CHAPTER 2 THEORY OF DEMAND AND SUPPLY

UNIT 1 – LAW OF DEMAND AND ELASTICITY OF DEMAND

Theories of demand and supply are probably most fundamental concepts of economics and
are the backbone of market economy. Demand and Supply analysis is an extremely powerful
analytical tool. There are two separate laws – i.e. Law of Demand and Law of Supply. Each
works independently of the other.

Meaning of Demand:
‘Demand’ refers to quantity of goods or service that consumers are willing and able to
purchase at various prices during a given period of time. It may be noted that mere desire
to purchase is not demand. Demand must be backed by ability to purchase and willingness
to purchase. Hence, Demand = Desire + Ability + Willingness to purchase a particular
commodity. Unless Desire is backed by Ability and Willingness to purchase, it does not
constitute demand.
Two things are to be noted about quantity demanded.
a) Quantity demanded is always expressed at a given price. At different prices, different
quantities of commodities are generally demanded.
b) Quantity demanded is a flow concept. It is always expressed in relation to time. For
example – 1,000 oranges per day, 50 liters of milk per week etc.

What determines demand?

1) Price of a commodity
Ceteris paribus, i.e. other things remaining constant, the demand for a commodity is
inversely related to price. Price is the most basic factor that affects the demand for a
commodity.

2) Price of related commodities

Related commodities may either imply substitute goods or complementary goods.
➢ Substitute goods are those which can be used in place of one another. Substitute
goods are also called as competing goods. For example – tea and coffee, ink pen and
ball pen etc.
➢ Complementary goods or competing goods are those which are used together or
simultaneously. For example – tea and sugar, cars and petrol, pen and ink etc.
When commodities are substitutes, a fall in the price of one will lead to fall in demand for
the other.
When commodities are complements or competing, a fall in the price of one will lead to
rise in the demand for the other.

Following table summarizes the effect of change in prices of related goods:

Substitute Goods Complementary Goods
Change in Price of Effect on demand of Change in Price of Effect on demand of
substitute goods main commodity complementary goods main commodity
Increase Increase Increase Decrease
Decrease Decrease Decrease Increase

3) Level of Income
Demand for a commodity depends on the level of income of the household. Income and
demand are directly related to each other. The nature of relationship between income
and quantity demanded depends upon the nature of consumer goods. Most of the
consumption goods fall under the category of normal goods. However, there are certain
commodities whose quantity demanded decreases with an increase in income. These
goods are called as inferior goods.

4) Taste and Preferences of Consumers

Tastes and preferences of consumers also affect the demand. In business world, this
concept is termed as brand loyalty. In other words, if a consumer is attached to a
particular brand, he will keep on buying the commodity of that brand even though its
price might increase. Taste and preferences also result in people discarding old goods and
replacing them with new ones although they might have used the old ones for some more
period of time.
It is important to know the concept of Demonstration Effect or bandwagon effect as
well. Demonstration effect is nothing but buying a commodity because others are doing
even though it is not affordable because a consumer feels that it’s a sign of prestige. On
the contrary, when a product becomes common among all, some people decrease or
altogether stop its consumption, this is called Snob Effect. Highly priced goods are
consumed by status seeking rich people to satisfy their need for conspicuous
consumption, this is called Veblen Effect.

5) Size and Composition of Population

Greater the size of population more will be the quantity demanded. The composition of
population also determines what commodities will be demanded by the society.

6) Future Expectations
If a consumer expects a change in price in future, he will change his present demand
accordingly. Thus, a commodity might be bought today even though it is costly, if the
consumer expects that the price is going to rise even further. Also, a commodity might not
be bought today even though it is cheap if the consumer expects a further fall in the price.
Future expectations play a significant part in Share Market transactions.

7) The Level of National Income and its Distribution

When the wealth of a country is unevenly distributed, the propensity to consume of the
Country will be relatively less, because the propensity to consume of the rich people is
Less than that of the poor people and vice versa.
8) Consumer credit facility and interest rates
Low interest rates encourage people to borrow which leads to demand and vice versa.

DEMAND FUNCTION

The demand functions state the relationship between the demand for a product (the
dependent variable) and its determinants (the independent or explanatory variables). A
demand function may be expressed as follows:

𝐷𝑥 = 𝑓(𝑃𝑥, 𝑀, 𝑃𝑦, 𝑃𝑐, 𝑇, 𝐴)

Where; Px = Price of the commodity,
M = Money Income,
Py = Price of its substitute,
Pc = Price of complementary,
T = Consumer taste and preference,
A = Advertisement effect

Law of Demand

Prof. Alfred Marshall has propounded the Law of Demand in his landmark book Principles
of Economics which was published in 1890. The law of demand is one of the most
important laws of economic theory. According to the Law of Demand, other things being
constant, if price of a commodity falls, the quantity demanded of that commodity will
rise and if the price of a commodity rises, the quantity demanded of that commodity
will fall. Thus, there is an inverse relation between price and quantity demanded, other
things being constant.
If other things do not remain constant, the law will not hold true. For example – an increase
in income might lead to increase in demand even though price is higher. Thus, for the law to
hold true, other factors should be constant.

Definition of the Law

Professor Marshall defined the law thus, “the greater the amount to be sold, the smaller must
be the price at which it is offered in order that it may find purchasers or in other words, the
quantity demanded increases with a fall in price and diminishes with a rise in price.

Demand Schedule:
Price Quantity Demanded (Units)
10 6,000
20 4,500
30 3,500
40 1,500
50 1,000
60 500
Demand Curve:

Rationale of the Law of Demand – Why does demand curve slope downward?

1) Law of Diminishing Marginal Utility

According to Marshall people will buy more quantity at a lower price because they want
to equalize the marginal utility of a commodity with its price. Hence a rational consumer
will not pay more for lesser satisfaction. The diminishing marginal utility and equalizing
it with price is the cause for downward sloping demand curve.

2) Substitution Effect
Hicks and Allen have explained the law in terms of substitution effect and income effect.
The result of substitution effect, as seen above, is that total demand for the commodity
whose price has fallen increases leading the demand curve to slope downwards.

3) Income Effect
When price of a commodity falls, a consumer can buy the same quantity of a commodity
with lesser money or he can buy more of the same commodity at same amount of money.
As a result of fall in price of commodity, consumer’s real income or purchasing
power increases.

4) Multi-purpose use and Arrival of new consumer

Certain commodities have multiple uses. If their prices fall they will be used for varied
purposes and demand for such commodities will increase. When the prices of such
commodities are high, they will be put to limited uses only. Thus, different uses of a
commodity make the demand curve slope downward reacting to changes in price. Due to
fall in price of the commodity new consumer are attracted towards markets which leads
to higher demand for the commodity

Exceptions to the Law of Demand

1) Prestige Goods / Articles of Snob Appeal

There are certain articles which are demand by the rich class from the society and their
demand goes up with an increase in price. Such articles do not follow the usual law of
demand. They are also called as conspicuous goods. This was found by Veblen in his
doctrine of “conspicuous consumption’ and hence this effect is called Veblen Effect
(named after American Economist Thorstein Veblen) or Prestige Goods Effect. This is
because some consumers think higher price of a commodity indicates higher utility. For
example – diamonds, expensive jewellery or expensive carpets. Higher the price of
diamonds, higher is the prestige value attached to them and hence higher is the demand
for them.

2) Giffen Goods
Some special varieties of inferior goods are called as Giffen Goods. Sir Robert Giffen, a
Scottish economist and statistician, was surprised to find out that as the price of bread
increased, the British workers purchased more bread and not less of it. This was
something against the law of demand. Why did this happen? The reason given for this is
that when the price of bread went up, it caused such a large decline in the purchasing
power of the poor people that they were forced to cut down the consumption of meat and
other more expensive foods. Since bread, even when its price was higher than before, was
still the cheapest food article, people consumed more of it and not less when its price went
up.
Sir Robert Giffen observed that there are certain goods whose demand does not increase
along with a decrease in price. Generally, those goods which are inferior with no close
substitute easily available and which occupy a substantial place in consumer’s budget
are called Giffen Goods. These goods are inferior goods. Such goods exhibit direct price
demand relationship.

3) Future Expectations about Prices

It is observed that when a consumer expects a price to change in the future, he tends to
change his present consumption and by doing this, he violates the law of demand. For
example - a consumer might delay the purchase of a commodity even though price is low,
for he expects a further fall in the price. This violates the law of demand.

4) Conspicuous necessities
Some goods become necessary for having a good life style, their demand is affected by
demonstration effect and their demand doesn’t show a tendency to fall are items of
conspicuous necessities.

5) Demand for Necessaries

The law of demand does not apply to necessaries of life. Irrespective of price change, people
have to consume minimum quantities of necessary commodities.

