility as described by the law of DMU follows from the conventional (and
realistic) assumption that the intensity of a given want keeps decreasing if the process of its satisfaction is
continued without interruption, that is, a single want can be fully satisfied provided the consumer consumes a
large enough quantity of the relevant good/service. In other words, during the process of its satisfaction, nothing
should happen to increase its intensity. For example, the consumer should not allow an unduly long interval
between the consumption of any two units of the good; he should not get news of an unexpected change in his
income or the price of the good, etc. It should also be noted that the good to be consumed should be homogeneous.
Its successive units should have the same technical specifications. Any change in them can cause a change in
the intensity of the want being satisfied and thereby violate the law of DMU.

Assumptions

Some of the assumptions of Law of DMU are as follows :

–All the units of the given commodity are homogenous i.e. identical in size, shape, quality, quantity etc.
– The units of consumption are of reasonable size. The consumption is normal.
 Lesson 2  Theory of Demand and Supply 35

– The consumption is continuous. There is no unduly long time interval between the consumption of the
successive units.
– The law assumes that only one type of commodity is used for consumption at a time.
– Though it is psychological concept, the law assumes that the utility can be measured cardinally i.e. it can
be expressed numerically.
– The consumer is rational human being and he aims at maximum of satisfaction.

Exceptions to the Law

The law of DMU is violated only if one or more of the assumptions upon which it is based get violated. Since
utility of a good is related to the mental perception of the consumer regarding the intensity of the want to be
satisfied and the capacity of the good to satisfy it, therefore, the law of DMU is violated if for some reason,
– the intensity of the want increases, or
– the consumer comes to think that the intensity of his want has increased.
It is for this reason that marginal utility of a good tends to increase if there is an unduly long interval between the
consumption of two units of a good. Marginal utility of a good may also increase, if the want of the consumer is
intensified by consuming a very small quantity of it (such as, a very little quantity of water given to a very thirsty
person).
Some of the exceptions to the law of DMU are as follows:
(a) Hobbies: In case of certain hobbies like stamp collection or old coins, every additional unit gives more
pleasure. MU goes on increasing with the acquisition of every additional unit.
(b) Miser: In the case of miser, greed increases with the acquisition of every additional unit of money.

Law of Equi-Marginal Utility

The law of diminishing marginal utility plays a crucial role in explaining the demand behaviour of a typical
consumer and determination of his equilibrium when he is facing the following circumstances.
– The consumer is allowed to buy all or some out of specified goods, say A, B, C….N.
– Each good obeys the law of DMU, and its marginal utility schedule is known.
– Each good has a fixed price for the consumer. It does not vary with the quantity purchased by the consumer.
– The amount of expenditure to be incurred by the consumer is given. However, the consumer need not
spend the same amount on each good, and their quantities can differ.
Consumer’s equilibrium is the solution of this problem. It describes the respective quantities of goods A, B,
C….N which the consumer buys. The law of equi-marginal utility describes the rule by which the consumer
takes this decision.
We assume that the consumer decides to divide his total expenditure between different goods by taking into
consideration not only their respective marginal utilities but also their per unit prices. A consumer is guided by
marginal utility which he can derive by spending each additional rupee. It is on this basis that he decides to
allocate his expenditure between alternative goods. If, for example, he finds that a rupee spent on Good A brings
greater utility than if it is spent on good B, he chooses to spend it on the A rather than on B. Thus, the consumer
tries to satisfy the following two conditions:
(a) The marginal utility derived from a good is not less than the price paid for it. That is, for good A, MUa  Pa, where
MUa is the marginal utility of good A and Pa is price per unit of good A. That is the ratio MUa/Pa must be 1.
(b) The ratio MUa/Pa = MUb/Pb that is marginal utilities derived from the expenditure of last rupee on all goods
are equal to each other. If for example, MUa/Pa > MUb/Pb, it means that the consumer can get greater
marginal utility by shifting some of his expenditure from good B to good A. By doing so, he is able to get
36 FP-BE

greater total utility by spending same amount of money. If however, the two ratios are equal, no addition to
the consumer’s total utility takes place by shifting his expenditure between goods.
Thus, the law of equi-marginal utility states that consumer distributes his expenditure between different goods in
such a way that the marginal utility derived from the last rupee spent on each good is the same.
Symbolically,
MUa/Pa = MUb/Pb = MUc/Pc = …..... = MUn/Pn (Consumer Equilibrium)
Thus, the consumer, while dividing his expenditure between goods considers both their marginal utilities and
prices. By equating the ratios of marginal utilities to prices of goods, the consumer succeeds in deriving maximum
possible utility from his expenditure. This is the best position which he can attain.
It is clear that the consumer’s equilibrium will change if there is a change in
– his total expenditure
– marginal utility schedule of any good
– price of any good
Table 2.4 provides a hypothetical application of the law of equi-marginal utility. It is assumed that our consumer
is to spend 12 rupees and choose between four goods, A, B, C and D. Figures in the first row reveal that the first
rupee spent on good A yields 40 units of utility for the consumer. If same rupee is spent on good B, the utility
derived by the consumer is 38 units. And so on.
Recalling that the consumer will spend each additional rupee on that good which brings him maximum marginal
utility (that is having highest MU/P), we note that he will spend his 1st rupee on good D which brings him 45 units
of utility. Similarly, the 2nd rupee is spent on good C (which brings 44 units of utility) ; the 3rd rupee is again spent
on D (with marginal utility of 42); the 4th and 5th rupees are spent on goods A and C (not necessarily in this order);
the 6th rupee goes to good D; 7th and 8th rupees are spent on goods A and B (not necessarily in this order); while
the remaining four rupees are spent one each on A, B, C and D (not necessarily in this order). As a result, in all,
he spends three rupees on A, two rupees on B, three rupees on C, and four rupees on D. The utility derived by
him is 114 units from A, 74 units from B, 120 units from C, and 162 units from D, the total being 470 units. Any
other division of his expenditure on these four goods would yield the consumer a smaller total utility. It should
also be noted that when marginal utility from a rupee spent on two or more goods is the same, the consumer
may spend it on either of them. Thus, in our example, we cannot say for certain whether the consumer will spend
4th rupee on A and 5th on C, or it will be the other way round. And if his total expenditure is only five rupees, the
5th rupee may be spent on either of the two goods with the same result.

Table: 2.4 Application of the Law of Equi-marginal Utility

Expenditure MUa/Pa MUb/Pb MUc/Pc MUd/Pd

1st Rupee 40 38 44 45
nd
2 Rupee 38 36 40 42
3rd Rupee 36 32 36 39
4th Rupee 34 29 32 36
th
5 Rupee 32 26 28 33
6th Rupee 20 23 24 30
th
7 Rupee 18 20 20 27
th
8 Rupee 16 17 16 24
9th Rupee 14 14 12 21
 Lesson 2  Theory of Demand and Supply 37

Fig. 2.4: Law of Equi-marginal Utility

The Law of Equi-marginal utility may also be explained with the help of a diagram.
In Fig. 2.4, X-axis represents expenditure in rupees on a good A, and Y-axis
represents the corresponding marginal utility, per rupee spent, from that good.
This gives a downward sloping curve (like MUa/Pa) for each good to which the
consumer allocates a part of his expenditure. In Fig. 2.4, we have four such
curves.
The consumer spends OA rupees on A, OB rupees on B, OC rupees on C, and
OD rupees on D. The utility of the last rupee spent on each of the four goods is
equal to OF.

Consumer Equilibrium under Utility Analysis

Equilibrium means a position of rest characterized by absence of change. Consumer equilibrium is the situation
when a consumer secures maximum satisfaction out of his expenditure. Basically, he attains the equilibrium
position at a point when he maximizes his total utility given his income and price of commodities he consumes.
Any deviation from this point places the consumer in the sub-optimal situation.
Under utility analysis, a consumer with a single commodity attains equilibrium at a point where MU = Price
If MU of additional unit of a commodity is more than its price then consumer will purchase the commodity, on the
other hand if MU from the purchase of additional unit is less than the price then he will not purchase the
commodity. He will purchase the commodity up to the point where MU derived from the purchase of additional
unit of commodity is equal to its price.
In case of two or more commodities, consumer attains equilibrium at a point where MU1=MU2=……….=MUn if
price for all commodities are the same. But in case of differences in prices, the equilibrium equation will be :
MU1/P1=MU2/P2=…………=MUn/Pn

Limitations of the Law

In reality, the Law of Equi-marginal utility suffers from several limitations which come in the way of its implementation
by the consumer. Some of the limitation are as follows:
(a) The assumption that the goods on which the consumer spends his money are perfectly divisible, i.e., goods
can be bought even in extremely small quantities does not hold true at times. The consumer is faced with
lumpy goods. They are not divisible into very small quantities. He has to buy an entire quantity of a good or
not at all. This is more so in the case of durable consumption goods. For example, he cannot buy half of a
shirt, one-tenth of a bicycle. Consequently, he fails to apply the law of equi-marginal utility in practice.
(b) The law also suffers from the unrealistic nature of its other assumptions. One such assumption is that the
consumer has complete knowledge of the prices and availability of all consumer goods. However, this is
generally not so. In several cases, the consumer does not possess sufficient information regarding the
prices of goods he is interested in. In some cases, he may have incorrect information regarding the price
and/or availability of a good.
(c) The law assumes independence of utility schedules of goods. It means that utility derived from one good
is not affected by the quantity purchased of other goods. In reality, however, many goods are related to
each other by being substitutes or complements to each other. In such cases, the marginal utility derived
from a given good depends not only upon its own quantity, but also upon the quantity of the related good.
(d) The law makes a questionable assumption that the consumer is able to accurately determine the marginal
utility schedules of all the goods.
38 FP-BE

DEMAND

Meaning of Demand
Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is
the amount of a product people are willing to buy at a certain price. Demand for a good by a consumer is not the
same thing as his desire to buy it. A desire becomes a demand only when it is ‘effective’ which means that, given
the price of the good, the consumer should be both willing and able to pay for the quantity which he wants to buy.
Thus three things are essential for a desire for a commodity to become effective demand.
– desire for a commodity
– willingness to pay
– ability to pay for the commodity
For instance, demand for Mercedez Benz can be considered as demand only when it is backed by desire,
willingness and ability to pay.

