Chapter:2 Foundations of Demand and Supply

Characteristics of consumer demand

1. Dynamic in nature
2. Depends on price
3. Depends on supply
4. Demand depends on the competition
5. Demand is affected by multiple factors
6. Demand is based on willingness and ability to pay
Demand analysis

Demand analysis is the process of assessing the demand for a

particular product or service in a market.
It examines the factors influencing consumer purchasing decisions,
such as price, preferences and the market conditions .
Approaches to analyzing consumer demand
1) The cardinal utility approach
2) The ordinal utility approach
3) The indifference curve analysis
4) The budget line approach
5) The demand curve analysis
6) The revealed preference theory
7) The econometric approach
The cardinal utility approach

The Cardinal Utility Approach is a concept in economics that assumes that

utility (satisfaction or happiness) derived from consuming goods and services
can be measured in absolute, numerical terms, just like weight or height.

This approach is primarily associated with classical economists like Jeremy

Bentham and Alfred Marshall and forms the basis of the marginal utility
theory.
The ordinal utility approach

The Ordinal Utility Approach is an economic theory that assumes

consumers can rank their preferences but cannot assign exact
numerical values to their satisfaction (utility).
This theory was developed by John Hicks
 The indifference curve analysis

The Indifference Curve Analysis is a fundamental concept in consumer behavior theory,

introduced by Francis Y. Edgeworth and further developed by John Hicks and R.G.D.
Allen. It is based on the Ordinal Utility Approach.
An indifference curve represents all the combinations of two goods that provide the same
level of satisfaction to a consumer. The consumer is indifferent between any of these
combinations.
Example:
A consumer gets the same satisfaction from the following combinations of coffee and tea:
•Bundle A: 3 cups of coffee + 5 cups of tea
•Bundle B: 4 cups of coffee + 3 cups of tea
•Bundle C: 2 cups of coffee + 7 cups of tea
The budget line approach

The Budget Line Approach is an economic concept that

illustrates the combinations of two goods that a consumer
can afford given their income and the prices of those goods.
It is a fundamental part of consumer choice theory, helping
to determine the optimal consumption bundle that
maximizes satisfaction.
The demand curve analysis

The demand curve approach is a fundamental concept in economics

that represents the relationship between the price of a good or service
and the quantity demanded by consumers. The demand curve
typically slopes downwards from left to right, reflecting the law of
demand: as the price of a good or service decreases, the quantity
demanded generally increases, and vice versa, assuming all other
factors remain constant (ceteris paribus)
The Revealed Preference theory
Revealed Preference Theory is a way to understand what people like by
looking at what they buy rather than asking them what they prefer. It was
introduced by economist Paul Samuelson to explain consumer behavior
without using the complex idea of utility. Revealed Preference Theory states
that a consumer's choices and purchasing behavior reveal their true
preferences, assuming they make rational and consistent decisions.
Main Idea:
Instead of asking people what they prefer, we observe their choices.
If someone chooses one product over another, it means they like that product more.
Their actual behavior reveals their preferences.
The Econometric approach

The econometric approach involves using mathematical and

statistical methods to analyze economic data and test
economic theories. It helps in making predictions, estimating
relationships between variables, and validating economic
models.
 Utility
Utility refers to want satisfying power of a commodity. It is the
satisfaction, actual or expected, derived from the consumption of a
commodity. Utility differs from person- to-person, place-to-place and
time-to-time.
In the words of Prof. Hobson, “Utility is the ability of a good to satisfy
a want”.
Total utility
Total utility refers to the total satisfaction obtained from the
consumption of all possible units of a commodity. It measures the
total satisfaction obtained from consumption of all the units of that
good.
For example, if the 1st ice-cream gives you a satisfaction of 20 utils
and 2nd one gives 16 utils, then TU from 2 ice-creams is 20 + 16 =
36 utils. If the 3rd ice-cream generates satisfaction of 10 utils, then
TU from 3 ice-creams will be 20+ 16 + 10 = 46 utils.
Marginal Utility (MU):