6) Speculative Goods
In the speculative market, particularly in stock and share market, more will be demanded
when prices are rising and less will be demanded when prices decline.
Expansion and Contraction of Demand
The law of demand says that when the price of a commodity falls, its quantity demanded
increases, other things being equal. When, as a result of decrease in price, the quantity
demanded increases, it is called as expansion of demand in economics. When as a result
of increase in price, the quantity demanded decreases, it is said that there is contraction of
demand.
Hence, to conclude it can be said that expansion and contraction of demand take place as a
result of changes in price only while all other determinants of demand remain constant.
Increase and Decrease in Demand
As seen above, when demand rises or falls due to change in price only, it is called as
expansion or contraction of demand. In other words, in expansion or contraction, all other
factors like income, tastes, prices of related goods etc. remain constant. These other factors
remaining constant means the position of the demand curve remains the same and the
consumer moves downwards and upwards on it.

Example:
Price Quantity of ‘X’ demanded Quantity of ‘X’ demanded
when average household when average household
income is Rs. 4,000 p.m. income is Rs. 5,000 p.m.
A 5 10 15
B 4 15 20
C 3 20 25
D 2 25 30
E 1 30 35
From the above diagram, it can be concluded that a rise in income shifts the demand curve
to the right and a fall in income will have the opposite effect of shifting the demand
curve to the left.

A rightward shift in demand curve (when A leftward shift in the demand curve
more is demanded at constant price) can (when less is demanded at constant price)
be caused by….. can be caused by….
rise in income A fall in income
a rise in the price of a substitute fall in the price of substitute
a fall in the price of a complement rise in price of a complement
redistribution of income to groups who redistribution of income away from the
favour this commodity. groups who favour this commodity.
a change in taste in favour of this change in taste against this commodity
commodity
an increase in population decrease in population

Movements along Demand Curve vs. Shift of Curve

It is important in economics to make a distinction between a movement along a demand

curve and a shift of whole demand curve.
A movement along a demand curve indicates a change in quantity demanded because of
price changes only, other factors remaining constant. A shift of demand curve indicates
that there is a change in demand at constant price, because of changes in other factors
affecting demand.
Thus, in economics when increase or decrease in demand is referred to, it indicates a shift of
the whole curve because of changes in one or more factors which were assumed to remain
constant.
To conclude, ‘change in demand’ represents shift of demand curve to the right or left resulting
from changes in factors such as income, tastes, prices of other goods etc. and ‘change in
quantity demanded’ represents movement upwards or downwards on the same demand
curve, resulting from change in price of a commodity only.

Elasticity of Demand
Law of demand clarifies that as the prices of goods and services go up, the demand for the
same falls, other things remaining constant. However, law of demand does not answer the
degree of change in quantity demanded. In other words, the law of demand does not tell
us by how much the demand changes.

Elasticity of demand is defined as the responsiveness of the quantity demanded of a good to

changes in one of the variables on which demand depends. These variables can be broadly
classified as price of a commodity, prices of related commodities, income of the consumer
and other factors on which demand depends. In other words, we are talking about three main
types of elasticity of demand, viz.:
a) Price elasticity of demand
b) Income elasticity of demand
c) Cross elasticity of demand

It is to be noted that when we talk of elasticity of demand, unless and until otherwise
mentioned, we are talking of price elasticity of demand.

Price Elasticity of Demand:

Price elasticity of demand expresses the response of quantity demanded of a good to a change
in its price. It is assumed that other things remain constant.

Thus, Price Elasticity of Demand =

Strictly speaking, the value of price elasticity varies from minus infinity to zero, since price
and quantity demanded are inversely related. Since there is an inverse relation between
price and demand, price elasticity is negative. But, for the sake of convenience, the
negative sign is ignored and only the numerical value of elasticity is considered.

Generally, in real world situations, it is observed that demand for goods like phones, TVs,
refrigerators, cars etc is elastic; demand for goods which are necessaries of life is inelastic.
Demand for salt may be perfectly inelastic or relatively inelastic. Demand for medicines
generally is perfectly inelastic.

Interpretation of numerical values of elasticity of demand:

The numerical value of elasticity of demand can assume any value between zero and infinity.
Elasticity is zero, if there is no change at all in quantity demanded when prices changes, i.e.
when quantity demanded do not respond to a price change.
Elasticity Interpretation
Zero – Perfectly Inelastic No change in quantity demanded when price changes.
One – Unitary Elastic % change in quantity demanded is equal to % change in price
Greater than one (> 1) – % change in quantity demanded is greater than % change in
Relatively elastic price
Lesser than one (< 1) – % change in quantity demanded is lower than % change in
Relatively inelastic price
Infinite – Infinitely elastic Small price change changes the demand by infinity.
Slight increase in price – Demand is zero
Slight decrease in price – Demand increases infinitely

Infinite / Perfectly Elastic Demand

When a change in price leads to infinite change in quantity demanded, it is known as
infinite elastic demand. When demand is infinitely elastic, demand curve is a horizontal
straight line parallel to X axis.

Diagram:
Perfectly Inelastic Demand
Irrespective of change in price, demand remains the same. This called as perfectly
inelastic demand. When demand is perfectly inelastic, demand curve is represented
by vertical straight line parallel to Y axis.
Diagram:
Unitary Elastic Demand
When a change in price leads to proportionate change in quantity demanded then
demand is unitary elastic. For example – Price falls by 50% and demand rises by 50%.
Demand curve slopes downward from left to right and it is neither flatter nor
steeper. The demand curve slopes steadily towards the X axis or is a rectangular
hyperbola.
Diagram:
Relatively Elastic Demand
When a change in price leads to more than proportionate change in quantity demanded,
it is known as relatively elastic demand. For example – price falls by 50% and demand
rises by 75%.
The slope of demand curve in this case is flatter.

Diagram:
Relatively Inelastic Demand
When a change in price leads to less than proportionate change in quantity demanded,
it is known as relatively inelastic demand. For example – price falls by 50% and demand
rises by 25%. The slope of demand curve in this case is steeper.

Diagram:
Methods of Computing Price Elasticity:

1. Total Outlay Method of Calculating Price Elasticity:

Prof. Marshall is associated with this method. The price elasticity of demand for a commodity
and the total expenditure or outlay made on it is greatly related to each other. By analyzing
changes in total outlay or expenditure, we can know the price elasticity of demand for the
good. When total expenditure at original price and total expenditure at changed price is
compared, we can compute the elasticity of demand. However, it should be noted that by
this method, we can only say whether the demand for good is elastic or inelastic; we
cannot find out the exact price elasticity.

When, as a result of the change in price of the good, the total expenditure does not change,
i.e. it remains the same; the price elasticity for the good is equal to unity. This is because
total expenditure made on a good can remain the same only if the proportional change in
quantity demanded is equal to proportional change in price. Thus, if there is 100% increase
in price of a good and if the price elasticity is unitary, total expenditure of the buyer of the
good will remain unchanged.

When, as a result of increase in price of a good, the total expenditure made on the good falls
or when as a result of decrease in price, the total expenditure made on good increases, we
say price elasticity of demand is greater than unity.

When, as a result of increase in price of a good, the total expenditure made on the good
increases, or when as a result of decrease in its price, the total expenditure made on the good
falls, we say that price elasticity of demand is less than unity.

Measurement of elasticity by this method can be better understood with the help of the
following example:
Sr. Price (Rs.) Demand (Units) Total Outlay Elasticity
10 12 120
A 8 15 120 Unitary or 1
12 10 120
10 12 120
B 8 20 160 Elastic or > 1
12 8 96
10 12 120
C 8 14 112 Inelastic or < 1
12 11 132
Thus, to summarize

Demand
Elastic Unitary Elastic Inelastic
Price Increases Expenditure Expenditure same Expenditure
decreases increases
Price Decreases Expenditure Expenditure same Expenditure
increases decreases

2. Ratio or Proportionate Method (Discussed Above)

3. Point Method or Geometric Method

Prof. Alfred Marshall has developed yet another method to measure elasticity of demand,
which is known as point or geometric method. At any point on demand curve, elasticity of
demand is measured with the help of following formula:

Point elasticity of demand = Lower segment of the demand curve below the given point
Upper segment of the demand curve above the given point

Or, Price Elasticity of Demand = L / U

Illustration for Point / Geometric Method:

Calculations:
Factors affecting elasticity of demand

1. Availability of substitutes
One of the most important determinants of elasticity is the degree of availability of close
substitutes. It can be said that goods which typically have close or perfect substitutes
have highly elastic demand curves. It should be noted that while as a group a good
may have inelastic demand, but when we consider its various brands, we say that a
particular brand has elastic demand. Thus, for example – demand for petrol is inelastic,
but demand for Indian Oil petrol might be elastic. In other words, if Indian Oil increases
its prices, people might shift to Bharat Petroleum, indicating that demand for a brand is
elastic. Demand for salt is inelastic, but if Tata Salt prices increase, people might shift to
Captain Cook Salt.

