Economic analysis for business

Dr. Bhati Rakesh 1 | P a g e
LECTURE NOTES FOR
MASTER OF BUSINESS ADMINISTRATION (M.B.A)
(FIRST YEAR-Semester-I)
SUBJECT CODE: (103)
SUBJECT: Economic Analysis for Business
Decisions
BY:
dR. Rakesh KUMAR Bhati

Course Outcomes: On successful completion of the course the learner will be able to
CO# COGNITIVE ABILITIES COURSE OUTCOMES
CO103.1 REMEMBERING DEFINE the key terms in economics.
CO103.2 UNDERSTANDING EXPLAIN the reasons for existence of firms and their decision making goals.
CO103.3 APPLYING MAKE USE OF the basic concepts of Demand, Supply, Demand
Forecasting, Equilibrium and their determinants.
CO103.4 ANALYSING ANALYSE cost function and the difference between short-run and long-run
cost function and establish the REATIONSHIP between production function
and
cost function.
CO103.5 ANALYSING EXAMINE the effect of non-price factors on products and services of
monopolistic and oligopoly firms.
CO103.6 EVALUATING DESIGN competition strategies, including costing, pricing, product
differentiation, and market environment according to the natures of
products, the market structures and Business Cycles.
1. Managerial Economics: Concept of Economy, Economics, Microeconomics, Macroeconomics. Nature and Scope of
Managerial Economics, Managerial Economics and decision-making. Concept of Firm, Market, Objectives of Firm: Profit
Maximization Model, Economist Theory of the Firm, Cyert and March’s Behavior Theory, Marris’ Growth Maximisation Model,
Baumol’s Static and Dynamic Models, Williamson’s Managerial Discretionary Theory. (6+1)
2. Utility & Demand Analysis: Utility – Meaning, Utility analysis, Measurement of utility, Law of diminishing marginal
utility, Indifference curve, Consumer’s equilibrium - Budget line and Consumer surplus. Demand - Concept of Demand, Types
of Demand, Determinants of Demand, Law of Demand, Elasticity of Demand, Exceptions to Law of Demand. Uses of the
concept of elasticity. Forecasting: Introduction, Meaning and Forecasting, Level of Demand Forecasting, Criteria for Good
Demand Forecasting, Methods of Demand Forecasting, Survey Methods, Statistical Methods, Qualitative Methods, Demand
Forecasting for a New Products. (Demand Forecasting methods - Conceptual treatment only numericals not expected) (8+1)
3. Supply & Market Equilibrium: Introduction, Meaning of Supply and Law of Supply, Exceptions to the Law of Supply,
Changes or Shifts in Supply. Elasticity of supply, Factors Determining Elasticity of Supply, Practical Importance, Market
Equilibrium and Changes in Market Equilibrium. Production Analysis: Introduction, Meaning of Production and Production
Function, Cost of Production. Cost Analysis: Private costs and Social Costs, Accounting Costs and Economic costs, Short run
and Long Run costs, Economies of scale, Cost-Output Relationship - Cost Function, Cost-Output Relationships in the Short Run,
and Cost-Output Relationships in the Long Run.
4. Revenue Analysis and Pricing Policies: Introduction, Revenue: Meaning and Types, Relationship between
Revenues and Price Elasticity of Demand, Pricing Policies, Objectives of Pricing Policies, Cost plus pricing. Marginal cost pricing.
Cyclical pricing. Penetration Pricing. Price Leadership, Price Skimming. Transfer pricing. Price Determination under
Perfect Competition- Introduction, Market and Market Structure, Perfect Competition, Price-Output Determination
under Perfect Competition, Short-run Industry Equilibrium under Perfect Competition, Short-run Firm Equilibrium under
Perfect Competition, Long-run Industry Equilibrium under Perfect Competition, Long-run Firm Equilibrium under
Perfect Competition. Pricing Under Imperfect Competition- Introduction, Monopoly, Price Discrimination under
Monopoly, Bilateral Monopoly, Monopolistic Competition, Oligopoly, Collusive Oligopoly and Price Leadership, Pricing Power,
Duopoly, Industry Analysis. Profit Policy: Break Even analysis. Profit Forecasting. Need for Government Intervention in
Markets. Price Controls. Support Price. Preventions and Control of Monopolies. System of Dual Price.
5. Consumption Function and Investment Function: Introduction, Consumption Function, Investment Function, Marginal
efficiency of capital and business expectations, Multiplier, Accelerator. Business Cycle: Introduction, Meaning and Features,
Theories of Business Cycles, Measures to Control Business Cycles, Business Cycles and Business Decisions.
Suggested Text Books:
1. Managerial Economics, Peterson, Lewis, Sudhir Jain, Pearson, Prentice Hall
2. Managerial Economics, D. Salvatore, McGraw Hill, New Delhi.
3. Managerial Economics, Pearson and Lewis, Prentice Hall, New Delhi
4. Managerial Economics, G.S. Gupta, T M H, New Delhi.
5. Managerial Economics, Mote, Paul and Gupta, T M H, New Delhi.
Suggested Reference Books:
1. Managerial Economics, Homas and Maurice, Tata McGraw Hill
2. Managerial Economics - Analysis, Problems and Cases, P.L. Mehta, Sultan Chand Sons, New Delhi.
3. Managerial Economics, Varshney and Maheshwari, Sultan Chand and Sons, New Delhi.
4. Managerial Economics, D.M.Mithani
5. Managerial Economics, Joel Dean, Prentice Hall, USA.
6. Managerial Economics by H L Ahuja, S Chand & Co. New Delhi.
Semester I 103 – Economic Analysis for Business Decisions
3 Credits LTP: 2:1:1 Compulsory Generic Core Course

INTRODUCTION
The discovery of managerial economics as a separate course in management studies has been
attributed to three major factors:
1] The growing complexity of business decision-making processes, because of changing market
conditions and the globalization of business transactions.
2] The increasing use of economic logic, concepts, theories, and tools of economic analysis in business
decision-making processes.
3] Rapid increase in demand for professionally trained managerial manpower.
It should be noted that the recent complexities associated with business decisions has increased the
need for application of economic concepts, theories and tools of economic analysis in business decisions.
The reason has been that making appropriate business decision requires clear understanding of existing
market conditions market fundamentals and the business environment in general. Business decision-
making processes therefore, requires intensive and extensive analysis of the market conditions in the
product, input and financial markets. Economic theories, logic and tools of analysis have been developed for
the analysis and prediction of market behaviours. The application of economic concepts, theories, logic, and
analytical tools in the assessment and prediction of market conditions and business environment has
proved to be a significant help to business decision makers all over the globe.
DEFINITION OF MANAGERIAL ECONOMICS
Managerial economics has been generally defined as the study of economic theories, logic and tools
of economic analysis, used in the process of business decision making. It involves the understanding and use
of economic theories and techniques of economic analysis in analyzing and solving business problems.
Economic principles contribute significantly towards the performance of managerial duties as well as
responsibilities. Managers with some working knowledge of economics can perform their functions more
effectively and efficiently than those without such knowledge. Taking appropriate business decisions
requires a good understanding of the technical and environmental conditions under which business
decisions are taken. Application of economic theories and logic to explain and analyse these technical
conditions and business environment can contribute significantly to the rational decision-making process.
According to McNair and Meriam, "Managerial Economics consists of the use of economic modes of thought
to analyse business situation."
Spencer and Siegelman have defined Managerial Economics as "The integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by management."
SCOPE OF MANAGERIAL ECONOMICS
Managerial economics comprises both micro- and macro-economic theories. Generally, the scope of
managerial economics extends to those economic concepts, theories, and tools of analysis used in analysing
the business environment, and to find solutions to practical business problems. In broad terms, managerial
economics is applied economics. The areas of business issues to which economic theories can be directly
applied are divided into two broad categories:
1. Operational or internal issues; and,
2. Environment or external issues.
Operational problems are of internal nature. These problems include all those problems which
arise within the business organization and fall within the control of management. Some of the basic internal
issues include: choice of business and the nature of product (what to produce); choice of size of the firm
(how much to produce); choice of technology (choosing the factor combination); choice of price (product
pricing); how to promote sales; how to face price competition; how to decide on new investments; how to
manage profit and capital; and, how to manage inventory.
UNIT– 1
UNIT -I Managerial Economics: Concept of Economy, Economics, Microeconomics,
Macroeconomics. Nature and Scope of Managerial Economics, Managerial Economics and
decision-making. Concept of Firm, Market, Objectives of Firm: Profit Maximization Model,
Economist Theory of the Firm, Cyert and March’s Behavior Theory, Marris’ Growth
Maximisation Model, Baumol’s Static and Dynamic Models, Williamson’s Managerial
Discretionary Theory.