Law of Demand
The consumer’s decisions are guided by several elements, such as price, income, tastes and preferences etc.
Among the many causal factors affecting demand, price is the most significant and the price- quantity relationship
called as the Law of Demand is stated as follows:
“The greater the amount to be sold, the smaller must be the price at which it is offered in order that it may find
purchasers, or in other words, the amount demanded increases with a fall in price and diminishes with a rise in
price”. In simple words other things being equal, quantity demanded will be more at a lower price than at higher
price. The law assumes that income, taste, fashion, prices of related goods, etc. remain the same in a given period.
The law indicates the inverse relation between the price of a commodity and its quantity demanded in the market.
Thus ‘Ceteris Paribus’;
(a) With a change in the price of the good, the consumer changes the quantity purchased by him. Normally,
the consumer buys more of a good when its price falls and reduces the quantity when its price increases.
(b) The quantity demanded must be related to the time interval over which it is purchased. For example, it is
meaningless to say that a consumer buys 5 kg of sugar when its price is Rs. 12 per kg. The quantity
bought must specify the time period, i.e., per day, per week, per month, or over some other period.
Factors determining demand for a commodity are: Price, Income of the consumer, Tastes & Preferences,
Demographic factors, Seasonal factors etc.

Three Alternative Ways of Expressing Demand

Demand for a good by an individual or the market as a whole is conventionally expressed in three alternative
forms, namely;
– a demand function
– a demand schedule
– a demand curve
Demand Function: A demand function of an individual buyer is an algebraic form of expressing his demand behaviour.
In it, the quantity demanded per period of time is expressed as a function of several variables. A demand function may
be in a generalized form or a specific form. In the latter case, the function describes the exact manner in which
quantity demanded is supposed to vary in response to a change in one or more independent variables.
General form of the demand function is Dx = f (Px, Y, T)
In a demand function Dx = f(Px, Y, T), the dependent variable is Dx, i.e. the demand for a commodity (a normal good)
and Px (price), Y (income) and T (tastes and preferences of a consumer) are independent variables. In other
 Lesson 2  Theory of Demand and Supply 39

words, the demand for a commodity is determined or dependent upon the mentioned three independent variables.
Example of a demand function for good X is Dx = 2000 – 10Px
where, Dx denotes quantity demanded of good X, Px denotes the price of good X.
Demand Schedule: A demand schedule is a tabular form of describing the relationship between quantities
demanded of a good in response to its price per unit, while all non-price variables remain unchanged. A demand
schedule has two columns, namely
– price per unit of the good (Px)
– quantity demanded per period (Dx)
The demand schedule is a set of pairs of values of Px and Dx.
There are two types of demand schedule, namely
– individual demand schedule
– market demand schedule
Table: 2.1 Individual Demand Schedule for Commodity X of individual A
Price per unit of Commodity X Quantity Demanded of Commodity X
A (Units)

10 6000

20 5000

30 4000

40 3000

50 2000

60 1000
From individual demand schedules one may draw the market demand schedule. Market demand schedule is
the horizontal summation of individual demand schedules. The illustration of market demand schedule is given
as under assuming there are only 2 consumers (A&B) in the market (See Table 2.2).

Table: 2.2 Market Demand Schedule for Commodity X

Per unit Price of Quantity Demanded of Quantity Demanded of Market Demand

Commodity X Commodity X by Commodity X by (Units)
(Rs) Consumer – A Consumer– B QA + QB
PA (Units) (Units)
QA QB

10 6000 9000 15000

20 5000 8000 13000

30 4000 7000 11000

40 3000 6000 9000

50 2000 5000 7000

60 1000 4000 5000

40 FP-BE

For instance, if the price of bike is Rs.50,000 and at this price, Consumer A demands 2 bikes and Consumer B
demands 1 bike then the market demand for the bike will be 3 (sum total of the demand of the two consumers).
Likewise by adding up the individual demand for a commodity at different price levels, we can ascertain the
market demand for the commodity.
Demand Curve: A demand curve is a graphic representation of the demand schedule. It is a locus of pairs of
price per unit (Px) and the corresponding demand-quantities (Dx). (See. Fig 2.1)

Fig. 2.1: Demand Curve of individual A

Fig 2.1 shows demand curve, where X-axis measures quantity

demanded and Y-axis shows prices. As the price increases from 10 to
60 the quantity demanded declines from 6000 to 1000, establishing a
negative relation among the two.
This, thus, implies that the conventional demand curve, other things
being constant, is downward sloping.
To explain the Law of Demand, various approaches may be employed
in analyzing its behaviour for a typical individual consumer. The Utility
approach is one of them.

DERIVATION OF LAW OF DEMAND — UTILITY ANALYSIS

Law of demand describes the changes in the market demand for a good in relation to its alternative prices. It
says that in normal situations, quantity demanded of a good falls when its price increases and vice versa. In
other words, the price and the quantity demanded of a good are inversely related to each other.
Utility approach helps in deriving the law of demand.

Fig. 2.5: Marginal Utility of Good and its Demand Curve

In Fig. 2.5, measure (a) units of good X along X-axis, and (b) units of marginal
utility of X (MUx) along Y-axis, and the marginal utility curve of X (MUx). Thus, for
example, point P on the MUx curve shows that the consumer derives PM units of
marginal utility when he buys OM units of X. In other words, the marginal utility of
Mth unit of X equals PM. Similarly, in case the consumer buys OM’ units of X, then
his marginal utility fall to P’M’.
Changing marginal utility of X can be combined with the rationality of the consumer
in deriving his demand decisions. Given the per unit price of X, he is ready to buy it
only if its marginal utility equals or exceeds it. Thus, if the price per unit of X is OB (=
PM) units of utility, then the consumer will buy just OM units of it. No more and no less.
If he buys a smaller quantity, he foregoes some surplus units of utility (which he gets over and above the price
paid) from earlier units of X. This is because the price X does not change with its quantity purchased by the
consumer. Though the consumer gets higher marginal utility from earlier units of X, the price paid by him for
those units does not increase. And if he buys more than OM units of X, he gets smaller utility from those
additional units, but has to pay the same price OB per unit. This reasoning can also be applied to the situation
where price per unit of X is OB’ (= P’M’). In that case the consumer buys just OM’ of X - neither more, nor less.
Translating these findings into overall demand decisions of the consumer, the consumer decides to buy more
of X when its price falls and vice versa.
 Lesson 2  Theory of Demand and Supply 41

Reasons for Negative Slope of the Demand Curve

Some of the major reasons for normal behaviour of the demand curve are listed below:
(a) The Law of Diminishing Marginal Utility: The law provides that when a consumer buys additional units of
a good, its marginal utility falls. A consumer always compares the marginal utility of a good with the price
to be paid for it; the price which he is willing to pay for additional unit of a good falls. Conversely, if the
price of a good falls, the consumer is induced to buy more of it. In other words, the price and quantity
demanded of a good move in opposite directions and the demand curved assumes a negative slope.
Units of oranges consumed Price of each orange Marginal Utiltiy
01 20 26
02 21 25
03 22 24
04 23 23
05 24 22

From the above table it can be concluded that a consumer will stop consumption at 4th unit of orange as
at this stage the price paid for the orange is equivalent to the marginal utility. Thus a consumer always
draws a comparison between the marginal utility of a good with the price to be paid for it. With the rise in
price of the commodity the willingness to pay for additional unit of a good falls and vice-versa.
(b) The Law of Equi-Marginal Utility: While deciding to buy a commodity, a consumer compares not only its
price with its own utility, but also with the possibility of a gain in utility by buying its substitute goods. In
other words, the consumer compares the ratio of marginal utility to price of one good with that of other
goods. If for example, MUa/Pa > MUb/Pb, it means that the consumer can get greater marginal utility by
shifting some of his expenditure from good B to good A. This induces him to substitute the lower priced
good for other goods.
(c) Increased Real Income: A fall in the price of a good increases the real income of the consumer. He is able
to buy more of the good under question, or buy more of other goods. Similarly, an increase in the price of
a good reduces his real income. In this case, the income effect leads to a reduction in the demand of the
good. This factor also contributes to the downward slope of demand curve.
A person ‘X’ has got Rs. 10,000 as the nominal income. Now the amount of goods and services he can
purchase with those Rs. 10,000 is nothing but real income. So when the price of a particular commodity
falls, the real income, i.e. the purchasing power of the customer increases and that is how at decreased
price customer can buy more of a particular commodity.

Change in Demand – Increase / Decrease versus Expansion/Contraction in Demand

The law demonstrates the price-quantity relationship while determining the demand schedule (curve/ function),
whereas there are various other factors that affect the demand schedule. It should be noted that the ‘location’ of
a demand curve (that is its distance from origin) is determined by factors other than its own price, while its slope
is determined by its price. In other words, demand for a good changes when
– a consumer moves from one point to another on the same demand curve (Movement along demand
curve)
– when the entire demand curve shifts its position (Movement from one demand curve to the other)
Movement along Demand Curve: A demand curve is drawn on the assumption that all factors determining the
42 FP-BE

demand behavior of a consumer, other than the price of the good itself, remain the same. When price of the good
changes, the consumer moves along the given demand curve and changes the quantity demanded of the good.
A reduction in quantity of demand on account of an increase in price is termed as ‘contraction’ of demand. In this
case, the consumer moves upwards along the demand curve. In contrast, if the price of the good falls, the consumer
moves downwards along the demand curve and buys more of the good. This is termed as ‘expansion’ of demand.