2. Position of commodity in consumer’s budget

The greater the proportion of income spent on a commodity, generally greater will be its
elasticity of demand. The demand for goods like common salt, matches is inelastic since
a consumer spends only fraction of his income on them.

3. Nature of need that a commodity satisfies

In general, luxury goods are price elastic while necessaries are price inelastic.

4. Number of uses to which a commodity can be put

The more possible uses of a commodity the greater will be its price elasticity and vice
versa. For example – Milk has many uses. If price decreases, greater quantity will be
bought as it can be used for many purposes.

5. Time period
The longer the time period one has, the more completely one can adjust. Thus, longer time
duration indicates elasticity of demand and a shorter duration indicates inelasticity of
demand.

6. Consumer habits
If a consumer is a habitual consumer of a commodity, no matter how much its price
changes, the demand for the commodity will be inelastic.

7. Tied demand
The demand for those goods which are tied to others is normally inelastic as against those
whose demand is of autonomous nature.

Income Elasticity of Demand

Income elasticity of demand is the degree if responsiveness of quantity demanded of a good
to a change in income of the consumer. It may be noted that there exists a direct
relationship between income and demand of a consumer.
There is a useful relationship between income elasticity of a good and the proportion of
income spent on it. The relationship between two is described in the following three
propositions:
a) If the proportion of income spent on good increases as the income increases, then income
elasticity for the good is greater than one.
b) If the proportion of income spent on good remains the same, then income elasticity of good
is equal to one.
c) If the proportion of income spent on good decreases as income rises, then income elasticity
for good is less than one.

It may be noted that demand for certain goods fall as income increases. These goods are
called as inferior goods.

Cross Elasticity of Demand

Price of related goods and demand

The demand for a particular commodity may change due to changes in the prices of related
goods. These related goods may be either complementary goods or substitute goods. This
type of relationship is studied under ‘Cross Demand’. Cross demand refers to the quantities
of a commodity or service which will be purchased with reference to changes in price, not of
that particular commodity, but of other inter-related commodities, other things remaining
the same.
It may be defined as the quantities of a commodity that consumers buy per unit of time, at
different prices of a ‘related article’, ‘other things remaining the same’. The assumption ‘other
things remaining the same’ means that the income of the consumer and also the price of the
commodity in question will remain constant.

Substitute Products
In the case of substitute commodities, the cross demand curve slopes upwards (i.e. positively)
showing that more quantities of a commodity, will be demanded whenever there is a rise in
the price of a substitute commodity. In the following diagram, the quantity demanded of tea
is given on the X axis. Y axis represents the price of coffee which is a substitute for tea. When
the price of coffee increases, due to the operation of the law of demand, the demand for coffee
falls. The consumers will substitute tea in the place of coffee. The price of tea is assumed to
be constant. Therefore, whenever there is an increase in the price of one commodity, the
demand for the substitute commodity will increase.

Complementary Products

In the case of complementary goods, a change in the price of a good will have an opposite
reaction on the demand for the other commodity which is complementary. For instance, an
increase in demand for pen will necessarily increase the demand for ink. The same is the
case with complementary goods such as bread and butter; car and petrol electricity and
electrical gadgets etc. The cross demand curve in this case is downward sloping (negative
slope).

Whenever there is a fall in the demand for fountain pens due to a rise in prices of fountain
pens, the demand for ink will fall, not because the price of ink has gone up, but because the
price of fountain pen has gone up. So, we -nd that there is an inverse relationship between
price of a commodity and the demand for its complementary good (other things remaining
the same).
Demand Forecasting

An organization faces several internal and external risks, such as high competition, failure
of technology, labour unrest, inflation, recession, and change in government laws.

Therefore, most of the business decisions of an organization are made under the conditions
of risk and uncertainty.

An organization can lessen the adverse effects of risks by determining the demand or sales
prospects for its products and services in future. Demand forecasting is a systematic process
that involves anticipating the demand for the product and services of an organization in
future under a set of uncontrollable and competitive forces.

Some of the popular definitions of demand forecasting are as follows:

According to Evan J. Douglas, “Demand estimation (forecasting) may be defined as a process

of finding values for demand in future time periods.”

In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a
specified future period based on proposed marketing plan and a set of particular
uncontrollable and competitive forces.”

Demand forecasting enables an organization to take various business decisions, such as

planning the production process, purchasing raw materials, managing funds, and deciding
the price of the product. An organization can forecast demand by making own estimates
called guess estimate or taking the help of specialized consultants or market research
agencies. Let us discuss the significance of demand forecasting in the next section.

Significance of Demand Forecasting:

Demand plays a crucial role in the management of every business. It helps an organization
to reduce risks involved in business activities and make important business decisions. Apart
from this, demand forecasting provides an insight into the organization’s capital investment
and expansion decisions.

The significance of demand forecasting is shown in the following points:

i. Fulfilling objectives:

Implies that every business unit starts with certain pre-decided objectives. Demand
forecasting helps in fulfilling these objectives. An organization estimates the current demand
for its products and services in the market and move forward to achieve the set goals.

For example, an organization has set a target of selling 50, 000 units of its products. In such
a case, the organization would perform demand forecasting for its products. If the demand
for the organization’s products is low, the organization would take corrective actions, so that
the set objective can be achieved.

ii. Preparing the budget:

Plays a crucial role in making budget by estimating costs and expected revenues. For
instance, an organization has forecasted that the demand for its product, which is priced at
Rs. 10, would be 10, 00, 00 units. In such a case, the total expected revenue would be 10*
100000 = Rs. 10, 00, 000. In this way, demand forecasting enables organizations to prepare
their budget.

iii. Stabilizing employment and production:

Helps an organization to control its production and recruitment activities. Producing

according to the forecasted demand of products helps in avoiding the wastage of the
resources of an organization. This further helps an organization to hire human resource
according to requirement. For example, if an organization expects a rise in the demand for
its products, it may opt for extra labour to fulfil the increased demand.

iv. Expanding organizations:

Implies that demand forecasting helps in deciding about the expansion of the business of the
organization. If the expected demand for products is higher, then the organization may plan
to expand further. On the other hand, if the demand for products is expected to fall, the
organization may cut down the investment in the business.

v. Taking Management Decisions:

Helps in making critical decisions, such as deciding the plant capacity, determining the
requirement of raw material, and ensuring the availability of labor and capital.

vi. Evaluating Performance:

Helps in making corrections. For example, if the demand for an organization’s products is
less, it may take corrective actions and improve the level of demand by enhancing the quality
of its products or spending more on advertisements.

vii. Helping Government:

Enables the government to coordinate import and export activities and plan international
trade.

Objectives of Demand Forecasting:

Demand forecasting constitutes an important part in making crucial business decisions.

The objectives of demand forecasting are divided into short and long-term objectives, which
are shown in Figure-1:
The objectives of demand forecasting (as shown in Figure-1) are discussed as follows:

i. Short-term Objectives:

Include the following:

a. Formulating production policy:

Helps in covering the gap between the demand and supply of the product. The demand
forecasting helps in estimating the requirement of raw material in future, so that the regular
supply of raw material can be maintained. It further helps in maximum utilization of
resources as operations are planned according to forecasts. Similarly, human resource
requirements are easily met with the help of demand forecasting.

b. Formulating price policy:

Refers to one of the most important objectives of demand forecasting. An organization sets
prices of its products according to their demand. For example, if an economy enters into
depression or recession phase, the demand for products falls. In such a case, the organization
sets low prices of its products.

c. Controlling sales:

Helps in setting sales targets, which act as a basis for evaluating sales performance. An
organization make demand forecasts for different regions and fix sales targets for each region
accordingly.

d. Arranging finance:

Implies that the financial requirements of the enterprise are estimated with the help of
demand forecasting. This helps in ensuring proper liquidity within the organization.

ii. Long-term Objectives:

Include the following:

a. Deciding the production capacity:

Implies that with the help of demand forecasting, an organization can determine the size of
the plant required for production. The size of the plant should conform to the sales
requirement of the organization.

b. Planning long-term activities:

Implies that demand forecasting helps in planning for long term. For example, if the
forecasted demand for the organization’s products is high, then it may plan to invest in
various expansion and development projects in the long term.

Factors Influencing Demand Forecasting:

Demand forecasting is a proactive process that helps in determining what products are
needed where, when, and in what quantities. There are a number of factors that affect
demand forecasting.

Some of the factors that influence demand forecasting are shown in Figure-2:

The various factors that influence demand forecasting (“as shown in Figure-2) are explained
as follows:

i. Types of Goods:

Affect the demand forecasting process to a larger extent. Goods can be producer’s goods,
consumer goods, or services. Apart from this, goods can be established and new goods.
Established goods are those goods which already exist in the market, whereas new goods are
those which are yet to be introduced in the market.

