Fundamental Concepts, Models &Methods 17

concept of incremental reasoning is quite helpful in optimal allocation of

resources.
Incremental Reasoning and Marginal Analysis-A Comparison
Incrernental reasoning and marginal analysis of economics are closely related. However, their
and similarities may be pointed out. In certain decision differences
problems incremental
while in some other cases marginal analysis is more suitable. These are reasoning is more efficient,
discussed below.
()Marginal analysis is related to a unit change in independent variable, say, increase in
a unit change in output. On the other hand, the incremental cost as a result of
reasoning is not restricted by a unit change, i.e., it
could be associated with a change in any number of units. Moreover, it may
not have any relationship with
quantity; there can be an incremental cost of quality improvement.
(ii) There are certain cases where marginal analysis is superior to
the selection of: incremental reasoning. These include
best product-mix, in cases where substitution between
products occurs at a
least-cost input-mix, where inputs are substitutable at a decreasing rate: decreasing
rate;
optimum input-level, where input-output relationship faces diminishing returns; and
optimum maturity of assets, having value decreasing over time.
(iii) Whenever the cost and revenue functions are
curvilinear, it is more
analysis, because by using incremental analysis it is not possible to capture the appropriate to use marginal
that lies between the initial point and the point of change. On the other hand, impact of the range of output
marginal
to-unit comparison and would, therefore, be able to capture the impact of all points. analysis calls for unit
(iv) In case of those functions which are linear, it is useful to use
only the end points of a range are to be compared, and marginal analysis incremental reasoning. In such a case
would
results than incremental reasoning. Then, why to go about doing the tedious job of also not give any different
impact as needed in marginal analysis? comparing the unit-by-unit
(v) In case of those alternatives which are discrete, marginal
analysis cannot be used. If a producer wants
to produce a particular level of output and wants to make a choice
between different
purpose, it is not possible to compare these processes in terms of marginal cost of movingtechnologies for the
another. One can nevertheless calculate incremental cost of moving from one process to from one process to
another.
(vi) In a sense, marginal analysis is a special case of incremental reasoning. The
analysis, however, is that it can be efficiently handled with the aid of algebra andadvantage with marginal
calculus which directly
determine optimum conditions.
2.1.2. Concept of Opportunity Cost. Resources being scarce, we
arè. therefore, forced to make a choice. If we choose to have more of cannot have everything we want. We
one thing, it
less of the other thing. For example, if the firm wants to produce more of good Xthenwill be necessary to have
produce less of good Y. Thus, producing a greater amount of X has opportunity cost of(given resources)Y.it will
producing less
Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of
alternatives is involved when carrying out a decision requires using a resource that is limited in
the firm. Opportunity cost, therefore, represents the benefits or supply with
revenue
gction rather than another. When a choice is made in favour of a particular forgone by pursuing one course of
desirable of all the given alternatives, it obviously implies that the next best alternative that appears to be most
The benefit of the next best alternative which has been sacrificed due to the alternative has not been chosen.
choice of the
known as the opportunity cost of the best alternative. Opportunity costs are not recorded best in
alternative is
the
records of the firm, but they have to be met if the firm aims at optimisation. Here are accounting
some of the illustrations
of the opportunity cost:
(a) The opportunity cost of the funds employed in one's own business is the
could have been earned had these funds been invested in the next amount of interest which
best channel of investment.
 Managerial Economics
both, the
(A) When a product.rather than a product is produced by using a machine which can produce
pportunity cost of producing is the amount of Y' sacrificed as a result.
oprortunities
no sacrifice of
() The opportunity cost of using an idle nmachine is zero, as its usc necds
one could have earned by
() The opportunity cost of ones labour in onc's own business is the income
aCvepting ajob outside.
ascertained. If there are no
Thus, it is clear that opportunity cOst requires that sacrifices must be clearly
Monetary costs can be
saitices, there is no opportunity cost. These sacrifices may be monetary or real.
Cpessed as explicit, while real costs are implicit. Evplicii costs are recognised inthat the accounts, e.g., the
sacrifices are not recorded in
rayments for labour, rw matenals, ctc. Implicit (or imputed) costs are
accounts, eg,cost of capital supplied by owners of business. Since opportunity cost includes both theexplicit
generally higher than its accounting
and implicit costs, the opportunity cost of an alternative, therefore, is
COst.
Ineremental Cost and Opportunity Cost--A Comparison
opportunity costs. Incremental cost is a
(1) There is a fundamental ditterence between incremental and incremental revenue, one can find
«ierenee in cost due to a decision. By subtracting incremental cost from
the gain trom a proposed change in the activin
(rather than difference in cost) of a
Opportunity cost, on the other hand, includes all the economic costs
chosen alternative to find the gain from
Scarceinput. Opportunity cost is subtracted from total revenue of the
the propOsed use of the input.
between the sunk costs (the costs that do not
(2) The incrementalcost concept is used to show the contrast
with a change in the level of business activity.
change with the change in activity) and the costs that change
the net revenue that could be generated in the
The opportunity cost, on the other hand, focuses attention on
next best alternative use of a scarce resource.
both the principles of incremental reasoning
2.1.3.Concept of Contribution. This concept takes help from contribution ofa unit of output to overheads
and opportunity cost. The concept of contribution tellsus about the scarce resources is involved. It also
mix when allocation of
and profit. It helps in determining the best product
order, to introduce a new product, to shut down,
indicates whether or not it is advantageous to accept a fresh
to continue with the existing plant, etc.
revenue from incremental cost. In case of a firm
Unitcontribution is the per unitdifference of incremental is likely to contribute very little to cost but
easily as it
with excess capacity, a new product can be introduced than none.On the other hand, if the firm has backlog
significantly to revenue. And,some contribution is better
for existing products then the new product, if introduced, will have to compete for the use of the
of orders
Insuch a case the choice between clearing
same production facilities which the existing products are using. product willdepend upon their respective
of anew
the backlog orders of the existing products and introduction basis
contributions. Production facilities willbe allocated on the of:which of these products can contribute
more. This suggests that the products should be compared on the basis of their contributions per unit of scarce
be determined.
resource used. The optimum product-mix can, thus,
machine-time availability, and rest of the
If the firm has only a single resource which is scarce, say,
contributions per unit of output. Instead we would
resources are abundantly available, we need not look at the
choice between 3 products, all needing to
look at contributions per nmachine-hour. If the firm has to make a then we would compare the contribution
available),
use the same scarce machine-time (other factors adequately
best use of the machine-time. This is shown with
per unit of machine-hour for each product and'evaluate the
the help of Table 2.2.
 19
Fundamental Concepts, Models & Methods

