Demand Analysis

and Elasticity of Demand

MBA ZC416, Managerial Economics
Agenda
• Introduction
• Circular Flow of Economy
• Concept and Definition of Demand
• Law of Demand and its Exceptions
• Concept and Definition of Supply
• Elasticity of Demand and its types
• Factors affecting elasticity of demand
• Measurement of elasticity
• Significance of elasticity of demand

• Consumer Theory
 Focus Areas
• Demand and Supply
• Elasticities of Demand
– Price Elasticity of Demand
– Income Elasticity
– Cross Elasticity
• Consumer Choice
– Budget Line
– Consumer Satisfaction Curves (Indifference Curves)
– Law of Choice (Law of Equi-marginal Utility)
The Circular Flow of Economic Activity

Labor services supplied by households

flow to firms, and goods and services
produced by firms flow to households.

Payment for goods and services flows

from households to firms, and payment
for labor services flows from firms to
households.
Input Markets and Output Markets:
The Circular Flow
• Input and output markets are connected through the behavior of both firms
and households.

• Firms determine the quantities and character of output produced and the
types and quantities of input demanded.

• Households determine the types and quantities of products demanded and

the quantities and types of inputs supplied.
Demand in Product/Output Markets
A household’s decision about what quantity of a particular
output, or product, to demand depends on a number of
factors, including:
▪ The price of the product in question.
▪ The income available to the household.
▪ The household’s amount of accumulated wealth.
▪ The prices of other products available to the household.
▪ The household’s tastes and preferences.
▪ The household’s expectations about future income,
wealth, and prices.
Quantity Demanded ?

• The amount (number of units) of a product that a

household would buy in a given period if it could buy all it
wanted at the current market price.
Changes in Quantity Demanded vs.
Changes in Demand

• The most important relationship in individual markets is that

between market price and quantity demanded.
Changes in Quantity Demanded vs.
Changes in Demand
• Changes in the price of a product affect the quantity demanded per period.

• Changes in any other factor, such as income or preferences, affect demand.

• Thus, we say that an increase in the price of Coca-Cola is likely to cause a

decrease in the quantity of Coca-Cola demanded.

• However, we say that an increase in income is likely to cause an increase in

the demand for most goods.
What is Demand ?

• A relation showing the quantities of a good that

consumers are willing and able to buy at various prices
per period, other things constant.
Demand for commodity implies

• Desire to acquire it

• Willingness to pay for it

• Ability to pay for it

Types of Demand
• Consumer goods vs. Producer goods
• Firm vs. Industry
• Autonomous vs. Derived
• Durable vs. Perishable
• Short-term vs. Long-term
Representation
• The general ‘law of demand’
• Demand table or schedule
• Demand graph
• Equations
– Q = f (P)
– Q = f (P, A, Y, Ps,...)
• A linear demand function Q= a+bP
LAW of DEMAND

Law of demand As price rises, quantity

demanded decreases. As price falls,
quantity demanded increases.

It is reasonable to expect quantity demanded to fall when price rises, ceteris paribus,
and to expect quantity demanded to rise when price falls, ceteris paribus. Demand
curves have a negative slope.
Demand Schedule

TABLE Anna’s Demand Schedule

for Telephone Calls
QUANTITY DEMANDED
PRICE (PER CALL) (CALLS PER MONTH)
Demand schedule A table
$ 0 30
showing how much of a .50 25
given product a household 3.50 7
would be willing to buy at 7.00 3
different prices. 10.00 1
15.00 0
Demand Curve

Tan 1200 = -1.73

A graph illustrating how

much of a given product a
household would be willing
to buy at different prices.

