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Analysis of Demand and Demand Forecasting 95
Notes
Unit 3: Analysis of Demand and Demand

Forecasting
Structure:
3.1 Meaning and Definitions of Demand
3.2 Determinants of Demand
3.3 Law of Demand
3.4 Features of Law of demand
3.5 Nature of Supply
3.6 The Law of Supply
3.7 Shift in demand and supply curves and market equilibrium
3.8 Demand Function
3.9 Elasticity of Demand
3.10 Elasticity of Supply
3.11 Measurement of Elasticity of Supply
3.12 Factors Determining Elasticity of Supply
3.13 Price Elasticity of Supply
3.14 Use of elasticity in Business-Decision Making
3.15 Utility
3.16 Meaning and Definitions of Utility
3.17 Characteristics of Utility
3.18 Concepts of Utility
3.19 Measurement of Utility
3.20 Cardinal Measurement
3.21 Law of Diminishing Marginal Utility
3.22 Consumer Surplus
3.23 Ordinal Measurement
3.24 Indifference Curves (features and properties)
3.25 Complements and Substitutes
3.26 Consumer Equilibrium
3.27 Individual Demand vs. Market Demand
3.28 Demand Forecasting
3.29 Techniques of Demand Forecasting
3.30 Summary
3.31 Check Your Progress
3.32 Questions and Exercises
3.33 Key Terms
3.34 Check Your Progress: Answers
3.35 Case Study
Amity Directorate of Distance and Online Education

96 Managerial Economics
Notes 3.36 Further Readings

3.37 Bibliography
Objectives
After studying this unit, you should be able to understand:

l Concept of Law of demand and supply
l Shift in demand and supply curves and market equilibrium
l Concept of Demand Function
l Elasticities of demand and supply
l Use of elasticities in business-decision making
l Meaning of utility, satisfaction
l Measurement of utility
l Concept of Cardinal measurement
l Law of diminishing marginal utility, consumer surplus
l Ordinal measurement
l Indifference curves features and properties
l Concept of Consumer equilibrium
l Individual demand vs. market demand
l Concept of Demand Forecasting
l Techniques of demand forecasting
3.1 Meaning and Definitions of Demand

Meaning of Demand
Demand is the amount of particular economic goods or services that a consumer
or group of consumers will want to purchase at a given price at a particular time.
Therefore, demand means desire backed up by adequate purchasing power to pay
for the product when demanded and willingness to spend the money for the satisfaction
of that desire.
Demand = Desire to buy + Ability to pay + Willingness to pay.
Definitions of Demand
According to Melvin and Boyes, “Demand is a relationship between two variables,
price and quantity demanded, with all other factors that could affect demand being held
constant”.
According to Prof. Bober, “Demand means the various quantities of a given
commodity or service which consumers would buy in one market in given period of time
at various prices or at various income or at various prices of related goods”.
According to Ferguson, “Demand refers to the quantities of commodity that the
consumers are able to buy at each possible price during a given period of time, other
things being equal”.
According to B. R. Schiller defines, “Demand is the ability and willingness to buy
specific quantity of a good at alternative prices in a given time period”.

3.2 Determinants of Demand Notes

The several determinants of demand for different goods and services are as follows:
I. Determinants of Individual Demand

1. Price: Price is the basic factor. A consumer usually decides to buy with
consideration of price. More quantity is demanded at low prices and less is
purchased at high prices. Hence, demand is a function of price. This relationship
is expressed as D = f (P). In this equation, demand is the dependant variable
and the price is the independent variable.
2. Income: A buyer’s income determines his/her purchasing capacity. Income is
an important determinant of demand.With the increase in income one can buy
more goods. Rich consumers usually demand more goods than poor customers.
Demand for luxurious and expensive goods is related to income.
3. Tastes, habits and preferences: Demand for many goods depends on the
person’s tastes, habits and preferences. Demand for several products like ice-
cream, chocolates, beverages and so on depends on individual’s tastes.
Demand for tea, betel, cigarettes, tobacco, etc. is a matter of habits.
Preferences of the consumers also changes from time to time. For example,
consumers prefer diesel car rather than petrol car because of fuel price factor.
4. People with different tastes and habits have different preferences for
different goods: A strict vegetarian will have no demand for meat at any price,
whereas a non-vegetarian who has liking for chicken may demand it even at
a high price. Similar is the case with demand for cigarettes by nonsmokers
and smokers.
5. Complementary and Substitutes: Complementary goods are those, which are
required to satisfy the other demand. These goods are consumed together. For
example, Bike and Petrol. If the demand for bikes increases, the demand for
petrol also increases. On the other hand substitutes are the goods, which could
be used as an alternative to some other goods. For example: Tea and Coffee.
If the price of coffee goes up, the demand for tea increases.
6. Consumer’s expectation: A consumer’s expectation about the future changes
in the prices of a given commodity also may affect its demand. When the
consumer expect its prices to fall in future, he will buy less at present. Similarly,
if he expects the price to rise in future, he will buy more at present.
7. Advertisement effect: In modern times, the preferences of a consumer can
be altered by advertisement and sales propaganda, to a certain extent only.
In fact, demand for many products like toothpaste, toilet soap, washing powder,
processed foods, etc., is partially caused by the advertisement effect in a
modern man’s life.
II. Determinants of Market Demand

1. Scale of preferences: The market demand for a product is greatly influenced
by the scale of preferences of the buyers in general. For example, when a large
section of population shifts its preferences from vegetarian foods to non-
vegetarian foods, the demand for the former will tend to decrease and that for
the latter will increase.
2. Distribution of income and wealth in the community: If there is an equal
distribution of income and wealth, the market demand for many products of

Notes common consumption tends to be greater than in the case of unequal

distribution.
3. Price of the product: At a low market price, market demand for the product
tends to be high and vice versa.
4. General standards of living and spending habits of the people: When
people in general adopt a high standard of living and are ready to spend more,
demand for many comforts and luxury items will tend to be higher than
otherwise.
5. Number of buyers in the market and the growth of population: The size
of market demand for a product obviously depends on the number of buyers
in the market. A large number of buyers will usually constitute a large demand
and vice versa. As such, growth of population over a period of time tends to
imply a rising demand for essential goods and services in general.
6. Age structure and sex ratio of the population: Age structure of population
determines market demand for many products in a relative sense. If the
population of a country comprises more of children, then demand for toys,
school bags etc., i.e., goods and services required by children will be much
higher. Similarly, sex-ratio has its impact on demand for many goods.
7. Future expectations: If buyers in general expect that prices of a commodity
will rise in future, then present market demand would be more as most of them
would like the commodity. The reverse happens if a fall in the future prices are
expected.
8. Level of taxation and tax structure: A progressively high tax rate would
generally mean a low demand for goods in general and vice versa. But, a highly
taxed commodity will have a relatively lower demand.
9. Inventions and innovations: Introduction of new goods or substitutes as a
result of inventions and innovations in a dynamic modern economy tends to
adversely affect the demand for the existing products, which as a result of
innovations, definitely become obsolete.
10. Fashions: Market demand for many products is affected by changing fashions.
For example, demand for commodities like jeans, salwar-kameej, etc., is based
on current fashions.
11. Climatic conditions: Demand for certain products is determined by climatic
or weather conditions. For example, in summer, there is a greater demand for
cold drinks, fans, coolers, etc. Similarly, demand for umbrellas and rain coats
are seasonal.
12. Culture: Demand for certain goods is determined by social customs, festivals,
etc. For example, during Dipawali days, there is a greater demand for sweets
and crackers, and during Christmas, cakes are more in demand.
3.3 Law of Demand

The law of demand states that “other things being constant, when the price of a
commodity rises, the demand for that commodity falls and when the price of a commodity
falls, the demand for that commodity rises”.
“The higher the price of a commodity, the smaller is the quantity demanded and
lower the price, larger the quantity demanded”.

Definitions of Law of Demand Notes

Samuelson defines, “Law of demand states that people will buy more at lower prices
and buy less at higher prices, ceteris paribus or other things remaining the same”.
According to Alfred Marshall, “The greater the amount to be sold, the smaller must
be the price at which it is offered in order that it may find purchasers; or, in other words,
the amount demanded increases with a fall in price and diminishes with a rise in price”.
Assumptions of Law of Demand
The law of demand will hold good only if the following conditions are fulfilled. They
are:
1) No changes in the Income of the consumer: There shouldn’t be any change
in the income of the consumer. If the price of a particular commodity has
increased, but on the contrary if the income of the consumer also increases
then the Law of demand will not be applicable.
2) No changes in the tastes and preferences: The consumers tastes, habits,
preferences, fashion shouldn’t change. If there is any changes in these
elements, the demand will not decrease, even though there is increase in the
price level. Hence, the law of demand will not be applicable.
3) No future expectations: The consumers should act according to the present
market conditions. If a consumer expects further increase in the price level,
he will demand more even though the present price is more and vice-versa.
4) No changes in the population: It is assumed that there are no changes in
the size of population. If the size of population of a country increases, there
will be more demand even though the prices are more and if the size of population
of a country is less, there will be less demand even though the prices are low.
5) No changes in the prices of complementary and substitute goods: When
the prices of substitutes and complement goods and services changes, the
demand for a particular product also changes. Hence in order to study the
demand tendency of a particular product, we have to assume that there will
be no changes in the prices of complementary and substitutes.
6) No change in the fashion: If the commodity concerned goes out the fashion
the buyer may not buy more of it even if the price is less.
7) No change in the range of goods available to the consumers: This implies
that there is no innovation and arrival of new varieties of product in the market
which may distort consumer’s preferences.
8) No change in government policy: The level of taxation and fiscal policy of
the government remains the same throughout the operation of the law.
Otherwise, changes in income-tax, for instance, may cause changes in
consumer’s income or commodity taxes levied by the government leads to
distortion in consumer’s preferences.
Exceptions to the Law of Demand
Law of Demand narrates that less quantity is purchased when the price is more and
more quantity is purchased at lesser prices. This may not be true always. There are few
instances where the consumer purchases more even if the price is more and purchases
less even when the prices are low. These cases are considered to be the exceptions for
the law of demand.

Notes For these cases, the demand curve will not be sloping downwards, as witnessed
in the earlier diagrams, instead, it slopes upwards from left to right as shown in the following
diagram.
As could be seen in the digram, the

consumer purchases OQ amount
of quantity at OP price and when
price increases from OP to OP1
the consumer also increases the
purchase from OQ to OQ1. This
makes the demand curve to slope
upwards.
Fig: Expection to the law of demand

The law of demand willn’t be applicable in certain cases. The exceptions to the Law
of demand may be listed as follows:
1. Giffin Goods: Sir Robert Giffin, an economist, 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. When the price
of bread went up, it caused decline in the purchasing power of the poor people
and they were forced to cut down the consumption of meat and other 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. Hence, necessary commodities are an exception to law of demand
because in their cases demand is strengthened with a rise in price and
weakened with the fall in price.
2. Brand Loyalty: If the consumers are loyal to a particular brand, they will
continue to buy even with the rise in the price of that particular brand. For
example, particular brand of shampoo, particular brand of toothpaste etc.
3. Future predictions: If the consumers expect further increase in price of a
commodity, they will buy more even though the present price is more. For
example, Prices of petrol.
4. Ignorance: Ignorance of the prices prevailing in the market makes the
consumers to buy more even at high prices and it is also observed that the
consumer will prefer high priced product because he assumes that high prices
means high quality and low prices means low quality. Hence to this kind of
ignorance, the law of demand willn’t be applicable.
5. Unavoidable circumstances: During some cases, we cannot go by the prices.
If the purchase of the product is inevitable, we have to purchase it, even at high
prices. For example, prices of medicine etc.
6. Prestige Goods/Veblen’s Effect: Thorstein Veblen, a noted American
Economist contends that, there are certain commodities which are purchased
by the rich people, not for their direct satisfaction, but for their snob appeal.

In case of such status value commodities, it is not the price which is important Notes
but he prestige conferred by that commodity, makes a person go for it. Example:
diamond jewellery, antiques, world famous paintings etc., Even though the
prices of these luxurious goods and services are high, rich consumers will prefer
to purchase it, because it increases the social status or the social prestige.
Hence in case of such goods and services the Law of Demand fails.
7. 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. These can be termed as “U” sector
goods.
8. Change in fashion: A change in fashion and tastes affects the market for a
commodity. When a broad toe shoe replaces a narrow toe, no amount of
reduction in the price of the latter is sufficient to clear the stocks. Broad toe
on the other hand, will have more customers even though its price may be going
up. The law of demand becomes ineffective.
9.Speculation: When people speculate about changes in the price of a commodity in
the future, they may not act according to the law of demand at the present
price say, when people are convinced that the price of a particular commodity
will rise still further, they will not contract their demand with the given price rise:
on the contrary, they may purchase more for the purpose of hoarding. In the
stock exchange market, some people tend to buy more shares when their prices
are rising, in the hope that the rising trend would continue, so they can make
a good fortune in future.
Importance of Law of Demand
The importance of law of demand can be summarized as follows:

1. Determination of price: Study of law of demand is helpful for a trader to fix
the price of a commodity. He knows how much demand will fall by increase
in price to a particular level and how much it will rise by decrease in price of
the commodity. The schedule of market demand can provide the information
about total market demand at different prices. It helps the management in
deciding whether how much increase or decrease in the price of commodity
is desirable.
2. Importance to Finance Minister: The study of this law is of great advantage
to the finance minister. If by raising the tax the price increases to such an extent
than the demand is reduced considerably. And then it is of no use to raise the
tax, because revenue will almost remain the same. The tax will be levied at
a higher rate only on those goods whose demand is not likely to fall substantially
with the increase in price.
3. Importance to the Farmers: Goods or bad crop affects the economic condition
of the farmers. If goods crop fails to increase the demand, the price of the crop
will fall heavily. The farmer will have no advantage of the good crop and vice-
versa.