Information regarding the demand, substitutes and level of competition of goods is known
only in case of established goods. On the other hand, it is difficult to forecast demand for the
new goods. Therefore, forecasting is different for different types of goods.

ii. Competition Level:

Influence the process of demand forecasting. In a highly competitive market, demand for
products also depend on the number of competitors existing in the market. Moreover, in a
highly competitive market, there is always a risk of new entrants. In such a case, demand
forecasting becomes difficult and challenging.

iii. Price of Goods:

Acts as a major factor that influences the demand forecasting process. The demand forecasts
of organizations are highly affected by change in their pricing policies. In such a scenario, it
is difficult to estimate the exact demand of products.

iv. Level of Technology:

Constitutes an important factor in obtaining reliable demand forecasts. If there is a rapid

change in technology, the existing technology or products may become obsolete. For example,
there is a high decline in the demand of floppy disks with the introduction of compact disks
(CDs) and pen drives for saving data in computer. In such a case, it is difficult to forecast
demand for existing products in future.

v. Economic Viewpoint:

Play a crucial role in obtaining demand forecasts. For example, if there is a positive
development in an economy, such as globalization and high level of investment, the demand
forecasts of organizations would also be positive.

Types of Forecasts

Forecasts can be of three types, which are explained as follows:

1. Short Period Forecasts:

Refer to the forecasts that are generally for one year and based upon the judgment of the
experienced staff. Short period forecasts are important for deciding the production policy,
price policy, credit policy, and distribution policy of the organization.

2. Long Period Forecasts:

Refer to the forecasts that are for a period of 5-10 years and based on scientific analysis and
statistical methods. The forecasts help in deciding about the introduction of a new product,
expansion of the business, or requirement of extra funds.

3. Very Long Period Forecasts:

Refer to the forecasts that are for a period of more than 10 years. These forecasts are carried
to determine the growth of population, development of the economy, political situation in a
country, and changes in international trade in future.

Among the aforementioned forecasts, short period forecast deals with deviation in long period
forecast. Therefore, short period forecasts are more accurate than long period forecasts.

4. Level of Forecasts:

Influences demand forecasting to a larger extent. A demand forecast can be carried at three
levels, namely, macro level, industry level, and firm level. At macro level, forecasts are
undertaken for general economic conditions, such as industrial production and allocation of
national income. At the industry level, forecasts are prepared by trade associations and based
on the statistical data.
Moreover, at the industry level, forecasts deal with products whose sales are dependent on
the specific policy of a particular industry. On the other hand, at the firm level, forecasts are
done to estimate the demand of those products whose sales depends on the specific policy of
a particular firm. A firm considers various factors, such as changes in income, consumer’s
tastes and preferences, technology, and competitive strategies, while forecasting demand for
its products.

5. Nature of Forecasts:

Constitutes an important factor that affects demand forecasting. A forecast can be specific
or general. A general forecast provides a global picture of business environment, while a
specific forecast provides an insight into the business environment in which an organization
operates. Generally, organizations opt for both the forecasts together because over-
generalization restricts accurate estimation of demand and too specific information provides
an inadequate basis for planning and execution.

Steps of Demand Forecasting:

The Demand forecasting process of an organization can be effective only when it is conducted
systematically and scientifically.

It involves a number of steps, which are shown in Figure-3:

The steps involved in demand forecasting (as shown in Figure-3) are explained as follows:

1. Setting the Objective:

Refers to first and foremost step of the demand forecasting process. An organization needs
to clearly state the purpose of demand forecasting before initiating it.

Setting objective of demand forecasting involves the following:

a. Deciding the time period of forecasting whether an organization should opt for short-term
forecasting or long-term forecasting

b. Deciding whether to forecast the overall demand for a product in the market or only- for
the organizations own products

c. Deciding whether to forecast the demand for the whole market or for the segment of the
market

d. Deciding whether to forecast the market share of the organization

2. Determining Time Period:

Involves deciding the time perspective for demand forecasting. Demand can be forecasted for
a long period or short period. In the short run, determinants of demand may not change
significantly or may remain constant, whereas in the long run, there is a significant change
in the determinants of demand. Therefore, an organization determines the time period on the
basis of its set objectives.

3. Selecting a Method for Demand Forecasting:

Constitutes one of the most important steps of the demand forecasting process Demand can
be forecasted by using various methods. The method of demand forecasting differs from
organization to organization depending on the purpose of forecasting, time frame, and data
requirement and its availability. Selecting the suitable method is necessary for saving time
and cost and ensuring the reliability of the data.

4. Collecting Data:

Requires gathering primary or secondary data. Primary’ data refers to the data that is
collected by researchers through observation, interviews, and questionnaires for a particular
research. On the other hand, secondary data refers to the data that is collected in the past;
but can be utilized in the present scenario/research work.

5. Estimating Results:

Involves making an estimate of the forecasted demand for predetermined years. The results
should be easily interpreted and presented in a usable form. The results should be easy to
understand by the readers or management of the organization.

DEMAND DISTINCTIONS

Certain important demand distinctions are as follows:

a. Producer’s goods and Consumer’s goods

b. Durable goods and Non-durable goods

c. Derived demand and Autonomous demand

d. Industry demand and Company demand

e. Short-run demand and Long-run demand

a. Producer’s goods and Consumer’s goods

Producer’s goods are those which are used for the production of other goods- either
consumer goods or producer goods themselves. Examples of such goods are machines
locomotives, ships etc. Consumer’s goods are those which are used for final consumption.
Examples of consumer’s goods are readymade clothes, prepared food, residential-
houses, etc.
b. Durable goods and Non-durable goods

Consumer’s goods may be further sub-divided into durable and non-durable goods
Non- durable consumer goods are those which cannot be consumed more than once
for example bread, milk etc. These will meet only the current demand. On the other hand,
Durable consumer goods are those which can be consumed more than once over a period
time, example, car, refrigerator, ready-made shirt, and
umbrella. The demand for durable goods is likely to be derived demand.

c. Derived demand and Autonomous demand

When a product is demanded consequent on the purchase of a parent product, its demand
is called derived demand. For example, the demand for cement is derived demand, being d
irectly related to building activity. If the demand for a product is independent
of the demand for other goods, then it is called autonomous demand.
But this distinction is purely arbitrary and it is very difficult to find out which product is
entirely independent of other products.

d. Industry demand and Company demand

The term industry demand is used to denote the total demand for the products of a partic
ular industry, e.g. the total demand for steel in the country. On the other hand, the term
company demand denotes the demand for the products of a particular company,
e.g. demand for steel produced by the Tata Iron and Steel Company.

e. Short –run demand and Long-run demand

Short run Demand refers to demand with its immediate reaction to price changes,
income fluctuations, etc., whereas long-run demand is that which will ultimately exist as
a result of changes in pricing, promotion or product improvement, after enough time is
allwed to let the market adjust to the new situation. For example, if electricity rates are
reduced, in the short run, the existing users will make greater use of electric appliances. In
the long run, more and more people will be induced to use electric appliances.

Methods of Demand Forecasting

Definition: Demand Forecasting is a systematic and scientific estimation of future demand

for a product. Simply, estimating the sales proceeds or demand for a product in the future is
called as demand forecasting.

There are several methods of demand forecasting applied in terms of; the purpose of
forecasting, data required, data availability and the time frame within which the demand is
to be forecasted. Each method varies from one another and hence the forecaster must select
that method which best suits the requirement.

There is no easy or simple formula to forecast the demand. Proper judgment along with the
scientific formula is needed to correctly predict the future demand for a product or service.
Some methods of demand forecasting are discussed below:
1] Survey of Buyer’s Choice
When the demand needs to be forecasted in the short run, say a year, then the most feasible
method is to ask the customers directly that what are they intending to buy in the forthcoming
time period. Thus, under this method, potential customers are directly interviewed.
This survey can be done in any of the following ways:

a. Complete Enumeration Method: Under this method, nearly all the potential buyers are
asked about their future purchase plans.

b. Sample Survey Method: Under this method, a sample of potential buyers are chosen
scientifically and only those chosen are interviewed.

c. End-use Method: It is especially used for forecasting the demand of the inputs. Under
this method, the final users i.e. the consuming industries and other sectors are
identified. The desirable norms of consumption of the product are fixed, the targeted
output levels are estimated and these norms are applied to forecast the future demand
of the inputs.
Hence, it can be said that under this method the burden of demand forecasting is on the buyer.
However, the judgments of the buyers are not completely reliable and so the seller should take
decisions in the light of his judgment also.

The customer may misjudge their demands and may also change their decisions in the future
which in turn may mislead the survey. This method is suitable when goods are supplied in bulk
to industries but not in the case of household customers.

2] Collective Opinion Method

Under this method, the salesperson of a firm predicts the estimated future sales in their region.
The individual estimates are aggregated to calculate the total estimated future sales. These
estimates are reviewed in the light of factors like future changes in the selling price, product
designs, changes in competition, advertisement campaigns, the purchasing power of the
consumers, employment opportunities, population, etc.