Table 2.2. Contribution Product-wise of a Multi-product Plant

Product Price Incremental cost Contribution Machine-time
per uni! required
per unii
(1) (2) (3) (4) (5)
Rs. 44.00 Rs. 26.00 Rs. 18.00 180 minutes
2 40.00 24.00 16.00 120
3 37.00 22.00 15.00 90
4 20.00 8.00 12.00 60
Aglance at Col. 4of the Table suggests that Product l is the best as its contribution per unit is larger than
that of the other products. But if we look carefully we also findthat Product l consumes more of the scarce
machine time compared to the other products. We, therefore, need to convert these contributions into per
machine time so as to make them comparable. This will then give the following results
Product Contribution per unit
Rs. 6.00 per machine- hour
2
8.00
10.00
4
12.00
Contribution per-unit-per-machine-time reveals that Product 4, which was considered the lowest
earlier, has become the largest contributor. This suggests that the order of contribution should be contributor
-only after taking into account the limitation of resources. Note that when worked out
there are more than one capacity
bottlenecks,the contribution exercise of the above type becomes quite complex. We have to take the
linear programming technique to solve such a problem. help of
The term "contribution to overhead and profits" is quite
term finds its most wide use in pricing, product-mix popular in modern management analysis. This
decisions, replacement analysis and capital budgeting.
2.1.4. Time Perspective. Economists often make a
these terms with a precision that is often missed in distinction between short run and long run. They use
within which some of the inputs (called fixed inputs) ordinary
cannot
discussion. By short run they mean that period
be altered, while in the long run all the
Thus, in the short run, change in output can be inputs can
be changed (i.e., there are no ixed inputs).
changing the intensiy of use of fixed inputs, while the same can be achieved by
scale of output, size of firm, etc. Economists try achieved in the long run by adjusting th
to study the effect of policy
costs, revenue, etc., in the light of these time decisions on variables like prices,
distinctions. Managerial
adhere to the strict theoretical time
of whether all the inputs are distinctions of an economist. They doeconomists, however, do not generally
not see the time distinction in terms
with immediate future and long variable or not. Rather toa managerial economist, short
period is synonymous
by him can be stated thus : A period with remote future. The way the principle of time perspective is seen
decision should take into account both the
revenues and costs so as to maintain a right short-run
balance between long-run and short-run and long-run effects on
From operational point of view, a manager
must make relevant perspectives.
implications of his policy. Haynes, Mote and Paul mention the distinction between the present and future
avoid the "image" of an exploiter. It pursued the case of a printing company which
was some idle capacity. It realised that the policy of never quoting prices below full cost, evenwanted to
if there
long-run repercussions of pricing below full cost
offset any short-run gain. Moreover, it did noi
want to project an impression that the would more than
market when demand was favourable but was firm wanted to exploit the
willing to reduce prices when
forthcoming.
2.1.5. The
adequate demand was not
Since future is Discounting Principle. This concept is, in away, an extension of the
unknown and incalculable, there concept oftime perspective.
is a lot of risk and
uncertainty about future. Moreover, the
20 Munagerial Eeonomics

return in future is less attractive than thc same return today. The future nust, therefore, be discountcd both for
the clenents of delay and risk of future.
The concept of discounting future is bascd on the fundlamental fact that a rupce now is worth more than
