Theory of Demand and Supply

UNIT
Law of Demand and
1 Elasticity of Demand

MEANING OF DEMAND
‰ The term ‘demand’ refers to the quantity of a good or service that buyers are willing and
able to purchase at various prices during a given period of time.
‰ The effective demand for a thing depends on
(i) desire
(ii) means to purchase and
(iii) willingness to use those means for that purchase.
‰ Unless desire is backed by purchasing power or ability to pay and willingness to pay, it
does not constitute demand.

MEANING OF QUANTITY DEMANDED

‰ Quantity demanded is the quantity of a commodity that people are willing to buy at a
particular price at a particular point of time.
‰ Two things are to be noted about the quantity demanded.
(i) The quantity demanded is always expressed at a given price. At different prices
different quantities of a commodity are generally demanded.
(ii) The quantity demanded is a flow. We are concerned not with a single isolated
purchase, but with a continuous flow of purchases and we must therefore express
demand as ‘so much per period of time’.

WHAT DETERMINES DEMAND?

Demand for a commodity increases or decreases due to a number of factors. The various
factors affecting demand are discussed below:
(a) Price of the commodity:
 The good’s own price is a key determinant of its demand.
 Ceteris paribus i.e. Other things being equal, the demand for a commodity is inversely
related to its price.
 It implies that a rise in the price of a commodity brings about a fall in the quantity
purchased and vice-versa. This happens because of income and substitution effects.
(b) Price of related commodities:
 Related commodities are of two types:
(i) complementary goods and
(ii) competing goods or substitutes.
 Complementary goods
¾ Complementary goods and services are those that are bought or consumed together
or simultaneously. Examples are: tea and sugar, automobile and petrol and pen
and ink.
¾ When two commodities are complements, a fall in the price of one (other things
being equal) will cause the demand for the other to rise and vice versa.
¾ There is an inverse relation between the demand for a good and the price of its
complement.
¾ For example, a fall in the price of petrol-driven cars would lead to a rise in the
demand for petrol. There is an inverse relation between the demand for a good
and the price of its complement
 Substitute goods
¾ Two commodities are called competing goods or substitutes when they satisfy the
same want and can be used with ease in place of one another. For example, tea
and coffee, ink pen and ball pen, different brands of toothpaste etc.
¾ When goods are substitutes, a fall in the price of one (ceteris paribus) leads to a fall
in the quantity demanded of its substitutes and vice versa.
¾ Demand of a commodity is directly related with price of substitute goods.
¾ For example, if price of a substitute good (say, coffee) increases, then demand
for given commodity (say, tea) will rise as tea will become relatively cheaper in
comparison to coffee.
(c) Disposable Income of the consumer:
 The purchasing power of a buyer is determined by the level of his disposable income.
Other things being equal, the demand for a commodity depends upon the disposable
income of the potential purchasers.
 Normal Goods: Normal goods are those that are demanded in increasing quantities
as consumers’ income increases. Most goods and services fall under the category of
normal goods. Household furniture, clothing, automobiles, consumer durables and
semi durables etc. fall in this category. When income is reduced (for example due to
recession), demand for normal goods falls.
 Inferior Goods (Also called as Giffen goods) : If any commodity is purchased by a
consumer just because of his low income level, then this commodity is termed as an
inferior commodity for that person. With Increase in income, demand for inferior
goods fall and vice versa.
 As the income level increase and people become richer, there is a relative decline in
the importance of food and other non durable goods in the overall consumption basket
and a rise in the importance of durable goods such as a TV, car, house etc.

