1. Demand and supply functions

2. Concept of utility Utility is a property common to all commodities and services desiredby a person. It has no physical or material existence and so it isinherent in a commodity. Any commodity which has a capacity to satisfy consumer want, it hasutility. Utility is subjective in nature. Utility has nothing to do withusefulness. Hence in economics, the concept of utility is legally,morally, socially and ethically neutral. 3. Approaches to utility It argues that a consumerhas the capacity tomeasure the level ofsatisfaction that shederives fromconsumption of a givenquantity of a commodity.CardinalUtility It argues that aconsumer cannotmeasure satisfactionnumerically orsubjectively insteadconsumer can rank thedifferent baskets orbundles so as tochoose the best basket.Ordinal 4. Marginal Utility& Total Utility Marginal utility is the utility of last unit or addition to totalutility by the consumption of one additional unit of commodity. MU10 = TU10 TU9 Total Utility- It is the sum of marginal utilities obtained fromconsumption of each successive unit of a commodity or service.If continuous units of a commodity 'X' are consumed, then TUx = MUx 5. Terms related to Utility Initial Utility:The amount of satisfaction to be obtained from the consumption of very firstunit of a commodity or service is called the initial utility e.g. the amount ofsatisfaction to be obtained from consumption of the first apple is units. It iscalled initial utility of the consumer. Positive Utility:When a consumer consumes successive units of a commodity or service, itsmarginal utility decreases. The utility obtained from the consumption of allthe units of a commodity or service before reaching the marginal utility equalto zero, is called positive utility. Saturation Point:By the consumption of that unit of a commodity where the marginal utilitydrops down to zero, is called the saturation point. 6. Terms related to Utility Negative Utility:By using the next unit of a commodity after saturation point, thatunit gives negative satisfaction to the consumer and marginal utilitybecomes negative, it is known as negative utility. Util:Although utility cannot be measured but in cardinal approach ofconsumer behavior, the term which is used as a unit of utility isknown as Util and arithmetic numbers (1, 2, 3, .......) are used. Forexample X ate an apple and got 10 Util of utility. 7. Law of diminishing marginal utility The law of diminishing marginal utility describes a familiar andfundamental tendency of human behavior. The law of diminishingmarginal utility states that: As a consumer consumes more and more units of a specificcommodity, the utility from the successive units goes on diminishing. Mr. H. Gossen, a German economist, was first to explain this law in1854. Alfred Marshal later on restated this law in the following words: The additional benefit which a person derives from an increase of hisstock of a thing diminishes with every increase in the stock thatalready has. 8. Schedule to lawUnit Total Utility Marginal utility1 glass of water 20 202 glass of water 32 123 glass of water 40 84 glass of water 42 25 glass of water 42 26 glass of water 39 -3 9. Marginal utility curve 10. Assumption of law The law of diminishing marginal utility is true under certain assumptions. These assumptions areas under:(i) Rationality: In the cardinal utility analysis, it is assumed that the consumer is rational. He aimsat maximization of utility subject to availability of his income.(ii) Constant marginal utility of money: It is assumed in the theory that the marginal utility ofmoney based for purchasing goods remains constant. If the marginal utility of money changeswith the increase or decrease in income, it then cannot yield correct measurement of the marginalutility of the good.(iii) Diminishing marginal utility: Another important assumption of utility analysis is that theutility gained from the successive units of a commodity diminishes in a given time period.(iv) Utility is additive: In the early versions of the theory of consumer behavior, it was assumed thatthe utilities of different commodities are independent. The total utility of each commodity isadditive.U = U1 (X1) + U2 (X2) + U3 (X3). Un (Xn) 11. Assumption of law Contiv) Consumption to be continuous: It is assumed in this law that the consumption ofa commodity should be continuous. If there is interval between the consumption ofthe same units of the commodity, the law may not hold good. For instance, if youtake one glass of water in the morning and the 2nd at noon, the marginal utility ofthe 2nd glass of water may increase.(vi) Suitable quantity: It is also assumed that the commodity consumed is taken insuitable and reasonable units. If the units are too small, then the marginal utilityinstead of falling may increase up to a few units.(vii) Character of the consumer does not change: The law holds true if there is nochange in the character of the consumer. For example, if a consumer develops ataste for wine, the additional units of wine may increase the marginal utility to adrunkard.