FIGURE Anna’s Demand Curve

P
1200
Factors determining demand
 Alex’s Demand Curve

Alex’s Demand Schedule for Gasoline

Price Quantity Demanded

(per unit) (Good X)
8.00 0
7.00 2
6.00 3
5.00 5
4.00 7
3.00 10
2.00 14
1.00 20
0.00 26

The relationship between price (P) and quantity demanded

(q) presented graphically is called a demand curve.
Demand curves have a negative slope, indicating that lower
prices cause quantity demanded to increase.
CALCULATING TOTAL REVENUE

In any market, P x Q is total revenue (TR) received by producers:

TR = P x Q
total revenue = price x quantity

Profit = Revenue - cost

MARGINAL REVENUE
• It is the additional revenue added by an additional unit of
output.

• In other words marginal revenue is the extra revenue that an

additional unit of product will bring a firm.

• Marginal revenue is the derivative of total revenue with respect

to demand.
Example
• TR = 100Q−Q^2
• MR = d(TR)/dQ = 100-2Q
• When Q = 60, MR = -20
Demand curves slope downward
• Law of Demand: The negative relationship between price and quantity
demanded: As price rises, quantity demanded decreases. As price falls,
quantity demanded increases.

• It is reasonable to expect quantity demanded to fall when price rises,

ceteris paribus, and to expect quantity demanded to rise when price
falls, ceteris paribus.
Other Properties of Demand Curves

1. They have a negative slope.

2. They intersect the quantity (X) axis, as a result of time limitations and
diminishing marginal utility.

3. They intersect the price (Y) axis, as a result of limited income and wealth.

The actual shape of an individual household demand curve whether it is

steep or flat, whether it is bowed in or bowed out depends on the unique
tastes and preferences of the household and other factors.
Classification of goods
Normal goods Goods for which demand goes up when income is higher
and for which demand goes down when income is lower.

Inferior goods Goods for which demand tends to fall when income rises.

Substitutes Goods that can serve as replacements for one another; when
the price of one increases, demand for the other increases.

Complements or Complementary goods Goods that “go together”; a

decrease in the price of one results in an increase in demand for the other
and vice versa.
Shift vs. Movement along a Demand Curve

Income rises

Price rises
Quantity demanded falls Demand for substitutes shifts right

Demand for complements shifts left

Supply of Product
Firms build factories, hire workers, and buy raw materials because they believe they can sell
the products they make for more than it costs to produce them.

Profit The difference between revenues and costs.

Quantity supplied The amount of a particular product that a firm would be willing and
able to offer for sale at a particular price during a given time period.

Supply schedule A table showing how much of a product firms will sell at alternative
prices.

Law of supply The positive relationship between price and quantity of a good
supplied: An increase in market price will lead to an increase in quantity supplied, and
a decrease in market price will lead to a decrease in quantity supplied.
Supply of Product

A producer will supply more when the price

of output is higher.

The slope of a supply curve is positive.

Supply is determined by choices made by

firms.

P – price of soya beans per bushel

Q – Bushels of soya beans produced per

year
Determinants of Supply
Assuming that its objective is to maximize profits, a firm’s decision
about what quantity of output, or product, to supply depends on:
1. The price of related products.
2. The cost of producing the product, which in turn depends on:
■ The price of required inputs (labor, capital, and land).
■ The technologies that can be used to produce the product.
Shift of Supply versus Movement Along a Supply Curve

Shift of Supply Schedule for Soybeans

following Development of a New
Disease-Resistant Seed Strain

Schedule S0 Schedule S1
Quantity Supplied Quantity Supplied
Price (Bushels per Year (Bushels per Year
(per Bushel) Using Old Seed) Using New Seed)
1.50 0 5,000
1.75 10,000 23,000
2.25 20,000 33,000
3.00 30,000 40,000
4.00 45,000 54,000
5.00 45,000 54,000

Shift of the Supply Curve for Soybeans following

Development of a New Seed Strain

When the price of a product changes, we move along the supply

curve for that product; the quantity supplied rises or falls.
When any other factor affecting supply changes, the supply
curve shifts.
Market Equilibrium
Market equilibrium is achieved when consumers are willing to buy the same quantity of goods the
producers are willing to sell.

When quantity demanded exceeds quantity supplied, price tends to rise.