Marginal utility is the additional utility derived from the consumption

of one more unit of the given commodity. It is the utility derived from
the last unit of a commodity purchased. As per given example, when
3rd ice-cream is consumed, TU increases from 36 utils to 46 utils.
The additional 10 utils from the 3rd ice-cream is the MU.
In the words of Chapman, “Marginal utility is addition made to total
utility by consuming one more unit of a commodity”.
Meaning of marginal utility theory
According to marginal utility theory, consumer will continue to buy
more of a good until the marginal utility of that good is equal to its
price.
Consumer try to get the most satisfaction of their money. If the
marginal utility of a product is higher than the price, they will buy
more. But if the marginal utility is lower than the price, they will stop
buying it.
Consumers aim to spend their money in a way that maximize total
utility.
Law of diminishing marginal utility
If a consumer takes more and more units of a commodity, the
additional utility he derives from an extra unit of the commodity
goes on falling. Thus, according to this law, the marginal utility
decreases with the increase in the consumption of a commodity.
When marginal utility decreases, the total utility increases at a
diminishing rate.
Suppose Mr. X is hungry and eats apple one by one. The first apple
gives him great pleasure (higher utility) as he is hungry; when he
takes the second apple, the extent of his hunger will reduce.
Therefore he will derive less utility from the second apple. If he
continues to take additional apples, the utility derived from the third
apple will be less than that of the second one. In this way, the
additional utility (marginal utility) from the extra units will go on
decreasing. If the consumer continues to take more apples, marginal
utility falls to zero and then becomes negative.
 Assumptions
1. The units of consumption must be in standard units e.g., a cup of tea, a bottle of cool
drink etc.
2. All the units of the commodity must be identical in all aspects like taste, quality,
colour and size.
3. The law holds good only when the process of consumption continues without any time
gap.
4. The consumer's taste, habit or preference must remain the same during the process of
consumption.
5. The income of the consumer remains constant.
6. The prices of the commodity consumed and its substitutes are constant.
7. The consumer is assumed to be a rational economic man. As a rational consumer, he
wants to maximize the total utility.
8. Utility is measurable.
 Demand under risk and uncertainty
Consumers would react to risk and uncertainty while taking purchase decisions.
When they face risk and uncertainty ,they often use certain strategies. These
strategies are the ways to protect themselves from potential losses or bad
choices because they unsure about what might happen in the future.
•Sticking to essentials Diversifying choices
•Seeking discounts and bargains postponing purchase
•Saving more money relying trusted brands
•Using insurance or warranties
 DEMAND ESTIMATION
• Demand estimation may be defined as the process of finding
current values of demand for various values of prices and other
determining
• Demand estimation refers to the process of determining the
expected demand for a product or service in the market. It
involves using historical data, statistical methods, and economic
theories to predict how much of a good or service consumers
will purchase at different price levels and under various market
conditions
 Steps in demand estimation
1. Identification of the variables
2. Collection of data
3. Development of a model
4. Estimation of the parameters of the model
5. Development of estimates based on the model
 Tools of demand estimation
• a) Consumer Survey Method
• Involves directly asking consumers about their purchasing
behavior and preferences.
• Methods include structured questionnaires, interviews, and
focus groups.
• Useful for estimating demand for new products or in markets
with limited historical data
• b) Delphi Method
• A panel of experts provides demand forecasts, and their
opinions are refined through multiple rounds of surveys.
• Helps in cases where historical data is unavailable or unreliable
• c) Market Experimentation
• Companies test different prices, promotions, or product
variations in controlled environments.
• Helps in understanding consumer responses before a full-scale
launch.
• Examples include test markets, A/B testing, and pilot projects
• D.statistical methods
• Statistical methods of demand estimation use mathematical models and
historical data to analyze the relationship between demand and its influencing
factors.
• Regression analysis is a common method that quantifies how demand changes
with variations in price, income, and other variables.
• Time series analysis helps forecast future demand by identifying trends,
seasonality, and cyclical patterns in past data.
• Econometric models incorporate multiple variables to provide more accurate
demand predictions, making them useful for policy-making and business
strategy
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