The microeconomic theories dealing with most of these internal issues include, among others:
 The theory of demand, which explains the consumer behaviour in terms of decisions on whether or
not to buy a commodity and the quantity to be purchased.
 Theory of Production and production decisions. The theory of production or theory of the firm
explains the relationship between inputs and output.
 Analysis of Market structure and Pricing theory. Price theory explains how prices are
determined under different market conditions.
 Profit analysis and profit management. Profit making is the most common business objective.
However, making a satisfactory profit is not always guaranteed due to business uncertainties. Profit
theory guides firms in the measurement and management of profits, in making allowances for the
risk premium, in calculating the pure return on capital and pure profit, and for future profit
planning.
 Theory of capital and investment decisions. Capital is the foundation of any business. It efficient
allocation and management is one of the most important tasks of the managers, as well as the
determinant of the firm’s success level. Some of the important issues related to capital include:
choice of investment project; assessing the efficiency of capital; and, the most efficient allocation of
capital.
Environmental issues are issues related to the general business environment. These are issues related to the
overall economic, social, and political atmosphere of the country in which the business is situated. The
factors constituting economic environment of a country include:
1. The existing economic system
2. General trends in production, income,
employment, prices, savings and investment,
and so on.
3. Structure of the financial institutions.
4. Magnitude of and trends in foreign trade.
5. Trends in labour and capital markets.
6. Governments economic policies.
7. Social organizations, such as trade unions,
consumers’ cooperatives, and producer
unions.
8. The political environment.
9. The degree of openness of the economy.
Managerial economics is particularly concerned with those economic factors that form the business
climate. In macroeconomic terms, managerial economics focus on business cycles, economic growth, and
content and logic of some relevant government activities and policies which form the business environment.
ECONOMIC ANALYSIS AND BUSINESS DECISIONS
Business decision-making basically involves the selection of best out of alternative opportunities open
to the business organization. Decision making processes involve four main phases, including:
 Phase One: Determining and defining the objective to be achieved.
 Phase Two: Collection and analysis of information on economic, social, political, and technological
environment.
 Phase Three: Inventing, developing and analyzing possible course of action.
 Phase Four: Selecting a particular course of action from available alternatives.
Note that phases two and three are the most crucial in business decision-making. They put the
manager’s analytical ability to test and help in determining the appropriateness and validity of decisions in the
modern business environment. Personal intelligence, experience, intuition and business acumen of the
manager need to be supplemented with quantitative analysis of business data on market conditions and
business environment. It is in fact, in this area of decision-making that economic theories and tools of economic
analysis make the greatest contribution in business. If for instance, a business firm plans to launch a new
product for which close substitutes are available in the market, one method of deciding whether or not this
product should be launched is to obtain the services of a business consultant. The other method would be for
the decision-maker or manager to decide.
In doing this, the manager would need to investigate and analyze the following thoroughly:
a) production related issues; and, (b) sales prospects and problems.
 With regards to production, the manager will be required to collect and analyze information or
data on:
(a) available production techniques;
(b) cost of production associated with each production technique;
(c) supply position of inputs required for the production process;
(d) input prices; (e) production costs of the competitive products; and,
(f) availability of foreign exchange, if inputs are to be imported.

 Regarding the sales prospects and problems, the manager will be required to collect and analyse
data on:
(a) general market trends;
(b) the industrial business trends;
(c) major existing and potential competitors, as well as their respective market shares;
(d) prices of the competing products;
(e) pricing strategies of the prospective competitors;
(f) market structure and the degree of competition; and,
(g) the supply position of complementary goods.
The application of economic theories in solving business problems helps in facilitating decision-making
in the following ways:
 First, it can give clear understanding of the various necessary economic concepts, including demand,
supply, cost, price, and the like that are used in business analysis.
 Second, it can help in ascertaining the relevant variables and specifying the relevant data. For example,
in deciding what variables need to be considered in estimating the demand for two different sources of
energy, petrol and electricity.
 Third, it provides consistency to business analysis and helps in arriving at right conclusions.
IMPORTANCE OF MANAGERIAL ECONOMICS
In a nutshell, three major contributions of economic theory to business economics have been enumerated:
1. Building of analytical models that help to recognize the structure of managerial problems, eliminate the
minor details that can obstruct decision making, and help to concentrate on the main problem area.
2. Making available a set of analytical methods for business analyses thereby, enhancing the analytical
capabilities of the business analyst.
3. Clarification of the various concepts used in business analysis, enabling the managers avoids conceptual
pitfalls.
USES OF MANAGERIAL ECONOMICS : Managerial economics accomplishes several objectives.
 First, it presents those aspects of traditional economics, which are relevant for business decision
making it real life. For the purpose, it calls from economic theory the concepts, principles and
techniques of analysis which have a bearing on the decision making process. These are, if necessary,
adapted or modified with a view to enable the manager take better decisions. Thus, managerial
economics accomplishes the objective of building suitable tool kit from traditional economics.
 Secondly, it also incorporates useful ideas from other disciplines such a psychology, sociology, etc., if
they are found relevant for decision making. In fact managerial economics takes the aid of other
academic disciplines having a bearing upon the business decisions of a manager in view of the carious
explicit and implicit constraints subject to which resource allocation is to be optimized.
 Thirdly, managerial economics helps in reaching a variety of business decisions.
 What products and services should be produced? What inputs and production techniques should be
used? How much output should be produced and at what prices it should be sold? What are the best
sizes and locations of new plants? How should the available capital be allocated?
 Fourthly, managerial economics makes a manager a more competent model builder. Thus he can
capture the essential relationships which characterize a situation while leaving out the cluttering
details and peripheral relationships.
 Fifthly, at the level of the firm, where for various functional areas functional specialists or functional
departments exist, e.g., finance, marketing, personal production, etc., managerial economics serves as an
integrating agent by coordinating the different areas and bringing to bear on the decisions of each
department or specialist the implications pertaining to other functional areas. It thus enables business
decision making not in watertight compartments but in an integrated perspective, the significance of
which lies in the fact that the functional departments or specialists often enjoy considerable autonomy
and achieve conflicting coals.
 Finally, managerial economics takes cognizance of the interaction between the firm and society and
accomplishes the key role of business as an agent in the attainment of social and economic welfare. It
has come to be realized that business part from its obligations to shareholders has certain social
obligations. Managerial economics focuses attention on these social obligations as constraints subject to
which business decisions are to be taken. In so doing, it serves as an instrument in rehiring the
economic welfare of the society through socially oriented business decisions.

ECONOMIC OBJECTIVES OF FIRMS
The main objectives of firms
are given in figure but sometimes there
is an overlap of objectives. For
example, seeking to increase market
share, may lead to lower profits in the
short-term, but enable profit
maximisation in the long run.
PROFIT MAXIMISATION
Usually, in economics, we assume firms are concerned with maximising profit. Higher profit means:
1. Higher dividends for shareholders.
2. More profit can be used to finance research and development.
3. Higher profit makes the firm less vulnerable to takeover.
4. Higher profit enables higher salaries for workers
ALTERNATIVE AIMS OF FIRMS
However, in the real world, firms may pursue other objectives apart from profit maximisation.
 PROFIT SATISFICING: In many firms, there is a
separation of ownership and control. Those who
own the company (shareholders) often do not get
involved in the day to day running of the company.
This is a problem because although the owners
may want to maximise profits, the managers have
much less incentive to maximise profits because
they do not get the same rewards, (share
dividends)
Therefore managers may create a minimum
level of profit to keep the shareholders happy, but
then maximise other objectives, such as enjoying
work, getting on with other workers. (e.g. not
sacking them) This is the problem of separation
between owners and managers. This ‘principal-agent‘ problem can be overcome, to some extent, by giving
managers share options and performance related pay although in some industries it is difficult to measure
performance.
The traditional theory does not distinguish between owners and managers’ interests. The recent theories of
firm, which are also called managerial and behavioral theories of firm, assume owners and managers to be
separate entities in large corporations with different goals and motivation.
Some important alternative objectives of business firms, especially of large business corporations are also
discussed.
 BAUMOL’S HYPOTHESIS OF SALES REVENUE MAXIMIZATION
According to Baumol, “maximization of sales revenue is an alternative
to profit maximization objective“. The reason behind this objective is to clearly distinct ownership and
management in large business firms. This distinction helps the managers to set their goals other than
profit maximization goal. Under this situation, managers maximize their own utility function. According to
Baumol, the most reasonable factor in managers utility functions is maximization of the sales revenue.
The factors, which help in explaining these goals by the managers, are following:
 Salary and other earnings of managers are more closely related to seals revenue than to profits.
 Banks and financial corporations look at sales revenue while financing the corporation.
 Trend in sale revenue is a good indicator of the performance of the business firm. It also helps in
handling the personnel problems.
 Increasing sales revenue helps in enhancing the prestige of managers while profits go to the owners.
 Managers find profit maximization a difficult objective to fulfill consistently over time and at the same
level. Profits may fluctuate with changing conditions.
 Growing sales strengthen competitive spirit of the business firm in the market and vice versa.

So far as empirical validity of sales revenue maximization objective is concerned, realistic evidences are
unsatisfying. Most empirical studies are, in fact, based on inadequate data because the necessary data is mostly
not available. If total cost function intersects the total revenue (TR) function before it reaches its highest point,
Baumol’s theory fails. It is also argued that, in the long run, sales maximization and
profit maximization objective can be merged into one. In the long run, sales maximization lends to yield only
normal levels of profit, which turns out to be the maximum under competitive conditions. Thus,
profit maximization is not inequitable with sales maximization objective.
 MARRIS’S HYPOTHESIS OF MAXIMIZATION OF FIRM’S GROWTH RATE
According to Robin Marris, managers maximize firm’s growth rate subject to managerial and financial
constraints. Marris defines firms balanced growth rate (G) as follows: G = Gd = Gc
where,
 Gd = growth rate of demand for firms product.
 Gc = growth rate of capital supply to the firm.
In simple words, a firm’s growth rate is considered to be balanced when demand for its product and
supply of capital to the firm increase at the same rate. The two growth rates according to Marris, are translated
into two utility functions such as:
 Manager’s utility function
 Owner’s utility function
The manager’s utility function (Um) and owner’s utility function (Uo) may be specified as follows:
 Um = f (salary, power, job security, prestige, status) and
 Uo = f (output, capital, market-share, profit, public esteem).
Owner’s utility function (Uo) implies growth of demand for firms’ products and supply of capital.
Therefore, maximization of Uo mans maximization of demand for a firm’s products or growth of supply of
capital.
According to Marris, by maximizing these variables, managers maximize both their utility function and
that of the owner’s. The, managers can do so because most of the variables such as salaries status, job security,
power, etc., appearing in their own utility function and those appearing in the utility function of the owners
such as profit, capital market, share, etc. are positively and strongly correlated with the size of the firm. These
variables depend on the maximization of the growth rate of the firms. The managers, therefore, seek
to maximize a steady growth rate. Marris’s theory, though more accurate and sophisticated than Baumol’s sales
revenue maximization has its own weaknesses. It fails to deal satisfactorily with the market condition of
oligopolistic interdependence. Another serious shortcoming is that it ignores price determination, which is the
main concern of profit maximization hypothesis. In tbe opinion of many economists, Marris’s model too, does
not seriously challenge the profit maximization hypothesis.
 WILLIAMSON’S HYPOTHESIS OF MAXIMIZATION OF MANAGERIAL UTILITY FUNCTION
Like Baumol and Marris, Williamson argues that managers are very careful in pursuing the objectives
other than profit maximization The managers seek to maximize their own utility function subject to a
minimum level of profit. Managers’ utility function (U) is expressed below:
U = f(S, M, ID)
where,
 S = additional expenditure on staff
 M = Managerial emoluments
 ID = Discretionary investments
According to Williamson’s hypothesis, managers maximize their utility function subject to a satisfactory
profit. A minimum profit is necessary to satisfy the shareholders and also to secure the job of managers. The
utility functions which managers seek to maximize include both quantifiable variables like salary and slack
earnings anti non-quantitative variable such as prestige power, status, job security, professional excellence, etc.
The non-quantifiable variables are expressed in order to make them work effectively in terms of expense
preference defined as satisfaction derived out of certain types of expenditures.
Like other alternative hypotheses, Williamson’s theory too suffers from certain weaknesses. His model
fails to deal with the problem of oligopolistic interdependence. Williamson’s theory is said to hold only where
rivalry between firms is not strong. In case there is strong rivalry, profit maximization is claimed to be a more
appropriate hypothesis. Thus, Williamson’s managerial utility function too does not offer a more satisfactory
hypothesis than profit maximization.