When the price in a market rises, quantity demanded falls and quantity supplied rises until
an equilibrium is reached at which quantity demanded and quantity supplied are equal.
 Point of Equilibrium

PA
A
L2 Supply Consumer and Producer surplus

Pe
Area of triangle APPe P
Price Area of triangle APPe = Consumer Surplus
Area of triangle BPPe = Producer Surplus
= ½ PPe * APe (1/2 base* height)
PbB Demand
Area of triangle BPPe =
L1
½ PPe * Bpe = producer surplus Qe
O
Quantity demanded or supplied

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
 Profit Motive Deadweight Loss

Producer Surplus = CKMN

Consumer Surplus = ANM A D
E Overall economic surplus =
Overall Economic Surplus
Consumer Surplus + Producer Surplus
= Area of CKMN + Area of ANM
Area of triangle ABP + Area of triangle CP
= Area of AMKC
M = Area of triangle ACP
N
(Price)

B P MC = d(TC)/dQ
F
D(TC) = MCdQ
K TC = ʃ(MC)dQ from 0 to L

J
C

O I L G 32
 Tax Regimes Deadweight Loss

Initial Supply Curve: p = a+bQ

Tax Imposed = T (payable by supplier)

Example: A manufacturer was selling his proudct at

Rs. 200 per kg. A flat tax of Rs. 10/ kg was imposed which
the suppliers chose to absorb and not pass on to the
Customer. (Had they passed on it would have affected the
Demand curve).
P
Part of the price retained by supplier = p-T
New Supply Curve p-T = a+bQ
p = a+T+bQ
The new supply curve would be pushed up by T as shown
in accompanying diagram.

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
Demand and Supply in Product Markets: A quick recap

• A demand curve shows how much of a product a household would buy if it could
buy all it wanted at the given price. A supply curve shows how much of a product a
firm would supply if it could sell all it wanted at the given price.

• Quantity demanded and quantity supplied are always per time period—that is, per
day, per month, or per year.

• The demand for a good is determined by price, household income and wealth,
prices of other goods and services, tastes and preferences, and expectations.
Demand and Supply in Product Markets: A quick recap

• The supply of a good is determined by price, costs of production, and prices of

related products. Costs of production are determined by available technologies
of production and input prices.

• Be careful to distinguish between movements along supply and demand curves and
shifts of these curves. When the price of a good changes, the quantity of that good
demanded or supplied changes—that is, a movement occurs along the curve. When
any other factor changes, the curve shifts, or changes position.

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
Demand and Supply in Product Markets: A quick recap

• Market equilibrium exists only when quantity supplied equals quantity

demanded at the current price.
Elasticity of Demand

• It allows us to analyze demand with greater precision.

• It is a measure of how much buyers and sellers respond to

changes in market conditions.
Elasticity of Demand
• Elasticity of Demand measures the degree of responsiveness
of the quantity demanded of a commodity to a given change in
any of the determinants of demand.

•
%A
elasticity of A with respect to B =
%B
Types of Elasticity of Demand
• Price elasticity of demand

• Income elasticity of demand

• Cross elasticity of demand

PRICE ELASTICITY OF DEMAND
SLOPE AND ELASTICITY

FIGURE 1 Slope Is Not a Useful Measure of Responsiveness

PRICE ELASTICITY OF DEMAND

price elasticity of demand The ratio of

the percentage of change in quantity
demanded to the percentage of change
in price; measures the responsiveness
of demand to changes in price.

% change in quantity demanded

price elasticity of demand =
% change in price
 Example
In a market, the demand for rice went up from 100 ton to 150 ton when the price fell from Rs. 50/kg to Rs. 40/kg.
Calculate the price elasticity of demand.