a rupco carned a year after. Evon if onc is certain about future incomo, yct it must be discounted because to
wait for future implies a sacrifice for the present. For cxample, you are given a choice of Rs. I,000 today or
Rs. 1,000 next yeur. Naturally you will ch0ose Rs. I,000 toduy, Supposc you can carn 0 per cent nterest
cduring a ycar, you may say that 'lwould be indifleront bctwcon Rs. I,000 today and Rs. 1,00 next year', ie.,
Rs. 1,100 has the prescnt worth of Rs. L,000. For making a deciN0on regarding investment which will yicld a
rcturn ovcr a period ot tinc, it is, theroforo, advisable to find its net present worth. Unless these relurns are
discounted to find their prescnt worth, it is not possible to judye whcther or not it is worth undertaking the
investment today. The net worth may be caleulated for various investment proposals: some of which may yield
higher rcturns in the carlier years, while others higher returns in the later years. Some investments may yicld
higher rcturns for only a limited nunmber of ycars, whilc the others a small return for a longer period. Thus,
a diffcrent
cven thc samc amount of investmcnt in two alternative uses may have different annual returns and
duration of such returns. Totransform these returns into acommon measure we use the discounting principle.
Now, had he not
Supposc an investor wants to invest Rs, 100, assuming that tho bank rate of interest is 10%.
invested he would have earned at least this rate of interest and his money would havogrown from Rs. 100 to
In
Rs. 110ncxt ycar. So, he would invest only when his investment becomes worth at least Rs. I10 next ycar.
cqual to Rs.
other words, Rs. l10 next year have a prescnt worth of Rs. I00, i.e., to him Rs. 110 next ycar are
100today. Thus, in case of present worth, we bring all of the future rupces up to today's rupees.
we can
Supposc a sum of Rs. 100 is duc after I ycar. Let the rate of interest be 10 per cent. Then,
determinc the sum to be invested now so as to producc the return (R) of Rs. 100 at the cnd of 1 year. Thc
present value or the discounted value of Rs. 100 will then be,
R 100
Rs. 90,90.
(1+i) 1.10
value of Rs. 100
The same reasoning can be used to find the present valuc of longer periods. A present
due two years later would be,
Rs. 100 Rs. 100 Rs. 100
Rs. 82.64.
(1+i)? (.10)? 1.21
We can thus write the present worth of astream of income sprcad over n ycars (i.e., R,, Ry,... R,) as
R R, Ry
(1+)'(1+ i)²' (1+ i)' (1+ i)"
The sum of present valucs of returns for n years would thus be
R, t....+ R,
(1+i) (1+i² (|+i (1+)"
2.1.6. Risk andUncertainty. Economic theory of the firm generally assumes that the firm has perfect
knowledge of its cost and demand relationships andof its environment. Uncertainty is not allowed to influence
the decisions ofthe firm: the firm proceeds to maximise the profits after it has acquired the relevant information
oncosts and revenue. Yet, we know that in the real world, uncertainty influences the estimation of costs and
revenues, and hence the decisions of the firm. Management deals with decisions which have long-term bearing.
and since future conditions are not perfectly predictable, there is always a sense of risk and uncertainty about
the outcome of such decisions. Moreover, when afirm is operating in amarket along with the rest of the firms,
there is generally an element of uncertainty regarding the actions and reactions of the competitors. The
consumers, to satisfy whose wants the firm exists, also have shifting choices. Also, there are unexpected
environmental changes,like changes in governmental policies, national and internationalpolitical scene, etc.
 .anywell-informed manager either in the private or the public sector should have aguod understanding of
what economists call consumer demand theory. After all, consumer demand affects not only marketing deci.
sions but also decisions in the areas ofproduction, distribution, inventories, and so forth.
MAURICE AND SMITHSON