 CYERT-MARCH HYPOTHESIS OF SATISFYING BEHAVIOR
Cyert-March hypothesis is an extension of Simon’s hypothesis of firms’ satisfying behavior Simon had
argued that the real business world is full of uncertainties. Accurate and adequate data are not readily
available. If data are available, managers have little time and ability to process them. Managers also work under
a number of constraints. Under such conditions it is not possible for the firms to act in terms of consistency
assumed under profit maximization hypothesis. Nor do the firms seek to maximize sales and growth. Instead
they seek to achieve a satisfactory profit or a satisfactory growth and so on. This behavior of business firms is
termed as satisfaction behavior.
Cyert and March added that, apart from dealing with uncertainty, managers need to satisfy a variety of
groups of people such as managerial staff, labor, shareholders, customers, financiers, input suppliers,
accountants, lawyers, etc. All these groups have conflicting interests in the business firms. The manager’s
responsibility is to satisfy all of them. According to the Cyert-March, “firm’s behavior is satisfying behavior
which implies satisfying various interest groups by sacrificing firm’s interest or objectives.” The basic
assumption of satisfying behavior is that a firm is an association of different groups related to various activities
of the firms such as shareholders, managers, workers, input supplier, customers, bankers, tax authorities, and
so on. All these groups have some expectations from the firm, which are needed to be satisfied by the business
firms. In order to clear up the conflicting interests and goals, managers form an objective level of the firm by
taking into consideration goals such as production, sales and market, inventory and profit.
These goals and objective level are set on the basis of the managers past experience and their
assessment of the future market conditions. The objective level is also modified and revised on the basis of
achievements and changing business environment. But the behavioral theory has been criticized on the
following grounds:
 Though the behavioral theory deals with the activities of the business firms, it does not explain the
firm’s behavior under dynamic conditions in the long run.
 It cannot be used to predict the firm’s activities in the future.
 This theory does not deal with the equilibrium of the business industry.
 This theory fails to deal with interdependence of the firms and its impact on firms behavior.
 ROTHSCHILD’S HYPOTHESIS OF LONG-RUN SURVIVAL AND MARKET SHARE GOALS
Rothschild suggested another alternative objective and alternative to profit maximization to a business
firm. According to Rothschild, the primary goal of the firm is long-run survival. Some other economists have
suggested that attainment and retention of a market share constantly, is an additional objective of the business
firms. The managers, therefore, seek to secure their market share and long-run survival. The firms may seek
to maximize their profit in the long run though it is not certain.
The evidence related to the firms to maximize their profits in the long run, is not certain. Some
economists argue that if management is kept separate from the ownership, the possibility of
profit maximization is reduced. This means that only those firms with the objective of profit maximization can
survive in the long run. A business firm can achieve all other subsidiary goals easily by maximizing its profits.
The motive of business firms behind entry-prevention is also to secure a constant share in the market. Securing
constant market share also favors the main objective of business firms of profit maximization.

UTILITY:
Why do you buy the goods and services you do? It must be because they provide you with satisfaction—you
feel better off because you have purchased them. Economists call this satisfaction utility. The term utility refers
to the want satisfying power of a commodity or service assumed by a consumer to constitute his demand for
that commodity or service.
• Utility is synonymous with "Pleasure", "Satisfaction" & a Sense of Fulfillment of Desire.
• Utility “WANT SATISFYING POWER" of a Commodity.
• Utility is a Psychological Phenomenon.
• Utility refers to Abstract Quality whereby an Object serves our Purpose. - Jevons
• Utility is the Quality of a Good to Satisfy a Want. - Hibdon
• Utility is the Quality in Commodities that makes Individuals want to buy them. Mrs. Robinson
FEATURES OF UTILITY:
• Utility is Introspective or Subjective: It deals with the Mental Satisfaction of a Man. For Example,
Liquor has Utility for a Drunkard but for a Teetotaler, it has no Utility.
• Utility is Relative: Utility of a Commodity never remains same. It varies with Time, Place & Person. For
Example, Cooler has utility in summer but not during Winter.
• Utility is Not Essentially Useful: A Commodity having Utility need not be Useful. E.g., Liquor is not
useful, but it Satisfies the Want of an Addict thus have Utility for Him.
• Utility is Ethically Neutral: Utility has nothing to do with Ethics. Use of Liquor may not be good from
the Moral Point of View, but as these Intoxicants Satisfy wants of the Drunkards, they have utility
UTILITY AND SATISFACTION:
The term utility is, however, distinct from satisfaction. Utility implies potentiality of satisfaction in a
commodity. It serves as a basis to induce the consumer to buy the commodity. But, the real satisfaction is the
end result of the consumption of a given commodity.
Though utility and satisfaction are psychological, there is a distinctive gap between the two experiences. Utility
is anticipation of satisfaction visualized. Satisfaction is the actual realization. Sometimes, satisfaction derived
from the consumption of a commodity may be less or more than what is expected in the visualization of utility.
For example when a consumer buys a motor car and if it starts giving him trouble his satisfaction so
realized from the use of the motor car will be less than what he had estimated about his utility. Nonetheless in
economic theory for the sake simplicity and convenience in analysis, economist usually assumes utility and
satisfaction as synonymous terms.
TOTAL UTILITY AND MARGINAL UTILITY:
The concepts of total utility and the marginal utility are the basic concepts used in the cardinal measurement of
utility.
1. Total utility (TU): "Total utility is the total satisfaction obtained from all units of a particular commodity
consumed over a period of time". The total utility associated with a good is the level of happiness derived
from consuming the good. Formula: TUx = ΣMUx
2. Marginal utility (MU): "Marginal utility means an additional or incremental utility. Marginal utility is the
change in the total utility that results from unit one unit change in consumption of the commodity within a
given period of time". Marginal utility is a measure of the additional utility that is derived when an
additional unit of the good is consumed. Marginal utility, thus, can also be described as difference between
total utility derived from one level of consumption and total utility derived from another level of
consumption. Formula: MU = ΔTU /ΔQ
UNIT – 2
Utility & Demand Analysis: Utility – Meaning, Utility analysis, Measurement of utility, Law of
diminishing marginal utility, Indifference curve, Consumer’s equilibrium - Budget line and Consumer
surplus. Demand - Concept of Demand, Types of Demand, Determinants of Demand, Law of Demand,
Elasticity of Demand, Exceptions to Law of Demand. Uses of the concept of elasticity. Forecasting:
Introduction, Meaning and Forecasting, Level of Demand Forecasting, Criteria for Good Demand
Forecasting, Methods of Demand Forecasting, Survey Methods, Statistical Methods, Qualitative
Methods, Demand Forecasting for a New Products. (Demand Forecasting methods - Conceptual
treatment only numericals not expected)

MEASUREMENT OF UTILITY:
Economists use an abstract measure for the amount of satisfaction you receive from something; it is
called a 'util'. A util is an abstraction because it isn't something in the physical world like an inch or rupee. It is
something inside your head, it represents one unit of satisfaction or happiness. You might get 25 utils of
satisfaction from eating a bowl of ice cream while someone else would only get 5 utils of satisfaction. Utils is the
term used by Marshall for expressing the measurement of imaginary units of utility or satisfaction
Utility being an introspective phenomenon cannot be directly measured in a precise manner. Economist
however adopted an indirect measurement of utility in terms of ’price’ a consumer is willing to pay for a given
commodity. When a consumer is willing to pay a high price for a commodity, it means there is high utility
estimated by him for that commodity and vice versa. But, this is just a rough indication it suggests no precise
and proportionate measurement of utility.
From the stand point of theory, however, there are 2 basic approaches to the measurement of utility namely:
(1) Cardinal approach 2. Ordinal approach
The terms cardinal and ordinal have been taken from mathematics. The numbers 1,2,3,4,5,6, etc are
cardinal in the sense that number 6 is twice the size of number 3 and number 4 is twice the size of 2. In the
cardinal analysis, the utility contained in commodities are made quantifiable. For example: an orange may yield
to a consumer utility of 10 units whereas a mango yields 20 units. From this it is clear that the consumer
derives twice as much utility from a mango compared to an orange. The units of measurements are purely
imaginary and the cardinal analysis termed the imaginary units of utility of ‘utils’.
On the other hand Prof Hicks Allen and their followers among the modern economists have suggested an
ordinal measurement of utility. In their view utility cannot be quantified so its numerical expression is
unrealistic.
The ordinal measurements are 1st, 2nd, 3rd, 4th, 5th, 6th etc. It is not possible from this ranking to know the
actual size of related number. The 2nd need not be twice as that of 1st, the size may be of any pattern.
For example: 1st, 2nd, 3rd, could be 10, 15, 25, or 10, 20, 45 or 55, 65, 95 etc. According to ordinalists, utility
being subjective and a mental concept cannot be measured and to quantify utility is absurd.
Ordinal approach contains that the theory of consumer behaviour can be explained or analyzed even
without measuring utility as the cardinal approach does. In the all ready stated example the ordinalists say that
the consumer prefers a banana to an orange and rank the commodities in the scale of preferences without
taking the trouble of measuring the imaginary quantum of utility. This method of ordinal approach is also
called’ indifference curve approach’.
Dr. Alfred Marshall and his followers advocated the cardinal approach to utility, while, the modern
economists like Hicks, Allen, supported the ordinal approach. Hence the cardinal approach has come to be
known as, Marshallian utility analysis” and the ordinal approach is called ‘Hicksian’s indifference approach’.
THE LAW OF DIMINISHING MARGINAL UTILITY:
This law was first of all developed by H.H Gossen in 1854 AD, which is also the first law of Gassen. This
law is based on universal human experience. It explains that for
more units of commodity; its M.U derived from each additional
unit diminishes in comparison to the previous unit. Hence the
law of diminishing marginal utility implies that consumption of
each successive units of a particular commodity gives less and
lesser satisfaction to the consumer if a consumer consumes it in a
certain time period.
Prof. Boulding defines the law of diminishing marginal
utility in the following words,” As a consumer increases the
consumption of any one commodity, keeping constant, the
consumption of all other commodities, the marginal utility of the
variable commodity must eventually decline”.
Marshall has defined the law thus: “the additional benefits
which a person derives from a given stock of thing diminish with
every increase in the stock that he already has”.
This law simply states that as the consumer consumes more and more units of a particular commodity, the
marginal utility of additional unit goes on diminishing. But the law does not state the rate of decline.