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(d) Tastes and preferences of buyers:
 Tastes and preferences of the consumer directly influence the demand for a commodity.
 Goods which are modern or more in fashion command higher demand than goods
which are of old design or are out of fashion.
 Consumers may perceive a product as obsolete and discard it before it is fully utilised
and then prefer another good which is currently in fashion.
 External effects such as’ demonstration effect’,’ bandwagon effect’, Veblen effect and
‘snob effect’ do play important roles in determining the demand for a product.
 Demonstration effect, a term coined by James Duesenberry, refers to the desire of
people to emulate the consumption behaviour of others. In other words, people buy or
have things because they see that other people are able to have them.
 Bandwagon effect refers to the extent to which the demand for a commodity is
increased due to the fact that others are also consuming the same commodity. It
represents the desire of people to purchase a commodity in order to be fashionable or
stylish or to conform to the people they wish to be associated with.
 Snob effect - refers to the extent to which the demand for a consumers’ good is
decreased owing to the fact that others are also consuming the same commodity. This
represents the desire of people to be exclusive; to be different; to dissociate themselves
from the “common herd.” For example, when a product becomes common among all,
some people decrease or altogether stop its consumption.
 ‘Veblen effect’ (named after the American economist Thorstein Veblen) states that
Highly priced goods are consumed by status seeking rich people to satisfy their need
for conspicuous noticeable consumption.
(e) Consumers’ Expectations
 Consumers’ expectations regarding future prices, income, supply conditions etc.
influence current demand.
 If the consumers expect increase in future prices, increase in income and shortages in
supply, more quantities will be demanded.
 If they expect a fall in price or fall in income they will postpone their purchases of
nonessential commodities and therefore, the current demand for them will fall.
(f) Other factors: Apart from the above factors, the demand for a commodity depends
upon the following factors:
i. Size of population: Generally, larger the size of population of a country or a region,
larger would be the number of buyers and the quantity demanded in the market
would be higher at every price. The opposite is the case when population is less.
ii. Age Distribution of population:
¾ If a larger proportion of people belong to older age groups relative to younger age
groups, there will be increased demand for geriatric old and weak care services,
spectacles, walking sticks, etc and less demand for children’s books.
¾ Similarly, if the population consists of more of children, demand for toys, baby
foods, toffees, etc. will be more.

Law of Demand and Elasticity of Demand 5

 iii. The level of National Income and its Distribution:
¾ The level of national income is a crucial determinant of market demand. Higher
the national income, higher will be the demand for all normal goods and services.
¾ If the national income is unevenly distributed [few very rich people while the
majority are very poor], the propensity to consume of the country will be relatively
less and consequently, the demand for consumer goods will be comparatively less.
¾ However, if the distribution of income is more equal, then the propensity to consume
of the country as a whole will be relatively high indicating higher demand for goods.
iv. Consumer-credit facility and interest rates:
¾ Availability of credit facilities induces people to purchase more than what their
current incomes permit them.
¾ Low rates of interest encourage people to borrow and therefore demand will be
more and vice versa.
v. Government policies and regulations:
¾ The governments influence demand through its taxation and subsidy policies.
¾ While taxes increase prices and decrease the quantity demanded, subsidies decrease
the prices and increase the quantity demanded. For example taxes on luxurious
goods and subsidies for solar panels.
¾ Similarly total bans, restrictions and higher taxes may be used by government to
restrict the demand for socially undesirable goods and services.
¾ Government’s policy on international trade also will affect the domestic demand
for goods and services.

TRY YOUR UNDERSTANDING 1.1

1. Demand for a commodity refers to
(a) desire for the commodity
(b) need for the commodity
(c) quantity demanded of that commodity
(d) quantity of the commodity demanded at a certain price during any particular period
of time
2. Demand is a
(a) flow concept (b) stock concept
(c) none of these (d) partially a flow concept
3. In economics, demand refers to
(a) quantity demanded at a particular time
(b) quantity demanded backed by ability to pay
(c) quantity demanded for normal & inferior goods
(d) quantity demanded at a specific price during a particular period of time

6 Business Economics and BCK

 4. When price of z rises it causes an increase in demand for goods X then X & Z are
(a) complementary goods (b) inferior goods
(c) substitute goods (d) necessities
5. When price of z rises then the quantity in demand of goods X reduces. what is the
relationship between X & Z
(a) complementary goods (b) inferior goods
(c) substitute goods (d) necessities
6. The consumer demand those goods which gave
(a) Both positive & negative utility (b) Positive utility
(c) Negative utility (d) None of these

ANSWER
1. (d) 2. (a) 3. (d) 4. (c) 5. (a) 6. (c)

DEMAND FUNCTION
Demand function shows the relationship between quantity demanded for a particular
commodity and the factors influencing it.
It is expressed as: Dx = f (Px, Pr, Y, T, F)
Where,
Dx = Demand for Commodity x; Px = Price of the given Commodity x;

Pr = Prices of Related Goods; Y = Income of the Consumer;

T = Tastes and Preferences; F = Expectation of Change in Price in future.