(viii) No change to fashion: Customs and tastes: If there is a sudden change in fashionor customs or taste of a consumer, it can than make the law inoperative.(ix) No change in the price of the commodity: there should be any change in theprice of that commodity as more units are consumed. 12. Limitation to law (i) Case of intoxicants: Consumption of liquor defies the low for a shortperiod. The more a person drinks, the more likes it. However, this is trueronly initially. A stage comes when a drunkard too starts taking less andless liquor and eventually stops it. (ii) Rare collection: If there are only two diamonds in the world, thepossession of 2nd diamond will push up the marginal utility. (iii) Application to money: The law equally holds good for money. It istrue that more money the man has, the greedier he is to get additional unitsof it. However, the truth is that the marginal utility of money declines withrichness but never falls to zero. 13. Law of equi-marginal utility The law of equi marginal utility was presented in 19th century byan Australian economists H. H. Gossen. It is also known as law ofmaximum satisfaction or law of substitution or Gossens secondlaw. A consumer has number of wants. He tries to spend limitedincome on different things in such a way that marginal utility of allthings is equal. When he buys several things with given moneyincome he equalizes marginal utilities of all such things. The lawof equi marginal utility is an extension of the law of diminishingmarginal utility. The consumer can get maximum utility byallocating income among commodities in such a way that lastdollar spent on each item provides the same marginal utility. 14. Statement of law A person can get maximum utility with his given income when itis spent on different commodities in such a way that the marginalutility of money spent on each item is equal". It is clear that consumer can get maximum utility from theexpenditure of his limited income. He should purchase suchamount of each commodity that the last unit of money spend oneach item provides same marginal utility. 15. Assumption of law There is no change in the prices of the goods. The income of consumer is fixed. The marginal utility of money is constant. Consumer has perfect knowledge of utility obtained from goods. Consumer is normal person so he tries to seek maximumsatisfaction. The utility is measurable in cardinal terms. Consumer has many wants. The goods have substitutes. 16. Schedule and explanation The law of substitution can be explained with the help of anexample. Suppose consumer has six dollars that he wants to spendon apples and bananas in order to obtain maximum total utility.The following table shows marginal utility (MU) of spendingadditional dollars of income on apples and bananas:Money ($) M.U. of apples M.U. of Bananas1 10 82 9 73 8 64 7 55 6 46 5 3 17. The above schedule shows that consumer can spend six dollars in different ways: $1 on apples and $5 on bananas. The total utility he can get is:[(10) + (8+7+6+5+4)] = 40. $2 on apples and $4 on bananas. The total utility he can get is:[(10+9) + (8+7+6+5)] = 45. $3 on apples and $3 on bananas. The total utility he can get is:[(10+9+8) + (8+7+6)] = 48. $4 on apples and $2 on bananas. This way the total utility is:[(10+9+8+7) + (8+7)] = 49. $5 on apples and $1 on bananas. The total utility he can get is:[(10+9+8+7+6) + (8)] = 48. Total utility for consumer is 49 utils that is the highest obtainable with expenditure of $4on apples and $2 on bananas. Here the condition MU of apple = MU of banana i.e 7 = 7is also satisfied. Any other allocation of the last dollar shall give less total utility to theconsumer. 18. Limitations The law is not applicable in case of indivisible goods. The consumer isunable to divide the goods to adjust units of utility derived fromconsumption of goods. The law is not applicable in case of indivisiblegoods. The consumer is unable to divide the goods to adjust units of utilityderived from consumption of goods. There is no measurement of utility. It is psychological concept. It is notpossible to express it into quantitative form. The law does not hold well in case fashion and customs. The people like tospend money on birthdays, marriages and deaths. The does not hold well in case of very low income. The maximization ofutility is not possible due to low income. 19. Limitations continues.. The law is not applicable in case of durable goods. The calculation of marginal utility ofdurable goods is impossible. The law fails when goods of choice are not available. The consumer is bound to usecommodity, which provides low utility due to non availability of goods having high utility. There are certain lazy consumers. They do not care for maximum utility. The law fails tooperate in case of laziness of consumers. They go on consuming goods with comparingutility. There is no measurement of utility. It is psychological concept. It is not possible toexpress it into quantitative form. The law does not hold well in case fashion and customs.The people like to spend money on birthdays, marriages and deaths. It does not work when there are frequent prices changes. The consumer is unable tocalculate utility of different commodities. Changing price levels create confusion in theminds of consumers. 