The principle underlying this method is that as the salesmen are closest to the consumers they
are more likely to understand the changes in their needs and demands. They can also easily
find out the reasons behind the change in their tastes.

Therefore, a firm having good sales personnel can utilize their experience to predict the
demands. Hence, this method is also known as Salesforce opinion or Grassroots approach
method. However, this method depends on the personal opinions of the sales personnel and is
not purely scientific.

3] Barometric Method

This method is based on the past demands of the product and tries to project the past into the
future. The economic indicators are used to predict the future trends of the business. Based on
future trends, the demand for the product is forecasted. An index of economic indicators is
formed. There are three types of economic indicators, viz. leading indicators, lagging indicators,
and coincidental indicators.

The leading indicators are those that move up or down ahead of some other series. The lagging
indicators are those that follow a change after some time lag. The coincidental indicators are
those that move up and down simultaneously with the level of economic activities.

4] Market Experiment Method

Another one of the methods of demand forecasting is the market experiment method. Under
this method, the demand is forecasted by conducting market studies and experiments on
consumer behaviour under actual but controlled, market conditions.

Certain determinants of demand that can be varied are changed and the experiments are done
keeping other factors constant. However, this method is very expensive and time-consuming.

5] Expert Opinion Method

Usually, market experts have explicit knowledge about the factors affecting demand. Their
opinion can help in demand forecasting. The Delphi technique, developed by Olaf Helmer is one
such method.

Under this method, experts are given a series of carefully designed questionnaires and are asked
to forecast the demand. They are also required to give the suitable reasons. The opinions are
shared with the experts to arrive at a conclusion. This is a fast and cheap technique.

6] Statistical Methods
The statistical method is one of the important methods of demand forecasting. Statistical
methods are scientific, reliable and free from biases. The major statistical methods used for
demand forecasting are:

a. Trend Projection Method: This method is useful where the organization has a sufficient
amount of accumulated past data of the sales. This date is arranged chronologically to
obtain a time series. Thus, the time series depicts the past trend and on the basis of it,
the future market trend can be predicted. It is assumed that the past trend will continue
in the future. Thus, on the basis of the predicted future trend, the demand for a product
or service is forecasted.

b. Regression Analysis: This method establishes a relationship between the dependent

variable and the independent variables. In our case, the quantity demanded is the
dependent variable and income, the price of goods, the price of related goods, the price
of substitute goods, etc. are independent variables. The regression equation is derived
assuming the relationship to be linear. Regression Equation: Y = a + bX. Where Y is the
forecasted demand for a product or service.
PART B – THEORY OF SUPPLY
Introduction:
The term supply refers to amount of goods or services that the producers are willing and able
to offer to the market at various prices during a period of time. Two important points apply
to supply:
a) Supply refers to what firms offer for sale, not necessarily to what they succeed in selling.
What is offered for sale may not get sold.
b) Supply is a flow. The quantity supplied is ‘so much’ per unit of time, per day, per week
etc.

Determinants of Supply:
Although price is the primary determinant of supply, various other factors also affect the level
of supply. These are discussed below:

a) Price of the Good

Other things being equal, the higher the relative price of a good, the greater is the
quantity of it that will be supplied. This is because goods are produced by the firms to
earn profits, and therefore, profits rise if the price of a product rises.

b) Price of Related Goods

If the prices of other goods rise, they become relatively more profitable than the goods in
question. It implies that if price of Y commodity rises, the quantity supplied of X
commodity will fall.

c) Prices of Factors of Production

A rise in the price of factors of production will cause an increase in the cost of making
those goods that use a great deal of that factor. Since cost of production increases, the
profitability will be lower and hence the supplier will prefer that commodity which uses
lesser of the factor whose price has risen. Hence increase in cost of production reduces
the supply for that commodity.

d) State of technology
The supply of a particular product depends upon the state of technology also. Inventions
and innovations make it possible to produce more or better quality goods with same
resources and thus they tend to increase quantity supplied of some products and to
reduce the quantity supplied of products that are displaced.

e) Government Policy
The production of a good may be subject to imposition of commodity taxes like excise
duty, customs duty, sales tax etc. These raise the cost of production and hence quantity
supplied would increase only if the price of the goods in market increases. Subsidies, on
the other hand, reduce the cost of production and thus provide incentive to the firm to
increase its supply.
f) Nature of competition and size of Industry
Under Competitive conditions supply will be more, similarly when there are large no of
the firms supply will be more.

Law of Supply
This refers to the relationship of quantity supplied of a good with one or more related variables
which have an influence on supply. The main variable that influences the supply is the price
of the commodity in question. Other things remaining constant, as price of the commodity
increases, there is more supply of that commodity in the market and the supply falls if there
is decrease in the price of the commodity. This behaviour of producers is studied under the
law of supply.

Law of supply can be better understood with the help of Table:

Price (in Rs.) Quantity (in units)
1 10
2 20
3 30
4 40
5 50

Diagram:

The table clearly shows that more and more units of the commodity are being offered for sale
as the price of the commodity is increased. As seen in figure above, supply curve SS slope
upwards from left to right, indicating direct relationship between price and quantity supplied.

Assumptions of Law of Supply:

While stating law of supply the phrase ‘keeping other factors constant or ceteris paribus’ is
used. This phrase is used to cover the following assumptions on which the law is based:
1. Price of other goods is constant;
2. There is no change in the state of technology;
3. Prices of factors of production remain the same;
4. There is no change in the taxation policy;
5. Goals of the producer remain the same.

Reasons for Law of Supply:

The main reasons for operation of law of supply are:

1. Profit Motive:
The basic aim of producers, while supplying a commodity, is to secure maximum profits.
When price of a commodity increases, without any change in costs, it raises their profits. So,
producers increase the supply of the commodity by increasing the production. On the other
hand, with fall in prices, supply also decreases as profit margin decreases at low prices.

2. Change in Number of Firms:

A rise in price induces the prospective producers to enter into the market to produce the
given commodity so as to earn higher profits. Increase in number of firms raises the market
supply. However, as the price starts falling, some firms which do not expect to earn any
profits at a low price either stop the production or reduce it. It reduces the supply of the given
commodity as the number of firms in the market decreases.

3. Change in Stock:
When the price of a good increases, the sellers are ready to supply more goods from their
stock. However, at a relatively lower price, the producers do not release big quantities from
their stocks. They start increasing their inventories with a view that price may rise in near
future.

Exceptions to Law of Supply:

As a general rule, supply curve slopes upwards, showing that quantity supplied rises with a
rise in price. However, in certain cases, positive relationship between supply and price may
not hold true. The various exceptions to the law of supply are:

1. Future Expectations:
If sellers expect a fall in price in the future, then the law of supply may not hold true. In this
situation, the sellers will be willing to sell more even at a lower price. However, if they expect
the price to rise in the future, they would reduce the supply of the commodity, in order to
supply the commodity later at a high price.

2. Agricultural Goods:
The law of supply does not apply to agricultural goods as their production depends on
climatic conditions. If, due to unforeseen changes in weather, the production of agricultural
products is low, then their supply cannot be increased even at higher prices.

3. Perishable Goods:
In case of perishable goods, like vegetables, fruits, etc., sellers will be ready to sell more even
if the prices are falling. It happens because sellers cannot hold such goods for long.

4. Rare Articles:
Rare, artistic and precious articles are also outside the scope of law of supply. For example,
supply of rare articles like painting of Mona Lisa cannot be increased, even if their prices are
increased.

5. Backward Countries:
In economically backward countries, production and supply cannot be increased with rise in
price due to shortage of resources.

6. Savings
Normally, when the rate of interest rises, saving increases. But some people want to have
fixed regular income by way of interest. They might save less at higher rate of interest and
save more at lower rate of interest.

7. Labour Supply
In case of labour, as wage rate rises, the supply of labour (i.e. number of hours the labour is
willing to work) would also rise. So the supply curve slopes upwards, but the supply of labour
decreases, with a further rise in the wage rate. Thereafter, supply curve of labour slopes
backward. This is because the worker would prefer leisure to work after receiving higher
amount of wages. Thus, after a certain point, when wage rate continues to rise, the labour
supply tends to fall.

Backward bending labour-supply curve:

Change in Supply:
When supply of a commodity changes due to changes in other factors at the same price, it is
known as ‘change in supply.’ Change in supply may be:
a) Increase in Supply; or
b) Decrease in Supply

Increase in Supply: Increase in Supply refers to rise in the supply of a given commodity due
to favorable changes in other factors such as decrease in the prices of inputs, decrease in
tax, technological upgradation etc. price remaining constant. The supply curve shifts to
the right of the original supply curve.

Decrease in Supply: Decrease in Supply refers to fall in supply of a commodity due to

unfavorable changes in other factors such as increase in the prices of inputs, increase in
taxes, technological degradation etc. price remaining constant. The supply curve shifts to
the left of the original supply curve.