THE LAW OF DEMAND

‰ As per Prof. Alfred Marshall: “The greater the amount to be sold, the smaller must be
the price at which it is offered in order that it may find purchasers or in other words
the amount demanded increases with a fall in price and diminishes with a rise in price”.
‰ The law of demand states that other things being equal, when the price of a good rises
the quantity demanded of the good will fall.
‰ Thus, there is an inverse relationship between price and quantity demanded, other things
remains constant (i.e. ceteris paribus).
‰ If these factors which determine demand also undergo a change, then the inverse price-
demand relationship may not hold good.
‰ For example, if incomes of consumers increases, then an increase in the price of a commodity,
may not result in a decrease in the quantity demanded of it.
Law of Demand and Elasticity of Demand 7
Hypothetical Demand Schedule

Price Quantity Demanded

5 1
4 2
3 3
2 4
1 5

THE DEMAND SCHEDULE

‰ A demand schedule is a table showing the quantities of a good that buyers would choose
to purchase at different prices, per unit of time, with all other variables held constant.
‰ A demand schedule is drawn upon the assumption that all the other influences remain
unchanged.
Price Quantity Demanded
A 5 1
B 4 2
C 3 3
D 2 4
E 1 5

THE DEMAND CURVE

‰ A demand curve is a graphical presentation of the demand schedule.
‰ By convention, the vertical axis of the graph measures the price per unit of the good.
The horizontal axis measures the quantity of the good, which is usually expressed in some
physical measure per time period.
‰ It shows the relationship between the quantities of a good that buyers are willing to buy
and the price of the good.
‰ The negative or downward slope indicates that the quantity demanded increases as the
price falls (depicting Law Of Demand)
‰ The slope of a demand curve is - ∆P/∆Q (i.e Y
the change along the vertical axis divided by the
change along the horizontal axis). The negative D
Price in `

sign of this slope is consistent with the law of 1

demand.
2
‰ The demand curve for a good does not have to 3
be linear or a straight line; it can be curvilinear-
4
meaning its slope may vary along the curve. If the
5 D
change in quantity demanded does not follow a
X
constant proportion, then the demand curve will O 1 2 3 4 5 Quantity
be non linear. Quantity Demanded (in units)

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MARKET DEMAND SCHEDULE
‰ Market demand schedule refers to a tabular statement showing various quantities of a
commodity that all the consumers are willing to buy at various levels of price, during a
given period of time.
‰ It is the sum of all individual demand schedules at each and every price.
‰ Market demand schedule can be expressed as: Dm - DA + DB + …….
Where Dm is the market demand and DA + DB + are the individual demands of Household
A, Household B and so on.
Market Demand Schedule

Price Individual Demand (in units) Market Demand (in units) {Da + DB)
(Rs.) Household A (DA) Household B (DB)
5 1 2 1+2 = 3
4 2 3 2+3=5
3 3 4 3+4=7
2 4 5 4+5=9
1 5 6 5 + 6 = 11

MARKET DEMAND CURVE

‰ Market demand curve refers to a graphical representation of market demand schedule.
It is obtained by horizontal summation of individual demand curves.
‰ Market demand curve ‘DM’ also slope downwards due to inverse relationship between
price and quantity demanded.
‰ Market Demand Curve is Flatter than individual demand curve, as when price changes
then proportionate change in market demand is more than proportionate change in
individual demand.