Price Elasticity of Demand = % change in demand / % change in price

% change in demand = (Final Demand – Initial Demand)/ initial Demand = (150-100)/100 = 50%
% change in price = (Final Price – Initial Price)/Initial price = (40-50)/50 = -10/50 = -20%
Price Elasticity of Demand = 50%/(-20%) = 50/(-20) = -2.5
Price Elasticity of Demand is expressed as a positive number. Price Elasticity = 2.5 (-2,5).
(-)2.5

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
Price Elasticity of Demand
• Elasticity of Demand

• Quantity demanded of a commodity in

response to a given change in price

• Always negative

• Relationship between the price and the

demand is inverse
PRICE ELASTICITY OF DEMAND

FIGURE 2 Perfectly Elastic and Perfectly Inelastic Demand Curves

% change in quantity demanded

price elasticity of demand =
% change in price
Degree of Price Elasticity of Demand

• Inelastic Demand (e<1): Quantity demanded does not respond

strongly to price changes.

• Elastic Demand (e>1): Quantity demanded responds strongly

to changes in price.
Degree of Price Elasticity of Demand
• Perfectly Inelastic: Quantity demanded does not respond
to price changes.

• Perfectly Elastic: Quantity demanded changes infinitely

with any change in price.

• Unitary Elastic (e=1): Quantity demanded changes by the

same percentage as the price.
% change in quantity demanded
price elasticity of demand =
% change in price
Price Elasticity: Impact on Revenue
Elastic (e>1) Unitary Elastic Inelastic (e<1)
Price rises TR falls No change in TR rises
TR
Price falls TR rises No change in TR falls
TR

TR = P*Q
d(TR)/dP = d(PQ)/dP = Q+PdQ/dP
e = [d(Q)/Q]/[d(P)/P] = -Pd(Q)/QdP
Pd(Q)/dP = -eQ
d(TR)/dP = Q-eQ = Q(1-e)
As you can see if e >1 (elastic), TR would fall with increase in P. If e=1 (Unitary elastic), TR is unchanged.
If e<1 (inelastic), TR would rise with increase in price.
Price elasticity of Demand
Urban India Short Run Long Run
Butter 1.478 2.78
Petrol 0.3 0.9
Tea 0.718 1.14
Coffee 0.292 0.685
Burger 1.49 2.79
Clothing 1.1 2.88
Price elasticity of Demand

Goods/Services Price Elasticity

Brinjals 3.5
Cabbage 2.8
Health insurance 1.9
Public transport 1.0
Electricity for domestic 0.5
purpose
CALCULATING ELASTICITIES
CALCULATING PERCENTAGE CHANGES

To calculate percentage change in quantity demanded

using the initial value as the base, the following formula is
used:

change in quantity demanded

% change in quantity demanded = x 100%
Q1

Q2 - Q1
= x 100%
Q1
CALCULATING ELASTICITIES
We can calculate the percentage change in price in a similar way. Once again, let us use the
initial value of P—that is, P1—as the base for calculating the percentage. By using P1 as the
base, the formula for calculating the percentage of change in P is simply:

change in price
% change in price = x 100%
P1

P2 - P1
= x 100%
P1
CALCULATING ELASTICITIES
ELASTICITY IS A RATIO OF PERCENTAGES

Once all the changes in quantity demanded and price have been converted into percentages,
calculating elasticity is a matter of simple division. Recall the formal definition of elasticity:

% change in quantity demanded

price elasticity of demand =
% change in price
CALCULATING ELASTICITIES Arc Elasticity
THE MIDPOINT FORMULA
midpoint formula
A more precise way of calculating percentages using the value halfway between P1 and P2
for the base in calculating the percentage change in price, and the value halfway between
Q1 and Q2 as the base for calculating the percentage change in quantity demanded.

change in quantity demanded

% change in quantity demanded = x 100%
(Q1 + Q2 ) / 2

Q2 - Q1
= x 100%
(Q1 + Q2 ) / 2
CALCULATING ELASTICITIES
Using the point halfway between P1 and P2 as the base for
calculating the percentage change in price, we get

change in price
% change in price = x 100%
( P1 + P2 ) / 2

P2 - P1
= x 100%
( P1 + P2 ) / 2
CALCULATING ELASTICITIES

TABLE 5.2 Calculating Price Elasticity with the Midpoint Formula

First, Calculate Percentage Change in Quantity Demanded (%QD):
change in quantity demanded Q2 - Q1
% change in quantity demanded = x 100% = x 100%
(Q1 + Q2 ) / 2 (Q1 + Q2 ) / 2