Notes 3.4 Features of Law of demand

Important features of Law of Demand are as follows:
1. Inverse Relationship
It states the inverse relationship between price and quantity demanded. It simply
affirms that an increase in price will tend to reduce the quantity demanded and a fall in
price will lead to an increase in the quantity demanded.
2. Qualitative, not Quantitative
It makes a qualitative statement only, i.e. it indicates the direction of change in the
amount demanded and does not indicate the magnitude of change.
3. No Proportional Relationship
It does not establish any proportional relationship between change in price and the
resultant change in demand. If the price rises by 10%, quantity demanded may fall by
any proportion.
4. One-Sided
Law of demand is one sided as it only explains the effect of change in price on the
quantity demanded. It states nothing about the effect of change in quantity demanded
on the price of the commodity.
3.5 Nature of Supply

Supply of a commodity is often confused with the ‘stock’ of that commodity available
with the producers. Stock of a commodity, more or less, will equal the total quantity
produced during a period less the quantity already sold out. But we know that the producers
do not offer whole of their stocks for sale in the market, a part of industrial produces is
kept back in godowns and is offered for sale in the market when it can fetch better prices.
In other words the amount offered for sale may be less than the stocks of the commodity.
The term ‘supply’ shows a relationship between quantity and price. By supply we mean
various quantities of a commodity which producers will offer for sale at a particular time
at various corresponding prices.
Supply schedule and supply curve
If demand is held constant, an increase in supply leads to a decreased price, while

a decrease in supply leads to an increased price. This relationship can be illustrated in
the form of a table called supply schedule and the data from the table may be given a
diagrammatic representation in the form of a curve.
Supply Schedule
Price (P) Quantity (Q)
2 5
4 8
3 9
5 15
7 20

Supply Curve Notes
Supply Function
Supply function refers to the mathematical function that relates price and quantity
supplied for goods or services. The supply function tells how many units of a good that
producers are willing to produce and sell at a given price. It shows the quantities of goods
and services a producer would provide at various prices.
In a supply function, the determinants of supply can be summarized as under:
Sx = f (Px, Pf, Py…, Pz, O, T, t, s) where, Sx = the supply of commodity X.
Px = the price of X.
Pf = the set prices of the factor inputs employed for producing X.
O = factors outside the economic sphere.
T = technology used, t = tax and s = subsidy.
3.6 The Law of Supply

The law of supply reflects the general tendency of the sellers in offering their stock
of a commodity for sale in relation to the varying prices. It describes seller’s supply
behaviour under given conditions. It has been observed that usually sellers are willing to
supply more with a rise in prices.
“Other things remaining unchanged, the supply of a commodity expands with a rise
in its price, and contracts with a fall in its price”.
The law of supply can be approached from two different contexts. The first is that
it represents the sum total of production plus carryover stocks. The other context for supply
describes the behaviour of producers. The market or total supply represents the quantities
producers are willing to sell over a range of prices for any given time period. At the individual
level, you may be willing to produce a given product as long as the market price is equal
to or greater than the cost of producing that product. The total supply is the sum of the
individual quantities of product that each farmer brings to the market. Market supply is
represented by an upward sloping curve with price on the vertical axis and quantity on
the horizontal axis:
Notes
An increase in price in most instances will result in farmers wanting to increase the
quantity of a given product they will bring to the market; therefore the relationship between
the price and supply is positive. Market supply will be affected by other variables in addition
to the price. Factors that have been identified as important in determining supply behaviour
include; the number of firms producing the product, technology, the price of inputs, the
price of other commodities which could be produced, and the weather.
With higher prices the producers of goods and services will receive greater profits.
Greater profits will result in the means to expand production increasing the supply. This
increased supply will ultimately satisfy the existing demand such that any additional
production must be met with new demand in order for the price increases to be sustained.
The firms which handle your grain or livestock products are not free to set prices as they
choose. They can raise prices only if consumers are willing and able to pay more. Lower
prices are the market's signal to farmers that they have produced too much of something
or that it is something consumers do not want. To be a good marketer, you need to accept
the "discipline of the marketplace". A good marketer learns to produce for the market.
Assumptions Underlying the Law of Supply
The law of supply is conditional, since we have stated it under the assumption:
i) No change in Cost of production: It is assumed that the price of the product
changes, but there is no change in the cost of production. If the cost of
production increases along with the rise in the price of product, the sellers will
not find it worthwhile to produce more and supply more.
ii) No change in method of Production: The technique of production is assumed
to be unchanged. This is essential for the cost to remain unchanged. With the
improvement in technique, if cost of production is reduced, the seller would
supply more even at falling prices.
iii) Fixed scale of production: During a given period of time, it is assumed that
the scale of production is held constant. If there is a change in scale of
production, the level of supply will change, irrespective of the changes in the
price of the product.
iv) Government policies are unchanged: Government policies like taxation
policy, trade policy, etc., are assumed to be constant. For instance, an increase
in or totally fresh levy of excise duties would imply an increase in the cost or
in case there is fixation of quotas for the raw materials or imported components

for a product, then such a situation will not permit the expansion of supply with Notes
a rise in prices.
v) Unchanged transport costs: It is assumed that the transport facilities and
transport costs are unchanged. Otherwise, a reduction in transport cost implies
lowering of cost of production, so that more would be supplied even at a lower
price.
vi) No speculation: The law also assumes that the sellers do not speculate about
the future changes in the price of the product. If, however, sellers expect prices
to rise further in future, they may not expand supply with the present price rise.
vii) The prices of substitutes are held constant: The law assumes that there
are no changes in the prices of other products. If the price of some other product
rises faster than that of the given product in consideration, producers might
transfer their resources to the other product which is more profit yielding due
to rising prices. Under this situation, more of the product in consideration may
not be supplied, despite the rising prices.
Extension and Contraction in Supply
The law of supply refers to the change in supply due to a change in price. If, with
a rise in price, the supply rises, it is called extension of supply. If, with a fall in price,
the supply declines, it is called contraction of supply. The change in the quantity of supply
in accordance with the price change is thus called either “extension” or “contraction” of
supply and refers to the same supply curve.
Increase and Decrease in Supply
These two terms are introduced to explain the changes in supply without any change
in price. Sometimes, there might be more supply forthcoming in the market without a
change in price, in which case it is called increase in supply. If there is less supply
forthcoming in the market without a change in price, then it is called decrease in supply.
The change in supply due to causes or determinants other than price is called “decrease”
or “increase” in supply and can be shown on a different supply Curve.
Causes for Change in Supply
There are many causes which bring about a change in the conditions of supply.The
important factors are:
i) Change in technique of production: This has an important influence on
supply. An improvement in the technique of production might go a long way
in increasing the supply. For instance, introduction of highly sophisticated
machines increases the supply of goods.
ii) Policy of Government also influences supply: Taxes on production, sales,
import duties and import restrictions may reduce supply. It may also be
deliberately reduced by government policies.
iii) Cost of production: Given the price, the supply changes with the change in
the cost of production. If the cost of production increases because of higher
wages to workers or higher prices of raw materials, there will be a decrease
in supply. If the cost of production falls due to any of the above reasons, the
supply will increase.
iv) Supply depends on natural factors: There might be a decrease in the supply
due to floods, paucity of rainfall, pests, earthquakes, etc. Absence of the above

Notes calamities or an exceptionally good as well as timely monsoon might increase

supply.
v) Development of transport: Improvement in the means of transport obviously
increases the supply of goods as they facilitate the movement of goods from
one place to another.
Determinants of law of supply
There are four important determinants of law of supply as under:

i) Technology changes: Technology helps a producer to minimize his cost of
production.
ii) Resource supplies: The producer also has to pay for other resources such
as raw materials and labour. If his money is short on supplying a certain number
of products because of an increase in resource supplies, then he has to reduce
his supply.
iii) Tax/Subsidy: A producer aims to maximize his profit, but an increase in tax
will only increase his expenses, decreasing his capacity to buy resource
supplies and forcing him to reduce his supply.
iv) Price of other goods produced: A producer may not only produce on product
but other products as well. A producer's money is limited and if he increases
his supply in one product, he would have to decrease his supply in the other
product, no unless his sales increase.
3.7 Shift in demand and supply curves and market equilibrium

Since both the supply and demand curves can shift in either of the two directions,
we have to consider four cases of changes in demand and supply. These cases are so
important and universal in nature that they are often called ‘laws of supply and demand’.
These laws are derived for free markets that we are considering. Such markets have the
following features:
(i) The demand curve is downward sloping,
(ii) The supply curve is upward sloping.
(iii) The buyers and sellers are price-takers.
(iv) The buyers and sellers are maximizes.
The laws of demand and supply are applicable only when these conditions hold. If
anyone these conditions are not applicable the laws may not hold.
1. A Rise in Demand
Let us first consider a rise in demand as in Fig. The original demand curve is D
and the supply is S. Here p0 is the original equili-brium price and q0 is the equilibrium
quantity.
We may now consider a change in the conditions of demand such as a rise in the
income of buyers. If the income of the buyers rises the market demand curve for carrots
will shift to right to D’. This implies that consumers will now be willing to buy a larger
quantity at every price.
Thus at the original price P0 they will now be eager to buy q2 units. So excess
demand develops in the market. This excess demand q2-q0 creates market forces which

cause the equilibrium price to rise. The process will continue until a new equilibrium is Notes
reached as at point F where the new demand curve intersects the old supply curve. The
net result is a rise in market price to p1. The quantity sold also increase from q0 to q1
in this new equilibrium situation.
So we first consider (1) rightward shift of the demand curve (i.e., a rise in the demand
for a commodity) causes an increase in the equilibrium price and quantity (as is shown
by the arrows in Fig).
2. A Fall in Demand
Next we may consider the effect of a fall in demand. Demand may fall due to changes
in the conditions of demand. If, for example, there is a fall in the price of a substitute
for the commodity under consideration, consumers may want to buy smaller quantities
at every price.
Suppose D’ in Fig. is the original de-mand curve. Now the original price and quan-tity
are p1 and q1, respectively. Suppose a fall in demand leads to a leftward shift of the
.demand curve. The new demand curve is D. So an excess supply q1– q3 (=FG) develops
in the market.
As a result of the operation of the market forces price falls. The new equilibrium price
is p0. The new equilibrium quantity is q0. So we reach the second conclu-sion a leftward
shift of the demand curve (i.e., a fall in the demand for a commodity) causes a decrease
in the equilibrium price and quantity.
3. An Increase in Supply
In Fig. we consider the effect of a shift in the supply curve. Here S and D are original
supply and demand curves. The two curves meet at point E. So p0 and q0 are the original
equilibrium price and quantity. We may now examine the effect of a change in the
condi-tions of supply.
Such a change increases the quantities that producers are prepared to offer for sale
at each price. For example, there was a rightward shift of the supply curve due to increase
in the productivity of factors of production, caused by technological advance.
The Green Revolution which has occurred in India is an example of such a change.
Techno-logical progress has the effect of reducing the cost of production. As a result,

Notes a larger quan-tity (qt instead of q0) is offered for sale at a lower price (p1 instead of p0).
This happened in the computer industry in the late 90’s.
An increase in supply implies that a larger quantity is offered for sale at the same
price (q2, instead of q0 at p0) or the same quantity at a lower price (as point G indicates).
In other words, an excess of supply of q0 q2 (=EH) develops at the original price p0. It
sets in motion market forces which cause the price to fall.
Since there is not much demand for their product, producers find it difficult to sell
the entire output at the original price. They start charging lower price. Consumers know
about it and start paying a lower price. Conse-quently price starts falling and it ultimately
reaches the value p1. At this new price the equilibrium quantity is q1. Thus we reach
the third conclusion a rightward shift of the supply curve (i.e., an increase in the supply
of a commodity) causes a fall in the equilibrium price and an increase in equilibrium
quantity.
4. A Decrease in Supply
Finally, we may examine the effect of a rise in the price of a factor, such as wages
in a unionized industry. As a result, total cost will rise and the sellers will be willing to
offer a smaller quantity for sale at each price. In this case, the original supply curve is
S’. Equi-librium price and quantity are p1 and q1. Now the supply curve shifts to left. The
new supply curve is S.
At the original equilibrium price p1, the quantity offered for sale is zero but the quantity
demanded is still q1. So the entire quantity demanded (viz., q1) is excess demand. This
excess demand sets in motion market forces which tend to raise price. The process
continues until and unless the new equilibrium price p0 is reached.
At this price the quantity supplied and demanded are equated at q0. Thus we reach
the fourth and final conclusion a leftward shift in the supply curve (i.e., a decrease in the
supply of a commodity) leads to an increase in the equilibrium price and a fall in equilibrium
quantity.
Changes in Market Prices: Recap:
From our discussion so far we discover four possibilities for change in market price
as Figshows. In this figure we consider all the four possibilities of changes in demand
and supply.