Y
Market Demand curve
DM is flatter
5
than DA and DM
Price in `

3
2
1
DA DB DM
X
O 2 4 6 8 10 12
Quantity demanded (in units)

Law of Demand and Elasticity of Demand 9

Rationale of the Law of Demand (Why Demand Curve Slopes Downward)
The various reasons for operation of Law of Demand are:
1. Substitution Effect:
 It refers to substituting one commodity in place of other when it becomes relatively
cheaper.
 When price of the given commodity falls (say ball pen), it becomes relatively cheaper
as compared to its substitute (say ink pen) (assuming no change in price of ink pen).
As a result, demand for the given commodity (i.e. ball pen) rises
2. Income Effect:
 It refers to effect on demand when real income of the consumer changes due to change
in price of the given commodity.
 When price of the given commodity falls, it increases the purchasing power (real
income) of the consumer. Due to which, he can purchase more of the given commodity
with the same money income.
 For example, Chandu buys 2 ice-creams @ Rs.10 each with his pocket money of
Rs.20. If price of ice cream falls to Rs.5 each, then with the same pocket money,
chandu can buy 4 ice-creams due to an increase in real income.
3. Utility maximising behaviour of Consumers (Law Of Diminishing Marginal Utility):
 According to Marshall, the consumer has diminishing utility for each additional unit of
a commodity and therefore, he will be willing to pay only less for each additional unit.
 A rational consumer will not pay more for lesser satisfaction. He is induced to buy
additional units only when the prices are lower.
4. Arrival of new consumers: When the price of a commodity falls, more consumers start
buying it because some of those who could not afford to buy it earlier may now be able
to buy it. This raises the number of consumers of a commodity at a lower price and
hence the demand for the commodity in question increases.
5. Different uses: Many commodities have multiple uses. When the price of such commodities
are high (or rises) they will be put to limited uses only. If the prices of such commodities
fall, they will be put to more number of uses and therefore their demand will increase.
Example Milk.

EXCEPTIONS TO THE LAW OF DEMAND

The following are the important exceptions to the law of demand:
(a) Conspicuous goods (Veblen Effect):
 Articles of prestige value or snob appeal or articles of conspicuous consumption are
used by the rich people as status symbol for enhancing their social prestige such as
diamond, paintings, antiques etc.
 There demand is high at higher prices and if their prices fall, then their demand will
decrease as they are not considered as status symbol goods anymore.

10 Business Economics and BCK

  This was found out by Veblen in his doctrine of “Conspicuous Consumption” and hence
this effect is called Veblen effect or prestige goods effect.
 Veblen effect takes place as some consumers consider that if the commodity is expensive
then it has more utility.
(b) Giffen goods:
 Background: Sir Robert Giffen, a Scottish economist and statistician, was surprised
to find out that as the price of bread increased, the British workers purchased more
bread and not less of it. This was something against the law of demand. Why did this
happen? The reason given for this is that, when the price of bread went up, it caused
such a large decline in the purchasing power of the poor people that they were forced
to cut down the consumption of meat and other more expensive foods. Since bread,
even when its price was higher than before, was still the cheapest food article, people
consumed more of it and not less when its price went up.
 Those goods which are inferior, with no close substitutes easily available and which
occupy a substantial place in consumer’s budget are called ‘Giffen goods’.
 Such goods exhibit direct price-demand relationship.
 All Giffen goods are inferior goods; but all inferior goods are not Giffen goods.
¾ All Giffen goods are inferior goods because all Giffen goods have negative income
effect.
¾ But all inferior goods are not Giffen goods, as all inferior goods do not have
dominating negative income effect, i.e. negative income effect is not stronger than
positive substitution effect in case of all inferior goods.
(c) Conspicuous necessities:
 The demand for certain goods is affected by the demonstration effect of the consumption
pattern of a social group to which an individual belongs.
 Due to their constant usage these goods have become necessities of life.
 For example, TVs, refrigerators, coolers, cooking gas etc.
(d) Future expectations about prices:
 When the prices show increasing trend, consumers tend to buy larger quantities of
such commodities, expecting that the prices in the future will be still higher and vice
versa.
 For example, when there is wide-spread drought, people expect that prices of food
grains would rise in future. They demand greater quantities of food grains even at the
higher price.
(e) Incomplete information and irrational behaviour:
 Consumers have incomplete information and therefore make inconsistent decisions
regarding purchases.
 A household may demand larger quantity of a commodity even at a higher price
because it may be ignorant of the ruling price of the commodity.
 Consumers tend to be irrational and make impulsive purchases without any rational
calculations about the price and usefulness of the product and in such contexts the
law of demand fails.
Law of Demand and Elasticity of Demand 11
(f) Demand for necessaries:
 The law of demand does not apply much in the case of necessaries of life.
 Irrespective of price changes, people have to consume the minimum quantities of
necessary commodities.
(g) Speculative goods: In the speculative market, particularly in the market for stocks and
shares, more will be demanded when the prices are rising and less will be demanded
when prices decline.