By substituting the numbers from Figure 1(slide 32): PRICE ELASTICITY COMPARES THE
PERCENTAGE CHANGE IN QUANTITY
10 − 5 5 DEMANDED AND THE PERCENTAGE
% change in quantity demanded = x 100% = x 100% = 66.7% CHANGE IN PRICE:
(5 + 10) / 2 7.5
%QD 66.7%
=
Next, Calculate Percentage Change in Price (%P): %P - 40.0%
= 1.67
change in price P2 - P1 = PRICE ELASTICITY OF DEMAND
% change in price = x 100% = x 100%
( P1 + P2 ) / 2 ( P1 + P2 ) / 2 DEMAND IS ELASTIC

By substituting the numbers from Figure 1(slide 32):

2−3 -1
% change in price = x 100% = x 100% = - 40.0%
(3 + 2) / 2 2.5
Problem
• You are given market data that says when the price of pizza is
Rs. 4, the quantity demanded of pizza is 60 slices and the
quantity demanded of cheese bread is 100 pieces. When the
price of pizza is Rs. 2, the quantity demanded of pizza is 80
slices and the quantity demanded of cheese bread is 70 pieces.

a. Can the PED be calculated for either good? Why?

b. If so, what is the PED?
Solution
• In order to calculate PED we need two (quantity, price) pairs
for one good (two points along a certain good’s demand
curve). We are given this information for pizza. We are not
given this information for cheese bread.
• We have two (quantity, price) pairs for pizza. Specifically, (QD1 ,
P1 ) = (60, $4) and (QD2 , P2 ) = (80, $2) .
• PEDpizza = [Q2 – Q1]/Q1*P1/[P1 – P2] = [80-60]/60*4/[4-2] = 0.67
CALCULATING ELASTICITIES
ELASTICITY AND TOTAL REVENUE
In any market, P x Q is total revenue (TR) received by producers:

TR = P x Q
total revenue = price x quantity

When price (P) declines, quantity demanded (QD) increases.

The two factors, P and QD, move in opposite directions:

Effects of price changes P → QD 

on quantity demanded: and
P → QD 
Determinants of Price Elasticity of Demand
• Nature of Commodity

• Availability and proximity of Substitutes

• Proportion of Income spent on the Commodity

• Time frame

• Durability of the Commodity

Income elasticity of Demand

• Income elasticity measures the responsiveness of quantity

demanded to changes in income, holding the price of the good
& all other demand determinants constant.
Income elasticity of Demand

• Positive for a normal good

• Negative for an inferior good

• Zero for a neutral good

Income elasticity of Demand
• Luxury goods: Income elasticity is greater than 1

• Normal goods: Income elasticity is between 0 and 1

• Inferior goods: Income elasticity is negative

Cross elasticity of Demand

• Cross-price elasticity of demand (EXY) measures the

responsiveness of quantity demanded of good X to changes in the
price of related good Y, holding the price of good X & all other
demand determinants for good X constant
Cross-price elasticity of demand in the real world

Positive : Two goods are substitutes

Negative: Two goods are complements

Commodity X Commodity Y Cross-price elasticity

Tea (India) Coffee (India) 0.0385
Tea (India) Coffee (India) 0.3457 (long run)
Entertainment (US) Food (US) -0.72
Margarine (US) Butter (US) 1.53
 Consumer Choice

A consumer is one who takes decisions about what to buy for satisfaction of wants, both as an individual and as a
Member of household, is called a consumer.

A consumer is considered to be rational which means he is someone who seeks to maximise his/her satisfaction
(utility) in spending his/her income.

Equilibrium is a state of rest when the entity concerned (for example the consumer or the producer) achieve their
objective and stop further action.