Ceteris paribus, an increase in demand will bring about an extension of supply so Notes
that more is supplied at a higher price [Fig]. A fall in demand leads to a contraction of
supply with a smaller quantity purchased at a lower price [Fig]. Conversely, an increase
in supply causes an extension of demand so that more is bought at a lower price [Fig]
and a decrease in supply causes a contraction of demand so that less is purchased at
a higher price [Fig].
Complex Changes:
So long we were able to reach may firm conclusions regarding shifts of supply and
demand curves because we stuck to the ceteris paribus assumption, i.e., we considered
only one change at a time. But, in practice, it is possible for two factors to vary at the
same time. Suppose, there is a large rise in the demand for mangoes because of a rise
in per capita income of the people.
This may be followed by an unexpected bumper crop of mangoes. What will be the
final effect of such changes on the equilibrium price? The answer can be found from both
the following dia-grams. However, although both the quantity demanded and quantity
supplied increase in each case, in Fig. the market price falls and in Fig. it rises.
Thus, when multiple shifts in demand and supply curves are considered price may
rise or fall depending on the two magnitudes of changes a change in demand and a change
in supply.
Suppose, one is asked to consider the effect of a number of changes in the demand
and supply of a particular product. It is clear from Fig. that no firm conclusion can be
reached unless both changes move in the same direction; for example, an increase in

Notes supply and a decrease in demand at the same time will definitely lower the equilibrium
price.
The solution lies in explaining one change at a time. For instance, fast explain the
effect of an increase in demand and draw a diagram to illustrate it. Then explain the effect
of the increase in supply by drawing another diagram. So one must always stick to the
rule of explaining one change at a time unless one is having precise details of demand
and supply.
It is also possible to show that if the supply curve shifts to the left due to bad crop
and the demand curve shifts to the right due to rising per capita income, the same quantity
will be offered for sale at a higher price. In this case price will be higher as a result of
both types of changes but the equilibrium quantity will be the same.
Sometimes shifts of curves and movements cause confusion as the following
state-ment shows:
‘An increase in income causes demand to rise. The rise in demand causes an
increase in price. The increase in price causes an increase in supply, which pushes price
back towards its original level.’
There is no doubt that an increase in income certainly shifts the demand curve to
the right. As a result of a rise in demand, price rises. It is also true that the rise in price
tends to increase the quantity supplied. But the rest of the statement is wrong. How can
supply increase along the same supply curve (because there is no shift of the supply
curve)? In fact, there is an increase in quantity supplied along the same supply curve.
The mistake lies in confusing a movement along the supply curve, as a result of
a change in price, which does occur, with a shift in the supply curve which does not occur.
The following statement gives the correct version of the effects of a change that occurs
only in the conditions of demand, the conditions of supply remaining unchanged:
“An increase in income causes demand to rise. The rise in demand induces an
increase in the quantity supplied. Price settles at a new equilibrium level above the old
price, where the quantity consumers want to buy equals that which producers want to
sell.”
3.8 Demand Function

This relationship between price and demand could be represented through an
equation, called ‘Demand Function’. It assumes that other determinants of demand are
constant and only price is the variable and influencing factor. The relationship between
price and demand is usually an inverse or negative relation, indicating a larger quantity
demanded at a lower price and smaller quantity demanded at a higher price.
Demand function is a mathematical function showing relationship between the
quantity demanded of a commodity and the factors influencing demand.
Dx = f (Px, Py, T, Y, A, Pp, Ep, U)
In the above equation,
Dx = Quantity demanded of a commodity
Px = Price of the commodity
Py = Price of related goods
T = Tastes and preferences of consumer
Y = Income level Notes

A = Advertising and promotional activities
Pp = Population (Size of the market)
Ep = Consumer’s expectations about future prices
U = Specific factors affecting demand for a commodity such as seasonal changes,
taxation policy, availability of credit facilities, etc.
3.9 Elasticity of Demand

The law of demand simply explains the inverse relationship between price and
quantity demanded. It doesn’t specify how much more is purchased when price falls and
how much less is purchased when price rises. In order to understand the rate of change
in price and consequent changes in demand, elasticity of demand concept is used..
Elasticity is one of the most important concepts in neoclassical economic theory.
It is useful in understanding the incidence of indirect taxation, marginal concepts as they
relate to the theory of the firm and distribution of wealth and different types of goods.
Elasticity is also crucially important in any discussion of welfare distribution, in particular
consumer surplus, producer surplus or government surplus.
Meaning of Elasticity of Demand
Elasticity of demand is the responsiveness of demand for a commodity to changes

in its determinants.
Percentage change in quantity demanded of commodity

Elasticity of Demand =
Percentage change in its price
Definition of Elasticity of Demand
According to Marshall, “The elasticity or responsiveness of demand in a market is

great or small accordingly as the demand changes (rises or falls) much or little for a given
change (rise or fall) in price.”
Types of Elasticity of Demand
1. Price Elasticity of Demand

The extent of response of demand for a commodity to a given change in price, other
demand determinants remaining constant, is termed as the price elasticity of demand.
“The price elasticity of demand can be defined as the ratio of the relative change
in demand and price variables”.
It is generally defined as the responsiveness or the sensitiveness of demand to a
given change in the price of a commodity.
PED is a measure of responsiveness of the quantity of a good or service demanded
to changes in its price. The formula for the coefficient of price elasticity of demand for
a good is:

Pe D =

Notes The above formula usually yields a negative value, due to the inverse nature of the
relationship between price and quantity demanded, as described by the “law of demand”.
For the sake of convenience negative sign is ignored.
2. Income Elasticity of Demand
The income elasticity is defined as a ratio percentage or proportional change in the
quantity demanded to the percentage or proportional change in income.
Income elasticity is closely related to the population income distribution and the
fraction of a product’s sales attributable to buyers from different income brackets.
Specifically, when a buyer in a certain income bracket experiences an income increase
their purchase of a product changes to match that of individuals in their new income
bracket.
Percentage change in quantity demanded
YeD =
Percentage change in income
3. Cross Elasticity of Demand
In arriving at the price elasticity of demand, one takes into account the change in
demand due to a change in the price of the same commodity. In cross elasticity of demand,
we take into account the change in the price of commodity Y and its effects on the demand
for commodity X. The concept of cross elasticity is important in the case of commodities
which are substitutes and complementary. Tea and coffee are substitutes for each other,
pen and ink, car and petrol are complementary goods.
“The cross elasticity demand refers to the degree of responsiveness of demand for
a commodity to a given change in the price of some related commodity”.
Percentage change in quantity demanded of commodity A

XeD =
Percentage change in the price of commodity B
The cross elasticity of demand measures the responsiveness of the demand for a
good to a change in the price of another good. It is measured as the percentage change
in demand for the first good that occurs in response to a percentage change in price of
the second good. For example, if, in response to a 10% increase in the price of fuel,
the demand of new cars that are fuel inefficient decreased by 20%, the cross elasticity
of demand would be: 20%/10% = -2
A negative cross elasticity denotes two products that are complements, while a
positive cross elasticity denotes two substitute products. These two key relationships go
against one’s intuition, but the reason behind them is fairly simple: assume products A
and B are complements, meaning that an increase in the demand for A is caused by
an increase in the quantity demanded for B. Therefore, if the price of product B decreases,
then the demand curve for product A shifts to the right, increasing A’s demand, resulting
in a negative value for the cross elasticity of demand. The exact opposite reasoning holds
for substitutes.
4. Advertising or Promotional Elasticity of Demand
Advertising elasticity of demand is a measure of an advertising campaign’s
effectiveness in generating new sales. It is calculated by dividing the percentage change
in the quantity demanded by the percentage change in advertising expenditures. A positive
advertising elasticity indicates that an increase in advertising leads to an increase in
demand for the advertised good or service. Under this type of elasticity of demand a
measure of a market’s sensitivity to increases or decreases in advertising saturation.
Proportionate change in demand brought about by a unit change in advertising expenditure.
Percentage change in quantity demanded or sales Notes

AED =
Percentage change in Advertising expenditure
Factors influencing Advertising Elasticity of Demand (AED)

1. Type of product i.e. whether the product is already existing or new product
2. Brand name.
3. Number of competitors and substitutes in the market.
4. Strategies of competitors
5. Frequency of advertisements.
6. Mode of advertisements.
7. Time of advertisements.
8. Other factors influencing demand like tastes, professions, income etc.
Applications or Uses of Advertising Elasticity of Demand

1. It helps in evaluating success of adverting campaign.
2. It helps the firms in deciding advertising expenditure or budget.
3. It helps in choosing more effective media for promotion.
4. It helps in withdrawing ineffective promotional campaigns.
5. It helps in strategic management to respond to competitor’s promotional
policies.
6. It helps in building brands.
Limitations of Advertising Elasticity of Demand

1. The value of AED does not help in analyzing effect of advertising a single product.
2. Difficult to analyze the effectiveness of promotional strategies at a particular
period of time, especially when the campaigns are over a long period of time
3. The Purpose of campaigns may be to create brands, rather than only influencing
size of demand.
4. AED does not take into account effect of other factors influencing demand.
Price Elasticity of Demand
It is generally defined as the responsiveness or the sensitiveness of demand to a

given change in the price of a commodity. It is measured by using the following formula.
Elasticity is a measure of responsiveness or the degree of change. Hence Price
Elasticity of Demand could be described as percentage change in demand due to
percentage change in the price.

Pe D =
∆Q P
Pe D = ×
∆P Q
Elastic and Inelastic Demand

The terms elastic and inelastic demand do not indicate the degree of responsiveness
and unresponsiveness of the quantity demanded to a change in price. For example, a
Notes decline of 1% in price leads to 8% increase in the quantity demanded of a commodity.

In such a case, the demand is said to elastic. There are other products where the quantity
demanded is relatively unresponsive to price changes. A decline of 8% in price, for
example, gives rise to 1% increase in quantity demanded. Demand here is said to be
inelastic. The economists therefore, group various degrees of elasticity of demand into
five categories.
Degrees of Price Elasticity of Demand
The variation in demand is not uniform with a change in price. In case of some
products, a small change in price leads to a relatively larger change in quantity demanded.
1. Perfectly Elastic Demand
In this case, a very small change in price leads to infinite change in demand. The
demand curve is a horizontal curve and is parallel to OX axis, the numerical co-efficient
of perfectly elastic demand is ∞ .
Fig.: Perfectly elastic demand

2. Perfectly Inelastic Demand
In this case, whatever may be the change in price quantity demanded will remain
perfectly constant. The demand curve is a vertical straight line and is parallel to OY axis.
The numerical co-efficient of perfectly inelastic demand is O (zero). It may be presented
through a diagram as follows:
Original price was OP, Quantity purchased

at that price was OQ.
New price is OP1 and new quantity
purchased is still OQ.
When the price still increases to OP2 and
quantity purchased is still OQ only. Then
the demand is said to be perfectly inelastic.
Fig.: Perfectly inelastic demand

3. Relatively Elastic Demand Notes

In this case a slight change in price leads to more than proportionate change in
quantity demanded. This can be represented by a gradually sloping demand curve. The
numerical co-efficient of relatively elastic demand is > 1.
This can be diagrammatically represented as follows:
Original price was OP, Quantity

purchased at that price was OQ.
purchased is OQ1.
Price has decreased by 2% but demand
has increased by 5%.
Fig.: Relatively elastic demand
4. Relatively Inelastic Demand
In this case, a large change in price leads to less proportionate change in demand.
This can be represented by a steeply sloping demand curve. The numerical co-efficient
of relatively inelastic demand is <1.
Original price was OP, Quantity purchased

at that price was OQ.
purchased is OQ1.
Fig.: Relatively inelastic demand
5. Unitary Elastic Demand
In this case, any change in price brings about equal proportionate change in the
quantity demanded. The numerical co-efficient of unitary elastic demand is always 1.

Notes
Original price was OP, Quantity

purchased at that price was OQ.
purchased is OQ1.
Fig.: Unitary elastic demand
Nature of Elasticity of Demand
Elasticity of demand is a measure of relative changes in the amount demanded in

response to a small change in price. Certain goods are said to have an elastic demand
while others have an inelastic demand. The demand is said to be elastic when a small
change in price brings about considerable change in demand. On the other hand, the
demand for a good is said to be inelastic when a change in price fails to bring about
significant change in demand.
The concept of elasticity can be expressed in the form of an equation as:
Elasticity of Demand =
Determinants of Price Elasticity of Demand
The price elasticity of demand is not the same for all commodities. It may be or
low depending upon number of factors. These factors which influence price elasticity of
demand, in brief, are as under:
(i) Nature of Commodities: In developing countries of the world, the per capital
income of the people is generally low. They spend a greater amount of their
income on the purchase of necessaries of life such as wheat, milk, cloth etc.
They have to purchase these commodities whatever be their price. The demand
for goods of necessities is, therefore, less elastic or inelastic. The demand for
luxury goods, on the other hand is greatly elastic. For example, if the price of
burger falls, its demand in the cities will go up.
(ii) Availability of Substitutes: If goods have greater number of close substitutes
available in the market, the demand for the goods will greatly elastic. For
examples, if the price of Coca Cola rises in the market, people will switch over
to the consumption of Pepsi Cola, which is its close substitute. So the demand
for Coca Cola is elastic.
(iii) Proportion of the Income Spent on the Good: If the proportion of income
spent on the purchase of a good is very small, the demand for such a good
will become inelastic. For example, if the price of a box of matches or salt rises
by 50%, it will not affect the consumers demand for these goods. The demand

for salt, maker box therefore will be inelastic. On the other hand, if the price Notes
of a car rises from ` 6 lakh to ` 9 lakh and it takes a greater portion of the
income of the consumers, its demand would fall. The demand for car is,
therefore, elastic.
(iv) Time: The period of time plays an important role in shaping the demand curve.
In the short run, when the consumption of a good cannot be postponed, its
demand will be less elastic. In the long run if the rise price persists, people
will find out methods to reduce the consumption of goods. So the demand for
a good in the, long runs are elastic, other things remaining constant.
For example, if the price of electricity goes up, it is very difficult to cut back
its consumption in the short run. However, if the rise in price persists, people
will plan substitution gas heater, fluorescent bulbs etc. so that they use less
electricity. So the electricity of demand will be greater (Ed = > 1) in the long
run than in the short run.
(v) Number of Uses of a Good: If a good can be put to a number of uses, its
demand is greater elastic (Ed > 1).
For example, if the price of coal falls, its quantity demanded will rise
considerably because demand will be coming from households, industries
railways etc.
(vi) Addiction: If a product is habit forming say for example, cigarette, the rise in
its price would not induce much change in demand. The demand for habit forming
well is, therefore, less elastic.
(vii) Joint Demand: If two goods are jointly demand, then the elasticity of demand
depends upon the elasticity of demand of the other jointly demanded good. For
example, with the rise in price of cars, its demand is slightly affected, and then
the demand for petrol will also be less elastic.
Methods of Forecasting Price Elasticity of Demand
Various methods of measuring price elasticity of demand are as follows:

1. Total outlay or Total expenditure Method
Total outlay method of measuring elasticity of demand was developed by Marshall.
This method tries to measure change in total expenditure of the consumer or revenue of
a firm due to change in the price of a good.
Under this method the price elasticity of demand is measured by comparing the total
expenditure of the consumer, before and after variations in price. To measure the price
elasticity of demand by examining the change in total expenditure as a result of change
in the price and quantity demanded for a commodity. Total expenditure = price per unit
X total quantity purchased.
With the help of the following data, adopting total outlay method, find out the price
elasticity of demand and show its graphic representation.