ILLUSTRATION OF THE LAW:
To illustrate the tendency of the diminishing marginal utility, a hypothetical utility schedule computed through
the introspective method of inquiry in consumers consumption experience is stated as follows:
RELATIONSHIP BETWEEN TOTAL UTILITY AND MARGINAL UTILITY:
(i) The total utility curves starts at the origin as zero consumption of commodity yield zero utility.
(ii) The TU curve reaches at its maximum or at peak when MU is zero.
(iii) The MU curve falls through the graph. A special point occurs when the consumer gains no marginal utility
from consumption of commodity. After this point, marginal utility becomes negative.
(iv) The MU curve can be derived from the total utility curve. It is the slope of the line joining two adjacent
quantities on the curve.
ASSUMPTIONS OF THE LAW OF DIMINISHING MARGINAL UTILITY:
The law of diminishing marginal utility is conditional. Its validity is attributed to the following assumptions or
conditions:
1. Homogeneity: The law holds true only if all the successive units taken in the process of consumption are
homogeneous in character like quality size, taste, flavors, colour etc. If there is a change in the
characteristics of the units of the given commodity, it is quite likely that the marginal utility may tend to
increase rather than diminish with the successive addition unit of consumption.
2. Continuity: The consumption process is continuous at a given time, that is, units are taken one after
another successively without any interval of time. Indeed, the first cup of tea in the morning, and the
second one in the evening will not result in diminishing marginal utility.
3. Reasonability: The units of consumption are in reasonable size, that is, of normal standard unit. For
instance, we should think of a glass of milk, a cup of tea etc. and not a spoon of milk or tea.
4. Constancy: The law presumes that, there is no change in income, taste, habit or preference of the
consumer. Similarly, the price of the commodity is also assumed to be given.
5. Rationality: The consumer is assumed to be a rational economic man whose behaviour is normal and
who is aiming at maximization of satisfaction.
Above all, the Marshallian exposition of the law of diminishing marginal utility is based on the cardinal
measurement of utility. It is assumed that utility can be numerically expressed by the consumer, that is, he is
capable of mentioning the quantum of utility derived from each additional unit consumed or acquired by him.
CRITICISMS OF THE LAW:
Though the law expresses a universal tendency of consumer’s introspective behaviour, its traditional
exposition has been criticized on various counts.
1. The traditional or Marshallian explanation of the law presumes the cardinal measurement of utility. The
law assumes that utility can be numerically measured added or subtracted. This is rather not convincing
because utility being a subjective or introspective phenomena cannot be measured numerically. It is a
feeling experienced by the consumer. We cannot therefore have a objective measure of a subjective
feeling.
2. The law is based on unrealistic assumptions or conditions. The condition assumed like homogeneity,
continuity, constancy and rationality all together present at a time is very difficult to find in practice.
Units of a
Commodity
Total
Utility
Marginal
Utility
1 20 20
2 37 17
3 51 14
4 62 11
5 68 6
6 68 0
7 64 -4
8 50 -14

3. The application of the law to the indivisible bulky commodity seems to be absurd. Because no one would
normally buy at a time more than one unit of good like television set, refrigerator, scooter, motor car etc.
It would be absurd to talk of increase in the stock of such goods and marginal utility thus derived.
4. The law unrealistically assumes constant marginal utility of money, which is highly unsatisfactory, with
the increase in purchase of goods, for consumption, the marginal utility of money will increase due to the
diminishing stock of purchasing power.
IMPORTANCE OF THE LAW:
The law of diminishing marginal utility has great economic significance, theoretical as well as practical. From
the theoretical point of view the law is important because,
1. The law explains the behaviour and the equilibrium condition of a rational consumer with respect to a
single want and commodity.
2. The law of diminishing marginal utility is the basic law of economics. It provides the foundation for
various laws of consumption. The law of demand is the outcome of the law of diminishing marginal
utility. The law of demand states that larger quantities are purchased at a lower price. The reason is that
as more units of a commodity are purchased its marginal utility to the consumer becomes less and less
and so he gives lesser importance to additional units of a commodity. Therefore, he will buy additional
units of a commodity only at a lower price.
3. The law explains the Paradox of value (The diamond-water paradox): The value-in-use and value-in-
exchange for a commodity are different. Diamonds have great value-in-exchange, as they are scarce in
supply, they have greater marginal utility, and therefore, value is high. On the other hand, water is in
abundant supply and its marginal utility is very low. Therefore, it commands no price even though its
total utility is high. Thus water has great value in use but no value in exchange. Diamonds have great
value in exchange though they are less useful than water. The price of a commodity is thus, related to its
marginal utility.
4. Prof. Marshall has built up his theory of taxation and public expenditure on the basis of the law of
diminishing marginal utility. The principle of progression has been deduced in the theory of taxation by
the application of this law, to money. Further, it is argued that there should be equitable distribution of
wealth because the utility derived by the rich from money is much less than what could accrue to the
poor. If Rs. 100 deducted from the rich man’s income, means only a small sacrifice of comparatively little
utility, while the addition to the amount to the poor man’s income, will increase his satisfaction by more
than what a rich man has lost, therefore, methods should be devised to redistribute the national income
on a more equitable basis.
PRACTICAL SIGNIFICANCE OF THE LAW:
1. To the producer, the law serves as a guide to promote sales by reducing prices. Because, when the price
falls, to attain equilibrium the consumer has to decrease the marginal utility to that extent. To do this he
has to purchase more goods as the marginal utility diminishes only when the stock increases.
2. The law is useful to the finance minister in formulating an appropriate tax policy. He can justify
progressive taxation on higher income on the ground that rich people will feel relatively lesser impact of
the tax burden as the marginal utility of money is lower with the increase in income.
3. Similarly socialists can agitate for a redistribution of wealth to promote welfare on the ground that the
transfer will cause more gain to the poor and less sacrifice to the rich.
EXCEPTIONS TO THE LAW OF DIMINISHING MARGINAL UTILITY:
Under the assumptions of homogeneity, continuity, reasonability, constancy and rationality, the law is deemed
to be universal. In certain cases, however, it has been observed that a consumer tends to attain increasing
marginal utility with an increase in the stock of a commodity consumed or acquired. Such cases are treated as
exception to the law of diminishing marginal utility. These exceptions are:
1] Hobbies: It is often argued that in the case of hobbies like stamp collection, collection of antique goods,
collection of old coins etc, every additional unit gives more pleasure, that is, marginal utility, tends to
increase. No doubt this is true, but, it is not a genuine exception to the law of diminishing utility, because in
such cases, homogeneity condition of the law is violated. Indeed each time a new variety of stamp or coin or
antique is collected by a person but not of the same variety.

2] Alcoholics: The law seems to be inapplicable to alcoholics as intoxicants increases with every successive
dose of liquor. This is true, but the rationality condition of the law is violated. The introspective behaviour
of an alcoholic at that time is irrational or abnormal.
3] Misers: In the case of a miser, it is pointed out that greed increases with every additional acquisition of
money. Hence, the marginal utility of money does not diminish for him with more and more money. But,
when the miser spends his money his utility of the commodity will be diminishing perhaps more rapidly
than in the case of others. Hence, a miser’s behaviour cannot be a significance exception to the law of
diminishing marginal utility.
4] Music and poetry: In the case of music and poetry it’s commonly experienced that a repeat gives a better
satisfaction than the first one. Hence, it is thought that the law of diminishing marginal utility may not be
applicable here. But there is a limit to repeated hearing of the same music and poetry because, it will
become monotonous and yields disutility, so it is not a genuine exception to the law.
5] Reading: Since more reading gives more knowledge a scholar would get more and more satisfaction with
every additional book. But, here we may point out that it is not a real exception to the law as the condition
of homogeneity is violated here. Knowledge and satisfaction increases by reading different books and not
the same book over and over again.
THE LAW OF MAXIMUM SATISFACTION / THE LAW OF EQUI-MARGINAL UTILITY/ THE LAW OF
SUBSTITUTION:
This law is developed by H.H Gossen so it is also called the second law of Gossen. We know human wants are
unlimited but the resources to fulfill the wants are limited. A rational consumer always tries to maximize his
satisfaction by spending his limited money income. Consumer can maximize his satisfaction if he is able to
equalize the marginal utility derived from the consumption of different units of several commodities by
spending his all limited money income so that this law is known as law of maximum satisfaction or law of equi-
marginal utility.
This law is also known as law of substitution because consumer can maximize his/her satisfaction when he/she
substitutes the commodities having high marginal utility instead of commodities having the low marginal
utility. Mathematically it is expressed as:
This law is based on the following ASSUMPTIONS:
1. Consumers should be rational
2. Price of commodity remains constant
3. Income of consumers remains constant
4. Utility can be measured in numbers
5. Marginal utility of money remains constant
EXCEPTIONS/ LIMITATIONS of the law of substitution:
1. Utility can’t be measured in numbers: Utility can’t be measured in terms of numbers. It can only be
expressed in terms of range i.e. high or low.
2. Ignorance of consumers: If the consumer is ignorant about the availability of substitute goods in market
then he can’t substitute the commodity having high M.U instead of low.
3. Frequent change in price: This law assumes that price of commodity remains constant. Generally utility
is judged on the price. If the price changes then there is not application on the law of diminishing M.U. At
that time we can’t measure M.U of different commodity properly.
4. Influence of custom and fashion: In the case of commodity related to custom and fashion this law is not
applicable because while purchasing such commodity they don’t care about equalizing M.U from different
commodity.
5. M.U of money doesn’t remains constant: This law assumes that M.U of money is constant but in reality
M.U of money is changeable on the basis of amount of money with people.