4
Theory of Consumer Choice
LEARNING OBJECTIVES :
On reading this chapter, you should be able to
understand the basis of emergence of demand for goods and scrvices.
state the underlying assumptions of the theory of consumer's behaviour.
sociological factors of the consum
have an insight into the effects of changes in psychological and
er's behaviour.

their product but the market demand is

We know that management is interested in market demand of
begin our discusSion with the
merely the sum-total of individual consumer's demand. It is, therefore, that we
analysis of individual consumer's demand and then go no to discuss the market demand.
therefore, begin
Since the behaviour of individual demand depends upon the consumer behaviour, we.
our discussion with the theory of consumer behaviour.
4.1. THECARDINAL APPROACH TO CONSUMER EQUILIBRIUM
of these
Why do wepurchase commodities or services? Obviously, the answer would be that consumption
commodities and services give us satisfaction. The satisfaction which aconsumer gets by having or consum
d1fferent
ing goods or services is called utility by economists. Same commodity gives different utility to place to
consumers. Even for the same consumer, utility varies from unit to unit, from time to time and from
place.
4.1.1. Measurement of Utility. Conceptually, we measure utility in units called utils. Since utils are not
welldefined it is, in fact, not possible to measure utility in terms of these units. Yet we discuss them because
utils help us to understand the consumer's behaviour. It is useful analytically to distingursh between the two
utility concepts :(1) total utility, and (2) marginal utility.
Totalutility. The total utility refers to the sum-total of satisfactionwhich a consumer rceives by consum:
ine thevarious units of thecommodity The nore units ofa commodity he consumes, greater will be his total
utilityor satisfaction from it up to acertain point. As he keeps on increasing the consumption of the commod
ity, he eventually reaches the point of saturation represented by mavimum total ut1lity If further units of the
commodity are consumed, his total utility starts declining
Marginal utility. The marginal utility of agood is defined as the change in total ut1lity resulting from
ATU
unit change in the consumption of the good, ie., MU, = where MU,.ATU, and AQ, are marg1na.
utility, change in total utility and change in quantity of good Xrespectively
 Choice 55
Theory of Consumer

dTUx
Another way of finding marginal utility is bydifferentiating total utility function : MUx* dx
where utility function is taken as continuous rather than discrete.
To illustrate the concepts of TU and MU, let us take utility function TU, =10 Qy-O. As consumpuon
of X
changes the total and marginal utilities also undergo achange, as shown in Table 4.1.
Table 4.1:Utility Schedule (units)
Units of Total utility Discrete marginal Continuous
goodX (TUy) utility marginal utility
MUy = 4TUy/AOx MU, = dTU,IdOx
0 0
9
1 9
7
2 16 6
5
3 21 4
3
4 24 2
1
25
-1
6 24 -2
-3
21