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
 The Study of Choices
• We shall see how a consumer with a limited budget chooses
between two goods X and Y to maximize his/her satisfaction
(utility).
HOUSEHOLD CHOICE IN OUTPUT MARKETS
Every household must make three basic decisions:

1. How much of each product, or output, to

demand

2. How much labor to supply

3. How much to spend today and how much

to save for the future
HOUSEHOLD CHOICE IN OUTPUT MARKETS
THE BUDGET CONSTRAINT

Information on household income and wealth,

together with information on product prices, makes
it possible to distinguish those combinations of
goods and services that are affordable from those
that are not.

budget constraint The limits imposed on

household choices by income, wealth,
and product prices.
HOUSEHOLD CHOICE IN OUTPUT MARKETS

TABLE Possible Budget Choices of a Person Earning $1,000 Per Month After Taxes
MONTHLY OTHER
OPTION RENT FOOD EXPENSES TOTAL AVAILABLE?
A $ 400 $250 $350 $1,000 Yes
B 600 200 200 1,000 Yes
C 700 150 150 1,000 Yes
D 1,000 100 100 1,200 No

choice set or opportunity set The set of options that is

defined and limited by a budget constraint.
HOUSEHOLD CHOICE IN OUTPUT MARKETS
THE EQUATION OF THE BUDGET CONSTRAINT

In general, the budget constraint can be

written:

PXX + PYY = I,

where PX = the price of X, X = the

quantity of X consumed, PY = the price of
Y, Y = the quantity of Y consumed, and I
= household income.
 Budget Line Example
A consumer has gone to the market to buy apples and oranges.Oranges are selling at Rs. 100 per kg and apples for Rs.
200 per kg. His budget is Rs.1000. Draw the budget line and graphically represent it. How would the graph change if
the price of apple increased to Rs. 250 per kg. A
10

X and Y stand for consumption of apples and oranges respectively.

PX = Price of Apple = Rs. 200 per kg
8 PXX + PYY = I,

ORANGES
PY = Price of Orange = Rs.100 per kg
Budget Line Equation is PX X+ Py Y = B 6
200X+100Y = 1000 P (2 g of apples, 5 kg of oranges)
5
X=0, 100Y = 1000, Y=10. The consumer can invest his/her full budget in Budget Line
buying oranges alone. S/he would get 10 kg of oranges. 4
Y=0, 200X = 1000, X=5. The consumer uses the full budget to buy
apples and gets 5 kg of apples.

New Budge Line 250X+100Y=1000 2 Choice set

B
30/1/2016 MBA ZC416 MANAGERIAL
ECONOMICS Session 3
APPLES 1 2 3 4 5 7 9
HOUSEHOLD CHOICE IN OUTPUT MARKETS
The Budget Constraint More Formally

FIGURE Budget Constraint and Opportunity Set for Ann and Tom
 Explanation

B = Budget
Px = Price of item X
Py = Price of item Y
X = Consumption of X
Y = Consumption of Y

Money spent on X = XPx

Money remaining = B – XPx = Money spent on Y = YPy
Hence XPx + YPy = B

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
HOUSEHOLD CHOICE IN OUTPUT MARKETS
Budget Constraints Change When Prices Rise or
Fall

FIGURE The Effect of a Decrease in

Price on Ann and Tom’s
Budget Constraint

The budget constraint is defined by income, wealth, and prices. Within those limits, households are
free to choose, and the household’s ultimate choice depends on its own likes and dislikes.
THE BASIS OF CHOICE: UTILITY

utility The satisfaction, or reward, a product yields

relative to its alternatives. The basis of choice.
THE BASIS OF CHOICE: UTILITY
DIMINISHING MARGINAL UTILITY
marginal utility (MU) The additional satisfaction gained by
the consumption or use of one more unit of something.
MC = d(TC)/dQ
total utility The total amount of satisfaction obtained from MU = d(TU)/dQ
consumption
of a good or service.