Notes
Table: Total expenditure method

It is to be noted that when total expenditure increases, with a fall in price and
decreases with the rise in price, then price elasticity of demand is greater than 1. (relatively
elastic). When plotted on graph, it results as follows:
When the new outlay (expenditure) is

more than the original outlay, then
price elasticity is greater than one.
When the total expenditure remains the same even if there is change in the price,
then price elasticity of demand = 1. (Unitary elasticity). It may be shown as follows:
When the new outlay (expenditure)

remains the same like the original
outlay, then price elasticity is equal to
one.
When the total expenditure falls with a fall in price, and increases with a rise in price,
then the price elasticity of demand is lesser than 1 (relatively inelastic). It may be shown
as follows:

Notes
When the new outlay (expenditure) is

less than the original outlay, then
price elasticity is less than one.
Graphic Representation
Fig.: Total expenditure curve
3.10 Elasticity of Supply

Supply changes due to a change in price. The extent of change in supply in
accordance with the change in price is called elasticity of supply. When, with a little
change in price, there is a considerable change in supply, the supply is said to be elastic.
When, with a considerable change in price, there is little change in supply, the supply
is said to be less elastic. More precisely, with a small fall in price, when there is a big
contraction in supply, the supply is said to be elastic.
“Elasticity of supply is defined as the degree of responsiveness of supply of a product
in the market to a change in its price. Elasticity of supply may be measured as the ratio
of the percentage change or the proportionate change in quantity supplied to the
percentage or proportionate change in price”.
3.11 Measurement of Elasticity of Supply

There are two methods of measuring elasticity of supply: (i) the ratio method, and
(ii) the point method.
i) The Ratio Method: The numerical co-efficient of the degree of elasticity of
supply is obtained by using the ratio method. The co-efficient of elasticity of
supply may vary between zero and infinity.

Notes ii) The Point Method: On a given supply curve, the elasticity of supply at a point
P is measured by the ratio of the distance along the tangent from the point
P on the supply curve to the point where it intersects the horizontal axis and
the distance along the tangent from the point P on the supply curve to the point
where it intersects the vertical axis.
3.12 Factors Determining Elasticity of Supply

The elasticity of supply of commodities depends on a number of factors, such as:
i) Scale of production: Goods produced on a small scale have a relatively
inelastic supply, while goods produced on a large scale have a relatively elastic
supply.
ii) Technique of production: When advanced technology is adopted or capital
intensive technique of production is used, the supply of a product tends to be
more elastic. On the other hand, supply remains less elastic if labour intensive
technique or backward technology is adopted.
iii) The nature of commodities: By their very nature, commodities are generally
classified into perishable and durable. In the case of perishable commodities,
the supply is less elastic, whereas in the case of durable commodities, the
supply is more elastic.
iv) Time period: The operational time period involved in the process of production
basically determines the elasticity of supply of a product. In the short period,
the stock can be varied by producing with the existing size of the plant.
v) Number of products produced: When the big firms produce a variety of
products at a time, they can easily transfer the resources from one product
to the other so that the supply may become more elastic.
vi) Natural factors: Natural factors like climate, monsoon, fertility of soil, etc.
considerably affect the elasticity of supply of agricultural goods. The supply of
agricultural goods tends to be relatively inelastic, because these natural factors
are beyond the control of man. The seasonal nature of cultivation is the main
contributory factor making the supply of agricultural commodities less elastic.
vii) Nature of production: By its very nature of production, certain goods are
inelastic in supply, e.g., art works like painting etc.
viii) Mobility of factors: In those industries where there is a high degree of mobility
of factors of production, supply will be more elastic. Immobility of factors causes
inelasticity of supply.
3.13 Price Elasticity of Supply

Price elasticity of supply measures the relationship between change in quantity
supplied and a change in price. If supply is elastic, producers can increase output without
a rise in cost or a time delay.
If supply is inelastic, firms find it hard to change production in a given time period.
The formula for price elasticity of supply is:
Percentage change in quantity supplied divided by the percentage change in price
When PES > 1, then supply is price elastic
When PES < 1, then supply is price inelastic

When PES = 0, supply is perfectly inelastic Notes

When PES = infinity, supply is perfectly elastic following a change in demand
3.14 Use of elasticity in Business-Decision Making

Elasticity of demand is the sensitivity of quantity demanded of a commodity in
response to the change in factors related to that commodity.
Elasticity of demand may be of different types, depending upon the factor that is
responsible for causing the change in demand. Among them, price elasticity of demand
is one of the most common types and is also the most relevant to business.
Price elasticity of demand can be a useful tool for businessmen to make crucial
decisions like deciding the price of goods and services. It plays vital role in other business
procedures too. These uses are described below in brief.
Determination of price
The primary objective of any firm is to earn profit or increase revenue. Therefore,
increasing price of its products to maximize profit is one of the primary concerns of
producers.
However, during the course of increasing price, the producers must not forget that
demand and price share inverse relationship. They must be aware that demand falls with
rise in price. And thus, they must increase price of their commodity to that level where
their desired or optimal profit is still achievable.
Monopoly price determination
The situation where a single group or company controls all or almost all of market
for a particular good or service is called monopoly. The monopolistic market lacks
competition. Thus, the goods or services are often charged high prices in such market.
A monopolist while fixing the price of the market has to determine whether its product
is of elastic or inelastic nature.
If the product is inelastic (less or no effect on demand with change in price), the
producer can earn profit by setting high price. However, if the product is elastic (highly
affected by even slightest change in price), the producer must set low or at least reasonable
price so that the consumers are attracted to buy the goods.
Price determination of joint products
Joint products are various products generated by a single production procedure at

a single time. Sheep and wool, cotton and cotton seeds, wheat and hay, etc. are some
examples of joint products. We cannot separate the cost of producing wheat and hay,
as producing wheat will automatically produce the hay as well. However, since they are
two different products, we cannot sell them at the same price in the market. Price elasticity
of demand plays important role in determining the prices of these joint products.
Wage determination
Labor is one of the major factors of production, and wage is the fixed regular payment
made to the labor in return of their input. Degree of elasticity of commodity has potential
to affect the wage to be paid to the labor.

Notes If a commodity is of inelastic nature, the labor can force the employer to increase
their wage through extreme ways like strike. As a result, the company will have to consider
the demands of labor in order to meet the demand of consumers for the inelastic goods.
However, if the commodity is of elastic nature, labor unions and other associations
cannot force the employers to raise wage as the producers can alter the demand of their
products.
International trade
The change in price cannot bring drastic change in demand of the product in case
of inelastic commodity. But even a slight change in price can cause huge effect on demand
of elastic commodity.We have also known that higher price can be charged for inelastic
goods and lowest possible price must be set for elastic goods.
Taking into account the above information, a country may fix higher prices for goods
of inelastic nature. However, if the country wants to export its products, the nature
(elasticity/inelasticity) of the commodity in the importing country should also be
considered.
Importance to finance minister
Price elasticity of demand can also be used in the taxation policy in order to gain
high tax revenue from the citizens. One of the ways would be for the government to raise
tax revenue in commodities which are price inelastic.
For example: Government could increase the tax amount in goods like cigarettes
and alcohol. Given how these are the commodities people choose to purchase regardless
of the price tag, the tax revenue would -significantly rise.
3.15 Utility
The utility theory explains consumer behaviour in relation to the satisfaction that a
consumer gets the moment he consumes a good. This theory was developed and
introduced in 1870 by a British Economist, William Stanley Jevons. When we speak of
utility in economics, we refer to the satisfaction or benefit that a consumer derives of his
consumption. The utility theory of demand assumes that satisfaction can be measured.
The fundamental assumption of utility theory of demand is that the satisfaction that
a person derives in consuming a particular product diminishes or declines as more and
more of a good is consumed. In other words, as successive quantity of goods is consumed,
the utility we derive diminishes. This is called the law of diminishing marginal utility.
Another theory explaining consumer behaviour is the indifference preference theory.
Economist Vilfredo Pareto developed this modern approach to consumer behaviour. Under
this, that analysis of consumer behaviour is described in terms of consumer preferences
of various combinations of goods and services depending on the nature, rather than from
the measurability of satisfaction in our previous discussion of the utility theory. Under the
latter theory, consumer's taste and preferences were presented by the way of total and
marginal utility. An indifference curve is a locus of points each of which represents a
combination of goods and services that will give equal level of satisfaction to a consumer.
Utility is an abstract concept rather than a concrete, observable quantity. The units
to which we assign an "amount" of utility, therefore, are arbitrary, representing a relative
value. Total utility is the aggregate sum of satisfaction or benefit that an individual gains

from consuming a given amount of goods or services in an economy. The amount of a Notes
person's total utility corresponds to the person's level of consumption. Usually, the more
the person consumes, the larger his or her total utility will be. Marginal utility is the
additional satisfaction, or amount of utility, gained from each extra unit of consumption.
3.16 Meaning and Definitions of Utility
Meaning of Utility
Utility refers to an economic term referring to the total satisfaction received from
consuming a good or service. Utility increased with wealth but at a decreasing rate.
Definitions of Utility
According to, Mrs. Robinson, “Utility is the quality in commodities that makes
individuals wants to buy them.”
According to Hibdon, “Utility is the quality of a good to satisfy a want.”
3.17 Characteristics of Utility

The main characteristics of utility can be summarized as follows:
i) Utility is Subjective
Utility is subjective because it deals with the mental satisfaction of a man. A
commodity may have different utility for different persons. Cigarette has utility for a smoker
but for a person who does not smoke, cigarette has no utility. Utility, therefore, is
subjective.
ii) Utility is Relative
Utility of a good never remains the same. It varies with time and place. Fan has
utility in the summer but not during the winter season.
iii) Utility and usefulness
A commodity having utility need not be useful. Cigarette and liquor are harmful to
health, but if they satisfy the want of an addict then they have utility for him.
iv) Utility and Morality
Utility is independent of morality. Use of liquor or opium may not be proper from
the moral point of views. But as these intoxicants satisfy wants of the drinkards and
opiumeaters, they have utility for them.
3.18 Concepts of Utility

There are three concepts of utility:
i) Initial Utility
The utility derived from the first unit of a commodity is called initial utility. Utility
derived from the first piece of bread is called initial utility. Thus, initial utility, is the utility
obtained from the consumption of the first unit of a commodity. It is always positive.

Notes ii) Total Utility
Total utility is the sum of utility derived from different units of a commodity consumed
by a household.
According to Leftwitch, “Total utility refers to the entire amount of satisfaction
obtained from consuming various quantities of a commodity.”
Total utility can be calculated as:
TU = MU1 + MU2 + MU3 + _________________ + MUn
or
TU = EMU
Here TU = Total utility and MU1, MU2, MU3, + __________ MUn =
Marginal Utility derived from first, second, third __________ and nth unit.
iii) Marginal Utility
Marginal Utility is the utility derived from the additional unit of a commodity
consumed. The change that takes place in the total utility by the consumption of an
additional unit of a commodity is called marginal utility.
According to Chapman, “Marginal utility is the addition made to total utility by
consuming one more unit of commodity”.
Marginal utility can be measured with the help of the following formula:
MUnth = TUn – TUn-1
Here, MUnth = Marginal utility of nth unit,
TUn = Total utility of ‘n’ units,
TUn-l = Total utility of n-i units,
3.19 Measurement of Utility
1. Cardinal Utility Concept
The neo-classical economists propounded the theory of consumption (consumer

behavior theory) on the assumption that utility is cardinal. For measuring utility, a term
‘util’ is coined which means units of utility.
Following are the assumptions of the cardinal utility concept that were followed by
economists while measuring utility:
a. One untilequals one unit of money
b. Utility of money remains constant
However, over a passage of time, it has been felt by economists that the exact or
absolute measurement of utility is not possible. There are a number of difficulties involved
in the measurement of utility. This is because of the fact that the utility derived by a
consumer from a good depends on various factors, such as changes in consumer’s moods,
tastes, and preferences.