6. Individual goods: In the case of individual this law is not applicable because such goods like T.V,
motorcycle, fridge, etc are purchased once at a time. As a result there is not the possibility of comparison
of M.U of such goods among each other.
7. Shortage of goods: If there is shortage of goods in market there is no any question to equalize the M.U
from several commodities.
8. Addiction: This law is not applicable for addict because druggist, drunkard, etc are not ready to sacrifice
any single drop of drug or alcohol for other commodity.
CONSUMER SURPLUS
Dupuit originated the concept of consumer’s surplus. But, it was Marshall who popularized it by
presenting it in a most refined way. Marshall viewed that when a consumer buys a commodity, his satisfaction
derived from derived from it may be in excess of the dissatisfaction he has experienced in parting with money
for paying its price. This excess of satisfaction is called” consumer’s surplus”.
A consumer is willing to pay the price for a commodity upto its marginal utility compared with the
marginal utility of money which he has to pay. If the marginal utility of a commodity is high which is actual
market price is low, the consumer derives extra satisfaction, that is, consumer surplus. Consumer surplus
therefore can be measured as the difference between the maximum price the consumer is willing to pay for a
commodity and the actual market price charged for it.
As Marshall puts it, “the excess of the price which a consumer would be willing to pay rather than go
without the things over that which he actually does pay, is the economic measure of this surplus of satisfaction.
It may be called consumer’s surplus.”
This concept is based on the law of diminishing marginal utility. Prof. Marshall applies the phrase’
consumer’s surplus’ to the difference between the sum which measures total utility and that which measures
total exchange value(price paid). For, while the price that he has to pay for each unit is equal to the utility of
the marginal unit, the utility of each of the earlier units is more than that of the last. Therefore, he gains more
utility than he loses by making the payments. His gain is more than the loss. This is the source of his surplus
satisfaction. Thus: Consumer surplus=price prepared – actual price paid
Measurement of consumer surplus
Unit of marginal market consumer surplus
Commodity utility price price prepared-actual
X m.u market price
1 35 10 35-10 = 25
2 30 10 30-10 = 20
3 22 10 22-10 = 12
4 10 10 10-10 = 0
Total 4 units Total price/mu 57
Utility = 40
97
Thus,
CS = TU – (P x Q) 97 - (10 x 4) 97 – 40 CS = 57
Where, CS: Consumer surplus , TU: Total utility
P: Price , Q: Quantity
Consumer surplus can be diagrammatically represented:
If OP is price, OQ is the units purchased MU of OQ=price OP
total money paid=OP x OQ therefore, price paid OPQR
Price prepared to pay = total utility OMRQ
Therefore, OMRQ – OPRQ = MRP (CONSUMER SURPLUS)
ASSUMPTIONS:
This concept is based on the following assumptions.
(1) Cardinal measurement of utility.
(2) Constant marginal utility of money.
(3) The commodity in question does not have substitutes.

CRITICISMS:
(1) This law is based on certain assumptions and critics argue that these assumptions are unrealistic.
a. Utility cannot be measured cardinally; therefore, consumer’s surplus cannot be measured and
expressed numerically.
b. Marginal utility of money does not remain constant.
c. If commodities have substitutes, with the rising prices, he will purchase other goods rather than
pay a higher price for the same. The concept has no theoretical validity.
(2) It is meaningless to apply the doctrine of consumer’s surplus to necessaries as the utility derived from
necessaries as the utility derived from necessaries is infinite.
(3) The concept is imaginary and illusory. It does not exist in reality. We create surplus out of our
imagination.
(4) It is of no practical significance. Prof. Little says,” The doctrine of consumer’s surplus is a useless
theoretical toy”.
IMPORTANCE OF THE CONCEPT:
(1) The concept of consumer’s surplus does emphasize the amenities that we enjoy in a modern society.
Much of the consumer’s surplus, we enjoy depends on our surroundings and the opportunities of
consumption available to us, example, amenities of life in America as compared to Central Africa. It thus
clarifies conjectural importance. The concept enables us to compare the advantages of environment
and opportunities or conjectural benefits. The larger the consumer’s surplus, the better off is the
people. The concept, thus, serves as an index of economic betterment.
(2) It is useful in price policy of a monopoly firm. The monopolist can put a higher price on the goods if
consumer’s surplus is high, without causing any reduction in sales.
(3) It is of significance to the exchequer in determining indirect taxation. The finance minister can easily
levy more taxes where consumer’s surplus is high.
(4) By estimating the difference in consumer’s surplus resulting from a change in price, we can know and
compare the effects of a given change in the price of any commodity on the different classes of people.
It is, therefore, widely adopted in welfare economics.
(5) Gains from international trade can be measured in terms of consumer’s surplus obtained in the
imported goods.
INDIFFERENCE CURVE ANALYSIS:
Indifference Curve approach was first propouned by British economist Edgeworth in 1881 in his book
“Mathematical Physics.” The concept was further developed in 1906 by Italian economist Pareto, in 1913 by
British economist W .E. Johnson, and in 1915 by Russina economist Stutsky. The credit of rendering this
analysis as an important tool of theory of Demand goes to Hicks and Allen. In 1934, they presented it in a
scientific form in their article titled “A Reconsideration of the Theory of Value.” It was discussed in detail by
Hicks in his book, “Value and Capital”.
ASSUMPTIONS:
Indifference curve approach has the following main assumptions:
(1) Rational Consumer: It is assumed that the consumer will behave rationally. It means the consumer
would like to get maximum satisfaction out of his total income.
(2) Diminishing Marginal rate of Substitution: It means as the stock of a commodity increases with the
consumer, he substitutes it for the other commodity at a diminishing rate.
(3) Ordinal Utility: A consumer can determine his preferences on the basis of satisfaction derived from
different goods or their combinations. Utility can be expressed in terms of ordinal numbers, i.e., first,
second etc.
(4) Completeness: In a comparison of any two bundles, A = (xA, yA) and B = (xB, yB), an individual should
be able to say either (i) “I prefer A to B”; or (ii) “I prefer B to A”; or (iii) “I am indifferent between A and
B”, i.e., “I like equally A and B”. This property of preferences is called completeness. Essentially the
consumer is not allowed to say “I don’t know” or “I am not sure.”
(5) Transitivity: If a person states, “I prefer A to B,” as well as “I prefer B to C,” then he/she also has to prefer
A to C. This assumption says that preferences are consistent, so that comparisons between bundles A and C
are consistent with comparisons between bundles A and B and between B and C. Transitivity in indifference

means that a person who says, “I am indifferent between A and B,” as well as “I am indifferent between B
and C,” also has to be indifferent between A and C.
(6) More is preferred to less: A consumer preferences is that “more is better”. . Since “more is better”, if
bundle A = (xA, yA) has more of both goods than bundle B = (xB, yB), i.e., if xA > xB and yA > yB, then clearly
a consumer will prefer A to B. Similarly if bundle A has less of both goods than bundle B, then a consumer
will prefer B to A. However, if bundle A has more of X but less of Y than B, the comparison is not obvious.
The consumer may prefer A to B, or prefer B to A, or be indifferent between A and B.
INDIFFERENCE CURVE:
An indifference curve (IC) is a geometrical presentation of a consumer is scale of preferences. An IC is a
locus of all such points which shows different combinations of two commodities which yield equal satisfaction
to the consumer. Since the combination represented by each point on the indifference curve yields equal
satisfaction, a consumer becomes indifferent about their choice. In other words, he gives equal importance to
all the combinations on a given indifference curve.
According to Ferguson, “An indifference curve is a combination of goods, each of which yield the same
level of total utility to which the consumer is indifferent.”
According to Leftwitch, “A single indifference curve shows the different combinations of X and y that yield
equal satisfaction to the consumer.”
One can create a collection of all the bundles, A, B, C, D, ..., such that a particular consumer is indifferent
between any two of them. The line in X-Y space that connects the points in this collection {A, B, C, D, ...} is called
an indifference curve, I1 (Figure ).
Of course, the same consumer typically has many indifference curves.
For example, he has both A-B-C-D and E-F-G-H as indifference curves,
and he prefers any bundle on E-F-G-H to any on A-B-C-D.
In general, there is an indifference curve through any point in X-Y
space. Since “more is better,” an indifference curve cannot have a
positive slope. Indifference curves have a negative slope, and in
special cases zero slope. An indifference curve defines the
substitution between goods X and Y that is acceptable in the mind of
the consumer. As we move towards the Southeast along a typical
indifference curve the consumer receives more X and less Y, while she
declares that she is equally well off.
LAW OF DIMINISHING MARGINAL RATE OF SUBSTITUTION:
The concept of indifference curve analysis is based on law of
diminishing marginal rate of substitution. According to Prof. Bilas, “The
marginal rate of substitution of X for Y (MRSxy) is defined as the amount
of y which the consumer is just willing to give up to get one more unit of x
and maintain the same level of satisfaction.”
The marginal rate of substitution is equal to the ratio of the marginal
utilities,
MRS = Δy/Δx = - MUx/MUy
MOVE CHANGE IN UTILITY
A to C (MUy)(Δy)
C to B (MUx)(Δx)
────────────────────────────
TOTAL, A to B (MUx)(Δx) + (MUy)(Δy) = 0
Total change in utility between A and B is zero because A and B are on the same indifference curve. Rearranging
the terms in this we derive the slope of the indifference curve,
(MUy)(Δy) = -(MUx)(Δx) MRS = Δy/Δx = - MUx/MUy.