law of diminishing marginal utility The more of any one

good consumed in a given period, the less satisfaction
(utility)
generated by consuming each additional (marginal) unit of
the same good.
THE BASIS OF CHOICE: UTILITY
TABLE Total Utility and Marginal
Utility of Trips to the Club
Per Week
TRIPS TOTAL MARGINAL
TO CLUB UTILITY UTILITY
1 12 12
2 22 10
3 28 6
4 32 4
5 34 2
6 34 0

FIGURE Graphs of Frank’s Total

and Marginal Utility
 Trade off Example

Change in Change in
Chocolates Balloons chocolates Balloons

10 0

9 1 1 1

8 3 1 2

7 6 1 3

law of diminishing marginal utility The more of any one good consumed in a
given period, the less satisfaction (utility)
generated by consuming each additional (marginal) unit of the same good.
30/1/2016 MBA ZC416 MANAGERIAL
ECONOMICS Session 3
THE BASIS OF CHOICE: UTILITY
DIMINISHING MARGINAL UTILITY AND DOWNWARD-SLOPING DEMAND

FIGURE Diminishing Marginal Utility and

Downward-Sloping Demand
INCOME AND SUBSTITUTION EFFECTS
THE INCOME EFFECT

When the price of something

we buy falls, we are better
off. When the price of
something we buy rises, we
are worse off.
INCOME AND SUBSTITUTION EFFECTS
THE SUBSTITUTION EFFECT

Both the income and the substitution effects imply a negative relationship
between price and quantity demanded—in other words, downward-sloping
demand. When the price of something falls, ceteris paribus, we are better off,
and we are likely to buy more of that good and other goods (income effect).
Because lower price also means “less expensive relative to substitutes,” we are
likely to buy more of the good (substitution effect). When the price of something
rises, we are worse off, and we will buy less of it (income effect). Higher price
also means “more expensive relative to substitutes,” and we are likely to buy less
of it and more of other goods (substitution effect).
Customer Satisfaction (Indifference) Curves -
Assumptions
1. We assume that consumers have the ability to choose among the combinations of goods and
services available.

2. We assume that consumer choices are consistent with a simple assumption of rationality (to
maximize his satisfaction).

Change in Change in
Chocolates Balloons chocolates Balloons

10 0

9 1 1 1

8 3 1 2

7 6 1 3
Deriving Customer Satisfaction (Indifference)
Curve

An indifference curve is a
1,9
set of points, each point
representing a combination
3,8 of goods X and Y, all of
chocolates
which yield the same total
6,7 satisfaction (utility).

Change in Change in
Chocolates Balloons chocolates Balloons
10 0
9 1 1 1
Balloons 8 3 1 2
7 6 1 3
FIGURE An Indifference Curve
 Consumer Satisfaction Curve
• I went to the market to buy apples and oranges. I was fourth in
the queue. The seller asked me how many of each I wanted
and I replied “ 1 kg apples and 5 kg oranges.” (1,5)
• There was a shortage of oranges. After the first customer, the
seller told me over the queue that he probably be able to give
only 4 kg oranges (as the previous buyer has presumably
bought 1 kg oranges). “Sir” he shouts “I shall give you one
extra kg of apples.” I say “Yes.” (2,4)

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
 Consumer satisfaction Curve
• After the second customer he says “ Sorry, Can give you only 3
kg oranges. May I add one extra kilo apple?”
• What do I do with so many apples? I came here for only 1 kg
apples?
• “Sir, please take 1.5 kg apples instead.” I accept. (3.5,3)
• Finally when I am at his counter, he says “Sir, I can only give
you 2 kg oranges. To compensate for this 1 kg (of oranges), I
shall give you 2 kg apples extra apples instead. (5.5,2)
 Customer Satisfaction (Indifference) Curve
• (1,5), (2,4), (3.5, 3) and (5.5, 2) represent four points of equal
satisfaction for the consumer. A curve connecting the four
points is the consumer satisfaction curve or the indifference
curve. The customer is indifferent to the four options before
him.
Consumer Satisfaction (Indifference) Curves -
Properties

1. It slopes downwards from left to right

2. It is convex to the origin

3. It cannot intersect with another indifference curve

 Indifference Curves
Indifference Curves are convex to origin (that is they bulge towards the origin.)