Fig. 2.6: Expansion/Contraction and Increase/Decrease in Demand

Consider demand curve D1. When price of good X falls from PM to P’M’, the quantity
of good X bought by the consumer increases from OM to OM’ and MM’ is the
‘expansion in demand‘. In contrast, the reduction in demand from OM’ to OM (=
MM’) on account of increase in price from P’M’ to PM is the ‘contraction’ in demand.

Movement from One Demand Curve to the Other: If the quantity demanded changes without change in price,
the consumer shifts from one demand curve to the other. Such a movement is termed as ‘increase’ in demand
when the consumer moves to the outer demand curve to the right. And it is termed a ‘reduction’ in demand when
the movement is to the inner demand curve to the left. Thus, in Fig 2.6, we may consider two demand curves D1
and D2. With a given price OA per unit of X, the consumer buys OM, if he is on demand curve D1 and OM’ if he
is on demand curve D2. Thus, a shift from point P on D1 to point C on D2 is called an ‘increase’ in demand and a
shift in the reverse direction is termed a ‘reduction’ in demand.

Exceptions to the Law of Demand

The law of demand is widely applicable to a large number of goods. However, there are certain exceptions to it
on account of which a change in the price of a good does not lead to a change in its quantity demanded in the
opposite direction.
(a) Expected Change in the Price of a Good: While an actual change in the price of a good leads to a change
in its demand in the opposite direction, an expected change in its price changes the demand in the same
direction. When the price of a good is expected to increase, consumers increase the demand-quantity so
as to avoid paying a higher price later. Similarly, when the price of a good is expected to fall, the consumers
postpone their purchases of it.
(b) The consumer may not consider a good as ‘normal’ or ‘superior’. There are four types of such goods.
– Inferior Goods: Some goods are consumed generally by poorer sections of the society. It is believed that
with an increase in income such a consumer should move to a ‘better’ quality substitute good. For example,
with an increase in income, a typical poor consumer shifts his demand from coarse grains to finer varieties
of cereals. Therefore, with a fall in the price of a good (more so a necessity on which the consumer is
spending a large part of his budget), the real income of the consumer goes up. If, he considers the good
under consideration an inferior good, he reduces its demand and buys more of its substitute(s).
– Giffen Goods: Some special varieties of inferior goods are termed as Giffen goods. Cheaper varieties
of this category like bajra, cheaper vegetable like potatoes come under this category. Sir Robert
Giffen of Ireland first observed that people used to spend more their income on inferior goods like
potato and less of their income on meat. But potatoes constitute their staple food. When the price of
potato increased, after purchasing potato they did not have so many surpluses to buy meat. So the
 Lesson 2  Theory of Demand and Supply 43

rise in price of potato compelled people to buy more potato and thus raised the demand for potato.
This is against the law of demand. This is also known as Giffen paradox. So giffen goods are products
that people continue to buy even at high prices due to lack of substitute products.
– Ignorance: In some cases, the consumers suffer from the false notion that a higher priced good is of
better quality. This happens mainly in the case of those goods where a typical consumer is not able
to judge the quality easily. In such cases, the sellers may be able to sell more not by lowering the
price but by raising it.
– Conspicuous Consumption: Certain goods are meant for adding to one’s social prestige. These
form the part of ‘status symbol’ for showing that their user is a wealthy or cultured person. The
consumers consider it as a distinction to have these goods. In other words, a commodity may be
purchased not because of its intrinsic value but because it is expected to add to the social prestige of
the buyer. For example: Diamonds and expensive jewellery, expensive carpets. Their demand falls,
if they are inexpensive.
(c) Change in Fashion: A change in fashion and tastes affects the market for a commodity. When a broad toe
shoe replaces a narrow toe, no amount of reduction in the price of the latter is sufficient to clear the
stocks. Broad toe on the other hand, will have more customers even though its price may be going up.
The law of demand becomes ineffective.
(d) Complementary Goods: Law of demand may be violated in the case of complementary goods also. For
example: if the price of the DVD player falls leading to increase in its demand, in spite of rise in price of
DVDs, their demand will increase.

Determinants of Demand
Demand for a good by a consumer can vary in response to several factors such as its own price, prices of other
related goods, income of the consumer, tastes and preferences of the consumer etc.
Symbolically, Dx = f(Px, PY, Y, T,…) where Px is the price per unit of good X, PY, the prices of the related goods, Y
is the income of the consumer, T represents the tastes and preferences of the consumer. Following are the
leading determinants of demand:
(a) Price of the Commodity: The first determinant of the demand for a good is its own price. The consumer
compares the marginal utility expected from a good with its price and decides whether it is worth buying
or not. A fall in the price induces the consumer to buy more of the good and an increase in the price
causes a fall in demand.
(b) Prices of Related Commodities: Prices of related commodities also affect the demand of the commodity
(say X). There are two ways in which a good can be related to another good:
– Substitute goods: If the price of a substitute good, Y increases, the demand for that good falls and the
consumer wants to by more of X instead. In contrast, if the price of the substitute good falls the consumer
increases the demand for that good and hence wants to buy less of X. It has positive cross price effect.
– Complement goods: If the price of a complementary good, Y increase, the demand for that good falls
so does the demand of its complement X. In the same way, a fall in the price of a complementary
good causes an increase in the demand for X. It has negative cross price effect.
(c) Levels of Income: The demand for a good is also affected by the levels of the income of the consumer.
With an increase in income the consumer wants to buy more of a good. However, if the good is considered
an ‘inferior’ one, he is expected to reduce its demand when his income increases.
(d) Expected Change in Price: If price of a good is expected to increase, demand for that good also increases
and vice-versa. A consumer wants to buy a good before its price goes up and will postpone its purchase
if price is expected to fall.
44 FP-BE

(e) Other Factors: Other factors which affect the aggregate market demand for a good include the size of
population, the marketing and sale campaigns by the suppliers, the ‘selling expenses’ incurred by the
sellers, the tastes and preferences of the buyers, and distribution of income and wealth. For example, the
richer sections are likely to spend a smaller proportion of their incomes on basic necessities and a larger
proportion on luxuries and durable consumer goods.

REVIEW QUESTIONS

1. What are the determinants of demand?

2. Give reasons for negative slope of demand curve?
3. Explain law of diminishing marginal utility.
4. What are the exceptions to the law of demand?
5. Distinguish between expansion /contraction of demand with increase/ decrease of
demand.

SUPPLY

Meaning of Supply

Supply represents how much the market can offer. The quantity supplied refers to the amount of a good producers
are willing to supply when receiving a certain price. The supply of a good or service refers to the quantities of that
good or service that producers are prepared to offer for sale at a set of prices over a period of time. According to
Watson, Supply means a schedule of possible prices and amounts that would be sold at each price. The supply
is not the same concept as the stock of something in existence, for example, the stock of commodity X in Delhi
means the total quantity of Commodity X in existence at a point of time; whereas, the supply of commodity X in
Delhi means the quantity actually being offered for sale, in the market, over a specified period of time.
Law of Supply
The law of supply states that a firm will produce and offer to sell greater quantity of a product or service as the
price of that product or services rises, other things being equal. There is direct relationship between price and
quantity supplied. In this statement, change in price is the cause and change in supply is the effect. Thus, the
price rise leads to supply rise and not other wise. It may be noted that at higher prices, there is greater incentive
to the producers or firms to produce and sell more. Other things include cost of production, change of technology,
price of related goods (substitutes and complements), prices of inputs, level of competition and size of industry,
government policy and non-economic factors.
Thus ‘Ceteris Paribus’;
(a) With an increase in the price of the good, the producer is willing to offer more of goods in the market for sale.
(b) The quantity supplied must be related to the specified time interval over which it is offered.

Three Alternative Ways of Expressing Supply

Supply of a good by an individual producer/firm or the market/industry as a whole is conventionally expressed in

three alternative forms, namely;
– a supply function
– a supply schedule
– a supply curve
Supply Function: A supply function of an individual supplier is an algebraic form of expressing his behaviour
 Lesson 2  Theory of Demand and Supply 45

with regard to what he offers in market at the prevailing prices. In it, the quantity supplied per period of time is
expressed as a function of several variables.
General form of the supply function is Sx = f (Px, Cx, Tx)
Example of a supply function for good X is Sx = 200 + 15Px
where, Sx denotes quantity supplied of good X, Px denotes the price of good X, Cx represents cost of production
and Tx is technology of production.
Supply Schedule: A supply schedule is a tabular statement that shows different quantities or services that are
offered by the firm or producer in the market for sale at different prices at a given time. It describes the relationship
between quantities supplied of a good in response to its price per unit, while all non-price variables remain
unchanged. A supply schedule has two columns, namely
– price per unit of the good (Px)
– quantity supplied per period (Sx)
The supply schedule is a set of pairs of values of Px and Sx
There are two types of supply schedule, namely
– individual supply schedule
– market supply schedule

Table: 2.5 Individual Supply Schedule for Commodity X

Price per unit of Commodity X Quantity of Commodity X

A (Units)
10 1000
20 2000
30 3000
40 4000
50 5000
60 6000
Individual supply schedule relates to the supply of a good or service by one firm at different prices, other things
remains constant or equal. The market supply schedule, on the other hand, like market demand schedule is the
sum of the amounts of good supplied for sale by all the firms or producers in the market at different prices during
a given time. Let us assume, there are two producers for a good.