From the table it may be observed that when total utility is maximum, marginal utility falls to zero.
4.1.2. The Law of Diminishing Marginal Utility. This is the basic hypothesis of cardinal utility theory.
According to the law of diminishing marginal utility, "for any individual consumer the value that he attaches
to successive units ofa particular commodity will diminish steadily as his total consumption ofthatcommodity
increases, the consumption of allother goods being held constant." (R.G. Lipsey)
In other words, as the consumer consumes more, his total utility willincrease but at a decreasing rate.It
is a natural fact that when a consumer consumes additional units of aparticular good at a point of time, his
desire for every successive unit becomes less intense, consequently utility derived from each successive unit
diminishes. This is illustrated with the help of Table 4.1 and Fig. 4.1.
Utility (utils)
30

25
TU,
20

15

10

0 Units of Good X
1 2 3 4 6
MU,
Fig. 4.1. Diminishing Marginal Utility
 S6
Managerial Economics
Assumptions of the Law of Diminishing Marginal Utility
1. Various units of the good arc
homogeneous.
2. There is no time gap betwecn consumption of the different units.
3. Consumer is rational (i.e., has complete knowledge and maximises utility).
4. Tastes, prcferences and fashions remain unchangcd.
4.1.3. Hypothesis of Utility Maximisation (or, Equilibrium of the Consumer). We begin by the basic
assumption about the behaviour of the consumer that the individual consumer so acts with respect to hi
COnsumption decisions as to gain the largest possible 1otal utility (i.e., his action is rational), subject to his
income. Thus,the quantity ofa commodity that a consumcr purchasc is constraincd by both the law of dimin
Ishing marginal utility and the purchasing power with the consumer. In cquilibrium, the consumer balances
the utility of the good against its cost. That is, MU, - P,. So long as MU,> Py, he should buy that unit.

MU, > Price

MU,> Price
MU, Price
MU, Price
Markct Price ofX

MU,
2 3 4
Quantity of Good X
Fig, 4.2. Consumer's Equilibrium
Now, if we assumcthat the moncy a consumeris rcady to pay forcach unit ofagood rcflects thc marginal
utility of that good, we canrepresent themarginal utility curvc of agood in terms of money units. Duc to the
operation of law of diminishing marginal utility, such a curve will be downward sloping (Fig. 4.2). Now, if for
all units ofgood Xconsumer pays a pricc cqualto OP, the consumer will buy 5 units ofX, because for the first
4units MÚ, >Py and it is the cost of the 5th unit that cquals the utility he derives from it. He will not consume
beyond 5units as theutility from these units is less than thcir cost. The consumer is, thus, in equilibrium (i.e.,
gets maximum totalutility) if he consumes up to the point where the marginal utility of the good equals the
market price of the good. *
4.1.4. Law of Equi-marginal Utility. Case of MoreThan OneGood. In rcal life, consumers purchase
many goods with the hclp of their incomes, Each commodity has a price and cach of them provide lesser and
lesser utility as moreunits of it arc purchased. He has to dccide how he should spendhis limited income on
different goods so as to get maximum possible satisfaction. This problem of allocation of income betwcen
goods can be solved with the hclp of the law of cqui-narginal utility.
As different goods (e.g., shocs andcars), bave differcnt priccs, thcir utilities are comparable only if these
arereduced to a common unit:'utility per rupce spent'on cach ofgoods,(i.e., theratio MU,IP). With thehelp
of the marginalutility per rupee spent on cach good we can decide how much of cach of the good we should
buy. Suppose aconsumer buys cggs and novcls. Ifthe last rupec spent on cggs providesgrcater marginal utility
than thc last rupce spent on novels, the consumcr must obviously consumemorc cggsfor which he willreduce
fewer
the consumption of novcls. As morc cggs arc consumcd thcir marginal utility decreases, and as
*e.g. givcn utility fn: U 50x-2.5x' and P, 10, consumer cquilibrium : duldx = P, or 50 - 5x = 10.
 mamdAnalh:six 79