Diagrammatic Representation:

Increase in Supply Decrease in Supply

In the above diagram, quantity supplied is In the above diagram, quantity supplied is
shown on X axis and price on Y axis. shown on X axis and price on Y axis.

Variation in Supply:
When a quantity supplied of a commodity changes due to change in its price, other factors
remaining constant, it is called as variation in supply. In variation in supply, there is
movement on the same supply curve instead of complete shift of supply curve as in the case
of change of supply.
Variation can be further classified into:

a) Extension of Supply
It refers to the rise in supply due to rise in price of the commodity, other things remaining
constant. Extension of supply is also known as expansion of supply. Extension of supply
leads to an upward movement along the same supply curve.

b) Contraction of Supply
It refers to the fall in supply due to fall in price of the commodity, other things remaining
constant. Contraction of supply leads to downward movement along the same supply
curve.

Diagrammatic Representation:

Extension in Supply Contraction in Supply

Determination of Equilibrium Price and Quantity

In context of demand and supply, equilibrium is a situation in which quantity demanded

equals quantity supplied. The market clears itself and becomes stable (that is, at the market
equilibrium, every consumer who wishes to purchase the product at the market price is able
to do so, and the supplier is not left with any unwanted inventory).

Equilibrium price is the price at which the demand is equal to supply. Law of demand and
law of supply explain separately the ‘plans’ of consumers as to how much they would buy at
a given price and the ‘plans’ of producers as to how much they would offer for sale at the
given price. The demand curve and the supply curve really show what consumers and
producers would do if they were given the opportunity.

Although the demand would be very high at lower prices but in practice consumers may
never get the opportunity to buy the product at that low price because suppliers are not
willing to supply at that price. Similarly, although suppliers may be prepared to offer a large
amount for sale at a high price, they may not be able to sell it at all because the consumers
are not willing to buy at that price.

The demand for a product and the supply of a product are two sides of the market, and it is
necessary to bring these together to establish equilibrium in the market which is the point
where both the sides of the market are satisfied simultaneously. This can be better
understood with the help of the following illustration. Let us take demand and supply
schedule for good X and analyze equilibrium position. Equilibrium price is Rs. 40 and
equilibrium quantity is 9000 units.

Per unit Price of Quantity Quantity Supplied Description

Commodity X Demanded (Units) (Units)
10 12,000 3,000 Excess Demand
20 11,000 5,000 Excess Demand
30 10,000 7,000 Excess Demand
40 9,000 9,000 Demand = Supply
50 7,000 11,000 Excess Supply
60 5,000 13,000 Excess Supply
Graphical Representation of Equilibrium Point:

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

Effect of Change in Conditions of Demand and Supply on Market Price

The market price, or equilibrium price, is determined by the interaction of demand and
supply curves. The demand curve and the supply curve for a commodity are drawn up on
the assumption that all other factors which might affect the demand or supply of the
commodity remain constant. The equilibrium price will remain stable in the market as long
as these other factors of demand and supply do not change. If any of these factors change,
this will create excess demand or excess supply and so initial equilibrium price will also
change.

For example, a condition of drawing a demand curve is that level of income does not change.
If the level of income increases, there will be an increase in demand for a commodity X at the
existing market price. Hence, if the price remains the same, supply will be the same as before,
and with increased demand there will be a shortage, causing pressure on the existing price,
which suppliers will then raise. On other hand, if consumer’s level of income decreases, other
things remaining constant, with decreased demand there will be deficient demand/excess
supply, causing existing price to fall.
Remember,

– Excess demand for a commodity will cause a rise in its price.

– Excess supply of a commodity will cause a fall in its price.
– Price will settle at one point where the quantity demanded equals the quantity supplied—
the equilibrium price.
– An increase in demand (a movement of the demand curve to the right) will cause a rise in
price and a rise in the quantity bought and sold.
– A decrease in demand (a movement of the demand curve to the left) will cause a fall in
price and a fall in the quantity bought and sold.
– An increase in supply (a movement of the supply curve to the right) will cause a fall in
price and a rise in the quantity bought and sold.
– A decrease in supply (a movement of the supply curve to the left) will cause a rise in price
and a fall in the quantity bought and sold.

Effect of Change in Demand on the Market Price

This effect can be represented diagrammatically as follows:
In the above figure, the shift in demand curve from DD to D’D’ shows the effect of an increase
in demand as a result of an increase in consumers’ income levels. Before the increase in
demand, the equilibrium is shown by point E and equilibrium price was P0 and the
equilibrium output was Q0. With the increase in demand, demand curve shifted to D’D’. As
a result of the increase in demand, excess demand occurs at the price P0, causing suppliers
to expand output and raise the market price. As a result, excess demand got created resulting
in increase in price and quantity supplied. A new equilibrium (shown by point E) is
established at price P1 and at output Q1. Notice that a change in conditions of demand does
not cause a movement of the supply curve – this could only result from changes in conditions
of supply.
Effect of Change in Supply on Market Price
This effect can be represented diagrammatically as follows:
In Figure above, the supply curves SS and S’S’ show the effect of an increase in supply as a
result of a favorable change in the conditions of supply (such as a reduction in the costs of
production because of productivity improvements) — S’S’ being the new supply curve. Before
the increase in supply, the equilibrium price was P0 and the equilibrium output was Q0. As
a result of the increase in supply, excess supply occurs at the price P0, causing suppliers to
lower the price in order to expand demand. A new equilibrium price is established at P1 with
a higher equilibrium output at Q1. Notice again that a change in conditions of supply does
not cause a shift in the demand curve.

Elasticity of Supply

1. Perfectly Elastic Supply:

When there is an infinite supply at a particular price and the supply becomes zero with a
slight fall in price, then the supply of such a commodity is said to be perfectly elastic. In such
a case Es = ∞ and the supply curve is a c horizontal straight line parallel to the X-axis
Table: Perfectly Elastic Supply:
Price (in Rs.) Supply (in units)
30 100
30 200
30 300

Quantity supplied can be 100, 200 or 300 units at the same price of Rs. 30. As seen in the
diagram, quantity supplied can be OQ or OQ1or OQ2 at the same price of OP. It must be
noted that perfectly elastic supply is an imaginary situation.
2. Perfectly Inelastic Supply:
When the supply does not change with change in price, then supply for such a commodity is
said to be perfectly inelastic. In such a case, E s = 0 and the supply curve (SS) is a vertical
straight line parallel to the Y-axis as shown s in Fig

Table: Perfectly Inelastic Supply:

Price (in Rs.) Supply (in units)
20 20
30 20
40 20

Quantity supplied remains same at 20 units, whether the price is Rs. 20, Rs. 30 or 140. As
seen in the diagram, quantity supplied remains the same at OQ, with change in price from
OP to OP1 or OP2. It must be noted that perfectly inelastic supply is an imaginary situation.

3. Highly Elastic Supply:

When percentage change in quantity supplied is more than the percentage change in price,
then supply for such a commodity is said to be highly elastic. In such a case, E s > 1 and the
supply curve has an intercept on the Y-axis as shown in Fig.

Table: Highly Elastic Supply:

Price (in Rs.) Supply (in units)
10 100
15 200

As seen in the schedule, the quantity supplied rises by 100% due to a 50% rise in price. In
Figure, the quantity supplied rises from OQ to OQ1 with rise in price from OP to OP1. As
QQ1 is proportionately more than PP1 elasticity of supply is more than 1.

4. Less Elastic Supply:

When percentage change in quantity supplied is less than the percentage change in price,
then supply for such a commodity is said to be less elastic. In such a case, E s < 1 and the
supply curve has an intercept on the X-axis as shown in Fig.

Table: Less Elastic Supply:

Price (in Rs.) Supply (in units)
10 100
15 120

In Table, the quantity supplied rises by 20 % due to 50% rise in price. In Figure, the quantity
supplied rises from OQ to OQ1 with rise in price from OP to OP1. As QQ1 is proportionately
less than PP1, elasticity of supply is less than 1.

5. Unitary Elastic Supply:

When percentage change in quantity supplied is equal to percentage change in price, then
supply for such a commodity is said to the unitary elastic. In such a case, E s = 1 and supply
curve is a straight line passing through the origin as shown in Fig.

Table: Unitary Elastic Supply:

Price (in Rs.) Supply (in units)
10 100
15 150

In Table given above, the quantity supplied also rises by 50% due to 50% rise in price. In Fig.
9.27, the quantity supplied rises from OQ to OQ1 with rise in price from OP to OP1. As QQX is
proportionately equal to PP1, elasticity of supply is equal to 1.

Quick Recap – Coefficients of Es:

PART C – THEORY OF CONSUMER BEHAVIOUR
Meaning of Human Wants:
“Man is a bundle of desires.” In common language, there is not much difference between a
‘desire’ and a ‘want.’ But in economics, there is difference between a ‘desire’ and a ‘want’.