These factors are not possible to determine and measure. Therefore, no such Notes
technique has been devised by economists to measure utility. Utility; thus, is not
measureable in cardinal terms. However, the cardinal utility concept has a prime
importance in consumer behavior analysis.
2. Ordinal Utility Concept
Cardinal utility approach is based on the fact that the exact or absolute measurement
of utility is not possible. However, modern economists rejected the cardinal utility approach
and introduced the concept of ordinal utility for the analysis of consumer behavior.
According to them, it may not be possible to measure exact utility, but it can be
expressed in terms of less or more useful good. For instance, a consumer consumes
coconut oil and mustard oil. In such a case, the consumer cannot say that coconut oil
gives 10 utilsand mustard oil gives 20 utils.
Instead he/she can say that mustard oil gives more utility to him/her than coconut
oil. In such a case, mustard oil would be given rank 1 and coconut oil would be given
rank 2 by the consumer. This assumption lays the foundation for the ordinal theory of
consumer behavior.
According to neo-classical economists, cardinal measurement of utility is possible
in practical situations. Moreover, they believed that the concept of cardinal utility is useful
in analyzing consumer behavior. However, modern economists believed that utility is
related to psychological aspect of consumers; therefore, it cannot be measured in
quantitative terms.
In addition, they advocated that the ordinal utility concept plays a significant role
in consumer behavior analysis. Modern economists also believed that the concept of
ordinal utility meets the theoretical requirements of consumer behavior analysis even when
there is no cardinal measure of utility is available.
3.20 Cardinal Measurement

It is difficult to measure a qualitative concept such as utility, but economists try to
quantify it in two different ways: cardinal utility and ordinal utility. Both of these values
are imperfect, but they provide an important foundation for studying consumer choice.
In economics, utility simply means the satisfaction that a consumer experiences
from a product or service. Utility is an important factor in decision-making and product
choice, but it presents a problem for economists trying to incorporate it into
microeconomics models. Utility varies among consumers for the same product, and it can
be influenced by other factors, such as price and the availability of alternatives.
Cardinal utility is the assignment of a numerical value to utility. Models that
incorporate cardinal utility use the theoretical unit of utility, the util, in the same way that
any other measurable quantity is used. In other words, a basket of bananas might give
a consumer a utility of 10, while a basket of mangoes might give a utility of 20.
The downside to cardinal utility is that there is no fixed scale to work from. The idea
of 10 utils is meaningless in and of itself, and the factors that influence the number might
vary widely from one consumer to the next. If another consumer gives bananas autil value
of 15, it doesn't necessarily mean that he likes bananas 50% than the first consumer.
The implication is that there is no way to compare utility between consumers.

Notes One important concept related to cardinal utility the law of diminishing marginal utility,
which states that at a certain point every extra unit of a good will provide less and less
utility. While a consumer might assign his first basket of bananas a value of 10 utils,
after several baskets the additional utility of each new basket might decline significantly.
The values that are assigned to each additional basket can be used to find the point at
which utility is maximized or to estimate a customer's demand curve.
An alternative way to measure utility is the concept of ordinal utility, which uses
rankings instead of values. The benefit is that the subjective differences between products
and between consumers is eliminated and all that remains are the ranked preferences.
One consumer might like mangoes more than bananas, and another might prefer bananas
over mangoes. These are comparable, if subjective, preferences.
Utility is used in the development of indifference curves, which represent the
combination of two products that a certain consumer values equally and independently
of price. For example, a consumer might be equally happy with three bananas and one
mango or one banana and two mangoes. These are thus two points on the consumer's
indifference curve.
3.21 Law of Diminishing Marginal Utility

Dr. Marshall states this, law as follow: The additional benefit which a person derives
from a given increase of his stock of anything diminishes with the growth of the stock
that he has another words the law of DMU simply states that other things being equal,
the marginal utility derived from successive units of a given commodity goes on decreasing.
Hence the more we have of a thing; the less we want of it, because every successive
unit gives less and less satisfaction.
The law is explained with the help of following example:
Units of commodity Total Utility (TU) Marginal Utility (MU)

No. of mangoes
1 3 8
2 14 6
3 16 2
4 16 0
5 14 (-) 2
It will be better to know some terms for understanding the law and they are:
1. Initial Utility: It is the utility of the initial or the first unit. In the table initial
utility is 8
2. Total Utility: In column 3 of the table, it gives the total utility at each step.
For example it you consume on mango are total utility is 3, if you consume
two mangoes, the total utility is 14.
3. Zero Utility: When the consumption of a unit of a commodity makes no addition
to the total utility, then it is the point of zero utility. In our table, the TU after
the 3rd unit is consumed is 16 and ar the 4th also it is 16. Thus, the 4th mango
results in no increase. Thus is the point of zero utility. It is seen that the total
utility is maximum when the MU is zero.

4. Marginal Utility: The addition to the total utility by the consumption of the last Notes
unit considered just worthwhile. The can be worked out by using following
formula.
5. Negative Utility: It the consumption of a unit of a commodity is carried to
excess, then instead of giving any satisfaction, it may cause dissatisfaction.
The utility in such cases is negative. In the table given above the marginal utility
of the 5th unit is negative.
Assumptions:
The assumptions of the law of DMU are:

1. All the units of the given commodity are homogenous i.e. identical in size shape,
quality, quantity etc.
2. The units of consumption are of reasonable size. The consumption is normal.
3. The consumption is continuous. There is no unduly long time interval between
the consumption of the successive units.
4. The law assumes that only one type of commodity is used for consumption
at a time.
5. Though it is psychological concept, the law assumes that the utility can be
measured cardinally i.e. it can be expressed numerically.
6. The consumer is rational human being and he aims at maximum of satisfaction.
Exceptions:
The exceptions to the law of DMU are as follows:

1. Hobbies: In case of certain hobbies like stamp collection or old coins, every
addition unit gives more pleasure. MU goes on increasing with the acquisition
of every unit.
2. Drunkards: It is believes that every does of liquor Increases the utility of a
drunkard.
3. Miser: In the case of miser, greed increases with the acquisition of every
additional unit of money.
4. Reading: reading of more books gives more knowledge and in turn greater
satisfactions.
Importance of the Law of DMU

1. Basic of economic law and concepts: This law of DMU forms the basis of
law of demand, law of Equi-marginal utility, elasticity of demand etc.
2. Public finance: The Govt. can impose and justify progressive income tax on
the ground of this law, as the income increases, the MU of income diminishes.
3. Businessmen: A businessman or producer can increase the sale of his product
by fixing a lower price. Since consumers tend to buy more to equate MU with
price, a producer can expect a rise in sale.
3.22 Consumer Surplus

Consumer Surplus refers to an economic measure of consumer satisfaction, which
is calculated by analyzing the difference between what consumers are willing to pay for

Notes a good or service relative to its market price. A consumer surplus occurs when the
consumer is willing to pay more for a given product than the current market price.
Consumer surplus measures the welfare that consumers derive from their
consumption of goods and services, or the benefits they derive from the exchange of goods.
Consumer surplus is the difference between what consumers is willing to pay for
a good or service (indicated by the position of the demand curve) and what they actually
pay (the market price). The level of consumer surplus is shown by the area under the
demand curve and above the ruling market price.
Consider the demand for public transport shown in the diagram. The initial fare is
price P for all passengers and at this price, Q1 journeys are demanded by local users.
At price P the level of consumer surplus is shown by the area APB. If the bus
company cuts price to P1 the demand for bus journeys expands and the new level of
consumer surplus rises to AP1C. This means that the level of consumer welfare has
increased by the area PP1CB.

Consumer surplus = total willingness to pay for a good or service - the total amount Notes
consumers actually do pay.
If a zero fare is charged, consumers will demand bus journeys up to the point where
the demand curve cuts the x-axis.
When demand for a product is perfectly elastic, the level of consumer surplus is
zero since the price that people pay matches precisely the price they are willing to pay.
There must be perfect substitutes in the market for this to be the case.
When demand is perfectly inelastic the amount of consumer surplus is infinite.
Demand is invariant to a price change. Whatever the price, the quantity demanded remains
the same.
Note that both these situations are highly unlikely to exist - the vast majority of
demand curves for goods and services are downward sloping. When demand is inelastic,
there is a greater potential consumer surplus because there are some buyers willing to
pay a high price to continue consuming the product.
3.23 Ordinal Measurement

Ordinal Utility is propounded by the modern economists, J.R. Hicks, and R.G.D.
Allen, which states that it is not possible for consumers to express the satisfaction derived
from a commodity in absolute or numerical terms. Modern Economists hold that utility
being a psychological phenomenon, cannot be measured quantitatively, theoretically and
conceptually. However, a person can introspectively express whether a good or service
provides more, less or equal satisfaction when compared to one another.
In this way, the measurement of utility is ordinal, i.e. qualitative, based on the ranking
of preferences for commodities. For example: Suppose a person prefers tea to coffee and
coffee to milk. Hence, he or she can tell subjectively, his/her preferences, i.e. tea > coffee
> milk.
Assumptions:
The ordinal utility approach is based on the following assumptions:

a) A consumer substitutes commodities rationally in order to maximize his level
of satisfaction.
b) A consumer can rank his preferences according to the satisfaction of each
basket of goods.
c) The consumer is consistent in his choices.
d) It is assumed that each of the good is divisible.
e) It is assumed that the consumer has full knowledge of prices in the market.
f) The consumer's scale of preferences is so complete that consumer is indifferent
between them.
g) Two commodities are used by the consumer. It is also known as two
commodities model.
h) Two commodities X and Y are substitutes of each other. These commodities
can be easily substituted in various pairs.

Notes 3.24 Indifference Curves (features and properties)

Indifference Curve approach was first propounded 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”.
An indifference curve is a geometrical presentation of a consumer is scale of
preferences. It represents all those combinations of two goods which will provide equal
satisfaction to a consumer. A consumer is indifferent towards the different combinations
located on such a curve. Since each combination yields the same level of satisfaction,
the total satisfaction derived from any of these combinations remains constant.
An indifference curve 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.”
Assumptions of Indifference Curve Analysis

i) Rational behaviour of the consumer: It is assumed that individuals are rational
in making decisions from their expenditures on consumer goods.
ii) Utility is ordinal: Utility cannot be measured cardinally. It can be, however,
expressed ordinally. In other words, the consumer can rank his various
combinations of goods according to the satisfaction or utility of each basket.
iii) Diminishing marginal rate of substitution: In the indifference curve analysis,
the principle of diminishing marginal rate of substitution is assumed.
iv) Consistency in choice: The consumer, it is assumed, is consistent in his
behaviour during a period of time. For instance, if the consumer prefers
combination of A of goods to combination B of goods, he then remains
consistent in his choice. His preference, during another period of time does not
change. Symbolically, it can be expressed as: If A > B, then B > A.
v) Consumer’s preferences not self contradictory: The consumer’s preferences
are not self contradictory. It means that if combination A is ‘preferred over
combination B and combination B is preferred over C, then combination A is
preferred over C. Symbolically it can be expressed, If A > .B and B > C, then
A > C.
Indifference Schedule
An indifference schedule refers to a schedule that indicates different combinations

of two commodities which yield equal satisfaction. A consumer, therefore, gives equal
importance to each of the combinations: Supposing a consumer two goods, namely apples

and oranges. The following indifference schedule indicates different combinations of apples Notes
and oranges that yield him equal satisfaction.
Combination of Apple Oranges Apples Oranges

A 1 0
B 2 7
C 3 5
D 4 4
Properties of Indifference Curves
The main attributes or properties or characteristics of indifference curves are as

follows:
1. Indifference Curves are Negatively Sloped
The indifference curves must slope downward from left to right. 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.
In the above diagram, two combinations of commodity cooking oil and commodity
wheat is shown by the points a and b on the same indifference curve. The consumer is
indifferent towards points a and b as they represent equal level of satisfaction.
2. Higher Indifference Curve Represents Higher Level of Satisfaction

Indifference curve that lies above and to the right of another indifference curve
represents a higher level of satisfaction. 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.
In this diagram, there are three indifference curves, IC1, IC2 and IC3 which represents
different levels of satisfaction. The indifference curve IC3 shows greater amount of
satisfaction and it contains more of both goods than IC2 and IC1. IC3 > IC2 > IC1.

Notes
3. Indifference Curves are Convex to the Origin
This is an important property of indifference curves. They are convex to the origin.
As the consumer substitute’s commodity X for commodity Y, the marginal rate of
substitution diminishes as X for Y along an indifference curve. The Slope of the curve is
referred as the Marginal Rate of Substitution. The Marginal Rate of Substitution is the
rate at which the consumer must sacrifice units of one commodity to obtain one more
unit of another commodity.
In the above diagram, as the consumer moves from A to B to C to D, the willingness
to substitute good X for good Y diminishes. The slope of IC is negative. In the above
diagram, diminishing MRSxy is depicted as the consumer is giving AF > BQ > CR units
of Y for PB = QC = RD units of X. Thus indifference curve is steeper towards the Y axis
and gradual towards the X axis. It is convex to the origin.
If the indifference curve is concave, MRSxy increases. It violets the fundamental

feature of consumer behaviour.
If commodities are almost perfect substitutes then MRSxy remains constant. In such
cases the indifference curve is a straight line at an angle of 45 degree with either axis.