Table: 2.6 Market Supply Schedule for Commodity X

Per unit Price of Quantity Supplied Quantity Supplied of Market Supply
Commodity X of Commodity X Commodity X by (Units)
A by Producer– A Producer – B QA + QB
PX (Units) (Units)
QA QB
10 1000 2000 3000
20 2000 3000 5000
30 3000 4000 7000
40 4000 5000 9000
50 5000 6000 11000
60 6000 7000 13000
46 FP-BE

Supply Curve: The individual supply curve is a graphical representation of the information given in individual
supply schedule. The higher the price of the commodity or product, the greater will be the quantity of supply
offered by the producer for sale and vice versa, other things remains constant.

Fig. 2.7: Supply Curve

Fig 2.7 shows supply curve of producer A, where X-axis is quantity supplied
and Y-axis shows prices. As the price increases from 10 to 60 the quantity
supplied rises from 1000 to 6000, establishing a positive relation among the
two.
This implies that the supply curve is upward sloping.

Reasons for positive slope of supply curve

Law of supply states that there exist positive relationship between the price of a product and its quantity supplied,
ceteris paribus. The supply curve slopes upward from left to right. It means that the supply of a product increases
with increase in its price and decreases with decrease in its price. Here, the question emerges that why law of
supply behave in this fashion and not otherwise.
Some of the reasons or explanations given by the economists in this regard are stated as under:
Producers hire and use resources in order to make profits from the sale of the output produced, at least in the
private enterprise sector of a mixed economy. In economics, it is assumed that a common objective of firms is
not only to make profits, but to maximize profits. Hence, since most firms could supply other products apart from
the good or service in question, it is unlikely that they would be prepared to supply large amounts of this good or
service if the price were very low, because this implies low profits after production costs have been taken into
account. Indeed, there must be some price at which no firms would be prepared to supply a product because it
is so low that it would not cover the minimum cost at which each unit of that product could be produced.
Conversely, the higher the price that firms can charge to sell a product, given the costs of the factors of production,
the more profitable that product becomes and the larger the amount that will be supplied to the market. Hence,
we can make the logical assumption that, other things being equal (including the number of firms in the market,
the scale of production of each firm and the costs of factors), the higher the price of a good or service, the
greater will be the quantity supplied of that good or service to the market, and vice versa.

Change in Supply – Increase / Decrease versus Expansion/Contraction in Supply

The ‘location’ of a supply curve (that is its distance from origin) is determined by factors other than its own price,
while its slope is determined by its price. In other words, supply for a good changes when
– a producer moves from one point to another on the same supply curve (Movement along supply curve)
– when the entire supply curve shifts its position (Movement from one supply curve to the other)
Movement along Supply Curve: An increase in price will increase the quantity supplied, but a decrease in
price will reduce the quantity supplied. The supply curve is positively sloped- upward and to the right, as against
the demand curve which is negatively sloped.
A reduction in quantity of supply on account of a decrease in price is termed as ‘contraction’ in supply. In this
case, the supplier moves downwards along the supply curve. In contrast, if the price of the good rises, the
 Lesson 2  Theory of Demand and Supply 47

supplier moves upwards along the supply curve and offers to sell more of the good. This is termed as ‘expansion’
in supply.
Thus Increase/Decrease and Expansion/Contraction in the Supply can be summarized in the following manner:
Expansion/Contraction in the Supply
• When the price of the good changes the producer moves along the given supply curve and changes the
quantity supplied
• An increase in the quantity of supply due to an increase in price is termed as expansion in supply of that good.
• If the price of the good falls the producer moves downwards along the supply curve and sells less of the
good. This is called contraction in the supply of that good.

Fig. 2.8: Change in Quantity Supplied

Fig 2.8 shows supply curve, where X axis is quantity supplied and Y axis
shows prices.
Movement along the supply curve is shown in this fig, where the change
in quantity supplied is only on account of the change in own price of the
commodity, other things being equal.
Contraction in Supply

Expansion in Supply

Movement from One Supply Curve to the Other: If the supply changes without change in price, the supplier
shifts from one supply curve to the other. Such a movement is termed ‘increase’ in supply when the producer
moves to the outer supply curve to the right. And it is termed a ‘reduction’ in supply when the movement is to the
inner supply curve to the left.
Increase/Decrease in Supply
• The location of a supply curve (that is the distance from origin) is determined by factors other than its own
price, while its slope is determined by its price.
• If the supply changes without change in the price, the manufacturer shifts from one supply curve to the
other. Such a movement is called increase or decrease in supply.

Fig. 2.9: Change in Supply

Thus, in Fig 2.9, we may consider supply curves S’ and S” which shift to
the left and right from supply curve S implying decrease and increase in
supply respectively.



48 FP-BE

Exceptions to the Law of Supply

The normal law of supply is widely applicable to a large number of goods. However, there are certain exceptions
to it on account of which a change in the price of a good does not lead to a change in its supply in the same
direction. The law of supply is not a universal principle that applies to all markets under all circumstances. There
are, in fact, numerous important exceptions to the law of supply.
(a) Expected Change in the Price of a Good: While an actual change in the price of a good leads to a change
in its supply in the same direction, an expected change in its price changes the supply in the opposite
direction. When the price of a good is expected to increase, supplier decreases the supply-quantity so as
to avoid selling at lower prices in current period and sell more at even higher prices in future period.
(b) Monopoly: If the supply side of the market is controlled by small number of sellers then the law of supply
might not operate. For example, in case of monopoly (single seller) may not necessarily offer a larger
quantity supplied even though the price is higher. Market control by the monopolist allows it to set the
market price based on demand conditions, without cost constraints imposed from the supply side.
(c) Competition: Other market structures like oligopoly and monopolistic competition might be facing more
competition, thereby offering to sell larger quantities at lower prices and negating the law of supply.
(d) Perishable Goods: In cases of perishable goods the supplier would offer to sell more quantities at lower
prices to avoid running into losses due to damage of the product.
(e) Legislation Restricting Quantity: Suppliers cannot offer to sell more quantities at higher prices where the
government has put regulations on the quantity of the good to be offered or the price ceiling at which the
good is to be offered in market. Producers are unable to play with either of the factors on their own.
(f) Agricultural Products: Since the production of agricultural products can not be increased beyond a limit,
the supply can also not be increased beyond this limit even if the prices are higher; the producer is unable
to offer larger quantities.
(g) Artistic and Auction Goods: The supply of such goods can not be increased or decreased easily. Thus, it
is difficult to offer larger quantities even if the prices shoot up.

Determinants of Supply
At any point in time, the total quantity supplied of a good or service in the market is influenced by number of
factors. Some of the important factors include the following:
(a) Costs of the Factors of Production: The cost of factor inputs such as land, labour, capital, raw materials
etc. is one of the determinant factors which influence the market supply of a product. For instance: if the
price of labour goes up, then the supply of the product will decline due to higher labor cost.
(b) Changes in Technology: The change in technology as a result of constant research and developments in
terms of improved machinery, improved method of organization and management helps the business
units or firms to reduce the cost of production. All this contributes significantly to increase the market
supply at given prices.
(c) Price of Related Goods (Substitutes): Prices of related commodity also affect the supply of the commodity
(say X). If the price of a substitute good, Y increases, the supply for that good increases and the producer
would shift the allocation of resources to Y from X.
(d) Change in the Number of Firms in the Industry (Market): A change in number of firm in the industry as a result
of profitability also influences the market supply of a good. For example, an increase in number of firms in the
industry attracted by higher profit would increase the quantity supplied of good over the range of prices.
(e) Taxes and Subsidies: A change in government fiscal policy in terms of change in tax rate or amount of
subsidy may influence the supply of a good in the market. A decrease/increase in the amount of tax/
subsidy on the good would allow firms to offer larger amount of a good at a given range of prices.
 Lesson 2  Theory of Demand and Supply 49

(f) Goal of a Business Firm: The goal of a business firm such as profit maximization, sales maximization or
both is also responsible to influence the market supply of a good or service. In case the firm is interested
to maximize profit, the same may be attained by decreasing the market supply of a good under certain
conditions whereas as goal of sales maximization will increase the supply.
(g) Natural Factors: Natural Factors such as climatic changes, particularly in the case of agricultural products
influence its supply.
(h) Changes in Producer or Seller Expectations: The supply curve like the demand curve is drawn for a
certain time period. If the expectations of the future prices change drastically in a market. For example,
prices of good and service are expected to rise suddenly, the firm would hold current production from the
market in anticipation of higher prices and thus influences supply of the good.

DETERMINATION OF EQUILIBRIUM PRICE AND QUANTITY

In economics, equilibrium is a situation in which:
– there is no inherent tendency to change
– quantity demanded equals quantity supplied
– the market clears itself and becomes stable (That is, at the market equilibrium, every consumer who
wishes to purchase the product at the market price is able to do so, and the supplier is not left with any
unwanted inventory.)
– Equilibrium price is the price at which the demand is equal to supply.
Law of demand and law of supply explains separately the ‘plans’ of consumers as to how much they would buy at
a given price and the ‘plans’ of producers as to how much they would offer for sale at the given price. The demand
curve and the supply curve really show what consumers and producers would do if they were given the opportunity.
Although the demand would be very high at lower prices in practice consumers may never get the opportunity to
buy the product at that low price because suppliers are not willing to supply at that price. Similarly, although
suppliers may be prepared to offer a large amount for sale at a high price, they may not be able to sell it all
because the consumers are not willing to buy at that high a price.
The demand for a product and the supply of a product are two sides of the market, and it is necessary to bring
these together to establish equilibrium in the market which is the point where both the sides of the market are
satisfied simultaneously.
This can be better understood with the help of following illustration. (See Table 2.7). Let us take demand and
supply schedule for good X and analyze equilibrium position. Equilibrium price is Rs. 40 and equilibrium quantity
is 9000 units.