20. Practical implications- The law of equi marginal utility is helpful in the field of production. Theproducer has limited resources. He uses limited resources to purchaseproduction factors. He tries to equalize marginal utility of all factors. Hewishes to get maximum output and profit. National income is distributed among factors of production according to thislaw. An entrepreneur can pay factors of production equal to marginalproduct measured in money terms. He will substitute one factor for anotheruntil marginal productivity of all factors is equal to prices of their services. The law is used in the field of exchange. The people like to exchange acommodity having low utility with a commodity having high utility. Thereis maximum benefit from exchange of commodities. The law is helpful inexchange of wealth, trade, import and export 21. Practical implication continues. The law is applicable in consumption. A rational consumer tries toget maximum satisfaction when he spends his limited resources onvarious things. He tries to equalize weighted marginal utility of allthe things. The law is applicable in public finance. The government can spendits revenue to get maximum social advantage. The marginal utilityof each dollar spent in one sector must be equal to marginal utilityderived from all other sectors. The law is helpful in prices. Due to scarcity of commodity its pricesgo up. The law tells us to use substitute commodity, which is lessscarce. The result is that the price of commodity comes down. 22. Law of demand In economic terminology the term demand conveys a wider anddefinite meaning than in the ordinary usage. Ordinarily demandmeans a desire, whereas in economic sense it is something morethan a mere desire. It is interpreted as a want backed up by the - purchasing power. Further demand is per unit of time such as per day, per week etc.moreover it is meaningless to mention demand without referenceto price. Demand for anything means the quantity of that commodity,which is bought, at a given price, per unit of time. 23. Demand price relationship This law explains the functional relationship between price of acommodity and the quantity demanded of the same. It is observed that the price and the demand are inversely relatedwhich means that the two move in the opposite direction. An increase in the price leads to a fall in the demand and viceversa. Other things being equal, the demand for a commodity variesinversely as the price 24. Demand Schedule 25. Demand Curve 26. Assumptions of law The law of demand in order to establish the price-demandrelationship makes a number of assumptions as follows: Income of the consumer is given and constant. No change in tastes, preference, habits etc. Constancy of the price of other goods. No change in the size and composition of population. These Assumptions are expressed in the phrase other thingsremaining equal. 27. Exceptions to law Continuous changes in the price lead to the exceptional behavior. If the priceshows a rising trend a buyer is likely to buy more at a high price forprotecting himself against a further rise. As against it when the price startsfalling continuously, a consumer buys less at a low price and awaits a furtherin price. Giffen's Paradox describes a peculiar experience in case of inferior goods.When the price of an inferior commodity declines, the consumer, instead ofpurchasing more, buys less of that commodity and switches on to a superiorcommodity. Hence the exception. Conspicuous Consumption refers to the consumption of those commoditieswhich are bought as a matter of prestige. Naturally with a fall in the price ofsuch goods, there is no distinction in buying the same. As a result the demanddeclines with a fall in the price of such prestige goods. Ignorance Effect implies a situation in which a consumer buys more of acommodity at a higher price only due to ignorance. 28. Factors affecting demand The law of demand, while explaining the price-demand relationship assumes otherfactors to be constant. In reality however, these factors such as income, population,tastes, habits, preferences etc., do not remain constant and keep on affecting thedemand. As a result the demand changes i.e. rises or falls, without any change inprice. Income: The relationship between income and the demand is a direct one. It meansthe demand changes in the same direction as the income. An increase in income leadsto rise in demand and vice versa. Population: The size of population also affects the demand. The relationship is adirect one. The higher the size of population, the higher is the demand and vice versa. Tastes and Habits: The tastes, habits, likes, dislikes, prejudices and preference etc.of the consumer have a profound effect on the demand for a commodity. If aconsumers dislikes a commodity, he will not buy