Every desire cannot be a want. If a poor person desires to have a car, his desire cannot be
called a want. A desire can become a want only when a consumer has the means (i.e. money)
to purchase the thing and he is also ready to spend the means (money). For a desire to
become a want, the following four elements must be present.

1. The desire for a thing.

2. Efforts to satisfy the desire.

3. The means (i.e. money) to purchase the thing.

4. Readiness to spend the means (i.e. money) to satisfy the desire.

Characteristics of Human Wants:

Human wants have certain characteristics or features, which can be explained as below.

1. Wants are Unlimited:

Man is a bundle of wants and his wants are numerous. Man remains busy throughout his
life in order to satisfy these wants. When one want is satisfied, another want crops up. In
this way, wants arise one after another. The second want arises after the satisfaction of the
first want, the third after the second and so on. This endless circle of wants continues
throughout human life. Thus wants are unlimited.

The importance of this characteristic lies in the fact that wants are unlimited and men are
always busy in making efforts to satisfy their wants. This is the main reason of the continuous
economic progress in the world.

2. Each Particular Want can be satisfied:

We cannot satisfy all our wants because the means to satisfy them are limited. But a person
can satisfy a particular want. For example, hunger can be satisfied by taking food. He may
take one, two, three or more pieces of bread. Ultimately, he will say that he does not want
more bread.

3. Wants are Competitive:

We can satisfy only a few wants and not all wants because our means are limited. Therefore,
we always have to make a relative comparison of the intensity of our different wants. Only
that want is satisfied first which is the most urgent.

4. Wants are Complementary:

Wants are competitive but a few wants are complementary to each other. To satisfy one want
for a good, we have to arrange for another good also.

5. Some Wants are both Competitive and Complementary:

Certain wants are competitive as well as complementary to each other. For instance,
labourers are required to operate machines. Therefore, the demand for labour is a
complementary want for machines. But, at the same time, machines can be used in place of
labour for the production of goods. Here, machines reduce the want for labour and thus
wants for machine and labour are also competitive to each other.

6. Some Wants Recur:

Most wants recur. If they are satisfied once, they arise again after a certain period. We take
food and our hunger is satisfied. But after a few hours, we again feel hungry, and we have to
satisfy our hunger every time with food. Therefore, hunger, thirst, etc. are such wants which
occur time and again.

7. Some Wants become Habits:

Certain wants become habits. For example, the continuous use of opium, liquor, cigarettes,
etc. become habits.

8. Wants are Alternative:

Some wants are alternative. We can satisfy our hunger either with rice, bread, vegetables,
fruit, meat, eggs, milk, etc.

Meaning of Utility:
Utility refers to want satisfying power of a commodity. It is the satisfaction, actual or
expected, derived from the consumption of a commodity. Utility differs from person- to-
person, place-to-place and time-to-time. In the words of Prof. Hobson, “Utility is the ability
of a good to satisfy a want”.

According to classical economists, utility can be measured, in the same way, as weight or
height is measured. For this, economists assumed that utility can be measured in cardinal
(numerical) terms. By using cardinal measure of utility, it is possible to numerically
estimate utility, which a person derives from consumption of goods and services. But, there
was no standard unit for measuring utility. So, the economists derived an imaginary
measure, known as ‘Util’. Utils are imaginary and psychological units which are used to
measure satisfaction (utility) obtained from consumption of a certain quantity of a
commodity.

Utils cannot be taken as a standard unit for measurement as it will vary from individual to
individual. Hence, several economists including Marshall, suggested the measurement of
utility in monetary terms. It means, utility can be measured in terms of money or price,
which the consumer is willing to pay.

Total Utility (TU):

Total utility refers to the total satisfaction obtained from the consumption of all possible
units of a commodity. It measures the total satisfaction obtained from consumption of all
the units of that good.
TU can be calculated as:
TUn = U1 + U2 + U3 +……………………. + Un
Where:

TUn = Total utility from n units of a given commodity

U1, U2, U3,……………. Un = Utility from the 1st, 2nd, 3rd nth unit
n = Number of units consumed

Marginal Utility (MU):

Marginal utility is the additional utility derived from the consumption of one more unit of
the given commodity. It is the utility derived from the last unit of a commodity purchased.
In the words of Chapman, “Marginal utility is addition made to total utility by consuming
one more unit of a commodity”.

MU can be calculated as: MUn = TUn – TUn-1

Where: MUn = Marginal utility from nth unit; TUn = Total utility from n units;
TUn-1 = Total utility from n – 1 units; n = Number of units of consumption

ATU = TU/No. of Units = TU/n

MU = Change in Total Utility/ Change in number of units = ∆TU/∆Q

The concepts of TU and MU can be better understood from the following schedule and
diagram:

Table 2.1: TU and MU

Ice-creams Marginal Utility Total Utility
Consumed (MU) (TU)
1 20 20
2 16 36
3 10 46
4 4 50
5 0 50
6 -6 44

In Fig. 2.1, units of ice-cream, are shown along the X-axis and TU and MU are measured
along the Y-axis. MU is positive and TU is increasing till the 4th ice-cream. After consuming
the 5th ice-cream, MU is zero and TU is maximum.
This point is known as the point of satiety or the stage of maximum satisfaction. After
consuming the 6th ice-cream, MU is negative (known as disutility) and total utility starts
diminishing. Disutility is the opposite of utility. It refers to loss of satisfaction due to
consumption of too much of a thing.

Law of DMU

Law of diminishing marginal utility (DMU) states that as we consume more and more units
of a commodity, the utility derived from each successive unit goes on decreasing.

In making choices, most people spread their incomes over different kinds of goods. People
prefer a variety of goods because consuming more and more of any one good reduces the
marginal satisfaction derived from further consumption of the same good. This law expresses
an important relationship between utility and the quantity consumed of a commodity.

After that point, if he is forced to consume even one more glass of juice, it will lead to
disutility. Such a decrease in satisfaction with consumption of successive units occurs due
to ‘Law of diminishing marginal utility’.

Law of DMU has universal applicability and applies to all goods and services. This law was
first given by a German economist H.H. Gossen. That is why, it is also known as ‘Gossen’s
first law of consumption’.

Assumptions of Law of Diminishing Marginal Utility:

The law of DMU operates under certain specific conditions. Economists call them the
‘assumptions’ of this law.

These are as follows:

1. Cardinal measurement of utility:
It is assumed that utility can be measured and a consumer can express his satisfaction in
quantitative terms such as 1, 2, 3, etc.

2. Monetary measurement of utility:

It is assumed that utility is measurable in monetary terms.

3. Consumption of reasonable quantity:

It is assumed that a reasonable quantity of the commodity is consumed. For example, we
should compare MU of glassfuls of water and not of spoonful’s. If a thirsty person is given
water in a spoon, then every additional spoon will yield him more utility. So, to hold the law
true, suitable and proper quantity of the commodity should be consumed.

4. Continuous consumption:
It is assumed that consumption is a continuous process. For example, if one ice-cream is
consumed in the morning and another in the evening, then the second ice-cream may provide
equal or higher satisfaction as compared to the first one.

5. No change in Quality:
Quality of the commodity consumed is assumed to be uniform. A second cup of ice-cream
with nuts and toppings may give more satisfaction than the first one, if the first ice-cream
was without nuts or toppings.
6. Rational consumer:
The consumer is assumed to be rational who measures, calculates and compares the utilities
of different commodities and aims at maximising total satisfaction.

7. Independent utilities:
It is assumed that all the commodities consumed by a consumer are independent. It means,
MU of one commodity has no relation with MU of another commodity. Further, it is also
assumed that one person’s utility is not affected by the utility of any other person.

8. MU of money remains constant:

As a consumer spends money on the commodity, he is left with lesser money to spend on
other commodities. In this process, the remaining money becomes dearer to the consumer
and it increases MU of money for the consumer. But, such an increase in MU of money is
ignored. As MU of a commodity has to be measured in monetary terms, it is assumed that
MU of money remains constant.

9. Fixed Income and prices:

It is assumed that income of the consumer and prices of the goods which the consumer
wishes to purchase remain constant.

It must be noted that ‘Utility approach to Consumer’s Equilibrium’ is based on all these
assumptions.

Diagrammatic Explanation of Law of DMU:

Units Total Marginal
of Ice Utility Utility
Cream (In (In Utils)
utils)
1 20 20
2 36 16
3 46 10
4 50 4
5 50 2
6 44 -6

In the diagram, units of ice-cream are shown along the X-axis and MU along the Y-axis. MU
from each successive ice-cream is represented by points A, B, C, D and E. As seen, the
rectangles (showing each level of satisfaction) become smaller and smaller with increase in
consumption of ice-creams.