Table 2.7: Demand and Supply Schedule for Commodity or Good X

Per unit Price of Quantity Demanded of Quantity Supplied of Description

Commodity X Commodity X in the Commodity X in the
(A) market (Units) market (Units)
PX QD QS
10 12000 3000 Excess Demand
20 11000 5000 Excess Demand
30 10000 7000 Excess Demand
40 9000 9000 Demand = Supply
50 7000 11000 Excess Supply
60 5000 13000 Excess Supply
50 FP-BE

Fig. 2.11: Demand and Supply Curves

Fig 2.11 shows a demand and a supply curve, where X axis is quantity
and Y axis shows prices.
In the figure the market equilibrium is established based on the data
from Table 2.7
The equilibrium is the state when Demand equals Supply which is at
point E.

EFFECT OF CHANGES IN THE CONDITIONS OF DEMAND AND SUPPLY ON MARKET PRICE

The market price, or equilibrium price, is determined by the interaction of demand and supply curves. Remember
that the demand curve and the supply curve for a commodity are drawn up on the assumption that all other
factors which might affect the demand for or supply of the commodity remain constant. The equilibrium price
will remain stable in the market as long as these other factors of demand and supply do not change. If any of
these factors change, this will create excess demand or excess supply and so initial equilibrium price will also
change.
For example, a condition of drawing a demand curve is that level of income does not change. If the level of
income increases, there will be an increase in demand for a commodity X at the existing market price. Hence,
if the price remains the same, supply will be the same as before, and with increased demand there will be a
shortage, causing pressure on the existing price, which suppliers will then raise. On other hand, if consumer’s
level of income decreases, other things remaining constant, with decreased demand there will be deficient
demand/excess supply, causing existing price to fall.

Fig. 2.12: Effect of Changes in Demand and Supply on Market Price

This effect can be represented diagrammatically as in Figure 2.12 making

use of the technique of shifting the position of the demand curve to
represent a change in conditions of demand.
In Figure 2.12, the demand curves DD and D’D’ show the effect of an
increase in demand as a result of a favorable change in conditions of
demand (such as an increase in consumers’ income levels) — D’D’ being
the new demand curve. Before the increase in demand, the equilibrium
price was P0 and the equilibrium output was Q0.

As a result of the increase in demand, excess demand occurs at the price P0, causing suppliers to expand
output and raise the market price. A new equilibrium is established at P1 and a new higher equilibrium output at
Q1. Notice that a change in conditions of demand does not cause a movement of the supply curve—this could
only result from changes in conditions of supply.
 Lesson 2  Theory of Demand and Supply 51

Fig. 2.13: Effect of Change in Supply on Market Price

In Figure 2.13, the supply curves SS and S’/S’ show the effect of an
increase in supply as a result of a favorable change in the conditions of
supply (such as a reduction in the costs of production because of
productivity increases)— S’S’ being the new supply curve. Before the
increase in supply, the equilibrium price was P 0 and the equilibrium
output was Q0. As a result of the increase in supply, excess supply
occurs at the price P0, causing suppliers to lower the price in order to
expand demand. A new equilibrium price is established at P 1 with a
higher equilibrium output at Q1. Notice again that a change in conditions
of supply does not cause a shift in the demand curve.

It is useful to summarize the effects of changes in the conditions of demand and of supply on the equilibrium
price and output, assuming that we are operating in a free market.

Laws of Demand and Supply in a Free Market

In economics a law is a statement of general tendency – a prediction of what is likely to happen in so many
cases that it can be generalized into a law. The laws of demand and supply state that:
– Excess demand for a commodity will cause a rise in its price.
– Excess supply of a commodity will cause a fall in its price.
– Price will settle at one point where the quantity demanded equals the quantity supplied—the equilibrium price.
– An increase in demand (a movement of the demand curve to the right) will cause a rise in price and a rise
in the quantity bought and sold.
– A decrease in demand (a movement of the demand curve to the left) will cause in price and a fall in the
quantity bought and sold.
– An increase in supply (a movement of the supply curve to the left) will cause a fall in price and a rise in the
quantity bought and sold.
– A decrease in supply (a movement of the supply curve to the left) will cause a rise in price and a fall in the
quantity bought and sold.

ELASTICITY OF DEMAND AND SUPPLY

Meaning of Elasticity

Perhaps one of the most useful concepts in demand and supply analysis, certainly from the point of view of a
person interested in business strategy, is that of elasticity. Elasticity refers to the ratio of the relative change in a
dependent to the relative change in an independent variable i.e. elasticity is the relative change in the dependent
variable divided by the relative change in the independent variable. For example, the ratio of percentage change
in quantity demanded to percentage change in some other factor like price or income.

Elasticity of Demand

Elasticity of demand forms part of demand analysis and it helps in measurement of the magnitude of relationship
between demand and its determinant. Elasticity of demand is mainly of three types :
52 FP-BE

– Price Elasticity of Demand

– Cross Price Elasticity of Demand
– Income Elasticity of Demand

Price Elasticity of Demand

The law of demand indicates the direction of change in demand in response to a change in price. It does not
express the magnitude of change in demand in response to a change in price. This information is provided by
the tool of elasticity of demand. The concept of elasticity of demand refers to the degree of responsiveness of
demand of a good to a change in its price.
According to Marshall “the elasticity (or responsiveness) of demand in a market is great or small according as
the amount demanded increases much or little for a given fall in price or diminishes much or little for a given rise
in price”.
Elasticity of demand differs with different commodities. For the same commodity, elasticity of demand differs
from person to person. It may be noted that the elasticity of demand has a negative sign because of the negative
relationship between price and demand.

The formula for calculating price elasticity is:

Ed = Change in Quantity Demanded

Change in Price

There are five cases of Elasticity of Demand in which it responds:

– Perfectly elastic demand
– Perfectly inelastic demand
– Relatively elastic demand
– Relatively inelastic demand
– Unitary elastic demand
Perfectly elastic demand: The demand is said to be perfectly elastic when a very insignificant change in price
leads to an infinite change in quantity demanded. A very small fall in price causes demand to rise infinitely.
Likewise a very insignificant rise in price reduces the demand to zero. This case is theoretical which is never
found in real life. The demand curve in such a situation is parallel to X-axis. Numerically, elasticity of demand is
said to be equal to infinity. (Ed = )
Perfectly inelastic demand: The demand is said to be perfectly inelastic when a change in price produces no
change in the quantity demanded of a commodity. In such a case quantity demanded remains constant regardless
of change in price. The amount demanded is totally unresponsive to change in price. The demand curve in such
a situation is parallel to Y-axis. Numerically, elasticity of demand is said to be equal to zero. (Ed = 0)
Relatively elastic demand: The demand is relatively more elastic when a small change in price causes a
greater change in quantity demanded. In such a case a proportionate change in price of a commodity causes
more than proportionate change in quantity demanded. For example: If price changes by 10% the quantity
demanded of the commodity changes by more than 10%. The demand curve in such a situation is relatively
flatter. Numerically, elasticity of demand is said to be greater than 1. (Ed > 1)
Relatively inelastic demand: It is a situation where a greater change in price leads to smaller change in
 Lesson 2  Theory of Demand and Supply 53

quantity demanded. The demand is said to be relatively inelastic when a proportionate change in price is greater
than the proportionate change in quantity demanded. For example: If price falls by 20% quantity demanded
rises by less than 20%. The demand curve in such a case is relatively steeper. Numerically, elasticity of demand
is said to be less than 1. (Ed < 1)
Unitary elastic demand: The demand is said to be unit when a change in price results in exactly the same
percentage change in the quantity demanded of a commodity. In such a situation the percentage change in both
the price and quantity demanded is the same. For example: If the price falls by 25%, the quantity demanded
rises by the same 25%. It takes the shape of a rectangular hyperbola. Numerically, elasticity of demand is said
to be equal to 1. (Ed = 1).

Fig. 2.14 Types of Price Elasticity

Fig 2.14 shows various demand curves, where X-axis shows quantity
demanded and Y-axis shows prices.
Different types of price elasticity discussed above can be shown in a
diagram.
E>1
DD1 – Perfectly Elastic Demand
DD2 – Elastic Demand
DD3 – Unitary Elastic Demand
DD4 – Inelastic Demand
DD5 – Perfectly Inelastic Demand

Methods of Measuring Price Elasticity of Demand

Price elasticity of demand can be measured through three popular methods. These methods are:
– Percentage Method or Arithmetic Method
– Total Expenditure Method
– Graphic Method or Point Method
1. Percentage Method
According to this method, price elasticity is estimated by dividing the percentage change in quantity demanded
by the percentage change in price of the commodity. Thus, given the percentage change of both quantity
demanded and price; the elasticity of demand can be derived. If the percentage change in quantity demanded
is greater that the percentage change in price, the elasticity will be greater than one.
If percentage change in quantity demanded is less than percentage change in price, the elasticity is said to be
less than one. But if percentage change of both quantity demanded and price is same, elasticity of demand is
said to be unit.
Ed = (D/D) / (P/P)
= (D/P) X (P/D)

Where, D is the change in demand and P is the change in price, while original demand and price are D and
P respectively.
54 FP-BE

2. Total Expenditure Method

Total expenditure method was formulated by Alfred Marshall. The elasticity of demand can be measured on the
basis of change in total expenditure in response to a change in price. It is worth noting that unlike percentage
method a precise mathematical coefficient cannot be determined to know the elasticity of demand.
By the help of total expenditure method, it is determined whether the price elasticity is equal to one, greater than
one, less than one. In this method, the initial expenditure before the change in price and the expenditure after
the change in price are compared.
Total Outlay/ Expenditure = Price x Quantity Demanded
If, with a fall in price, it is found that the expenditure remains the same, elasticity of demand is said to be one (Ed
= 1), if the total expenditure increases the elasticity of demand is said to be greater than one (Ed > 1), if the total
expenditure diminishes with the fall in price, elasticity of demand is less than one (Ed < 1), and vice-versa.