it despite a fall in price. On theother hand a very high price also may not stop him from buying a good if he likes itvery much. 29. Other Prices: This is another important determinant of demand for acommodity. The effects depends upon the relationship between thecommodities in question. If the price of a complimentary commodity rises,the demand for the commodity in reference falls. Advertisement: This factor has gained tremendous importance in themodern days. When a product is aggressively advertised through all thepossible media, the consumers buy the advertised commodity even at ahigh price and many times even if they dont need it. Fashions: Hardly anyone has the courage and the desire to go against theprevailing fashions as well as social customs and the traditions. This factorhas a great impact on the demand. Imitation: This tendency is commonly experienced everywhere. This isknown as the demonstration effects, due to which the low income groupsimitate the consumption patterns of the rich ones. This operates even atinternational levels when the poor countries try to copy the consumptionpatterns of rich countries. 30. Variation and changes in demand The law of demand explains the effect of only-one factor viz., price, on thedemand for a commodity, under the assumption of constancy of otherdeterminants. In practice, other factors such as, income, population etc. cause the rise orfall in demand without any change in the price. These effects are differentfrom the law of demand. They are termed as changes in demand in contrast to variations in demandwhich occur due to changes in the price of a commodity. In economic theory a distinction is made between (a) Variations i.e. extension and contraction in demand due to price and (b) Changes i.e. increase and decrease in demand due to other factors. 31. Variations in demand refer to those which occur due tochanges in the price of a commodity. These are two types. Extension of Demand: This refers to rise in demand due toa fall in price of the commodity. It is shown by adownwards movement on a given demand curve. Contraction of Demand: This means fall in demand due toincrease in price and can be shown by an upwardsmovement on a given demand curve. 32. Changes in demand imply the rise and fall due to factorsother than price. It means they occur without any change in price. They are oftwo types. Increase in Demand: This refers to higher demand at thesame price and results from rise in income, population etc.,this is shown on a new demand curve lying above theoriginal one. Decrease in demand: It means less quantity demanded atthe same price. This is the result of factors like fall inincome, population etc. this is shown on a new demand lyingbelow the original one. 33. Concluding Remarks The law of demand explains the functional relationship betweenprice and demand. In fact, the demand for a commodity depends not only on the priceof a commodity but also on other factors such as income,population, tastes and preferences of the consumer. The law of demand assumes these factors to be constant and statesthe inverse price-demand relationship. Barring certain exceptions,the inverse price- demand relationship holds good in case of thegoods that are bought and sold in the market. 34. Concluding Remarks.. The law of demand explains the direction of a change as it statesthat with a rise in price the demand contracts and with a fall inprice it expands. However, it fails to explain the extent ormagnitude of a change in demand with a given change in price. In other words, the law of demand merely shows the direction inwhich the demand changes as a result of a change in price, butdoes not throw any light on the amount by which the demandwill change in response to a given change in price. Thus, the law of demand explains the qualitative but not thequantitative aspect of price- demand relationship. 35. Base for elasticity of demand Although it is true that demand responds to change in price of acommodity, such response varies from commodity to commodity. Some commodities are more responsive or sensitive to change inprice while some others are less. The concept of the elasticity ofdemand has great significance as it explains the degree ofresponsiveness of demand to a change in price. It thus elaborates the price-demand relationship. The elasticity ofdemand thus means the sensitiveness or responsiveness of demandto a change in price. 