If two commodities are perfect complements, the indifference curve will have a right Notes
angle.
In reality, commodities are not perfect substitutes or perfect complements to each
other. Therefore MRSxy usually diminishes.
4. Indifference Curves cannot intersect each other
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.
In the above diagram, two indifference curves are showing cutting each other at point
B. The combinations represented by points B and F given equal satisfaction to the
consumer because both lie on the same indifference curve IC2. Similarly the combinations
shows by points B and E on indifference curve IC1 give equal satisfaction top the consumer.
If combination F is equal to combination B in terms of satisfaction and combination
E is equal to combination B in satisfaction. It follows that the combination F will be
equivalent to E in terms of satisfaction. This conclusion looks quite funny because
combination F on IC2 contains more of good Y (wheat) than combination which gives more
satisfaction to the consumer. We, therefore, conclude that indifference curves cannot cut
each other.
5. Indifference Curves do not Touch the Horizontal or Vertical Axis

Notes 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.
In the above diagram, it is shown that the indifference IC touches Y axis at point
P and X axis at point S. At point C, the consumer purchase only OP commodity of Y
good and no commodity of X good, similarly at point S, he buys OS quantity of X good
and no amount of Y good. Such indifference curves are against our basic assumption.
Our basic assumption is that the consumer buys two goods in combination.
Theory of revealed preference
Revealed preference theory is attributable to Paul Samuelson in his article

“Consumption Theory in Terms of Revealed Preference”, 1948. According to Samuelson,
a consumer with a given income will buy a mixture of products; as his income changes,
the mixture of goods and services will also change. It is assumed that the consumer will
never select a combination which is more expensive than that which was previously
chosen. An economic theory of consumption behavior which asserts that the best way
to measure consumer preferences is to observe their purchasing behavior. Revealed
preference theory works on the assumption that consumers have considered a set of
alternatives before making a purchasing decision. Thus, given that a consumer chooses
one option out of the set, this option must be the preferred option.
Consumer theory depends on the existence of preferences which materialize into
utility functions. These utility functions are maximized by consumers subject to a budget
restraint. The issue is that it is difficult to accept that individuals really have a definite
mathematical formula in mind when choosing between different options. What revealed
preference theory does is work backwards to assume that we can deduce these utility
functions from consumer behaviour. Analyzing these choices leads us backwards to a
set of preferences that influences the choices they make. It therefore allows economists
to study consumer behaviour empirically.
There are two main axioms to the theory, both based on completeness and transitivity:
i) WARP (Weak Axiom of Revealed Preference): If A is revealed preferred to
B (A RP B), then it must be so in every case. That is, if a consumer ever chooses
B, then we must assume that A was previously chosen and that the budget
constraint had enough ‘left over’ to allow a consumer to choose B as well.
ii) SARP (Strong Axiom of Revealed Preference): This adds transitivity. If there
are only two goods, then it is clear that WARP already defines a consumer’s
choice: A over B. However, the SARP adds the idea of indirectly revealing
preferences: if A is chosen over B and B over C, SARP and transitivity dictate
that A is also preferred to C, so A is indirectly revealed to be preferable to C
(A R* C). This drastically reduces the amount of empirical evidence necessary
to define consumer preferences.
In the case shown in the adjacent figure, we know that C is indirectly preferred to
B (C R* B) because it allows us to reach a higher utility curve. Because C and B define
a space (R*) and we know that C, B and A are contained within R*(R*{(C,B)}), then we
can say that C RP A RP B, that is, by knowing from observation that C is indirectly
preferred to B, we can tell that C is revealed as preferable to A (C RP A) and that A
is revealed as preferable to B (A RP B).

Notes
If we think of A, B and C as infinitely complex bundles of goods, we can map out

all a consumer’s choices. In theory, we can track this backwards to actually build utility
functions if we have access to unlimited data. Without actually having to do this, we can
aggregate consumer data to reveal general truths about a certain population’s preferences.
3.25 Complements and Substitutes

In economics, a complementary good or complement is a good with a negative cross
elasticity of demand, in contrast to a substitute good. This means a good's demand is
increased when the price of another good is decreased. Conversely, the demand for a
good is decreased when the price of another good is increased. If goods A and B are
complements, an increase in the price of A will result in a leftward movement along the
demand curve of A and cause the demand curve for B to shift in; less of each good will
be demanded. A decrease in price of A will result in a rightward movement along the
demand curve of A and cause the demand curve B to shift outward; more of each good
will be demanded. Basically this means that since the demand of one good is linked to
the demand of another good, if a higher quantity is demanded of one good, a higher quantity
will also be demanded of the other, and if a lower quantity is demanded of one good,
a lower quantity will be demanded of the other. The prices of complementary goods are
related in the same way: if the price of one good rises, so wills the price of the other,
and vice versa. With substitute goods, however, the price and quantity demanded of one
good is related inversely to the price and quantity demanded of a substitute good, meaning
that if the price or quantity demanded of one good rises, the price or quantity demanded
of its substitute will fall.
When two goods are complements, they experience joint demand. For example, the
demand for razor blades may depend upon the number of razors in use; this is why razors
have sometimes been sold as loss leaders, to increase demand for the associated blades.
Recent work in food consumption has elucidated the psychological processes by
which the consumption of one good (e.g., cola) stimulates demand for its complements
(e.g., a cheeseburger, pizza, etc.). Consumption of a food or beverage activates a goal
to consume its complements: foods that consumers believe would produce super-additive
utility (i.e., would taste better together). Eating peanut-butter covered crackers, for
instance, increases the consumption of grape-jelly covered crackers more than eating plain
crackers. Drinking cola increases consumers' willingness to pay for a voucher for a

Notes cheeseburger. This effect appears to be contingent on consumers' perceptions of what

foods are complements rather than their sensory proportion.
3.26 Consumer Equilibrium

Consumer equilibrium refers to the combination of goods that will give the highest
level of satisfaction to a consumer that is within his purchasing power.
Assumptions of Consumers Equilibrium
The various assumptions of consumers equilibrium:

1. Consumer is rational and so maximizes 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.
3.27 Individual Demand vs. Market Demand
Individual Demand
The individual demand is the demand of one individual or firm. It represents the
quantity of a good that a single consumer would buy at a specific price point at a specific
point in time. While the term is somewhat vague, individual demand can be represented
by the point of view of one person, a single family, or a single household.
Market Demand
Market demand provides the total quantity demanded by all consumers. In other
words, it represents the aggregate of all individual demands. There are two basic types
of market demand: primary and selective. Primary demand is the total demand for all of
the brands that represent a given product or service, such as all phones or all high-end
watches. Selective demand is the demand for one particular brand of product or service,
such as the iPhone or a Michele watch. Market demand is an important economic marker
because it reflects the competitiveness of a marketplace, a consumer’s willingness to buy
certain products and the ability of a company to leverage itself in a competitive landscape.
If market demand is low, it signals to a company that they should terminate a product
or service, or restructure it so that it is more appealing to consumers.
3.28 Demand Forecasting

Demand forecasting is based on the statistical data about past behavior and empirical
relationships of the demand determinants. Demand forecasting is not a speculative
exercise into the unknown. It is essentially a reasonable judgement of future probabilities
of the market events based on scientific background. Demand forecasting is an estimate
of the future demand. It cannot be hundred per cent precise. But, it gives a reliable
approximation regarding the possible outcome, with a reasonable accuracy. It is based Notes
on the mathematical laws of probability.
Demand forecasting is the area of predictive analytics dedicated to understanding
consumer demand for goods or services. That understanding is harnessed and used to
forecast consumer demand. Knowledge of how demand will fluctuate enables the supplier
to keep the right amount of stock on hand. If demand is underestimated, sales can be
lost due to the lack of supply of goods. If demand is overestimated, the supplier is left
with a surplus that can also be a financial drain. Understanding demand makes a company
more competitive in the marketplace. Understanding demand and the ability to accurately
predict it is imperative for efficient manufacturers, suppliers, and retailers. To be able to
meet consumers’ needs, appropriate forecasting models are vital. Although no forecasting
model is flawless, unnecessary costs stemming from too much or too little supply can
often be avoided using data mining methods. Using these techniques, a business is better
prepared to meet the actual demands of its customers.
Meaning of Demand Forecasting
Demand forecasting refers to the expectation about the future course of the market
demand for a product. It involves techniques including both informal methods, such as
educated guesses, and quantitative methods, the use of historical sales data or current
data from test markets.
“Demand forecasting means expectation about the future course of the market
demand for a product”.
Levels of Demand Forecasting
Demand forecasting may be undertaken at the following levels:

1. Micro level: It refers to the demand forecasting by the individual business firm
for estimating the demand for its product.
2. Industry level: It refers to the demand estimate for the product of the industry
as a whole. It is undertaken by an Industrial or Trade Association. It relates
to the market demand as a whole.
3. Macro level: It refers to the aggregate demand for the industrial output by the
nation as a whole. It is based on the national income or aggregate expenditure
of the country. Country’s consumption function provides an estimate for the
demand forecasting at macro level.
Importance of Demand Forecasting
Importance of demand forecasting can be summerised as follows:

i) Important for production planning: Demand forecasting is a prerequisite for
the production planning of a business firm. Expansion of output of the firm should
be based on the estimates of likely demand, otherwise there may be
overproduction and consequent losses may have to be faced.
ii) Sales forecasting: Sales forecasting is based on the demand forecasting.
Promotional efforts of the firm should be based on sales forecasting.
iii) Control of business: Demand forecasting is important for controlling the
business on a sound footing, it is essential to have a well conceived budgeting
of costs and profits that is based on the forecast of annual demand/sales and
prices.

Notes iv) Inventory control: A satisfactory control of business inventories, raw materials,
intermediate goods, semi-finished product, finished product, spare.
v) Growth and long-term investment programmes: Demand forecasting is
necessary for determining the growth rate of the firm and its long-term investment
programmes and planning.
vi) Stability: Stability in production and employment over a period of time can be
made effective by the management in the light of the suitable forecasting about
market demand and other business variables and smoothening of the business
operations through counter-cyclical and seasonally adjusted business
programmes.
Features of Demand Forecasting
The main features of demand forecasting are the following:

i) It is in terms of specific quantities.
ii) It is undertaken in an uncertain atmosphere.
iii) A forecast is made for a specific period of time which would be sufficient to
take a decision and put it into action.
iv) It is based on historical information and the past data.
v) It tells us only the approximate demand for a product in the future.
vi) It is based on certain assumptions.
vii) It cannot be 100% precise as it deals with future expected demand.
Characteristics of Demand Forecasting
Eight major characteristics can be identified with forecasting methods to identify key
characteristics of good demand forecasting methods:
i) Time horizon: The length of time over which a decision is being made has
a bearing on the appropriate technique to use depending on the time i.e. short
and long demand forecasting can be measured.
ii) Level of details: The level of detail needed should match the focus of decision
making unit in the forecast.
iii) Stability: Forecasting in situations that are relatively stable over time requires
less attention than those that are in constant flux.
iv) Pattern of data: As different forecasting methods vary in their ability to identify
different patterns it is useful to make the pattern in the data fit with the method
that suits it the most.
v) Type of methods: Other assumptions are also made in each forecasting
method that must fit the situation under consideration
vi) Cost: Several costs are associated with adapting forecasting procedure within
an organization like managerial development, storage, operation and opportunity
in terms of other techniques that might have been applied.
vii) Accuracy: It is measured by the degree of deviation between past forecast and
current actual performance or present forecast and future performance.
viii) Ease of application: Models must be chosen within the abilities of the user
to understand them and within the time allowed for using them.

Essentials of Demand Forecasting Method Notes

The essentials of demand forecasting method can be summarized as follows:
1. Simplicity: A simpler method is always more comprehensive than a
complicated one.
2. Economy: It should involve lesser costs as far as possible. Its costs must be
compared against the benefits of forecasts.
3. Quickness: It should yield quick results. A time consuming method may delay
the decision making process.
4. Accuracy: Forecast should be accurate as far as possible. Its accuracy must
be judged by examining the past forecasts in the light of the present situation.
5. Plausibility: It implies management’s understanding of the method used for
forecasting. It is essential for a correct interpretation of the results.
6. Flexibility: Not only is the forecast to be maintained up to date, there should
be possibility of changes to be incorporated in the relationships entailed in
forecast procedure from time to time.
Types of Demand Forecasting (on the basis of Time)
1. Short-term Demand Forecasting

Short-term forecasting relates to a period not exceeding a year. Professor E.J.
Douglas prefers to use the term demand estimation for short-term demand forecasting.
To him demand estimation refers to the determination of the volume of current demand
for a firm’s product, for a short period say over a month or a year.
Short-term forecasts relate to the day-to-day particulars which are concerned with
tactical decisions under the given resource constraints; as in the short run, the available
resources, scale of operations etc., are fixed or unalterable, by and large. In short-term
forecasting, a firm is primarily concerned with the optimum utilization of its existing
production capacity.
Usefulness of Short-term forecasting
1. Evolving a sales policy: A short-term demand forecasting is useful in evolving
a suitable sales policy in view of the seasonal variation of demand and so as
to avoid the problem of short supply or overproduction of the firm’s products
in the market.
2. Determining price policy: Short-term sales forecasting will help the firm in
determination of a suitable price policy to clear off the stocks during offseason,
and to take advantage in the peak season.
3. Evolving a purchase policy: In view of the short-term forecasting of material
prices, a firm can evolve a rational purchase policy for buying raw materials and
control its inventory stocks with a greater economy.
4. Fixation of sales targets: Demand and sales forecasting in the short-term helps
the business firm in setting sales targets and for establishing controls over the
business. It is no use fixing high sales targets, when sales forecasting reveals
a decline in a quarter.
5. Determining short-term financial planning: A firm’s short-term financial policy
and planning can be suitably determined on the basis of short-term demand
forecasting. A firm’s need for cash depends on its production and sales. Without
sales forecasting a rational financial planning is not possible.

Notes 2. Medium-Term Demand Forecasting

Medium-Term demand forecasting refers to the forecasts prepared for intermediate
period between long term and short term during which the firm’s scale of operations or
the production capacity may continue. Medium-Term demand forecasting is followed by
a firm which is subjected to the medium term variation of the business cycle. Business
organization such as cotton industries, garments manufacturers and parts and tools
manufacturers often practices the medium term demand forecasting. Medium-term
forecasts are normally for the periods of 1 to 3 years.
3. Long-Term Demand Forecasting
Long-term forecasting refers to the forecasts prepared for long period during which
the firm’s scale of operations or the production capacity may be expanded or reduced.
Long-term forecasts are normally for the periods exceeding a year, usually 3-5 years
or even a decade or more. Functionally, the long periods which permit alternations in the
scale of production differ from industry to industry and firm to firm.
Usefulness of Long-term forecasting
1. Importance for Business planning: Long-term forecasting is of great
assistance to long term business planning. Long-term demand potential will
provide the required guidelines for planning of a new business unit or for the
expansion of the existing one. Capital budgeting by a firm is based on the long-
term demand forecasting.
2. Manpower planning: It is essential to determine long-term sales forecast for
an appropriate manpower planning by the firm in view of its long-term growth
and progress of the business.
3. Long-term financial planning: Finance is the kingpin of the modern business.
In view of the long-term demand and sales forecasting and the production
planning, it becomes easier for the firm to determine its long-term financial
planning and programmes for raising the funds from the capital market.
Sources of Data Collection for Demand Forecasting
The marker research may be based on two types of sources of data collection, viz.:
primary sources and secondary sources, providing primary data and secondary data,
respectively.
Secondary Sources of Data
Secondary data or information’s are those which are obtained from someone else’s
records. These data are already in existence in the recorded or published forms.
Secondary data are like finished products since they have been processed
statistically in some form or the other. In a market research for the demand analysis,
a beginning may be made with the collection of secondary data, which would provide clues
for further inquiry. There are sufficient secondary sources for collecting the required
information for market and demand analysis.
The main sources of secondary data are:
(i) Official publications of the Central, State and Local governments, such as Plan
documents, Census of India, Statistical Abstracts of the Indian Union, Annual
Survey of Industries, Annual Bulletin of Statistics of Exports and Imports,
Monthly Studies of Production of Selected Industries, Economic Survey,
National Sample Survey Reports, etc.

