Managerial Economics

UNIT 2

Ms. Monika Kadam

Assistant Professor
What is Demand?
1. Desire to acquire a product-willingness to have it

2. Ability to pay for it-purchasing power to buy it

3. Willingness to spend on it

4. Given/particular price

5. Given/particular time period

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Definition of Demand

• According to Benham, “The demand for any thing at a

given price is that amount of it, which will be bought at a
time at that price.”
• According to Prof. Meyers, “The demand for a good is a
schedule of the amount that buyers would be willing to
purchase at all possible prices at any one instant of
time.”

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Distinct concepts of demand
1. Direct and derived demand
1. Direct demand refers to the demand for goods meant for final consumption.
2. Derived demand refers to the demand for those goods which are needed for
further production of a particular good
2. Domestic and industrial demand
3. Perishable and durable goods demand: Perishable goods are used for
meeting immediate demand, while durable goods are meant for
current as well as future demand.
4. New and replacement demand: New demand is meant for an
addition to stock, while replacement demand is meant for
maintaining the old stock of capital/asset intact.
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5. Final and intermediate demand: The demand for semi-
finished goods and raw materials is derived and induced
demand as it is dependent on the demand for final goods.
6. Short run and long run demand: The distinction between
these two types of demand is made with specific reference
to time element.
7. Autonomous and induced demand: The demand for
complementary goods such as bread and butter, pen and
ink, tea, sugar milk illustrate the case of induced demand.
Autonomous demand for a product is totally independent
of the use of other product, which is rarely found in the
present world of dependence.
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8. Total market and segmented market demand: Total
market and segmented market demand: A market for a
product may have different segments based on location,
age, sex, income, nationality etc.
9. Individual and Market Demand: The demand of an
individual for a product over a period of time is called as
an individual demand, whereas the sum total of demand
for a product by all individuals in a market is known as
market/collective demand.
10. Company and industry demand: The company’s
demand is similar to an individual demand, whereas the
industry’s demand is similar to the total demand.
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What is Individual Demand?
Individual demand refers to a person’s desire for a product or service
(or a household).

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Factors affecting Individual Demand
Price of the Commodity

Income of the purchaser

Person’s Taste’s and Habits

Substitutes and Complementary Products and their Relative Prices

Consumer’s Expectation about the Future Change in Price

Effects of Advertisement and Sales Propaganda

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What is Market Demand?
• Market demand refers to
the demand of all
consumers of a good or
service at a given price,
with other factors as
money income, tastes,
and preferences, prices
of other goods constant.
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Determinants of Market Demand
Consumers’
Price of Consumer
Product Price Choices and
Related Goods Income
Preferences

Advertising Expectations Performance Consumer-

Expenses of consumers Effect credit facility

Distribution of
Population of
National
the country
Income
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Demand Function
Demand function is a comprehensive formulation which specifies the factors
that influence the demand for the product.
Dx = f(Px , Py , Pz , B, A, E, T, U)
Where,
Dx = Demand for item x
Px = Price of item x
Py = Price of substitutes
Pz = Price of complements
B = Income of consumer
E = Price expectation of the user
A = Advertisement Expenditure
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What is the market demand equation?
Qdx = f(Px, Y, P1……Pn-1, T, A ,Ey, Ep, P, D, u)
Qdx,Px,Y,P1…Pn-1,T,A, Ey,Ep,U are the same as the individual
demand function P = population D = distribution of
consumers in various categories such as income, age, sex
etc.,
Qd = a – b(P)
Where,
“Qd” stands for the quantity demanded
“a” represents all factors affecting the price
other than your product’s price.
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Market Demand Curve

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 BASIS INDIVIDUAL DEMAND MARKET DEMAND

Market demand for a commodity

Individual Demand implies the
refers to the aggregate quantity of
quantity demanded of a commodity
the commodity demanded by all the
Meaning by a single potential consumer, firm,
potential consumers in the market at
or household, at different price
different price levels, over a certain
levels, and during a given period.
period.