how the
induate
quantity demanded for a product is relatcd to the valuc of their respcctive variablc in the
demand
tunction. If we assume that we know the value of the paramcters, then by substituting the arsumed
demandfunction we get afunction likethis :
aluesinthe
2,--200 P, +100 Y,+0.001 Pop, +0.05 A,.
We findfrom
the above cquation that refrigerators' demand falls by 200) units for each Re. 1 increase in its
price:itincreases by 100units for each Re. l increase in per capita incomc; it
incrcases by 0.00 l units for each
population;: and it increases by 0.05 units for every additional rupce spentton advertisement.
alditionalpersonin
a illustrate, if we assume P,= Rs. 4,000, Y,= Rs. 1,000, Pop, == 700,000,000 and 4,=Rs. 100,000,000
then by
substituting these values in the above cquation we gct,
-200 x 4,000+ 100 × 1,000 + .001 x 700,000,000 +.05 x 100,000,000 =5,000,000 units.
Tlustration 1. It was found that the cstimated demand function for 1.5 ton air-conditioners of Kenstar in
aparticularzone:
Q=6,000 - .5 P+ .002 |+.0004 A+.05 P,+ .00003 N.
Where Oand Pare thequantity and price of ACsrespectively; I is the annual disposable income per family; 1
wthe advertising expenditure of Kenstar in the zone, P, is the average price of competing brands; and Nis the
population of the zone. Find the estimated quantity demanded when P= Rs. 20,000, I= Rs. 20,000;
ERS. 2,00,00,000, P. =Rs. 15,000; and N=6,00,00,000. What willbe the change in quantity demanded it
Pis reduced to Rs. 18,000and A to Rs. 1,50,00.0002
Solution. The following table shows the calculation of quantitydemanded as per the demand function given
here.
Variable Value Coefficient Total

Constant 8,000 +8,000

P= Rs. 20,000 -0.5 - 10,000
|= Rs. 20,000 +.002 + 40
A = Rs. 2,00,00,000 +.0004 + 8000
P.= Rs. 15000 +.05 +750
N= 6,00,00,000 +.00003 + 1800
Total Q=8590

When P reduces to Rs. 18000 and Ato Rs. 1,75,00,000 then in the total column we will have values as:
Q=+8,000 + (Rs. 18,000 x0.5) + Rs. 40 + (Rs. 1,75,00,000 × .0004) + 750 + 1800 = 8595.