(ii) Trade and technical or economic journals and publications like the Economic Notes
and Political Weekly, Indian Economic Journal, Stock Exchange Directory,
Basic Statistics and other information supplied by the Centre for Monitoring
Indian Economy, etc.
(iii) Official publications like the Reserve Bank of India, e.g., Annual Report on
Currency and Finance, Monthly Bulletin of Reserve Bank of India, etc.
(iv) Official publications of international bodies like the IMF, UNO, World Bank, etc.
(v) Market reports and trade bulletins published by stock exchange, trade
associations, large business houses, chambers of commerce, etc.
(vi) Publications brought out by research institutions, universities, associations, etc.
(vii) Unpublished data such as firm’s account books showing data about sales,
profits, etc.
(viii) Secondary data should not be taken at their face value and are never to be
used blindly.
3.29 Techniques of Demand Forecasting

The methods of demand forecasting can be broadly classified into two categories
such as i) survey method and ii) statistical method. The detail explanations of demand
forecasting methods are given below:
A. Survey Method of Demand Forecasting
The Survey method is the method of gathering data by asking questions to people
who are thought to have desired information. A formal list of questionnaire is prepared.
Generally a non disguised approach is used. The respondents are asked questions on
their demographic interest opinion.
Advantages of Survey Method

i) Surveys are relatively inexpensive (especially self-administered surveys).
ii) Surveys are useful in describing the characteristics of a large population. No
other method of observation can provide this general capability.
iii) They can be administered from remote locations using mail, email or telephone.
iv) Consequently, very large samples are feasible, making the results statistically
significant even when analyzing multiple variables.
v) Many questions can be asked about a given topic giving considerable flexibility
to the analysis.
vi) There is flexibility at the creation phase in deciding how the questions will be
administered: as face-to-face interviews, by telephone, as group administered
written or oral survey, or by electronic means.
vii) Standardized questions make measurement more precise by enforcing uniform
definitions upon the participants.
viii) Standardization ensures that similar data can be collected from groups then
interpreted comparatively (between-group study).
Disadvantages of Survey Method

i) A methodology relying on standardization forces the researcher to develop
questions general enough to be minimally appropriate for all respondents,

Notes possibly missing what is most appropriate to many respondents.

ii) Surveys are inflexible in that they require the initial study design (the tool and
administration of the tool) to remain unchanged throughout the data collection.
iii) The researcher must ensure that a large number of the selected sample will
reply.
iv) It may be hard for participants to recall information or to tell the truth about
a controversial question.
v) As opposed to direct observation, survey research (excluding some interview
approaches) can seldom deal with “context.”
vi) Unwillingness of respondents to provide information
vii) This requires salesmanship on the part of the interviewer.
viii) The interviewer may assure that the information will be kept secret or apply the
technique of offering some presents.
Types of Survey Methods
1. Expert Opinion Method

In this method, the firm makes an effort to obtain the opinion of experts who have
long standing experience in the field of enquiry related to the product under consideration.
If the forecast is based on the opinion of several experts then the approach is called
forecasting through the use of panel consensus. Although the panel consensus method
usually results in forecasts that embody the collective wisdom of consulted experts, it
may be at times unfavourably affected by the force of personality of one or few key
individuals. To counter this disadvantage of panel consensus, another approach is
developed called the Delphi method. In this method a panel of experts is individually
presented a series of questions pertaining to the forecasting problem. Responses acquired
from the experts are analyzed by an independent party that will provide the feedback to
the panel members. Based on the responses of other individuals, each expert is then asked
to make a revised forecast. This process continues till a consensus is reached or until
further interactions generate no change in estimates.
The main advantage of the experts’ opinion survey method is its simplicity. It does
not require extensive statistical or mathematical calculations however this method has
its own limitations. It is purely subjective. It substitutes opinion in place of analysis of
the situation. Experts may have different forecasts or any one among them may influence
others. Who knows experts may be biased or have their own intentions behind providing
their opinions. If the consulted experts are genuinely reliable then panel consensus could
be perhaps the best method of forecasting.
2. Consumers Survey Method
Consumers Survey is undertaken by questioning consumer’s about what they are
planning or intending to buy. A questionnaire may be prepared and mailed to the
consumers. Or it may be sent through enumerators.
In the questionnaire, the respondents may be asked for their reactions to hypothetical
changes in demand determinants such as price, income, prices of substitutes, advertising
etc.
Survey methods constitute another important forecasting tool, especially for short-
term projections. The most direct method of estimating demand in the short- run is to
conduct the survey of buyers’ intentions. The consumers are directly approached and are
asked to give their opinions about the particular product. The questionnaire must be

carefully prepared bearing in mind the qualities of a good questionnaire. Consumers Survey Notes
may acquire three forms: a) Complete Enumeration Survey, b) Sample Survey and c) End-
Use Method.
a) Complete Enumeration Survey
Under this, the forecaster undertakes a complete survey of all consumers whose
demand he intends to forecast. Once this information is collected, the sales forecasts
are obtained by simply adding the probable demands of all consumers. The principle merit
of this method is that the forecaster does not introduce any bias or value judgment of
his own. He simply records the data and aggregates. But it is a very tedious and
cumbersome process; it is not feasible where a large number of consumers are involved.
Moreover if the data are wrongly recorded, this method will be totally useless.
Complete Enumeration Survey covers all the consumers. It resembles the Census
Data Collection which considers the entire population. In this case all the consumers are
covered and information is obtained from all regarding the prospective demand for the
product under consideration. The method of Complete Enumeration has the advantage of
being absolutely unbiased as far as consumer opinions are concerned. We can obtain
complete information by contacting every possible present, past or would be consumers
of the product. No doubt it is not very easy to carry out the survey on such a large scale.
Even the collected information will be difficult and too tedious to be analyzed. The reliability
on such consumers’ information may be questionable, if the opinions are not authentic.
b) Sample Survey
Under this method, the forecaster selects a few consuming units out of the relevant
population and then collects data on their probable demands for the product during the
forecast period. The total demand of sample units is finally blown up to generate the total
demand forecast. Compared to the former survey, this method is less tedious and less
costly, and subject to less data error; but the choice of sample is very critical. If the sample
is properly chosen, then it will yield dependable results; otherwise there may be sampling
error. The sampling error can decrease with every increase in sample size.
In case of the sample survey method, few consumers are selected to represent the
entire population of the consumers of the commodity consumed. The total demand for
the product in the market is then projected on the basis of the opinion collected from
the sample. The most important advantage of this method is that it is less expensive and
less tedious compared to the method of complete enumeration. The sample chosen should
not be too small or too large. This method if applied carefully will yield reliable results
especially in case of new brands and new products.
c) End-Use Method
Under this method, the sales of a product are projected through a survey of its end-
users. A product is used for final consumption or as an intermediate product in the
production of other goods in the domestic market, or it may be exported as well as
imported. The demands for final consumption and exports net of imports are estimated
through some other forecasting method, and its demand for intermediate use is estimated
through a survey of its user industries.
A given product may have different end uses. For example: milk may have different
end uses such as milk powder, chocolates, sweet -meats like ‘barfi’ etc. Therefore the
end users of milk are identified. A survey is planned of the end users and the estimated
demands from all segments of end users are added.

Notes 3. Market controlled experiment method

Under this method the main determinants of demand of a product like price,
advertising, packaging, and quality are identified. Here the market divisions must be
homogeneous with regard to income, population, caste, religion, sex, age, tastes,
preference.
Merits:
i) It is a carefully carried out exercise which helps researcher to come out with
a demand function indicating quantities.
ii) This method can be used to check the results of demand forecasting obtained
from other methods.
Demerits:
i) These methods are expensive and time consuming.
ii) These methods are risky as they might send wrong signals to the consumers,
dealers and competitors.
iii) It is difficult to satisfy the conditions of homogeneity.
4. Delphi Method
In Delphi Method, an attempt is made to arrive at a consensus of opinion. The

participants are supplied with responses to previous questions from others in the group
by a leader. The leader provides each expert with opportunity to react to the information
given by others, including reasons advanced, without disclosing the source.
Delphi method facilitates anonymity of the respondent’s identity. This enables
respondents to be frank and forthright in giving their views. It facilitates posing the problem
to the experts at one time and has their response nearly as good as pooling the panelists
together.
5. Consumer Clinics Method
An artificial market situation is created and “consumer clinics” selected. Consumers

are asked to spend time in an artificial departmental store and different prices are set
for different buyer groups. The responses to the price changes are observed and necessary
decisions taken.
B. Statistical Methods of Demand Forecasting
Statistical methods of demand forecasting include the Time Series Analysis, Moving
Averages, Exponential Smoothing, Index Numbers, Regression Analysis as well as
Econometric Models and Input-Output Analysis. These methods use various types of
statistical equations and mathematical models to estimate long term demand for a product.
Types of Statistical Methods
1. Trend Projection Method

Trend projection method is a classical method of business forecasting. This method
is essentially concerned with the study of movement of variable through time. The use
of this method requires a long and reliable time series data. The trend projection method
is used under the assumption that the factors responsible for the past trends in variables
to be projected (e.g. sales and demand) will continue to play their part in future in the

same manner and to the same extend as they did in the past in determining the magnitude Notes
and direction of the variable.
Advantages of Trend Projection
Advantages of trend projection method are as follows:
i) Trend projection method is reliable to estimate the future course of action.
ii) This method is popular in business forecasting.
iii) It is very simple method.
iv) The marketing manager can understand the future demand in market.
Disadvantages of Trend Projection
Disadvantages of trend projection method are as follows:
i) Trend projection method is quite expensive.
ii) This method is not useful for short term forecasting.
iii) Trend projection method does not disclose the information which can be used
for formulating various business policies.
Methods of Finding Trend
(a) The Least Square Method
A statistical technique to determine the line of best fit for a model. The least squares
method is specified by an equation with certain parameters to observed data. This method
is extensively used in regression analysis and estimation.
The Method of least square can be used either to fit a straight line trend or a parabolic
trend. The straight line trend is represented by the equation:
Σ Σ
Yc = a + bx Here, a = and b=
Σ
Where, Yc = Trend value to be computed,
X = Unit of time (independent variable),
a = Constant to be calculated,
b = Constant to be calculated.
(b) The Moving Average Method
The moving average is one of the most useful and objective tools available to the
technical analyst. Moving averages show the average value of a security’s price over a
certain number of time periods. The most commonly used moving averages are the 20,
30, 50, 100 and 200 day averages. Moving averages smooth a data series and make it
easier to spot trends and smooth out price and volume fluctuations or noise that can
confuse interpretation. It moves because for each calculation, the latest x number of time
periods’ data is used. Using the data from prior time periods, a moving average lags the
market. The method of Moving Average is useful when the market demand is assumed
to remain fairly steady over time.
2. Economic Indicators
An economic indicator is a statistic about the economy. Economic indicators allow

analysis of economic performance and predictions of future performance. One application
of economic indicators is the study of business cycles.

Notes Economic indicators include various indices, earnings reports, and economic
summaries. Examples: unemployment rate, quits rate, housing starts, Consumer Price
Index, Consumer Leverage Ratio, industrial production, bankruptcies, Gross Domestic
Product, broadband internet penetration, retail sales, stock market prices, money supply
changes.
Types of Economic Indicators
Economic indicators can be classified into three categories according to their usual
timing in relation to the business cycle: leading indicators, lagging indicators, and
coincident indicators.
i) Leading indicators
Leading indicators are indicators that usually change before the economy as a whole
changes. They are therefore useful as short-term predictors of the economy. Stock market
returns are a leading indicator: the stock market usually begins to decline before the
economy as a whole declines and usually begins to improve before the general economy
begins to recover from a slump. Other leading indicators include the index of consumer
expectations, building permits, and the money supply.
ii) Lagging indicators
Lagging indicators are indicators that usually change after the economy as a whole
does. Typically the lag is a few quarters of a year. The unemployment rate is a lagging
indicator: employment tends to increase two or three quarters after an upturn in the general
economy.
iii) Coincident indicators
Coincident indicators change at approximately the same time as the whole economy,
thereby providing information about the current state of the economy. There are many
coincident economic indicators, such as Gross Domestic Product, industrial production,
personal income and retail sales. A coincident index may be used to identify, after the
fact, the dates of peaks and troughs in the business cycle.
3. Other Statistical Methods
i) Exponential Smoothing
In this technique more recent data are given more weight age. This is based on the
argument that the more recent the observations, the more its impact on future and therefore
is given relatively more weight than the earlier observations.
ii) Index Numbers
The Index Numbers offer a device to measure changes in a group of related variables
over a period of time. In case of index numbers a Base Year which is given the value
of 100 and then express all subsequent changes as a movement of this number. The most
commonly used is the Laspeyres’ Price Index.
iii) Correlation and Regression
Correlation refers to the interdependence or co-relationship of variables. It reflects
the closeness of the linear relationship between x and Y.
Regression is a way of describing how one variable, the outcome, is numerically
related to predictor variables. The dependent variable is also referred to as Y, dependent
or response and is plotted on the vertical axis (ordinate) of a graph.