Depicts the relationship between Depicts the relationship between the

Curve quantity demanded by a single total quantity demanded and the
consumer, as we change the price. market price of the goods.

Summation of Individual demand of

Inter-Relationship Component of Market Demand.
all buye₹
Demand curve
Steeper Relatively flatter
appears
It does not always follow the law of
Law of Demand DME Law School
It always follows the law of demand.
14
demand
Law of Demand

When the When the

price goes
price goes
up…
down…

When the When the

quantity quantity
demanded
demanded
goes down…
goes up… DME Law School 15
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Why the demand curves slopes downward only?
1. Application of the law of diminishing marginal utility: The marginal utility
curve slopes downward, hence the demand curve also slopes downward to the
right.
2. Substitution effect: The commodity under question becomes cheaper with
fall in its price in comparison to its substitutes, therefore demand increases.
3. Income effect: With fall in price of the commodity, demand increases due to
increase in real income as a result of positive income effect.
4. Falling prices attract new consumers as the commodity now becomes
affordable to them.
5. With fall in price of the commodity consumers start using it in less important
uses, therefore demand increases. Generally, commodities have different /
varied uses.
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Exceptions to the Law of Demand
Veblen Effect

Speculative Goods

Giffen Effect or Giffen Paradox

Demand for Necessities

Scarcity or Inflation
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Extension and Contraction of Demand

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 Shift in Demand
(Increase or Decrease in demand)

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Utility
The simple meaning of ‘utility’ is ‘usefulness’. In economics
utility is the capacity of a commodity to satisfy human wants.
Utility is the quality in goods to satisfy human wants. Thus, it is
said that “Wants satisfying capacity of goods or services is
called Utility.”
According to Prof. Waugh “Utility is the power of commodity to
satisfy human wants.”
In economics, production refers to the creation of
utilities in several ways.

1. Form Utility 2. Place Utility

3. Time Utility 4. Service Utility

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 Types of Utility

(i) Marginal (ii) Total (iii) Average

Utility Utility Utility
1. Marginal Utility: It is the additional satisfaction gained from
each extra unit of consumption. It decreases with each
additional increase in the consumption of a good.

Marginal Utility (M.U.) = Change in T.U. / Change in Total Quantity = Δ TU/ Δ Q

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2. Total Utility: The sum of the total satisfaction from
the consumption of specific goods or services. It
increases as more goods are consumed.

Total Utility (T.U.) = U1 + U2 + … + Un

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3. Average Utility: One can obtain it by dividing the
total unit of consumption by the number of
total units. Suppose there are total n units, then

Average Utility (A.U.) = T.U. / Number of units = T.U. / n

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Relationship between MU and TU

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 50

40

30

20
UTILITY

MU
TU

10 AU

0
1 2 3 4 5 6 7

-10

-20
Unit of Bread

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Measurement of Utility
 Cardinal Utility

• This theory assumes that utility is a cardinal concept which means it is

a measurable or quantifiable concept.
• It helps an individual to express his satisfaction in numbers by
comparing different commodities.

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Assumptions of Cardinal Utility Analysis

1. Rationality
2. Utility is cardinally Measurable
3. Constant Marginal Utility of Money
4. Diminishing Marginal Utility
5. Independent Utilities
6. Limited Resources (Money)
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 Laws under cardinal utility theory

Law of Diminishing Law of Equi-

Marginal Utility DME Law School Marginal Utility 32
Assumptions of Law of DMU

Cardinal measurement of utility

Monetary measurement of utility
Consumption of reasonable quantity
Continuous consumption
No change in Quality
Rational consumer
Independent utilities
MU of money remains constant
Fixed Income and prices

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Example: DMU

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Total Utility & Marginal Utility

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 Limitations of Law of DMU

Inapplicability Constant
Unrealistic
to certain marginal utility
assumptions
goods of money

Change in
Other
other people’s
possessions
stock
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 Law of Equi-Marginal Utility (LEMU)
“The law of equi-marginal utility states that the consumer will distribute his
money income between the goods in such a way that the utility derived from
the last rupee spent on each good is equal.”