For a convex indifference curve, its slope goes from high on the left to low on the right. This means that, as the
consumer has more Y, she is willing to give up less and less in X in exchange for acquiring equal amounts of Y.
Her indifference curves exhibit diminishing marginal rate of substitution. i.e.
1
U
U
X
Y
MRS





PROPERTIES OF INDIFFERENCE CURVES:
The important characteristics of indifference curves are as follows:
(1) Indifference Curves are Negatively Sloped: As the consumer increases the consumption of X
commodity, he has to give up certain units of Y commodity in order to maintain the same level of
satisfaction. Therefore indifference curve slopes downward from left to right. This means that an
indifference curve is negatively sloped.
(2) Indifference Curve Cannot Intersect Each Other: Given the
definition of indifference curve and the assumptions behind it, the
indifference curves cannot intersect each other. It is because at the
point of tangency, the higher curve will give as much as of the two
commodities as is given by the lower indifference curve. This is
absurd and impossible.
(3) Higher Indifference Curve Represents Higher Level: A
higher indifference curve that lies above and to the right of
another indifference curve represents a higher level of satisfaction
and combination on a lower indifference curve yields a lower
satisfaction. In other words, we can say that the combination of
goods which lies on a higher indifference curve will be preferred
by a consumer to the combination which lies on a lower
indifference curve.
(4) Indifference Curve are Convex to the Origin: This is an
important property of indifference curves. They are convex to the
origin (bowed inward). This is equivalent to saying that as the
consumer substitutes commodity X for commodity Y, the marginal
rate of substitution diminishes of X for Y along an indifference
curve. Hence it can never be a straight line nor concave to the
origin because of MRS xy
(5) Indifference Curves do not Touch the Horizontal or Vertical
Axis: One of the basic assumptions of indifference curves is that
the consumer purchases combinations of different commodities.
He is not supposed to purchase only one commodity. In that case
indifference curve will touch one axis. This violates the basic
assumption of indifference curves.
SOME EXCEPTIONAL SHAPES OF INDIFFERENCE CURVES:
Indifference curves where Goods X and Y are
perfect substitutes. The gray line perpendicular
to all curves indicates the curves are mutually
parallel.
Indifference curves for perfect complements
X and Y. The elbows of the curves are
collinear.

PERFECT SUBSTITUTES AND COMPLEMENTS:
 Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is
constant.
 Two goods are perfect complements when the indifference curves for the goods are shaped as right
angles [L-shape]
THE BUDGET LINE:
The budget line shows all the different combinations of commodities
that a consumer can purchase, given his money income and the prices of
commodities. The budget line can be written as follows:
Px.X + Py.Y = M
Where, Px is the price of commodity X, Py is the price of commodity
Y M : is the consumer’s income
Subtracting Px.X from both sides of the above equation gives
Py.Y = M - Px.X
Divide each side of above equation by Py yields;
X
P
P
P
M
Y
y
x
y


Slope is given by the change in Y due to change in X; -
y
x
P
P
ΔX
ΔY

The slope of the budget line in the ratio of the prices of the two goods ( i.e.
Y
X
P
P

)
CHANGES IN THE BUDGET LINE:
(1) Parallel Shifts: if the consumer’s money income increases or decreases, or if the prices changes for both
goods decrease or increase proportionally, then the budget line will shift out to the right in a parallel
manner, or in to the left in a parallel manner.
(2) Inward Pivots: if the price of one good increases, the budget line will pivot inward with respect to that
good’s axis. In the example below, the price of Good X increases.
(3) Outward Pivots: if the price of one good decreases, the budget line will pivot outward with respect to
that good’s axis. In the example below, the price of Good Y decreases.
CONSUMER’S EQUILIBRIUM - INDIFFERENCE CURVE ANALYSIS:
According to the ordinal approach, a consumer has a given scale of preference for different combinations of two
goods. By just comparing the levels of satisfaction, he can derive maximum satisfaction out of a given money
income.
Consumer’s equilibrium refers to a situation in which a consumer with given income and given prices
purchases such a combination of goods and services as gives him maximum satisfaction and he is not willing to
make any change in it.
ASSUMPTIONS OF CONSUMER’S EQUILIBRIUM:
1. Consumer is rational and so maximises his satisfaction from the purchase of two goods.
2. Consumer’s income is constant.
3. Prices of the goods are constant.
4. Consumer knows the price of all things.
5. Consumer can spend his income in small quantities.
6. Goods are divisible.
7. There is perfect competition in the market.
8. Consumer is fully aware of the indifference map.

CONDITIONS OF CONSUMER’S EQUILIBRIUM:
There are two main conditions of consumer’s equilibrium;
(i) Price line should be tangent to the indifference curve, i.e. MRSxy = Px / Py
(ii) Indifference curve should be convex to the point of origin.
(iii) Price line should be tangent to indifference curve:
CONSUMER EQUILIBRIUM:
In order to maximize total utility, TU, the consumer will choose
units of the two goods, X and Y, so that
MRSX,Y =
Y
x
MU
MU
=
Y
x
P
P
(From the ordinal utility analysis)
In case of equilibrium: Slope of indifference curve = slope of
price line
The above expression is equivalent to…
X
x
P
MU
=
Y
Y
P
MU
(From the cardinal utility analysis)
Note Importantly: Both of the expressions above guarantee that TOTAL utility will be maximized.
Given convex and smooth indifference curves, the consumer maximizes utility at a point A, where the slope of
the indifference curve (MRS) is equal to the slope of the budget constraint. At the chosen point A we have
tangency of the indifference curve and the budget constraint line (Figure),
px/py = MRS = MUx/MUy, i.e., MUx/px = MUy/py.
This means that the consumer receives equal satisfaction for the last dollar spent in each good.
Slope of indifference curve = (Y1-Y0)/(X1-X0)
BREAKING UP PRICE EFFECT INTO INCOME AND SUBSTITUTION EFFECT (WITH DIAGRAM)
A consumer chooses between good 1 and good 2. Giver her income, m, the prices of the goods, p11 and p2, and
her preferences, she chooses that basket of goods that maximizes her utility. In Figure its means that she
initially chooses point A. If the price of good 1 falls from p11 to p12, the budget line rotates outwards from BL1 to
BL2. When the consumer chooses a new basket, she ends up in point B.
Her consumption of good 1 has consequently increased from q11 to q12, which is the total effect. It consists of
the income effect (i.e. on the increase in purchasing power) and substitution effect (i.e. on the change in the
slope of the budget line).
If the relative prices change, the slope of the budget
line changes. All budget lines that have the same
relative prices as BL2 must also have the same slopes
as that budget line. Furthermore, for the consumer to
have the same utility as before, she must consume on
the same indifference curve as she did before, i.e. on
I1. We therefore construct an imaginary budget line,
BL*, that has the same slope as BL2 and that, just as
BL1, is a tangent to I1. (However, since it has a
different slope than BL1, it must touch I1 at different
point than that budget line does.)
If this had been the real situation, the consumer
would have chosen point C. She had then increased
her consumption of good 1 from q11 to q1*. At the
same time, she would have decreased her consumption of good 2. This substitution from good 1 to good 2
depends on the change in the relative price, but it does not result in any change in the level of utility. This part
is the substitution effect.
The remaining change, from q1 * to q12, is the part that depends on the increase in the consumer’s purchasing
power. As she moves to a higher indifference curve, from I1 to I2, she increases her utility. This part is the
income effect.

CRITISM:
Robertson, Armstrong, Knight etc. have criticized indifference curve analysis on account of the following.
(1) Unrealistic assumption: Indifference curve analysis is based on the assumption that a consumer
has complete knowledge regarding the preference of two goods. In reality, he cannot take quick
decisions in real life in respect of different combinations.
(2) Complex analysis: Indifference curve analysis can explain easily that behaviour of the consumer
which is restricted to the combination of only two goods. If the consumer wants combinations of more
than two goods, then indifference curve analysis becomes highly complex.
(3) Imaginary: Indifference curve analysis is based on imaginary combinations. A consumer does not
decide always like a computer as to which of the combinations of two goods he would prefer.
(4) Assumption of Convexity: This theory does not explain why an indifference curve is convex to the
point of origin. In real life, it is not necessary that all goods should have diminishing marginal rate of
substitution.
(5) Unrealistic combinations: When we consider different Combinations of two goods, sometimes we
come across such funny combinations that have no meaning for the consumer. For instance, there is a
combination of 10 shirts + 2 pairs of shoes. If in the subsequent combinations shirts are given up to get
more pairs of shoes then we way arrive at a combination representing 2 shirts + 10 pairs of shoes,
which is ridiculous.
(6) Impractical: Indifference curve analysis is based on the unrealistic assumption that goods are
homogenous. ‘This assumption holds good only under perfect competition, which is more 9 theoretical
concept. In real life, monopolistic and oligopolistic conditions are found more prevalent.
INTRODUCTION: CONCEPT OF DEMAND
Demand theory attempts at answering questions regarding the magnitude of demand for a product or
service based on its importance to human wants. It also attempts to assess how demand is impacted by changes
in prices and income levels and consumers preferences/utility. Based on the perceived utility of goods and
services to consumers, companies are able to adjust the supply available and the prices charged.
In economics, demand has a specific meaning distinct from its ordinary usage. In common language we treat
‘demand’ and ‘desire’ as synonymously. This is incongruent from its use in economics. In economics, demand
refers to effective demand which implies three things:
Desire for a commodity
Sufficient money to purchase the commodity, rather the ability to pay
Willingness to spend money to acquire that commodity
For instance, a person may desire to own a car but unless he has the required amount of money with him and
the willingness to spend that amount on the purchase of a car, his desire shall not become a demand.
The following should also be noted about demand:
Demand always alludes to demand at price. The term ‘demand’ has no meaning unless it is related to
price. For instance, the statement, 'the weekly demand for potatoes in Pune city is 10,000 kilograms'
has no meaning unless we specify the price at which this quantity is demanded.
Demand always implies demand per unit of time. Therefore, it is vital to specify the period for which
the commodity is demanded. For instance, the statement that demand for potatoes in Pune city at Rs. 8
per kilogram is 10,000 kilograms again has no meaning, unless we state the period for which the
quantity is being demanded.
A complete statement would therefore be as follows: 'The weekly demand for potatoes in Pune city at Rs.
8 per kilogram is 10,000 kilograms'. It is necessary to specify the period and the price because demand
for a commodity will be different at different prices of that commodity and for different periods of time.
Demand is an effective desire, i.e., a desire which is backed by willingness and ability to pay for a
commodity in order to obtain it.
In the words of Prof. Hibdon:"Demand means the various quantities of goods that would be purchased
per time period at different prices in a given market".