Table: 2.8 Total Outlay and Expenditure method

Price Total Expenditure Elasticity of Demand

Increases Less than 1
INCREASES Remains Same Equal to 1
Falls More than 1
Falls Less than 1
FALLS Remains Same Equal to 1
Increases More than 1

The relationship presented in above table may also be shown graphically as under.
Fig. 2.15 : Price Elasticity of Demand using Total Outlay Method

In Fig 2.15, demand for commodity X is unitary elastic over the

price range OP1 to OP2 because total outlay or expenditure
does not change with change in price. Demand is inelastic
over the price range O to OP 1 because total expenditure
increases or decreases with increase or decrease in prices
respectively. Demand is elastic over the price range OP2 to
OP3 because total outlay increases with decrease in prices
and decreases with increase in prices.

Total Expenditure or Total Outlay method has certain drawbacks. Firstly, it is not able to give us an exact
numerical measure of elasticity of demand. It only tells us whether the elasticity is equal to, less than, or more
than one. Therefore, this method fails to compare demand elasticities of different goods. Secondly, it is not
possible to use this method in measuring demand elasticity when demand changes in the same direction as the
price, as in the case of giffen goods.
 Lesson 2  Theory of Demand and Supply 55

3. Graphic Method
Graphic method is otherwise known as Point Method or Geometric Method. According to this method, elasticity
of demand is measured on different points on a straight line demand curve. The price elasticity of demand at a
point on a straight line is equal to the lower segment of the demand curve divided by upper segment of the
demand curve at that point.
Thus, at mid point on a straight-line demand curve, elasticity will be equal to unity; at higher points on the same
demand curve, but to the left of the mid-point, elasticity will be greater than unity, at lower points on the demand
curve, but to the right of the midpoint, elasticity will be less than unity.
At a corner point on demand curve where there is no lower segment, elasticity of demand is equal to zero (Ed = )
and where there is no upper segment on demand curve, elasticity of demand is equal to infinity, (Ed = )

Fig. 2.16: Point Elasticity of Demand on a Straight Line Demand Curve

In Fig. 2.16, if the demand curve is a straight line and meets (or is
extended to meet) X-axis and Y-axis at points B and A respectively,
then elasticity of demand at point P on the demand curve is given by the
ratio:

Segment of demand curve from point P to X- axis

Segment of demand curve from point P to Y- axis

Fig. 2.17 Elasticity of Demand for Curvilinear Demand Curve

When demand curve is curvilinear instead of a straight line, and we

want to measure elasticity of demand at a point P on it, we should draw
a tangent to it at point P, consider as if the tangent is the demand curve,
and use the same approach as before in measuring elasticity of demand.
Thus, in Fig. 2.17, elasticity of demand at point P equals PB/AP = BM/
OM, while at point P’ it is P’B’/A’P’ = B’M’/OM’.

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

Price elasticity of demand is dependent upon a number of factors as follows:

(a) Price Level: The demand is elastic for moderate priced goods but, the demand for very costly and very
cheap goods is inelastic. The rich do not bother about the prices of the goods that they buy. Very costly
goods are demanded by the rich people and hence their demand is not affected much by changes in prices.
For example, increase in the price of maruti car from Rs. 3,00,000 to Rs. 3,20,000 will not make any
noticeable difference in its demand. Similarly, the changes in the price of very cheap goods (such as salt)
will not have any effect on their demand, for their consumption which is very small and fixed.
56 FP-BE

(b) Availability of Substitutes: If a good has close substitutes, the price elasticity of demand for a commodity
will be very elastic as some other commodities can be used for it. A small rise in the price of such a
commodity will induce consumers to switch their consumption to its substitutes. For example gas, kerosene
oil, coal etc. will be used more as fuel if the price of wood increases. On the other hand, the demand of
such commodities is inelastic which have no substitutes such as salt.
(c) Time Period: A typical consumer finds it difficult to adjust his consumption of a good in the short run. He
needs time to adjust to the changed situation. Therefore, demand elasticity of a good tends to increase in
the long run.
(d) Proportion of Total Expenditure Spent on the Product: Elasticity of demand for a good is also dependent
upon the proportion of a consumer’s budget spent on it. On account of a price rise of a good, a consumer
feels more concerned if he is spending a large proportion of his budget on it. The extent of change in
demand by the consumer is not significant in the case of those goods on which the consumer spends a
very small proportion of his monthly budget. In the former case elasticity of demand is higher, while in the
latter cases, it is low.
For example out of total monthly expenses of Rs10,000, the amount spent on multiplex tickets is Rs500,
then a change in the price to Rs600 will not matter and there will be no change in demand.
(e) Habits: Some products which are not essential for some individuals are essential for others. If individuals
are habituated of some commodities the demand for such commodities will be usually inelastic, because
they will use them even when their prices go up. A smoker generally does not smoke less when the price
of cigarette goes up.
(f) Nature of the Commodities: The demand for necessities is inelastic and that for comforts and luxuries is
elastic. This is so because certain goods which are essential will be demanded at any price, whereas
goods meant for luxuries and comforts can be dispensed with easily if they appear to be costlier.
(g) Various Uses: A commodity which has several uses will have an elastic demand such as milk, wood etc.
On the other hand, a commodity having only one use will have inelastic demand. The consumer finds it
easier to adjust the quantity demanded of a good when it is to be used for satisfying several wants than
if it is confined to a single use. For this reason, a multiple-use good tends to have more elastic demand.
(h) Postponing Consumption: Usually the demand for commodities, the consumption of which can be
postponed has elastic demand as the prices rise and are expected to fall again. For example, the demand
for v.c.r. is elastic because its use can be postponed for some time if its price goes up, but the demand for
rice and wheat is inelastic because their use cannot be postponed when their prices increase.

Cross Price Elasticity of Demand

The change in the demand of a good x in response to a change in the price of good y is called ‘cross price
elasticity of demand’. Its measure is

Ed = Change in Quantity Demanded of Good X

Change in Price of Good Y
Symbolically, = (Dx /Py) / (Dx /Py)

– Cross price elasticity may be infinite or zero.

– Cross price elasticity is infinite if the slightest change in the price of good Y causes a substantial change
in the quantity demanded of good X. It is always the case with goods which are perfect substitutes.
– Cross price elasticity is positive if the change in the price of good Y causes a change in the quantity
demanded of good X in same direction. It is always the case with goods which are substitutes.
 Lesson 2  Theory of Demand and Supply 57

– Cross price elasticity is negative if the change in the price of good y causes a change in the quantity
demanded of good X in opposite direction. It is always the case with goods which are complements of
each other.
– Cross price elasticity is zero, if a change in the price of good Y does not affect the quantity
demanded good X. In the case of goods which are not related to each other, cross elasticity of demand is zero.

Income Elasticity of Demand

According to Stonier and Hague: “Income elasticity of demand shows the way in which a consumer’s purchase
of any good changes as a result of change in his income.” It shows the responsiveness of a consumer’s purchase
of a particular commodity to a change in his income. Income elasticity of demand means the ratio of percentage
change in the quantity demanded to the percentage change in income.

Ey = Percentage Change in Quantity Demanded of Good X

Percentage Change in Real Income of Consumer
Symbolically, Ey = (Dx /Y) / (Dx /Y) Where, Y denotes income of the consumer

It is noteworthy that sign of income elasticity of demand is associated with the nature of the good in question.
Normal Goods: Normal goods have a positive income elasticity of demand so as consumers’ income rises,
demand also increases.
– Normal necessities have an income elasticity of demand between 0 and 1. For example, if income increases
by 10% and the demand for fresh fruit increases by 4%, then the income elasticity is +0.4. Demand is
rising less than proportionately to income.
– Luxuries have an income elasticity of demand, Ed>1 i.e. The demand rises more than percentage change
in income. For example, an 8% increase in income might lead to a 16% rise in the demand for restaurant
meals. The income elasticity of demand in this example is +2. Demand is highly sensitive to income
changes.
Inferior goods: Inferior goods have a negative income elasticity of demand. Demand falls as income rises. For
examples, as income increases, the demand for cigarettes goes up against the low-priced local bidis.

Price Elasticity of Supply

The law of supply indicates the direction of change in quantity supplied in response to a change in price. It does
not express the magnitude of change in amount supplied in response to a change in price. This information is
provided by the tool of elasticity of supply. Like the elasticity of demand, the elasticity of supply is the relative
measure of the degree of responsiveness of quantity supplied of a commodity to a change in its price.
The, greater the responsiveness of quantity supplied of a commodity to the change in its price, the greater is its
elasticity of supply. To be more precise, the elasticity of supply is defined as a percentage change in the quantity
supplied of a product divided by the percentage change in price. It may be noted that the elasticity of supply has a
positive sign because of the positive relationship between price and supply.