MU falls from 20 to 16 and then to 10 utils, when consumption is increased from 1 st to

2nd and then to 3rd ice-cream. 5th ice-cream has no utility (MU= 0) and this is known as the
‘Point of satiety’. When 6th ice-cream is consumed, MU becomes negative. MU curve slopes
downwards showing that MU of successive units is falling.
LAW OF EQUI MARGINAL UTILITY

The Law of equi marginal Utility is another fundamental principle of Economics. This law is
also known as the Law of substitution or the Law of Maximum Satisfaction.

We know that human wants are unlimited whereas the means to satisfy these wants are
strictly limited. It, therefore’ becomes necessary to pick up the most urgent wants that can
be satisfied with the money that a consumer has. Of the things that he decides to buy he
must buy just the right quantity. Every prudent consumer will try to make the best use of
the money at his disposal and derive the maximum satisfaction.

Explanation of the Law:

In order to get maximum satisfaction out of the funds we have, we carefully weigh the
satisfaction obtained from each rupee ‘had we spend If we find that a rupee spent in one
direction has greater utility than in another, we shall go on spending money on the former
commodity, till the satisfaction derived from the last rupee spent in the two cases is equal.

It other words, we substitute some units of the commodity of greater utility tor some units
of the commodity of less utility. The result of this substitution will be that the marginal
utility of the former will fall and that of the latter will rise, till the two marginal utilities are
equalized. That is why the law is also called the Law of Substitution or the Law of equi
marginal Utility.

Limitations of the Law of Equi-marginal Utility:

Like other economic laws, the law of equi-marginal utility too has certain limitations or
exceptions. The following are the main exception.

(i) Ignorance:
If the consumer is ignorant or blindly follows custom or fashion, he will make a wrong use
of money. On account of his ignorance he may not know where the utility is greater and
where less. Thus, ignorance may prevent him from making a rational use of money. Hence,
his satisfaction may not be the maximum, because the marginal utilities from his
expenditure cannot be equalised due to ignorance.

(ii) Inefficient Organisation:

In the same manner, an incompetent organiser of business will fail to achieve the best
results from the units of land, labour and capital that he employs. This is so because he
may not be able to divert expenditure to more profitable channels from the less profitable
ones.

(iii) Unlimited Resources:

The law has obviously no place where this resources are unlimited, as for example, is the
case with the free gifts of nature. In such cases, there is no need of diverting expenditure
from one direction to another.

(iv) Hold of Custom and Fashion:

A consumer may be in the strong clutches of custom, or is inclined to be a slave of fashion.
In that case, he will not be able to derive maximum satisfaction out of his expenditure,
because he cannot give up the consumption of such commodities. This is specially true of
the conventional necessaries like dress or when a man is addicted to some intoxicant.

(v) Frequent Changes in Prices:

Frequent changes in prices of different goods render the observance of the law very difficult.
The consumer may not be able to make the necessary adjustments in his expenditure in a
constantly changing price situation.

Consumer Surplus

Consumer surplus is an economic measure of consumer benefit, which is calculated by

analyzing the difference between what consumers are willing and able to pay for a good or
service relative to its market price, or what they actually do spend on the good or service. A
consumer surplus occurs when the consumer is willing to pay more for a given product than
the current market price.

Indifference Curve:
When a consumer consumes various goods and services, then there are some combinations,
which give him exactly the same total satisfaction. The graphical representation of such
combinations is termed as indifference curve.

Indifference curve refers to the graphical representation of various alternative combinations

of bundles of two goods among which the consumer is indifferent. Alternately, indifference
curve is a locus of points that show such combinations of two commodities which give the
consumer same satisfaction. Let us understand this with the help of following indifference
schedule, which shows all the combinations giving equal satisfaction to the consumer.

Table 2.5: Indifference Schedule

Combination ofApples Bananas
Apples and(A) (B)
Bananas
P 1 15
Q 2 10
R 3 6
S 4 3
T 5 1

As seen in the schedule, consumer is indifferent between five combinations of apple and
banana. Combination ‘P’ (1A + 15B) gives the same utility as (2A + 10B), (3A + 6B) and so on.
When these combinations are represented graphically and joined together, we get an
indifference curve ‘IC1’ as shown in Fig. 2.4.
In the diagram, apples are measured along the X-axis and bananas on the Y-axis. All points
(P, Q, R, S and T) on the curve show different combinations of apples and bananas. These
points are joined with the help of a smooth curve, known as indifference curve (IC 1). An
indifference curve is the locus of all the points, representing different combinations, that are
equally satisfactory to the consumer.
Every point on IC1, represents an equal amount of satisfaction to the consumer. So, the
consumer is said to be indifferent between the combinations located on Indifference Curve
‘IC1’. The combinations P, Q, R, S and T give equal satisfaction to the consumer and therefore
he is indifferent among them. These combinations are together known as ‘Indifference Set’.

Indifference Map:
Indifference Map refers to the family of indifference curves that represent consumer
preferences over all the bundles of the two goods. An indifference curve represents all the
combinations, which provide same level of satisfaction. However, every higher or lower level
of satisfaction can be shown on different indifference curves. It means, infinite number of
indifference curves can be drawn.

In Fig. 2.5, IC1 represents the lowest satisfaction, IC 2 shows satisfaction more than that of
IC1 and the highest level of satisfaction is depicted by indifference curve IC 3. However, each
indifference curve shows the same level of satisfaction individually.
It must be noted that ‘Higher Indifference curves represent higher levels of satisfaction’ as
higher indifference curve represents larger bundle of goods, which means more utility
because of monotonic preference.

Marginal Rate of Substitution (MRS):

MRS refers to the rate at which the commodities can be substituted with each other, so that
total satisfaction of the consumer remains the same. For example, in the example of apples
(A) and bananas (B), MRS of ‘A’ for ‘B’, will be number of units of ‘B’, that the consumer is
willing to sacrifice for an additional unit of ‘A’, so as to maintain the same level of satisfaction.

MRSAB = Units of Bananas (B) willing to Sacrifice / Units of Apples (A) willing to Gain
MRSAB = ∆B/∆A
MRSAB is the rate at which a consumer is willing to give up Bananas for one more unit of
Apple. It means, MRS measures the slope of indifference curve.

It must be noted that in mathematical terms, MRS should always be negative as numerator
(units to be sacrificed) will always have negative value. However, for analysis, absolute value
of MRS is always considered.

The concept of MRSAB is explained through Table 2.6 and Fig. 2.6

Properties of Indifference Curve:

1. Indifference curves are always convex to the origin:
An indifference curve is convex to the origin because of diminishing MRS. MRS declines
continuously because of the law of diminishing marginal utility. As seen in Table 2.6, when
the consumer consumes more and more of apples, his marginal utility from apples keeps on
declining and he is willing to give up less and less of bananas for each apple. Therefore,
indifference curves are convex to the origin (see Fig. 2.6). It must be noted that MRS indicates
the slope of indifference curve.

2. Indifference curve slope downwards:

It implies that as a consumer consumes more of one good, he must consume less of the other
good. It happens because if the consumer decides to have more units of one good (say apples),
he will have to reduce the number of units of another good (say bananas), so that total utility
remains the same.

3. Higher Indifference curves represent higher levels of satisfaction:

Higher indifference curve represents large bundle of goods, which means more utility because
of monotonic preference. Consider point ‘A’ on IC X and point ‘B’ on IC2 in Fig. 2.5. At ‘A’,
consumer gets the combination (OR, OP) of the two commodities X and Y. At ‘B’, consumer
gets the combination (OS, OP). As OS > OR, the consumer gets more satisfaction at IC2.
4. Indifference curves can never intersect each other:
As two indifference curves cannot represent the same level of satisfaction, they cannot
intersect each other. It means, only one indifference curve will pass through a given point on
an indifference map. In Fig. 2.7, satisfaction from point A and from B on IC 1 will be the same.
Similarly, points A and C on IC 2 also give the same level of satisfaction. It means, points B
and C should also give the same level of satisfaction. However, this is not possible, as B and
C lie on two different indifference curves, IC 1 and IC2 respectively and represent different
levels of satisfaction. Therefore, two indifference curves cannot intersect each other.

Assumptions of Indifference Curve

The various assumptions of indifference curve are:

1. Two commodities:
It is assumed that the consumer has a fixed amount of money, whole of which is to be spent
on the two goods, given constant prices of both the goods.

2. Non Satiety:
It is assumed that the consumer has not reached the point of saturation. Consumer always
prefer more of both commodities, i.e. he always tries to move to a higher indifference curve
to get higher and higher satisfaction.

3. Ordinal Utility:
Consumer can rank his preferences on the basis of the satisfaction from each bundle of
goods.

4. Diminishing marginal rate of substitution:

Indifference curve analysis assumes diminishing marginal rate of substitution. Due to this
assumption, an indifference curve is convex to the origin.

5. Rational Consumer:
The consumer is assumed to behave in a rational manner, i.e. he aims to maximize his total
satisfaction.