Units of Commodity X Marginal Utility of X Units of Commodity Y Marginal Utility of Y

1st unit (1st Rupee) 20 1st unit (1st Rupee) 16
2nd unit (2nd Rupee) 18 2nd unit (2nd Rupee) 14
3rd unit (3rd Rupee) 16 3rd unit (3rd Rupee) 12
4th unit (4th Rupee) 14 4th unit (4th Rupee) 10
5th unit (5th Rupee) 12 5th unit (5th Rupee) 8
6th unit (6th Rupee) 10 6th unit (6th Rupee) 6
7th unit (7th Rupee) 8 7th unit (7th Rupee) 4
8th unit (8th Rupee) 6 8th unit (8th Rupee) 2
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Units of Commodity X Marginal Utility of X Marginal Utility of Y
1st unit 20 (1st Rupee) 16 (3rd Rupee)
2nd unit 18 (2nd Rupee) 14 (5th Rupee)
3rd unit 16 (4th Rupee) 12 (7th Rupee)
4th unit 14 (6th Rupee) 10
5th unit 12 (8th Rupee) 8
6th unit 10 6
7th unit 8 4
8th unit 6 2
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Limitations of the Law of Equimarginal Utility

(i) Ignorance

(ii) Inefficient Organisation

(iii) Unlimited Resources

(iv) Hold of Custom and Fashion

(v) Frequent Changes in Prices

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Practical Importance of the Law of Substitution

(i) Consumption

(ii) Production

(iii) Exchange

(iv) Distribution

(v) Public Finance

(vi) Influences Prices

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 ORDINAL UTILITY
• According to ordinal theory, utility cannot be measured in
numerical terms but can be ranked in comparison with other
goods.
• Ordinal utility is more realistic as it relies on qualitative
measurement
• The concept of ordinal utility is based on indifference curve
analysis.
• Ordinal utility approach pioneered by Hicks and Allen.
• The ordinal utility is measured in terms of ranking of
preferences of commodity when compared to each other.
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 Assumptions
i. Rationality

ii. Ordinal Utility

iii. Transitivity and Consistency of Choice

iv. Non-satiety

v. Diminishing Marginal Rate of Substitution

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 Indifference Curve
An indifference curve is a curve that represents all the combinations of
goods that give the same satisfaction to the consumer.

Indifference Schedule Indifference Curve

14
Good X Good Y 12

10
1 12

GOOD Y
8

6
2 8
4

3 5 2

0
1 2 3 4 5
4 3
GOOD X

Good Y
5 2
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 Indifference Map
16
Good X IC1 IC2 IC3
1 10 12 14
2 6 8 10
14
3 3 5 7
4 1 3 5
12 5 0 2 4

10
GOOD Y

4 IC3

2 IC2

0 IC1
1 2 3 4 5

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 Properties of Indifference Curve

Property 1 Slopes downward from left to right

Property 2 Convex to origin

Property 3 Do not intersect with each other

Property 4 Higher IC means higher satisfaction

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 Property 1 Property 2
Slopes downward from left to right Convex to origin

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Property 3 Property 4
Do not intersect with each other Higher IC means higher satisfaction

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 ELASTICITY OF DEMAND
• The concept of elasticity of demand was introduced by Marshall.
• This concept explains the relationship between a change in price and
consequent change in quantity demanded.
• It shows the rate at which changes in demand take place.
• Elasticity is the ratio of the percent change in one variable to the percent
change in another variable.