These involve the use of econometric methods to determine the nature and degree Notes
of association between/among a set of variables. Econometrics, you may recall, is the
use of economic theory, statistical analysis and mathematical functions to determine the
relationship between a dependent variable and one or more independent variables (like
price, income, advertisement etc.). The relationship may be expressed in the form of a
demand function. Such relationships, based on past data can be used for forecasting.
The analysis can be carried with varying degrees of complexity.
iv) Simultaneous Equations Method
Simultaneous Equations Method is a very sophisticated method of forecasting. It is
also known as the ‘complete system approach’ or ‘econometric model building’. This
method is normally used in macro-level forecasting for the economy as a whole; in this
course, our focus is limited to micro elements only.
The method is indeed very complicated. However, in the days of computer, when
package programmes are available, this method can be used easily to derive meaningful
forecasts. The principle advantage in this method is that the forecaster needs to estimate
the future values of only the exogenous variables unlike the regression method where he
has to predict the future values of all, endogenous and exogenous variables affecting the
variable under forecast. The values of exogenous variables are easier to predict than those
of the endogenous variables. However, such econometric models have limitations, similar
to that of regression method.
3.30 Summary
Demand is the amount of particular economic goods or services that a consumer
or group of consumers will want to purchase at a given price at a particular time.Law of
demand states that people will buy more at lower prices and buy less at higher prices,
ceteris paribus or other things remaining the same.
Supply of a commodity is often confused with the ‘stock’ of that commodity available
with the producers. Stock of a commodity, more or less, will equal the total quantity
produced during a period less the quantity already sold out.
Supply function refers to the mathematical function that relates price and quantity
supplied for goods or services. The supply function tells how many units of a good that
producers are willing to produce and sell at a given price. It shows the quantities of goods
and services a producer would provide at various prices.
The law of supply reflects the general tendency of the sellers in offering their stock
of a commodity for sale in relation to the varying prices. It describes seller’s supply
behaviour under given conditions. It has been observed that usually sellers are willing to
supply more with a rise in prices.
Elasticity of demand is the responsiveness of demand for a commodity to changes
in its determinants.
Elasticity of supply is defined as the degree of responsiveness of supply of a product
in the market to a change in its price. Elasticity of supply may be measured as the ratio
of the percentage change or the proportionate change in quantity supplied to the
percentage or proportionate change in price.
Price elasticity of supply measures the relationship between change in quantity
supplied and a change in price. If supply is elastic, producers can increase output without
a rise in cost or a time delay.

Notes Utility refers to an economic term referring to the total satisfaction received from
consuming a good or service. Utility increased with wealth but at a decreasing rate.
Ordinal Utility is propounded by the modern economists, J.R. Hicks, and R.G.D.
Allen, which states that it is not possible for consumers to express the satisfaction derived
from a commodity in absolute or numerical terms. Modern Economists hold that utility
being a psychological phenomenon, cannot be measured quantitatively, theoretically and
conceptually.
Market demand provides the total quantity demanded by all consumers. In other
words, it represents the aggregate of all individual demands. There are two basic types
of market demand: primary and selective. Primary demand is the total demand for all of
the brands that represent a given product or service, such as all phones or all high-end
watches.
3.31 Check Your Progress
I. Fill in the Blanks

1. Utility means______________
2. Marginal utility is equal to average utility at that time when average utility is
_________________
3. Total utility of a commodity is measured by which price of that
commodity__________
4. According to Marshall, the basis of consumer surplus is________________
5. Passive factor of production is_______________
II. True or False

1. Supply changes due to a change in price.
2. Utility increased with wealth but at a decreasing demand.
3. Utility is the quality in commodities that makes individuals wants to buy them.
4. Market demand provides the total quantity demanded by all consumers.
5. Elasticity of demand is the responsiveness of demand for a commodity to
changes in its determinants.
III. Multiple Choice Questions

1. Goods whose income elasticities are negative are called –
(a) Superior goods
(b) Inferior goods
(c) Normal goods
(d) Complements
2. The elasticity of supply measures the responsiveness of-
(a) Quantity supplied to changes in price
(b) Quantity demanded to changes in supply
(c) Quantity supplied to changes in income
(d) Quantity supplied to changes in demand

3. Supply is elastic if – Notes

(a) 1 percent change in price causes a larger percentage change in quantity
supplied
(b) The good in question is a normal good
(c) The slope of the supply curve is positive
(d) 1 percent change in price causes a smaller percentage change in quantity
supplied
4. Equilibrium relates to which of these -
(a) Market condition which oscillate
(b) Market state of falling price
(c) Market condition of rising price
(d) Market conditions which once achieved tends to persist
5. Under law of demand—
(a) Price of commodity is an independent variable
(b) Quantity demanded is a dependent variable
(c) Reciprocal relationship is found between price and quantity demanded
(d) All of the above
6. When a market is in equilibrium?
(a) Quantity demanded equals quantity supplied
(b) Excess demand and excess supply are zero
(c) The market is cleared by the equilibrium price
(d) All of the above
7. An individual demand curve slopes downward to the right because of the:
(a) Working of the law of diminishing marginal utility
(b) Substitution effect of decrease in price
(c) Income effect of fall in Price
(d) All the above
3.32 Questions and Exercises
I. Short Answer Questions

1. Define the term Demand.
2. What is Law of Demand?
3. Define the term Law of Supply.
4. What is Demand Function?
5. What is Elasticity of Demand?
6. What is Elasticity of Supply?
7. What is Price Elasticity of Supply?
8. Define the term Utility.
9. What is Cardinal Measurement?
10. What is Law of Diminishing Marginal Utility?
11. Define the term Consumer Surplus.
12. What is Ordinal Measurement?
Notes 13. What is Consumer Equilibrium?

14. What is Demand Forecasting?
II. Extended Answer Questions

1. Discuss in details about Determinants of Demand.
2. Discuss features of Law of demand.
3. Explain nature of Supply.
4. Discuss shift in demand and supply curves and market equilibrium.
5. Explain in details about measurement of Elasticity of Supply.
6. Discuss about factors determining Elasticity of Supply.
7. Explain in details about Price Elasticity of Supply.
8. Discuss use of elasticity in Business-Decision Making.
9. Explain important characteristics of Utility.
10. Discuss about Law of Diminishing Marginal Utility.
11. Write note on: Consumer Surplus and Ordinal Measurement.
12. Discuss features and properties of Indifference Curves.
3.33 Key Terms

l Demand: Demand is the amount of particular economic goods or services that
a consumer or group of consumers will want to purchase at a given price at
a particular time.
l Law of Demand: Law of demand states that people will buy more at lower
prices and buy less at higher prices, ceteris paribus or other things remaining
the same.
l Supply: Supply of a commodity is often confused with the ‘stock’ of that
commodity available with the producers. Stock of a commodity, more or less,
will equal the total quantity produced during a period less the quantity already
sold out.
l Law of Supply: The law of supply reflects the general tendency of the sellers
in offering their stock of a commodity for sale in relation to the varying prices.
It describes seller’s supply behaviour under given conditions. It has been
observed that usually sellers are willing to supply more with a rise in prices.
l Elasticity of Demand: Elasticity of demand is the responsiveness of demand
for a commodity to changes in its determinants.
l Elasticity of Supply: Elasticity of supply is defined as the degree of
responsiveness of supply of a product in the market to a change in its price.
Elasticity of supply may be measured as the ratio of the percentage change
or the proportionate change in quantity supplied to the percentage or
proportionate change in price.
l Price Elasticity of Supply: Price elasticity of supply measures the relationship
between change in quantity supplied and a change in price. If supply is elastic,
producers can increase output without a rise in cost or a time delay.
l Utility: Utility refers to an economic term referring to the total satisfaction
received from consuming a good or service. Utility increased with wealth but
at a decreasing rate.

l Cardinal Utility Concept: The neo-classical economists propounded the theory Notes
of consumption (consumer behavior theory) on the assumption that utility is
cardinal. For measuring utility, a term ‘util’ is coined which means units of utility.
l Ordinal Utility Concept: Cardinal utility approach is based on the fact that
the exact or absolute measurement of utility is not possible. However, modern
economists rejected the cardinal utility approach and introduced the concept
of ordinal utility for the analysis of consumer behavior.
l Individual Demand: The individual demand is the demand of one individual or
firm. It represents the quantity of a good that a single consumer would buy at
a specific price point at a specific point in time. While the term is somewhat
vague, individual demand can be represented by the point of view of one person,
a single family, or a single household.
l Market Demand: Market demand provides the total quantity demanded by all
consumers. In other words, it represents the aggregate of all individual demands.
There are two basic types of market demand: primary and selective. Primary
demand is the total demand for all of the brands that represent a given product
or service, such as all phones or all high-end watches.
3.34 Check Your Progress: Answers

I. Fill in the Blanks
1. Power to satisfy a want
2. Maximum
3. Value in use
4. Law of diminishing marginal utility
5. Land and capital
II. True or False
1. True
2. False
3. True
4. True
5. True
III. Multiple Choice Questions
1. (b) 2. (a)
3. (a) 4. (d)
5. (d) 6. (d)
7. (d)
3.35 Case Study

Bright Ltd., is a market leader in detergents since seven years.
Put together both powder and liquid detergents, its brand “Klean-Kloth” currently
enjoys a 27% market share, Inspired by their success in the detergent segment, the
company attempted to enter the bath-soap segment, with a similar production and
marketing strategy. In 2005 it introduced its twin products, cake and liquid bathsoap, with
the name ‘klean-skin’, Its advertisements in the media showed the same person using
both the detergents and bath soap. The same advertisement carried both the products.

Notes The new product was released in all the areas by using the same dealers who distributed
the detergent.
However, the year-end evaluation by the company showed that the customer
response to klean-skin was lukewarm. Not only that the new product did not. Fare well,
but for the first time in seven years, the rate of growth of demand for klean kloth, showed
a decline.
Worried over the developments Bright Ltd.seeks to make a thorough analysis of the
situations.
Case.
Poser:
You are asked to take over the industry to review the demand for the product.In this
regard work out demand forecasting techniques and give new life for the product.
3.36 Further Readings

1. Paul A. Samuelson, William D. Nordhaus, Sudip Chaudhuri and Anindya Sen,
Economics, 19thedition, Tata McGraw Hill, New Delhi, 2010.
2. William Boyes and Michael Melvin, Textbook of economics, Biztantra,11th
Edition, 2015.
3. N. Gregory Mankiw, Principles of Economics, 7th edition, Cengage, New Delhi,
2014
4. Richard Lipsey and Alec Charystal, Economics, 12th edition, Oxford, University
Press, New Delhi, 2015.
5. Karl E. Case and Ray C. fair, Principles of Economics, 14th edition, Pearson,
Education Asia, New Delhi, 2016.
3.37 Bibliography
1. Managerial Economics- Theory and Applications, Dr. D.M Mithani, Himalaya
Publications.
2. Managerial Economics, D.N Dwivedi, 6th ed., Vikas Publication.
3. Managerial Economics, H. L Ahuja, S. Chand, 2011
4. Indian Economy, K P M Sundharam and Dutt, 64th Edition, S Chand
Publication.
5. Business Environment Text and Cases by Justin Paul, 3rd Edition, McGraw-
Hill Companies.
6. Managerial Economics- Principles and worldwide applications, Dominick
Salvatore, Oxford Publication, 6e, 2010
7. Managerial Economics, Atmanand, Excel BOOKS, 2/e, 2010
8. Managerial Economics, Yogesh Maheshwari, PHI, 2/e, 2011
9. Managerial Economics: Case study solutions- Kaushal H, 1/e., Macmillan, 2011
10. Paul A. Samuelson, William D. Nordhaus, Sudip Chaudhuri and Anindya Sen,
Economics, 19thedition, Tata McGraw Hill, New Delhi, 2010.
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Analysis of Demand and Demand Forecasting 95

Unit 3: Analysis of Demand and Demand

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Notes 3.36 Further Readings

After studying this unit, you should be able to understand:

3.1 Meaning and Definitions of Demand

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3.2 Determinants of Demand Notes

I. Determinants of Individual Demand

II. Determinants of Market Demand

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Notes common consumption tends to be greater than in the case of unequal

3.3 Law of Demand

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Definitions of Law of Demand Notes

Assumptions of Law of Demand

Exceptions to the Law of Demand

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As could be seen in the digram, the

Fig: Expection to the law of demand

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Importance of Law of Demand

The importance of law of demand can be summarized as follows:

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Notes 3.4 Features of Law of demand

3.5 Nature of Supply

Supply schedule and supply curve

If demand is held constant, an increase in supply leads to a decreased price, while

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Supply Curve Notes

3.6 The Law of Supply

Assumptions Underlying the Law of Supply

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Extension and Contraction in Supply

Increase and Decrease in Supply

Causes for Change in Supply

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Notes calamities or an exceptionally good as well as timely monsoon might increase

Determinants of law of supply

There are four important determinants of law of supply as under:

3.7 Shift in demand and supply curves and market equilibrium

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Changes in Market Prices: Recap:

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3.8 Demand Function

Y = Income level Notes

3.9 Elasticity of Demand

Meaning of Elasticity of Demand

Elasticity of demand is the responsiveness of demand for a commodity to changes

Percentage change in quantity demanded of commodity

Definition of Elasticity of Demand

According to Marshall, “The elasticity or responsiveness of demand in a market is

Types of Elasticity of Demand

1. Price Elasticity of Demand

Percentage change in quantity demanded of commodity

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Percentage change in quantity demanded of commodity A

Percentage change in quantity demanded or sales Notes

Factors influencing Advertising Elasticity of Demand (AED)

Applications or Uses of Advertising Elasticity of Demand

Limitations of Advertising Elasticity of Demand