36. Elasticity of demand- According to Marshall, the elasticity (or responsiveness) of demand ina market is great or small accordingly as the demand changes (rises orfalls) much or little for a given change (rise or fall) in price. Elasticity of demand is a measure of relative changes in the amountdemanded in response to a small change in price. The demand is said to be elastic when a small change in price bringsabout considerable change in demand. On the other hand, the demand for a good is said to be inelastic when achange in price fails to bring about significant change in demand. Ep = [Percentage change in quantity demanded / Percentage changein the price] 37. Price elasticity The concept of price elasticity reveals that the degree ofresponsiveness of demand to the change in price differs fromcommodity to commodity. Demand for some commodities is more elastic while that for certainothers is less elastic. Perfectly inelastic demand (ep = 0) Relatively less elastic demand (e < 1) Unitary elasticity (e = 1) Relatively more elastic demand (e > 1) Perfectly elastic demand (e = ) 38. Perfectly inelastic demand (ep = 0) This describes a situation in which demand shows no response to a change in price. Inother words, whatever be the price the quantity demanded remains the same. Relatively less elastic demand (e < 1) In this case the proportionate change in demand is smaller than in price Unitary elasticity demand (e = 1) When the percentage change in price produces equivalent percentage change indemand. Relatively more elastic demand (e > 1) In case of certain commodities the demand is relatively more responsive to the changein price. It means a small change in price induces a significant change in, demand. Perfectly elastic demand (e = ) This is experienced when the demand is extremely sensitive to the changes in price. Inthis case an insignificant change in price produces tremendous change in demand. 39. Determinants of elasticity Nature of the Commodity Number of Substitutes Available Number Of Uses Possibility of Postponement of Consumption Range of prices Proportion of Income Spent 40. Quiz Identify the elasticity of demand- Food grains Salt Luxuries or comforts Tea/coffee Electricity Milk Coal in railways Coal in household Umbrella Woolen clothes in rainy season Consumer durables Clothes for occassions 41. Income elasticity of demand Demand for a commodity changes in response to a change inincome of the consumer. The income effect suggests the effect of change in income ondemand. The income elasticity of demand explains the extent ofchange in demand as a result of change in income. In other words, income elasticity of demand means theresponsiveness of demand to changes in income. Thus, incomeelasticity of demand can be expressed as- EY = [Percentage change in demand / Percentage change inincome] 42. Income Elasticity of Demand Greater than One: When the percentage changein demand is greater than the percentage change in income, a greater portion ofincome is being spent on a commodity with an increase in income- incomeelasticity is said to be greater than one. Income Elasticity is unitary: When the proportion of income spent on acommodity remains the same or when the percentage change in income is equalto the percentage change in demand, EY = 1 or the income elasticity is unitary. Income Elasticity Less Than One (EY< 1): This occurs when the percentagechange in demand is less than the percentage change in income. Zero Income Elasticity of Demand (EY=o): This is the case when change inincome of the consumer does not bring about any change in the demand for acommodity. Negative Income Elasticity of Demand (EY< o): It is well known that incomeeffect for most of the commodities is positive. But in case of inferior goods, theincome effect beyond a certain level of income becomes negative. This impliesthat as the income increases the consumer, instead of buying more of acommodity, buys less and switches on to a superior commodity. The incomeelasticity of demand in such cases will be negative. 43. Cross Elasticity of Demand The concept of cross elasticity explains the degree of change in demand for X as, aresult of change in price of Y. This can be expressed as: EC = [Percentage Change in demand for X / Percentage change in price of Y] The relationship between any two goods is of two types. The goods X and Y can be complementary goods (such as pen and ink) orsubstitutes (such as pen and ball pen). In case of complementary commodities, thecross elasticity will be negative. This means that fall in price of X (pen) leads torise in its demand so also rise in t) demand for Y (ink). On the other hand, the cross elasticity for substitutes is positive which means a fallin price of X (pen) results in rise in demand for X and fall in demand for Y (ballpen) If two commodities, say X and Y, are unrelated there will be no change i. Demandfor X as a result of change in price of Y. Cross elasticity in cad of such unrelatedgoods will then be zero. 44. Importance of Elasticity The law of demand merely explains the qualitative relationship while theconcept of elasticity of demand analyses the quantitative price-demandrelationship. The Pricing policy of the producer is greatly influenced by the nature ofdemand for his product. If the demand is inelastic, he will be benefitedby charging a high price. If on the other hand, the demand is elastic, lowprice will be advantageous to the producer. The concept of elasticityhelps the monopolist while practicing the price discrimination. The price of joint products can be fixed on the basis of elasticity ofdemand. In case of such joint products, such as wool and mutton, cottonand cotton seeds, separate costs of production are not known. High priceis charged for a product having inelastic demand (say cotton) and lowprice for its joint product having elastic demand (say cotton seeds). 