DETERMINANTS OF DEMAND:
There are various factors affecting the demand for a commodity. They are:
(1) Price of the good: The price of a commodity is an important determinant of demand. Price and
demand are inversely related. Higher the price less is the demand and vice versa.
(2) Price of related goods: The price of related goods like substitutes and complementary goods also
affect the demand. In the case of substitutes, rise in price of one commodity lead to increase in demand
for its substitute. In the case of complementary goods, fall in the price of one commodity lead to rise in
demand for both the goods.
(3) Consumer’s Income: This is directly related to demand. A change in the income of the consumer
significantly influences his demand for most commodities. If the disposable income increases, demand
will be more.
(4) Taste, preference, fashions and habits: These are very effective factors affecting demand for a
commodity. When there is a change in taste, habits or preferences of the consumer, his demand will
change. Fashions and customs in society determine many of our demands.
(5) Population: If the size of the population is more, demand for goods will be more . The market
demand for a commodity substantially changes when there is change in the total population.
(6) Money Circulation: More the money in circulation, higher the demand and vice versa.
(7) Value of money: The value of money determines the demand for a commodity in the market.
When there is a rise or fall in the value of money there may be changes in the relative prices of different
goods and their demand.
(8) Weather Condition: Weather is also an important factor that determines the demand for certain
goods.
(9) Advertisement and Salesmanship: If the advertisement is very attractive for a commodity,
demand will be more. Similarly if the salesmanship and publicity is effective then the demand for the
commodity will be more.
(10) Consumer’s future price expectation: If the consumers expect that there will be a rise in prices in
future, he may buy more at the present price and so his demand increases.
(11) Government policy (taxation): High taxes will increase the price and reduce demand, while low
taxes will reduce the price and extend the demand.
(12) .Credit facilities: Depending on the availability of credit facilities the demand for commodities will
change. More the facilities higher the demand.
(13) Multiplicity of uses of goods: if the commodity has multiple uses then the demand will be more
than if the commodity is used for a single purpose.
DEMAND DISTINCTIONS: TYPES OF DEMAND
Demand may be defined as the quantity of goods or services desired by an individual, backed by the ability and
willingness to pay.
(1) Direct and indirect demand: (or) Producers’ goods and consumers’ goods: demand for goods that are
directly used for consumption by the ultimate consumer is known as direct demand (example: Demand for
T shirts). On the other hand demand for goods that are used by producers for producing goods and services.
(example: Demand for cotton by a textile mill)
(2) Derived demand and autonomous demand: when a produce derives its usage from the use of some
primary product it is known as derived demand. (example: demand for tyres derived from demand for car)
Autonomous demand is the demand for a product that can be independently used.(example: demand for a
washing machine)
(3) Durable and non durable goods demand: durable goods are those that can be used more than once,
over a period of time (example: Microwave oven) Non durable goods can be used only once (example:
Band-aid)
(4) Firm and industry demand: firm demand is the demand for the product of a particular firm. (example:
Dove soap) The demand for the product of a particular industry is industry demand (example: demand for
steel in India )

(5) Total market and market segment demand: a particular segment of the markets demand is called as
segment demand (example: demand for laptops by engineering students) the sum total of the demand for
laptops by various segments in India is the total market demand. (example: demand for laptops in India)
(6) Short run and long run demand: Short run demand refers to demand with its immediate reaction to
price changes and income fluctuations. Long run demand is that which will ultimately exist as a result of the
changes in pricing, promotion or product improvement after market adjustment with sufficient time.
(7) Joint demand and Composite demand: when two goods are demanded in conjunction with one another
at the same time to satisfy a single want, it is called as joint or complementary demand. (example: demand
for petrol and two wheelers) A composite demand is one in which a good is wanted for several different
uses. ( example: demand for iron rods for various purposes)
(8) Price demand, income demand and cross demand: Demand for commodities by the consumers at
alternative prices are called as price demand. Quantity demanded by the consumers at alternative levels of
income is income demand. Cross demand refers to the quantity demanded of commodity ‘X’ at a price of a
related commodity ‘Y’ which may be a substitute or complementary to X.
(a) Price Demand: The ability and willingness to buy specific quantities of a good at the prevailing
price in a given time period.
(b) Income Demand: The ability and willingness to buy a commodity at the available income in a
given period of time.
(c) Market Demand: The total quantity of a good or service that people are willing and able to buy at
prevailing prices in a given time period. It is the sum of individual demands.
(d) Cross Demand: The ability and willingness to buy a commodity or service at the prevailing price of
the related commodity i.e. substitutes or complementary products. For example, people buy more
of wheat when the price of rice increases.
LAW OF DEMAND:
The law of Demand is known as the “first law in market”. Law of demand shows the relation between price and
quantity demanded of a commodity in the market. Law of Demand states that the quantity demanded of a good
or service varies inversely with its price. In other words, when the price goes up, quantity demanded goes
down. Likewise, when the price goes down, quantity demanded goes up.
In the words of Marshall “the amount demanded increases with a fall in price and diminishes with a rise in
price”. According to Samuelson, “Law of Demand states that people will buy more at lower price and buy less at
higher prices”. So the relationship described by the law of demand is an inverse or negative relationship
because the variables (price and demand) move in opposite direction. It shows the cause and effect relationship
between price and quantity demand. The law of demand holds only in the short run.
Formula For Law of Demand: Qdx = f (Px) ceteris paribus
Ceteris Paribus. In economics, the term is used as a shorthand for indicating the effect of one economic
variable on another, holding constant all other variables that may affect the second variable.
ASSUMPTIONS OF LAW OF DEMAND:
Law of demand is based on certain basic assumptions. They are as follows
(1) There is no change in consumers taste and preference
(2) Income should remain constant.
(3) Prices of other goods should not change.
(4) There should be no substitute for the commodity.
(5) The commodity should not confer any distinction.
(6) The demand for the commodity should be continuous.
(7) People should not expect any change in the price of the commodity.

SCHEDULE OF LAW OF DEMAND:
The demand schedule of an individual for a commodity is a list or table of the different amounts of the
commodity that are purchased the market at different prices per unit of time. An individual demand schedule
for a good say shirt is presented in the table below:
Individual Demand Schedule for Shirts:
Price per shirt (In Rs.) 100 80 60 40 20 10
Quantity demanded per year Qdx 5 7 10 15 20 30
According to this demand schedule, an individual buys 5 shirts at Rs 100 per shirt and 30 shirts at Rs. 10 per
shirt in a year.
LAW OF DEMAND CURVE/DIAGRAM:
The law of demand can also be presented through a demand curve. A demand curve is a locus of points
showing various alternative price quantity combinations. Demand curve shows the quantities of a
commodity which a consumer would buy at different prices per unit of time, under the assumptions of the law
of demand
It is a graphical representation of the demand schedule.
In the figure, the quantity. demanded of shirts in plotted on
horizontal axis OX and "price is measured on vertical axis OY.
Each price- quantity combination is plotted as a point on this
graph. If we join the price quantity points a, b, c, d, e and f, we
get the individual demand curve for shirts.
The DD/ demand curve slopes downward from left to right. It
has a negative slope showing that the two variables price and
quantity work in opposite direction. When the price of a good
rises, the quantity demanded decreases and when its price decreases, quantity demanded increases, ceteris
paribus.
EXCEPTIONAL DEMAND CURVE:
The demand curve slopes from left to right upward if despite the increase in price of the commodity, people
tend to buy more due to reasons like fear of shortages or it may be an absolutely essential good. The law of
demand does not apply in every case and situation. The circumstances when the law of demand becomes
ineffective are known as exceptions of the law. Some of these important exceptions are as under.
(1) Giffen Goods: Some special varieties of inferior
goods are termed as Giffen goods such as bajra, potato
etc. Sir Robert Giffen of Ireland first observed that
people used to spend more of their income on inferior
goods like potato and less of their income on meat.
After purchasing potato the staple food, they did not
have staple food potato surplus to buy meat. So the
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.
(2) Conspicuous Consumption/Veblen Effect: Conspicuous consumption was introduced by economist
and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to
describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or
wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining
social status. So-called Veblen goods (also as know as snob value goods) reverse the normal logic of
economics in that the higher the price the more demand for the product. Some buyers have a desire to own