TRY YOUR UNDERSTANDING 1.2

1. The law of demand refers to relationship between
(a) price of a good & quantity demanded
(b) income & quantity demanded
(c) price of a good & quantity demanded of its substitute
(d) price of a good & quantity demanded of its complementary goods
2. The law of demand assumes that the following is constant
(a) price of related goods (b) income of the consumer
(c) tastes & preferences (d) All the above
3. Market demand is derived from individual demand curve by
(a) vertical summation (b) horizontal summation
(c) Both (a) & (b) (d) None of these

ANSWER
1. (a) 2. (d) 3. (b)

EXPANSION AND CONTRACTION OF DEMAND (MOVEMENT ALONG

THE DEMAND CURVE OR CHANGE IN QUANTITY DEMANDED)
‰ When quantity demanded of a commodity changes
Y
due to change in price of a commodity (other factors D
Movement along the

remain constant) then it is termed as change in quantity C Demand Curve

P2
demanded. A
Price in `

P
‰ Its graphical presentation is expressed as movement along P1
B

the demand curve. D

‰ Downward movement represents expansion of demand X

Q2 Q Q1
whereas upward movement represents contraction of
O
Quantity demanded (in units)
demand.

12 Business Economics and BCK

Expansion in Demand
It refers to increase in the quantity demanded due
Y
Expansion in Demand
D
to reduction in the price of commodity, other factors A
20
remains constant.

Price in `
‰ It leads to a downward movement along the same
B
demand curve.
15

‰ Also known as ‘Extension in Demand’ or ‘Increase in D

Quantity Demanded’. O 100 150

X

Expansion in Demand
Quantity demanded (in units)

Price (Rs.) Demand (units)

20 100
15 150

CONTRACTION IN DEMAND
It refers to a fall in the quantity demanded due to Y
Expansion in Demand
D
increase in the price of commodity, other factors B
25
remaining constant.

Price in `
‰ It leads to an upward movement along the same
A
demand curve. 20

‰ Also known as ‘Decrease in Quantity Demanded’. D

X
70 100
Price (Rs.) Demand (units)
O
Quantity demanded (in units)
20 100

25 70

INCREASE AND DECREASE IN DEMAND (SHIFT IN DEMAND CURVE

OR CHANGE IN DEMAND)
‰ When the demand of a commodity changes due to Y Shift in Demand Curve

change in any factor other than the own price of the

D1
D
D2
commodity, it is known as change in demand.
It is graphically expressed as a shift in the demand
Price in`

P
‰

curve.
Rightward Shift Indicated Increase in demand whereas
D1
‰ D
leftward shift indicates decrease in demand.
D2
X
O Q2 Q Q1
Quantity Demanded (in units)

Law of Demand and Elasticity of Demand 13

Increase in Demand Y
Increase in Demand
‰ When demand of a commodity increases due to any D
D1

factor other than price of a commodity then it is termed

Price in `
A
as increase in demand. 20 B

‰ It leads to a rightward shift of demand curve.

Price (Rs.) Demand (units) D1
D
20 100 O 100 150
X

20 150
Quantity Demanded (in units)

Decrease in Demand
Y
‰ When demand of a commodity decreases due to any Decrease in Demand

factor other than price of a commodity then it is termed

D
D1

as decrease in demand.

Price in `
20 B A

‰ It leads to a leftward shift of demand curve.