5.4. THE LAW OF DEMAND

5.4.1. The Law. Law ofdemand states that higher the price lower the quantity demanded, and vice versa.
Other things remaining constant, i.e. Or P), other things remaining same. That is, given prices of the
related goods, income andtastes and preferences of the consumer, if price of the good increases its quantity
demanded decreases, while ifprice of the good decreases its quantity demanded inçreases'. The demand
Curve can be expressed by a demand equation, which may be linear or quadratic in nature?. The linear demand
equation may be of the form : Q=-bp(e.g. Q= 2,345 - 3P). While a quadratic demand function may be like
Qa- bp/ (e.g. Q= 2,00,000 - 5000 VP ).
Ihe law of demandoperates due to the underlying effects of substitution and real income changes. Any
change in the commoity price affects amount demanded of the commodity intwo ways :
P(R})I
becomes
ice of the good may increase to a level where quantity demanded 1,600N
zero. For example, if a firm faces a demand curve: Q-2,00,000 - 5000 JP
then at P =0 (i.e. free supply of good), quantity demanded (0) becomes 2,00,000.
While at P = Rs. 1600, 0:=0. That is, when price goes up to Rs. 1600, the firm prices
itself out of the 2,00,000
market.
he lincar demand curve can also be expressed in anallows
equivalent form by solving for P(instead of Ø), e.g.
P=150-1.5Q.
of the maarket'. IfIhis as inverse
known1.50,
P =is 150- demand
it implies at P=
us to determine Pat which the firm
= 0, i.e. consumers will buy only if P< 150. 'prices itself out
150, which
curve,
80
Managerial Economics
() substitution effect of a price change; and
(ii) income effect of a pricc change.
When price of a goods decreases it becomes relatively cheaper. So, this goods is substitutedin place of
now rclatively costlier goods. Further, since one of the goods in the consumption bundle has becomc chcapcr,
the consumer is now left with some purchasing power after buying his initial bundle of goods. With thi
additional purchasing and
whenthe substitution power
realhe buys additional
incomc effects of aquantities of the
price changc arc goods in his consumption
taken together, we find thatbundle.
a fall in Thus
pricc
of agoods increases its quantity demanded, anda rise in its price reduces its quantity demandcd. Thus, the law
of demand holds good in case of normal goods.
We had seen in Indifference Curvc Analysis that in case ofthosc goods where positive income ffect is of a
lower magnitude than the negative substitution effcct the law of demandstill holds good. though such goods are
"inferior goods". It is only in case of those inferior goods where positive income effcct is lar stronger than
negative substitution effect that their combincd cffect becomes positive; the law of demand is then violated, i e.,
price and quzntity demanded move in the same direction. Such goods arc known as "Giffcn goods".
5.4.2. Individual and Market Demand Schedules. For an individual/household the amount demanded of
a commodity is different at different prices. Ifwe put in a tabular form the amount demanded of acommodity at
different price levels of the commodity, we get a demand schedule. Ademand schedule at any particular time
refers to the series of quantities the consumer is prepared to buy at its difjerent prices. An Imaginary demand
schedule for oranges for aconsumer, say A, is given in Table5.1. This demand schedule is for an individual
consumner and is, therefore, known as Individual demand schedule. In case we have similar demand schedules
by thcse
for allthe consumers in the market, we can then add up the quantities demanded of thec coinmodityTable 5.2)
consumers at each price and get a summed up schedule called the market demand schedule (shown in
Table 5.1. Demand for Oranges by Individual A
10 7 6
Price of oranges (Rs.)
11 13
Quantity demanded of oranges (dozen)
Table 5.2. Market Demand Schedule for Oranges
Quantity demanded of oranges market demand of
Price of oranges oranges (dozens)
(Rs. per dozen) by consumers (dozens)
A B D
3 4
10 1
3 6 4 14
7 2 7 25
11 4 12 10 37
7
13 6 14 12 45
diagramnati
5.4.3. Individual and Market Demand Curves. The demand schedule when represented
individual demand schedule, we get an
cally is known as a demand curve. When this diagram is based on an
individual demand curve. Fig. 5.4 depicts individual demand curve bascd on Table 5.1. Each point on the
curve shows the maNimum
demand curve DD depicts price-quantity combination ofthe consumer. The demand ofthe goods, under given
amount ofthe goods which the consumer would be willing to buy at cach possible priccmaximun price which an
conditions of demand. We can also say that the individual demand curve shows the
individual consumer or ahousehold would be prepared to pav for
different amounts of thegoods.
D
Since the quantity demanded in the market is the sum of the
Individual
Demand Curve individual demands of all consumers at cach price, the market de
mand curve for a given commodity is, therefore, the horizontal sum
mation of the individual demand curves. In Fig. 5.5, quantity de
mandcd by all consumers at cvery price is added up to get the mu
ket demand curve, DM:
Each point on the market demand curve, D,,. shows the maxi"
Units of Goods X mum amount of thegoods which all consumers taken together wozi
be willing to buy at each possible price of the goods, under gre
Fig. 5.4. Individual Demand Curve. conditions of demand.
 DemandAnalysis 81

Consumer A Consumer B Market

(Rs.) D
X
Good
20
20 DM
20
15
15 15
of
Price D, DM
D,
16
9 Good X 5 7 Good X (units) Good X
(units) (units)
Fig. S.5. Market Demand curve.