unusual or unique products to show that they are different from others. In this situation even when the
price rises the demand for the commodity will be more.
(3) Conspicuous Necessities: Certain things become the necessities of modern life. So we have to purchase
them despite their high price. The demand for T.V. sets, automobiles and refrigerators etc. has not gone
down in spite of the increase in their price. These things have become the symbol of status. So they are
purchased despite their rising price.
(4) Ignorance: A consumer’s ignorance is another factor that at times induces him to purchase more of the
commodity at a higher price. This is especially true, when the consumer believes that a high-priced and
branded commodity is better in quality than a low-priced one.
(5) Emergencies: During emergencies like war, famine etc, households behave in an abnormal way.
Households accentuate scarcities and induce further price rise by making increased purchases even at
higher prices because of the apprehension that they may not be available. . On the other hand during
depression, fall in prices is not a sufficient condition for consumers to demand more if they are needed.
(6) Future Changes in Prices: Households also act as speculators. When the prices are rising households
tend to purchase large quantities of the commodity out of the apprehension that prices may still go up.
When prices are expected to fall further, they wait to buy goods in future at still lower prices. So quantity
demanded falls when prices are falling.
(7) Change in Fashion: A change in fashion and tastes affects the market for a commodity. When a digital
camera replaces a normal manual camera, no amount of reduction in the price of the latter is sufficient to
clear the stocks. Digital cameras on the other hand, will have more customers even though its price may be
going up. The law of demand becomes ineffective.
(8) Demonstration Effect: It refers to a tendency of low income groups to imitate the consumption pattern
of high income groups. They will buy a commodity to imitate the consumption of their neighbors even if
they do not have the purchasing power.
(9) Speculative Goods / Outdated Goods / Seasonal Goods: Speculative goods such as shares do not
follow the law of demand. Whenever the prices rise, the traders expect the prices to rise further so they buy
more. Goods that go out of use due to advancement in the underlying technology are called outdated goods.
The demand for such goods does not rise even with fall in prices
(10) Seasonal Goods: Goods which are not used during the off-season (seasonal goods) will also be subject to
similar demand behaviour.
(11) Goods In Short Supply: Goods that are available in limited quantity or whose future availability is
uncertain also violate the law of demand.
FACTORS BEHIND THE LAW OF DEMAND:
The downward slope of the demand curve depicts the law of demand, i.e., the quantity of a commodity
demanded per unit of time increases as its price falls, and vice verse. The factors that make the law of demand
operate are following.
(1) Substitution Effect: When price of a commodity falls, prices of all other related goods (particularly of
substitutes) remaining constant, the goods of latter category become relatively costlier. Since utility
maximising consumers substitute cheaper goods for costlier ones, demand for the cheaper commodity
increases. The increase in demand on account of this factor is known a substitution effect.
(2) Income Effect: As a result of fall in the price of a commodity, the real income of the consumer increases.
Consequently, his purchasing power increases since he is required to pay less for the same quantity. The
increase in real income encourages the consumer to demand more of goods and services. The increase in
demand on account of increase in real income is known as income effect. It should however be noted that
the income effect is negative in case of inferior goods.
(3) Utility-Maximising Behavior: The utility-maximising behavior of the consumer under the condition of
diminishing marginal utility is also responsible for increase in demand for a commodity when its price
falls. As mentioned above, when a person buys a commodity, he exchanges his money income for the
commodity in order to maximise his satisfaction. He continues to buy goods and services so long as
marginal utility of his money (MUm) is less than the marginal utility of the commodity (MUo). Given the
price of a commodity, the consumer adjusts his purchases. so that. MUm = Po = MUo
(4) When price of the commodity falls, (MUm = Po) < MUo, and equilibrium is disturbed. In order to regain
his equilibrium, the consumer will have to reduce the MUo to the level of MUm. This he can do only by

purchasing more of the commodity. Therefore, the consumer purchases the commodity till MUm= Po =
MUo. This is another reason why demand for a commodity increases when its price decreases.
(a) Law of Diminishing Marginal utility: As the consumer buys more and more of the commodity, the
marginal utility of the additional units falls. Therefore the consumer is willing to pay only lower
prices for additional units. If the price is higher, he will restrict its consumption
(b) Principle of Equi- Marginal Utility: Consumer will arrange his purchases in such a way that the
marginal utility is equal in all his purchases. If it is not equal, they will alter their purchases till the
marginal utility is equal.
(5) Different uses of a commodity: Some commodities have several uses. If the price of the commodity is
high, its use will be restricted only for important purpose. For e.g. when the price of tomato is high, it will
be used only for cooking purpose. When it is cheaper, it will be used for preparing jam, pickle etc...
(6) Psychology of people: Psychologically people buy more of a commodity when its price falls. In other
word it can be termed as price effect.
(7) Tendency of human beings to satisfy unsatisfied wants.
MOVEMENTS ALONG THE DEMAND CURVE VS. SHIFT OF DEMAND CURVE:
ELASTICITY OF DEMAND
The concept of price-elasticity of demand was first of all introduced in economics by Dr. Marshall. It
refers to the degree of responsiveness of quantity demanded to the changes in the determinants of demand.
According to Alfred Marshall: "Elasticity of demand may be defined as the percentage change in quantity
demanded to the percentage change in price."
According to Kenneth Boulding: "Elasticity of demand measures the responsiveness of demand to changes in
price."
As a formula, this is: ε = Percentage Change in Quantity Demanded / Percentage Change in Price
It measures how much buyers respond to a percentage change in the price. Another way to write the formula is:
ε = (dq/q) / (dp/p)
This can be written as: ε = p .dq / q dp
For example: Quantity demanded is 20 units at a price of Rs.500. When there is a fall in price to Rs. 400 it
results in a rise in demand to 32 units. Therefore the change in quantity demanded is12 units resulting from the
change in price of Rs.100.
The Price Elasticity of Demand is = 500 / 20 x 12/100 = 3
Note that the law of demand implies that dq/dp < 0, and so ε will be a negative number. In some contexts, it is common to
introduce a minus sign in this formula to make this quantity positive. Slope (dq/dp) and elasticity (ε) are two different
concepts.
With linear demand curves, elasticity changes along the demand curve, however its slope does not. Elasticity is concerned
with responses in one variable to changes in the other variable. The slope of the curve is concerned with values of the
respective variables at each position along the curve (i.e., its' shape and direction). The elasticity can be measured
between two points on a demand curve (called arc elasticity) or on a point (called point elasticity).

THE DETERMINANTS OF PRICE ELASTICITY OF DEMAND:
The exact value of price elasticity for a commodity is determined by a wide variety of factors. The two
factors considered by economists are the availability of substitutes and time. The better the substitutes for a
product, the higher the price elasticity of demand.. The longer the period of time, the more the price elasticity of
demand for that product. The price elasticity of necessary goods will have lower elasticity than luxuries.
The elasticity of demand depends on the following factors:
(1) Nature of the commodity: The demand for necessities is inelastic because the demand does not change
much with a change in price. But the demand for luxuries is elastic in nature.
(2) Extent of use: A commodity having a variety of uses has a comparatively elastic demand.
(3) Range of substitutes: The commodity which has more number of substitutes has relatively elastic
demand. A commodity with fewer substitutes has relatively inelastic demand.
(4) Income level: People with high incomes are less affected by price changes than people with low incomes.
(5) Proportion of income spent on the commodity: When a small part of income is spent on the
commodity, the price change does not affect the demand therefore the demand is inelastic in nature.
(6) Urgency of demand / postponement of purchase: The demand for certain commodities are highly
inelastic because you cannot postpone its purchase. For example medicines for any sickness should be
purchased and consumed immediately.
(7) Durability of a commodity: If the commodity is durable then it is used it for a long period. Therefore
elasticity of demand is high. Price changes highly influences the demand for durables in the market.
(8) Purchase frequency of a product/ recurrence of demand: The demand for frequently purchased
goods are highly elastic than rarely purchased goods.
(9) Time: In the short run demand will be less elastic but in the long run the demand for commodities are
more elastic.
DEGREES OF PRICE ELASTICITY:
Different commodities have different price elasticity. Some commodities have more elastic demand while
others have relative elastic demand. Basically, the price elasticity of demand ranges from zero to infinity. It can
be equal to zero, less than one, greater than one and equal to unity.

MEASUREMENT OF ELASTICITY OF DEMAND:
1. Total Expenditure Method / Total Revenue Method / Total Outlay Method:
The price elasticity can be measured by noting the changes in total expenditure brought about by changes
in price and quantity demanded.
(i) If no change in total expenditure as change in price than Ed=1
(ii) If total expenditure and price changes in opposite direction Ed>1
(iii) If total expenditure and price changes in same direction Ed<1
Price elasticity
Of Demand
Direction of
price
change
Direction of
quantity
change
Direction of total
revenue change
TR = PQ
ED > 1
(elastic
demand)
P Q TR
P Q TR
ED < 1
(inelastic
demand)
P Q TR
P Q TR
2. Proportionate or Percentage Method:
Under this method elasticity of demand is measured by the ratio of the percentage change in quantity
demanded to the percentage in price.
Ed =
ice
Pr
change in
Percentage
Demanded
Quantity
change in
Percentage
= Ed =
Q
P
P
Q



Where, P = initial price Q= initial quantity ∆Q = Change in Quantity ∆P = Change in price
3. Geometric Method/Point Elasticity Method:
"The measurement of elasticity at a point of the demand curve is called point elasticity". The point
elasticity of demand method is used as a measure of the change in the quantity demanded in response to
a very small change in price. The point elasticity of demand is defined as: "The proportionate change in
the quantity demanded resulting from a very small proportionate change in price".
(i) Measurement of Elasticity on a Linear Demand Curve: The price elasticity of demand can also
be measured at any point on the demand curve. If the demand curve is linear (straight line), it has a
unitary elasticity at the mid point. The total revenue is maximum at this point.
Any point above the midpoint has elasticity greater than 1, (Ed > 1). Here, price reduction leads to
an increase in the total revenue (expenditure). Below the midpoint elasticity is less than 1. (Ed < 1).
Price reduction leads to reduction in the total revenue of the firm.
Graph / Diagram: The elasticity at each point on the demand curve can be traced with the help of
point method as: Ed = Lower Segment / Upper Segment
(ii) Arc Elasticity of Demand (Non Linear Demand Curve):
If the demand curve is non linear, then elasticity at a point can be measured by drawing a tangent
at the particular point. The Arc elasticity measures the "average" elasticity between two points on
the demand curve. The formula is simply (change in quantity/change in price)*(average
price/average quantity). It is defined as: "The average elasticity of a range of points on a demand
curve".
=
in prices
Difference
ces
Sum of pri
ntities
Sum of qua
tes
in quanti
Difference
 =
2
1
2
1
2
1
2
1
p
p
p
p
q
q
q
q





USES OF THE CONCEPT OF ELASTICITY:
The concept of elasticity of demand is of great importance in practical life. Its main points are given as under:
(1) Useful for Business: It enables the business in general and the monopolists in particular to fix the price.
Studying the nature of demand the monopolist fixes higher prices for those goods which have inelastic
demand and lower prices for goods which have elastic demand. In this way, this helps him to maximise his
profit.
(2) Fixation of Prices: It is very useful to fix the price of jointly supplied goods. In the case of joint products
like paddy and straw, the cost of production of each is not known. The price of each is then fixed by its
elastic and inelastic demand.
(3) Helpful to Finance Minister: It helps the Finance Minister to levy tax on goods. After levying taxes more
and more on goods which have inelastic demand, the Government collects more revenue from the people
without causing them inconvenience. Moreover, it is also useful for the planning.

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