The formula for calculating price elasticity of supply is:

ES = Percentage Change in Quantity Supplied

Percentage Change in Price

There are five cases of elasticity of supply in which it responds:

– Perfectly Elastic Supply
58 FP-BE

– Perfectly Inelastic Supply

– Relatively Elastic Supply
– Relatively Inelastic Supply
– Unitary Elastic Supply
Perfectly Elastic Supply: The supply is said to be perfectly elastic when a very insignificant change in price
leads to an infinite change in quantity supplied. A very small rise in price causes supply to rise infinitely. Likewise
a very insignificant fall in price reduces the supply to zero. The supply curve in such a situation is a horizontal
line running parallel to x-axis. Numerically, elasticity of supply is said to be equal to infinity. (Es = )
Perfectly Inelastic Supply: The supply is said to be perfectly inelastic when a change in price produces no
change in the quantity supplied of a commodity. In such a case, quantity supplied remains constant regardless
of change in price. The amount supplied is totally unresponsive of change in price. The supply curve in such a
situation is a vertical line, parallel to y-axis. Numerically, elasticity of supply is said to be equal to zero. (Es = 0)
Relatively Elastic Supply: The supply is relatively more elastic when a small change in price causes a greater
change in quantity supplied. In such a case a proportionate change in price of a commodity causes more than
proportionate change in quantity supplied. For example: If price changes by 10% the quantity supplied of the
commodity changes by more than 10%. The supply curve in such a situation is relatively flatter. Numerically,
elasticity of supply is said to be greater than 1. (Es > 1)
Relatively Inelastic Supply: It is a situation where a greater change in price leads to smaller change in quantity
supplied. The demand is said to be relatively inelastic when a proportionate change in price is greater than the
proportionate change in quantity supplied. For example: If price rises by 20%, quantity supplied rises by less
than 20%. The supply curve in such a case is relatively steeper. Numerically, elasticity of supply is said to be less
than 1. (Es < 1)
Unitary Elastic Supply: The supply is said to be unit when a change in price results in exactly the same
percentage change in the quantity supplied of a commodity. In such a situation the percentage change in both
the price and quantity supplied is the same. For example: If the price falls by 25%, the quantity supplied falls
by the same 25%. It is a straight line through the origin. Numerically, elasticity of supply is said to be equal to
1. (Es = 1)
(See Fig 2.18)

Fig. 2.18: Types of Price Elasticity

 Lesson 2  Theory of Demand and Supply 59

DETERMINANTS OF PRICE ELASTICITY OF SUPPLY

(a) Time Period: Time is the most significant factor which affects the elasticity of supply. If the price of a
commodity rises and the producers have enough time to make adjustment in the level of output, the
elasticity of supply will be more elastic. If the time period is short and the supply cannot be expanded after
a price increase, the supply is relatively inelastic.
(b) Ability to Store Output: The goods which can be safely stored have relatively elastic supply over the
goods which are perishable and cannot be stored.
(c) Factor Mobility: If the factors of production can be easily moved from one use to another, it will affect elasticity
of supply. The higher the mobility of factors, the greater is the elasticity of supply of the good and vice versa.
(d) Cost Relationships: If costs rise rapidly as output is increased, then any increase in profitability caused
by a rise in the price of the good is balanced by increased costs as supply increases. If this is so, supply
will be relatively inelastic. On the other hand, if costs rise slowly as output increases, supply is likely to be
relatively elastic.
(e) Excess Supply: When there is excess capacity and the producer can increase output easily to take
advantage of the rising prices, the supply is more elastic. In case the production is already up to the maximum
from the existing resources, the rising prices will not affect supply. The supply will be more inelastic.

THEORY OF CONSUMER’S BEHAVIOR

In the theory of consumer behaviour, the foremost important element is how a rational consumer makes choices
from the numerous commodities which are available to him. Consumer theory is concerned with how a rational
consumer would make consumption decisions. What makes this problem worthy of separate study, apart from
the general analysis of demand and supply theory, is its particular structure that allows us to derive economically
meaningful results. The structure arises because the consumer’s choice sets are assumed to be defined by the
consumer’s income or wealth.
There are two significant approaches of determining consumer behaviour:
– Marshallian Approach
– Indifference Curve Approach

Marshallian Approach
Alfred Marshall made a significant contribution to the study of consumer behaviour. Marshall attempted to derive
consumer’s equilibrium in a one commodity framework. He considers that the consumer allocates his income on one
good and the balance money income is composite good. To establish his theory, he made the following assumptions:
– Utility is cardinally measurable.
– Marginal utility of money remains constant.
– Demand for any single commodity is satiable i.e. Law of Diminishing Marginal Utility (DMU) holds true.
– Two different commodities can never be perfect substitute of each other.
– Utility functions are independent for different commodities.
– Consumer is a price taker in the market.
– Consumer must be rational in nature.
Marshall considered that the buyer consumes only one commodity X, whose price is P1. He consumes X1
amount of X out of his money income M. By consuming X1 units of X consumer gets U(X1), units of utility which
he sacrifices monetary utility of P1X1 (where =dU/dM i.e. marginal utility of money).
N(X1) = U(X1) – P1X1
In the Marshallian approach, the consumer tries to maximize the utility that he derives keeping in view the
money income he has in hand available to be spent on that good.
60 FP-BE

Limitations:
In spite of some good attempts, Marshallian theory is not free from criticism. These are:
(a) The assumption of constant MU of money is impractical.
(b) There are exceptions to the Law of Diminishing Marginal Utility. DMU may not always hold good.
(c) The assumption of independent utilities ignores substitute and complement goods, which is unrealistic in
nature.
(d) This theory is only applicable for a one-commodity framework, whereas there exist numerous commodities.
(e) Cardinal measurement of utility is unrealistic.
Marshall considered that the buyer consumes only one commodity X, whose price is P1. He consumes X1
amount of X out of his money income M. By consuming X1 units of X consumer gets U(X1), units of utility which
he sacrifices monetary utility of P1X1 (where =dU/dM i.e. marginal utility of money).

Indifference Curve Approach

Utility approach suffers from several drawbacks. For this reason, a consumer’s demand curve derived with the
help of utility approach also suffers from similar drawbacks. The technique of indifference curves tries to avoid
these drawbacks and provide a technically superior analysis of demand. It believes that human satisfaction being
a psychological phenomenon cannot be measured quantitatively in monetary terms as was attempted in Marshall’s
approach. In indifference curve approach, the preferences are ordered than to measure them in terms of money.
This approach, is, therefore an ordinal concept based on ordering of preferences compared with Marshall’s approach
of cardinality. This approach to consumer behaviour is best understood in three distinct steps:
– Consumer Preferences (Indifference curve)
– Budget Constraints (Budget Line)
– Consumer Choices (Equilibrium)

Indifference Curves
An indifference curve is a curve which represents all those combinations of goods which give same satisfaction
to the consumer. Since all the combinations on an indifference curve give equal satisfaction to the consumer,
the consumer is indifferent among them. In other words, since all the combinations provide same level of
satisfaction the consumer prefers them equally and does not mind which combination he gets.

Fig. 2.19: Indifference Curve Map

Assuming that there are two goods X and Y having their

respective utility schedules for a consumer, an indifference
schedule represents all those combinations of two goods from
which the consumer expects to derive same total satisfaction.
(See Figure 2.19)
 Lesson 2  Theory of Demand and Supply 61

Assumptions Underlying Indifference Curve Approach

1. The consumer is rational and possesses full information about all the relevant aspects of economic environment
in which he lives.
2. The consumer is capable of ranking all conceivable combinations of goods according to the satisfaction he
derives. Thus, if he is given various combinations say A, B, C, D, E he can rank them as first preference, second
preference and so on.
3. If a consumer happens to prefer A to B, he can not tell quantitatively how much he prefers A to B.
4. If the consumer prefers combination A to B, and B to C, then he must prefer combination A to C. In other
words, he has consistent consumption pattern behaviour.
5. If combination A has more commodities than combination B, then A must be preferred to B.

Properties of Indifference Curves

The following are the main characteristics or properties of indifference curves :
(a) Indifference curves slope downward to the right: This property implies that when the amount of one
good in combination is increased, the amount of the other good is reduced. This is essential if the level of
satisfaction is to remain the same on an indifference curve.
(b) Indifference curves are always convex to the origin: It has been observed that as more and more of
one commodity (X) is substituted for another (Y), the consumer is willing to part with less and less of the
commodity being substituted (i.e. Y). This is called diminishing marginal rate of substitution.
(c) Indifference curves can never intersect each other: No two indifference curves will intersect each other
although it is not necessary that they are parallel to each other. In case of intersection the relationship
becomes logically absurd because it would show that higher and lower levels are equal which is not possible.
(d) A higher indifference curve represents a higher level of satisfaction than the lower indifference
curve: This is because combinations lying on a higher indifference curve contain more of either one or
both goods and more goods are preferred to less.

Budget Line
A budget line or price line represents the various combinations of two goods which can be purchased with a
given money income and assumed prices of goods. For example, a consumer has weekly income of A60. He
purchases only two goods, X and Y. The price of good X is A6 and the price of good Y is A12. Given the assumed
income and the price, of the two goods, the consumer can purchase various combination of goods or market
combination of goods weekly. (See Figure 2.20)

Budget Line

In Fig 2.20, X axis and Y axis represents good X and good Y

respectively. AF is the budget line showing various combinations
of both goods that a consumer can afford in given income.
62 FP-BE

In indifference curves approach to demand analysis, Budget Line (BL) plays an integral role in the determination
of consumer’s equilibrium. It is a straight line joining two points on Y-axis and X-axis and has a negative slope.
Its starting point on Y-axis represents the amount of Y that can be bought with given income and at given price
of Y. Its end point on X-axis represents the maximum amount of X which consumer can buy with given income
and price of X.
The use of BL in determining a consumer’s equilibrium is illustrated in Fig. 2.21 where it is labelled AB. It begins
from point A on Y-axis and meets X-axis at point B. All the points along AB curve represent different combinations
of X and Y which the market permits the consumer to have with his given income and prices of two goods.
Fig. 2.21: Consumer’s Equilibrium

Fig 2.21 shows consumer’s equilibrium at point E where, Budget

line AB is tangent to the indifference curve IC2.

Which of the alternatives allowed by the market will be chosen by the consumer? Our assumption of economic
rationality of the consumer states that out of the available alternatives, the consumer will try to choose that
combination of X and Y which brings him to the highest indifference curve which the market permits him to
reach. In this context, we should note that the BL is a straight line and slopes downwards from left to right, and
the indifference curves are convex to the origin. Therefore, if we take any particular indifference curve, we come
across three possibilities. The BL
– does not touch it at all
– intersects it twice
– is tangent to it
– it should also be noted that a BL can be tangent to one and only one indifference curve
Given the assumptions, highest possible indifference curve that can be reached would be one, to which BL is
tangent. The point of tangency represents consumer’s equilibrium.