5.4.4. Why do Demand Curves Slope Downwards? The law of demand states that, other things remaining
commodity
the same, an individual consumer will buy more of a commodity at a lower price and less of that
several reasons
at a higher price. Generally the demand curves slope downwards from left to right. There are
for this.
diminishing
1. The law of diminishing marginal utility is at the root of the law of demand. The law of him goes on
utility to
utility states that as one goes on consuming more and more units of a commodity its
diminishing. In order to get maximum satisfaction, a consumer buys a commodity in such a way that marginal
equilibrium
utility of the commodity is equal to its price. It means that an individual consumer comes to anutility and the
marginal
where marginal utility isequal to price. A rational consumer always tries to equate the
price. When the price comes down, he buys more quantity to bring the marginal utility to the level of price.
take large quantities.
The price paid for a good, therefore, must be lowered if consumers are to be induced to utility is the basis of the law
And this is what the law of demand states. Thus, the law of diminishing marginal
of demand.
Thus the exiting buyers purchase
2. A commodity tends to be put to more use when it becomes cheaper.thus,
is, an extension of demand when
more andsome new consumers enter the market. The cumulative effect
price falls.
consumer's real income. The consumer
3. A fall in the price of a superior good will lead to a rise in the
superior good will result in a decline in
can, therefore, buy more ofit. On the contrary, a rise in the price of a
of it. The consequent increase or decrease
the consumer's real income, the consumer will, therefore, buy less attributed
may be to the income effect.
in a consumer's demand for the good under consideration
substitution effect also. A fall in the
4. Reason for a downward movement of a demand curve lies in the make it attractive to the buyers who
price of a good. while the prices of its substitutes remain unchanged, will
commodity, while the prices of its
will now demand more of it. On the contrary, a rise in the price of a now purchase less of it.
substitutes remain unchanged, will make it unattractive to the purchasers who will
with the help of some specific
5.4.5. Forms of Demand Function. It is useful to represent demand law
functional forms, like:
or p=a- bg
(1) 9=
a
p= -C
(2) q= --b, or q+b
p+c

or
p=a-b¡?
(3)
1

(4) 9ae-bp or
p= log
and so on.
-Theconcept offolasticity of demand and of cross-elasticity of demand are the essential heart of the meaning
economic concept offdemand."
ofthe CHESTER R. WASSON

6
Elasticity of Demand
And Demand Estimation
LEARNING OBJECTIVES :
After going through the present chapter, you should be able to
understand the meaning of elasticity of demand;
quantify the elasticity of demand;
interpret the coefficients of elasticity;
jdentify the determinants of demand elasticity:
learn the steps involved in the empirical estimatjon of demand.

6.1. ELASTICITY OF DEMAND

In an earlier chapter, we have seen that changes in price of the product, income of the households, prices
ofindicates
relatedonly
goods,thetastes and expectations, advertising expenses, etc., affect quantity demanded ofa good. This
directional impact of the changes in the factors influencing demand. Since change in any
demand determinant does not affect the demand of every good to the same extent (e.g., a change in income
level of the consumers do not affect their demand for clothing equally), the knowledge about direction of and
change in demand is, therefore, insufficient for any management to plan changes in the production/sales
plans. The management needs to know more : it must have information regarding the magnitude of the impact
of cach of these factors on the quantity demanded, as changes in them do not affect demand for each product
to the same extent. The firm is deeply concerned about the impact of these different factors on the quantity
demanded of the product. It is with the understanding of these impacts that the firm can hope to predict its
level of sales and sales revenue. This ability to predict revenue is crucial, as without an adequate level of sales
relative to costs the firm cannot be successful. Fortunately, the economist has a tool to measure the effect of
Changes in any one of the determinants in the demand function, viz., price, income, expectations, advertising
Cxpenditure, etc. This tool is known as elasticity of demand, which helps us in providing a quantitative value
Tor the responsiveness of the quantity demanded to change in each ofthe determinants in the demand function.
tiasticity of demand (E)is defined as the percentage change in quantity demanded caused by one percent
Change in the demand determinant under consideration, while other determinants are held constant. The
general equation for the measurement of elasticity of demand is :
Percentage change in quantity demandedof good X
Percentage change in determinant Z