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1. PRICE ELASTICITY OF DEMAND
• Price elasticity of demand measures the percentage change in
quantity demanded caused by a percent change in price. As such, it
measures the extent of movement along the demand curve.
Proportionate change in qty demanded of good x
E=
Proportionate change in price of good x

(% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑)

𝑃𝐸𝑜𝐷 =
(% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒)
• Percentage Change in Quantity Demanded= [QDemand(NEW) -
QDemand(OLD)] / QDemand(OLD)
• Percentage Change in Price= [Price(NEW) - Price(OLD)] / Price(OLD)
1. Elastic Demand - a change in price, results in a greater
than proportional change in the quantity demanded
ED>1.
2. Inelastic Demand - a change in price results in a less than
proportional change ed<1.
3. Unitary Demand - a change in price results in n equal
proportional change ed=1.
4. Perfectly Elastic Demand - demand changes even when
price remains unchanged. Ed= ∞
5. Perfectly Inelastic Demand - change in price does not
result in any change. Ed=0
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 Numericals
1. Consider the demand for a good. At price Rs 4, the demand for the good is 25 units.
Suppose price of the good increases to Rs 5, and as a result, the demand for the good
falls to 20 units. Calculate the price elasticity?

2. When price of a good is 13 per unit, the consumer buys 11 units of that good. When
price rises to 15 per unit, the consumer continues to buy 11 units. Calculate Price
Elasticity of Demand.

3. Suppose the price elasticity of demand for a good is -0.2. If there is a 5% increase in
the price of the good, by what percentage will the demand for the good go down?

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• Q1 = 25
• P1 =₹4 Change in QD = Q2- Q1 = 20-25 =-5
• P2 = ₹ 5 Change in P = P2-P1 = 5-4 = ₹1
• Q2 = 20
• PED = Change in QD/ Change in P * P1/Q1
= -5 / 1 * 4 / 25
= -4/5 = -0.8

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When price of a good is 13 per unit, the consumer buys 11
units of that good. When price rises to 15 per unit, the
consumer continues to buy 11 units. Calculate Price
Elasticity of Demand.

• Q1 = 11
• P1 =₹ 13 Change in QD = Q2- Q1 = 11-11 = 0
• P2 = ₹ 15 Change in P = P2-P1 = 15- 13= ₹ 2
• Q2 = 11
• PED = Change in QD/ Change in P * P1/Q1
• = 0 / 2 *13/11
• =0

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2. Cross Elasticity
• The responsiveness of demand of one good to changes in the price of a
related good – either a substitute or a complement.
• In economics, the cross elasticity of demand or cross-price 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.
Effect of Change in Price of Good Y on the
demand of Good X

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• Cross Price elasticity = % change in quantity demanded of X/ %
change in the price of Y
• CPED = Change in QD for x / Change in P for y * Py1 / Qdx1

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 Numericals
1. If the price of coffee rises from ₹ 45 per 250 grams to ₹ 55 per 250
grams per pack and as a result the consumer’s demand for tea
increases from 600 to 800 packs then what will be the cross elasticity
of demand of tea for coffee ?
2. Suppose the following demand function-for coffee in terms of price of
tea is given. Find out the cross elasticity of demand when price of tea
rises from ₹ 50 per 250 grams pack to ₹ 55 per 250 grams pack.
Qc = 100 + 2.5Pt
Where Qc is the quantity demanded of coffee in terms of packs of 250
grams and Pt is the price of tea.

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Suppose the following demand function-for coffee in terms of price of tea is
given. Find out the cross elasticity of demand when price of tea rises from
₹ 50 per 250 grams pack to ₹ 55 per 250 grams pack.
Qc = 100 + 2.5Pt
Q1c = 100 + 2.5*50 = 225 P1t = 50
Q2c = 100 +2.5 *55 = 237.5 p2t =55

CPED = Change in Qd for c/ Change in P of t * P1t/ Q1c

= 237.5-225 / 55-50 * 50 / 225
= 12.5/5 * 2/9
= 0.55

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If the price of coffee rises from ₹ 45 per 250 grams to ₹ 55 per 250 grams
per pack and as a result the consumer’s demand for tea increases from 600
to 800 packs then what will be the cross elasticity of demand of tea for
coffee
P1 = 45
P2 = 55
Q1 = 600 Change in P for coffee = 55-45 = 10
Q2 = 800 Change in QD for tea = 800-600 = 200
Cross Elasticity of D = % change in QD for tea/ % change in P of coffee
= change in Qd/ change in P * P1C / Q1T
= 200/ 10 * 45/ 600 = 1.5