45. Importance of Elasticity The concept of elasticity of demand is helpful to the Government in fixing the prices ofpublic utilities. The Elasticity of demand is important not only in pricing the commodities but also in fixingthe price of labour viz., wages. The concept of elasticity of demand is very important in the field international trade. Ithelps in solving some of the problems of international trade such as gains from trade,balance of payments etc. policy of tariff also depends upon the nature of demand for acommodity. The concept of elasticity of demand is useful to Government in formulation of economicpolicy in various fields such as taxation, international trade etc. (a) The concept of elasticity of demand guides the finance minister in imposing thecommodity taxes. He should tax such commodities which have inelastic demand so that theGovernment can raise handsome revenue. (b) The concept of elasticity of demand helps the Government in formulating commercialpolicy. Protection and subsidy is granted to the industries which face an elastic demand. 46. Supply- Conceptual framework Supply during a given period of time means the quantities of goodswhich are offered for sale at particular price. Supply is a relative term. It is always referred to in relation to priceand time. Supply is what the seller is able and willing to offer for sale. The law, reflects the general tendency of the sellers in offering theirstock of a commodity for sale in relation to the varying price. It is noted that usually sellers are willing to supply more as the priceincreases. 47. Statement of law- Ceteris Paribus, the supply of a commodity expands(I.e. rises)with a rise in its price, and contracts (I.e. falls) with a fall in itsprice. The law, thus, suggests that the supply varies directly with thechanges in price. So, a larger amount is supplied at a higher pricethan at lower price in the market. 48. Schedule to law-Price Supply ofCoffee1 62 93 124 155 18 49. Assumptions underlying the law Cost of production in unchanged No change in technique of production Fixed scale of production Government policies are unchanged No change in transport costs No speculation The prices of other goods are held constant. 50. Extension/Contraction of supply 51. Supply shiftersRATNEST 52. RESOURCE COST : RESOURCE COST If resource cost decreases supply Increases [makingmore $] If resource cost increases supply Decreases [making less $] ALTERNATIVE OUTPUT PRICE CHANGE : ALTERNATIVE OUTPUT PRICE CHANGE One opportunity cost ofproducing eggs is not selling chickens. An increase in the price people arewilling to pay for fresh chicken would make it more profitable to sellchickens and would thus increase the opportunity cost of producing eggs. Itwould shift the supply curve for eggs to the left, reflecting a decrease insupply. TECHNOLOGICAL IMPROVEMENT : TECHNOLOGICAL IMPROVEMENT An improvement in technologyusually means that fewer and/or less costly inputs are needed. If the cost ofproduction is lower, the profits available at a given price will increase, andproducers will produce more. With more produced at every price, the supplycurve will shift to the right, meaning an increase in supply 53. NUMBER OF SUPPLIERS : NUMBER OF SUPPLIERS A change in the number of sellers in an industry changesthe quantity available at each price and thus changes supply. An increase in thenumber of sellers supplying a good or service shifts the supply curve to the right; areduction in the number of sellers shifts the supply curve to the left EXPECTATIONS : EXPECTATIONS . If a change in the international political climate leads manyowners to expect that oil prices will rise in the future, they may decide to leave theiroil in the ground, planning to sell it later when the price is higher. Thus, there will be adecrease in supply; the supply curve for oil will shift to the left. SUBSIDIES : SUBSIDIES Free money from the government (subsidies) induces suppliers to supplymore. TAXES : TAXES If business have their taxes decreased, it moves the supply curve to the right.If business have their taxes increased, it moves the supply curve to the left. 54. Demand forecasting Demand forecasting is predicting the future demand for the firmsproduct. The knowledge about the future demand for the product helps a greatdeal in the following areas of business decision making. Planning and scheduling production Acquiring inputs Making provisions for finances Formulation of pricing strategy Planning advertisement. 55. Steps involved- Specifying the objective Determining time perspective Making choice of method for demand forecasting Collection of data and data adjustment Estimation and interpretation of result 56. TechniquesSurveymethodsStatisticalMethodsForecastingtechnique 57. Survey Methods Complete enumeration Sample survey End-use methodConsumersurvey Expert opinion Market studies andexperimentation.Opinion Poll