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
 Indifference Curves
They occur in a series with higher curves representing higher levels of consumer satisfaction.

orange

P3

P1
P
apple
30/1/2016 MBA ZC416 MANAGERIAL
ECONOMICS Session 3
 Indifference Curves
They curves DO NOT intersect each other.

oranges

apples

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
 Indifference Curves
Indifference Curves DO NOT touch the axes.

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
Consumer Equilibrium
CONSUMER CHOICE

FIGURE: Consumer Utility-Maximizing

Equilibrium
I/Py’ D

I/Px’

As long as indifference curves are convex to the origin, utility maximization will take place at the
point at which the indifference curve is just tangent to the budget constraint.
THE BASIS OF CHOICE: UTILITY
THE UTILITY-MAXIMIZING RULE

In general, utility-maximizing consumers spread out their

expenditures until the following condition holds:

MU X MUY
utility - maximizing rule : = for all pairs of goods
PX PY
 Law of Equi-marginal utility
• Let us say Mux / Px > Muy / Py
• This means Mux > Px * Muy / Py
• If the consumer buys 1 unit of X he gets additional utility Mux
and pays a price of Px. With Py he could have got one unit of Y
and enjoyed a utility of Muy; a utility per rupee of Muy / Py.
• After spending Px with X he forgoes the utility of Px *Muy / Py.
• If Mux > Px*Muy / Py he is better off buying 1 unit of X.
 Consumer Choice
• I am choosing between rice and wheat.
• Price of rice = Rs. 40/kg, Price of wheat = Rs. 50/ kg
• Marginal utility for rice = Murice ( utility of 1 kg of rice)
• Marginal utility for wheat = Muwheat (utility of 1 kg of wheat)
With Rs. 40, I buy 1 kg of rice = Murice
With same Rs. 40, 40/50 kg of wheat = 0.8 kg of wheat =
0.8Muwheat
If Murice > (40/50) Muwheat Murice / 40= Price > Muwheat / 50 = Pwheat
 Law of Equi-Marginal Utility
• Indifference Curve equation : TUx + TUy = constant
• d(TUx)/dx+ d(TUy)/dx = 0
• Mux + Muy (dy/dx) =0 d(Tuy)/dx = d(Tuy)/dy*dy/dx =
Muy*dy/dx
• Mux/Muy = - dy/dx = Px/Py
• Mux/Px = Muy/Py d(Tuy)/dx =
d(Tuy)/dy*dy/dx = Muy*dy/dx

PXX + PYY = I,
 Practice Question -1

Use consumer theory to explain the law of demand.

Law of demand states increase in price leads to decrease in demand.

Law of Equimarginal utility, Mux / Px = Muy / Py for equilibrium of consumption in a situation of choice.

Px increases. Equilibrium is disturbed.

Left hand side (LHS) is lower in value. As a consequence, the customer consumer more of item y, ignoring
Item X.

The demand for X goes down with its increase in price.

30/1/2016 MBA ZC416 MANAGERIAL

ECONOMICS Session 3
 Practice Question-2
The customer challenged the fruit-seller. “Man, you just cheated the previous customer. You charged him higher for
apples. The standard rate of apples is Rs. 200 per kg. You charged him Rs. 250. This is unfair business practice.”
The fruit-seller angrily retorted “Gentleman, you might have put on expensive clothes. But you seem to know nothing
economics. You probably did not notice that I sold him oranges at a lower price. The market is running short of apples.
By altering the prices, I changed his Budget line and delivered his intended total satisfaction. His position might have
changed, but he still stayed on the same Indifference curve. Go figure.”

B/Papple Original Budget Line

Papple *Qapple + Porange * Qorange = B

Apples P1

P2

B/Porange
Oranges
30/1/2016 MBA ZC416 MANAGERIAL
ECONOMICS Session 3
THANK YOU