LESSON ROUND UP

– Demand means a desire or a wish to buy and consume a commodity or service provided consumer has
adequate ability and is willing to buy.
– The consumer’s decisions are guided by several elements, such as income, tastes and preferences etc
and an assumption is established that these factors remain constant.
– Law of demand states that “the amount demanded increases with a fall in price and diminishes with a
rise in price”.
– Demand for a good by an individual or the market as a whole is conventionally expressed in three
 Lesson 2  Theory of Demand and Supply 63

alternative forms, namely;

– a demand function
– a demand schedule
– a demand curve
– Utility of a good is its expected capacity to satisfy a human want. To a consumer, the utility of a good is
the satisfaction which he expects from its consumption.
– Utility can be measured in two ways:
– Cardinal Approach
– Ordinal Approach
– When a consumer buys a good, the utility derived from it varies with its quantity, and generates three
concepts; namely
– Total Utility(TU)
– Average Utility(AU)
– Marginal Utility(MU)
– Law of diminishing marginal utility states that “the additional benefit which a person derives from a given
increase in his stock of a thing diminishes with every increase in the stock that he already has”.
– The law of equi-marginal utility states that consumer distributes his expenditure between different goods
in such a way that the marginal utility derived from the last rupee spent on each good is the same.
– Demand for a good can change in two ways:
– a consumer moves from one point to another on the same demand curve (Movement along demand
curve)
– when the entire demand curve shifts its position (Movement from one demand curve to the other)
– Demand Elasticity:
– Types of demand elasticity: Price elasticity of demand; Cross price elasticity of demand and Income
elasticity of demand.
– Five cases of elasticity of demand: Perfectly elastic demand; Perfectly inelastic demand; Relatively
elastic demand; Relatively inelastic demand and Unitary elastic demand
– Methods of measuring price elasticity of demand: Percentage method or Arithmetic; Total expenditure
method and Graphic method or Point method.
– Factors affecting the elasticity of demand: Price level; Availability of substitutes; Time period; Proportion
of total expenditure spent on the product; Habits; Nature of the commodities; Various uses and
Postponing consumption.
– Supply means the quantity of goods offered for sale at pre determined price at a certain point of time.
– Law of Supply states that a firm will produce and offer to sell greater quantity of a product or service as
the price of that product or services rises, other things being equal.
– Other things include cost of production, change of technology, price of related goods (substitutes and
complements), prices of inputs, level of competition and size of industry, government policy and non
economic factors.
64 FP-BE

– Supply of a good by an individual producer/firm or the market/industry as a whole is conventionally

expressed in three alternative forms, namely;
– a supply function
– a supply schedule
– a supply curve
– Supply for a good can change in two ways
– a producer moves from one point to another on the same supply curve (Movement along supply
curve)
– when the entire supply curve shifts its position (Movement from one supply curve to the other)
– Supply Elasticity:
– Five cases of elasticity of supply: Perfectly elastic supply; Perfectly inelastic supply; Relatively elastic
supply; Relatively inelastic supply and Unitary elastic supply
– Determinants of price elasticity of supply: Time period; Ability to store output; Factor mobility; Cost
relationships and Excess supply
– The market price, or equilibrium price, is determined by the interaction of demand and supply at a given
time with given conditions of demand and supply.
– Elasticity refers to the ratio of the relative change in a dependent to the relative change in an independent
variable. There are two types of elasticities:
• Elasticity of Demand
• Elasticity of Supply
– The consumer behaviour can be studied from two approaches;
• Marshallian Approach
• Indifference Curve Approach
– In the Marshallian approach, the consumer tries to maximize the utility that he derives keeping in view
the money income he has in hand available to be spent on that good.
– In indifference curve approach, the preferences are ordered than to measure them in terms of money.
This approach, is, therefore an ordinal concept based on ordering of preferences.

GLOSSARY

Ceteris Paribus Ceteris paribus or caeteris paribus is a Latin phrase, literally translated as “with
other things the same” or “all other things being equal or held constant”.
Demand Curve A demand curve is the curve showing the relationship between the quantities of a
good which consumers would be willing to purchase at alternative prices.
Law of Demand Ceteris paribus, the quantities demanded of a good and its own prices are inversely
related.
Supply Curve A supply curve is the curve showing relationship between the quantities supplied of
a commodity by the producer at alternative prices.
Law of Supply Ceteris paribus, the quantities supplied of a good and its own prices are positively
related.
 Lesson 2  Theory of Demand and Supply 65

Utility It is defined as a want satisfying power of a commodity. It is the sensation which an

individual derives from consuming a commodity. It can be measured on numerical
scale as well as ordinal.
Cardinal Utility Cardinal utility is a view of utility measurement based on the presumption that the
satisfaction of wants and needs is a quantifiable characteristic of human activity. In
other words, utility can be measured with numerical values (1, 2, 3, etc.) along a
scale. If so, then the utility generated from consumption can be evaluated against
an objective standard, which then makes it possible to compare utility among different
goods and among different people.
Ordinal Utility Ordinal utility is a view of utility measurement based on the presumption that the
satisfaction of wants and needs is not a quantifiable characteristic of human activity
and that preferences are subjective. Preferences among goods can be ranked
(first, second, third, etc.) but not measured according to a scale. In this regard,
consumers need only specify whether one good is more or less preferred than
another. How much more or less a good is preferred is not important.
Marginal Utility Marginal utility is the extra satisfaction generated from consuming one more unit of
a good.
Marginal Utility =change in total utility
change in quantity
Law of Diminishing The law of diminishing marginal utility means that the value of a good, the extra
Marginal Utility utility derived from good declines as more of the good is consumed. If the satisfaction
obtained from a good declines, then buyers are willing to pay a lower price, hence
demand price is inversely related to quantity demanded, which is the law of demand.
Consumers’ Consumer equilibrium exists when a consumer selects or buys the combination of
Equilibrium goods that maximizes utility. This is achieved by equating the marginal utility-price
ratio for each good consumed or by equating the ratio of prices and the ratio of
marginal utilities. In other words, buyers are willing to pay relatively higher prices
for goods that generate relatively more marginal utility.
Indifference Curve An indifference curve is a curve which represents all those combinations of goods
which give same satisfaction to the consumer. Since all the combinations on an
indifference curve give equal satisfaction to the consumer, the consumer is indifferent
among them.
MRS The rate at which an individual must give up “good A” in order to obtain one more
unit of “good B”, while keeping their overall utility (satisfaction) constant. The marginal
rate of substitution is calculated between two goods placed on an indifference curve,
which displays a frontier of equal utility for each combination of “good A” and “good
B”.
Price Elasticity of The relative response of a change in quantity demanded to a change in price. More
Demand specifically the price elasticity of demand is the percentage change in quantity
demanded due to a percentage change in price.
Cross Elasticity The relative response of a change in the demand for one good to a change in the price
of another good. More specifically the cross elasticity of demand is percentage change
in the demand for one good due to a percentage change in the price of another good.
Income Elasticity The relative response of a change in demand to a change in income. More
specifically the income elasticity of demand is the percentage change in demand
due to a percentage change in buyers’ income.
66 FP-BE

Price Elasticity of The relative response of a change in quantity supplied to a change in price. More
Supply specifically the price elasticity of supply is the percentage change in quantity supplied
due to a percentage change in price.
Normal Goods A normal good is a good that reacts positively to changes in buyers’ income. If buyers
have more income, then they purchase more of a normal good. If they have less income,
then they reduce purchases of a normal good.
Inferior Goods An inferior good is one that reacts negatively to changes in buyers’ income. If buyers
have more income, then they purchase less of an inferior good. If they have less income,
then they increase purchases of an inferior good.
Giffen Goods A consumer good for which demand rises when the price increases, and demand falls
when the price decreases. Such goods are exceptions to the law of demand.
Superior Goods Goods for which income elasticity of demand is greater than unity. For such goods the
proportion of money spent on the goods tends to increase as the income increases.

SELF-TEST QUESTIONS
1. Define the concept of utility and distinguish between the concepts of total utility, average utility and
marginal utility. Explain these concepts with the help of a numerical illustration and diagrams.
2. What is the relationship between marginal utility of a good and demand for it? How do you derive an
individual consumer’s demand curve for a good with the help of the concept of marginal utility?
3. What do you understand by demand for a good?
4. State and explain the law of demand. What is the reason for the negative slope of a demand curve?
5. Is the law of demand universally valid? If not, what are its exceptions? Why do these exceptions occur?
6. State and explain the law of equi-marginal utility. What are practical limitations of this law?
7. What are the determinants of demand for a good? Discuss any three of them?
8. Explain the determination of consumer’s equilibrium with the help of utility analysis
9. Discuss the law of supply. Explain any three of its determinants.
10. Explain with the help of diagram change in quantity supplied and shift in supply of a product.
11. Explain market equilibrium for a commodity in the market. What happens if demand for a product if
supply remains the same?
12. Define price elasticity of demand for a good. Discuss alternative methods of measuring it.
13. Distinguish between price, income and cross elasticities of demand.
14. Differentiate between total expenditure and proportionate methods of measuring elasticity of demand.
Highlight their respective merits and demerits.
15. Highlight the main determinants of elasticity of demand for a good.
16. Distinguish between increase/decrease of demand with expansion/contraction of demand. Why does a
demand curve shift its location?
17. What is elasticity of supply? Discuss its various determinants.
Suggested Readings
1. Misra and Puri:Modern Microeconomics
2. H. L. Ahuja :Modern Microeconomics
3. M. L. Seth:Principles of Economics