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Suppose the following demand function-for coffee in terms of price of tea is
given. Find out the cross elasticity of demand when price of tea rises
from ₹ 50 per 250 grams pack to ₹ 55 per 250 grams pack.
Qc = 100 + 2.5Pt
Q1C = 100 + 2.5*50 = 225
Q2C = 100 + 2.5 * 55 = 237.5
CPED = % change in QD for coffee/ % change in P
of tea
CPED = 237.5-225/55-50 *50/ 225 = 0.5

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• Change in Qd X = 800-600 = 200
• Change in P of Y = 55-45 = 10
• CPED = % change in quantity demanded of X/ % change in the price
of Y
• CPED = 200/10 * 45/600 = 1.5

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 3. Income elasticity of demand

• Income elasticity of demand measures the percentage change in

demand caused by a percent change in income.
• A change in income causes the demand curve to shift reflecting the
change in demand.
• YED is a measurement of how far the curve shifts horizontally along the
X-axis.
• Income elasticity can be used to classify goods as normal or inferior.
With a normal good demand varies in the same direction as income.
• With an inferior good demand and income move in opposite directions.
• The Income Elasticity of Demand: responsiveness of demand to changes
in incomes A positive sign denotes a normal good A negative sign
denotes an inferior good
MEASURING THE INCOME ELASTICITY
Income elasticity of demand (Yed) measures the relationship between a
change in quantity demanded and a change in real income
% change in demand
Yed =
% change in income
TYPES OF INCOME ELASTICITY
1. Positive Income Elasticity: a rise in income will cause a rise in demand a fall in
income will cause a fall in demand
2. Negative Income Elasticity: an increase in income will result in a decrease in
demand. a decrease in income will result in a rise in demand. also known as
inferior goods diagram of negative income elasticity
3. Zero Income Elasticity: this occurs when a change in income has no effect on
the demand for goods. A rise of 5% income in a rich country will leave the
demand for toothpaste unchanged
Question
1. Recently the average income level has gone up by 75% that resulted
in extra money which eventually resulted in an increase in
consumption of exotic cuisines by 25%. Calculate the income
elasticity of demand based on the given information.
IED = % change in Qd/ % change in I = 25 / 75 = 0.3

1. The weekly demand for cheap garments went down from 4,000
pieces to 2,500 pieces as the level of real income in the economy
increased from ₹75 per day to ₹125 per day. The reason is the shift in
preference due to the availability of extra money on the back of
increased income level. Calculate the income elasticity of demand
based on the given information.
The weekly demand for cheap garments went down from
4,000 pieces to 2,500 pieces as the level of real income in the
economy increased from ₹75 per day to ₹125 per day.
Q1 = 4000, Q2 = 2500, I1 = ₹75, I2 = ₹125
Change in Qd = 2500-4000 = -1500
Change in I = 125 -75 = ₹50

IED = Change in Qd/ Change in I * I1/ Q1

= -1500 / 50 * 75/4000
= -30 * 0.018
= - 0.54

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The weekly demand for cheap garments went down from
4,000 pieces to 2,500 pieces as the level of real income in the
economy increased from ₹75 per day to ₹125 per day.
Q1= 4000, Q2 = 2500, I1 = ₹75, I2 = ₹125
Change in Qd= 2500 – 4000 = -1500
Change in I = 125-75= ₹ 50
IED = Change in Qd/ Change in I * I1/ Q1
= -1500/50 * 75/4000
= - 0.56

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 Advertising Elasticity of Demand
• Advertising Elasticity of demand refers to the proportionate change in
demand of a commodity due to proportionate change in advertising
expense.
• Advertising elasticity is a measure of an advertising campaigns
effectiveness in generating sales.
Formula :
• AED = Proportionate change in Demand for product /Proportionate
change in Advertising expense
Application of Elasticity in Managerial
Decisions
1. Managerial Decision and Income Elasticity

2. Managerial Decision and Industry Elasticity

3. Managerial Decision and Expectation Elasticity

4. Managerial Decision and Market Share Elasticity

5. Managerial Decision and Promotional Elasticity

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