Price (Rs.) Demand (units)
D
20 100 D1
X
20 70
O 70 100
Quantity Demanded (in units)

Reasons for Increase in Demand Reasons for Decrease in Demand

‰ Rise in income, ‰ Fall in income
‰ Rise in the price of a substitute, ‰ Fall in the price of a substitute,
‰ Fall in the price of a complement, ‰ Rise in the price of a complement,
‰ Change in tastes in favour of this commodity, ‰ Change in tastes against this commodity,
‰ An increase in population, and ‰ Decrease in population, and
‰ Redistribution of income to groups who ‰ Redistribution of income away from
favour this commodity groups who favour this commodity.

TRY YOUR UNDERSTANDING 1.3

1. When price of a related good or income or taste changes, it brings about
(a) change in quantity demanded (b) change in demand
(c) increase in demand (d) decrease in demand
2. Rise in demand at original price is called
(a) expansion in demand (b) contraction in demand
(c) increase in demand (d) decrease in demand

14 Business Economics and BCK

 3. When price of a good changes, it brings about
(a) change in quantity demanded (b) change in demand
(c) expansion in demand (d) contraction in demand

ANSWER
1. (b) 2. (c) 3. (a)

ELASTICITY OF DEMAND
‰ Elasticity of demand is defined as the responsiveness of the quantity demanded of a good
to changes in one of the variables on which demand depends.
‰ In simple words, elasticity of demand is the percentage change in quantity demanded
divided by the percentage change in one of the variables on which demand depends.
‰ different measures of elasticity are price elasticity, cross elasticity, income elasticity,
advertisement elasticity and elasticity of substitution.
Note: Unless otherwise mentioned, it is price elasticity of demand which is usually referred
to as elasticity of demand.

PRICE ELASTICITY OF DEMAND

‰ Price elasticity of demand measures the sensitivity of quantity demanded to ‘own price’
or the price of the own commodity.
‰ Price elasticity of demand measure the responsiveness of quantity demanded of a
commodity, to a change in Price, assuming all the other factors as constant.
‰ The price elasticity of demand (also referred to as PED) tells us the percentage change in
quantity demanded for each one percent (1%) change in price.
∆Q
Price Elasticity = Ep =
∆P

Or
Change in quantity / Original Quantity
Ep= X 100
Change in Price / Original Price

Or
Change in quantity Original Price
Ep= ×
Original Quantity Change in Price

Or
∆Q P
Ep= X
Q ∆P

Where
Ep = Price Elasticity
Q = Original Quantity
P = Original Price
∆Q = Change In Quantity
∆P = Change In Price
Law of Demand and Elasticity of Demand 15
‰ The greater the value of elasticity, the more sensitive quantity demanded is to price.
‰ The value of price elasticity varies from minus infinity to approach zero.
‰ Since price and quantity are inversely related (with a few exceptions) price elasticity is negative,
but we ignore the negative sign and consider only the numerical value of the elasticity.
Example: The price of a commodity decreases from Rs 6 to Rs 4 and quantity demanded
of the good increases from 10 units to 15 units. Find the coefficient of price elasticity.

Ep=
∆Q P
X
Q ∆P
Ep = (-) 5/10 x 6/2
Ep = (-)1.5

POINT ELASTICITY
‰ The point elasticity of demand is the price elasticity of demand at a particular point on
the demand curve.
‰ The concept of point elasticity is used for measuring price elasticity where the change in
price is infinitesimal (extremely small).
Y
‰ Price elasticity is a key element in applying marginal
analysis to determine optimal prices.
t
‰ Marginal analysis works by evaluating “small” changes

Price
taken with respect to an initial decision, it is useful to R
measure elasticity with respect to an infinitesimally small
change in price.
X
Point elasticity makes use of derivative rather than finite O T
‰ Quantity
changes in price and quantity.
dq p
Ep= X
dp q
‰ Where dq /dp is the derivative of quantity with respect to price at a point on the demand
curve, and p and q are the price and quantity at that point.

GEOMETRIC METHOD (MEASUREMENT OF ELASTICITY ON A LINEAR

DEMAND CURVE)
‰ Elasticity varies along the curve as price and quantity change. Y
‰ The slope of a linear demand curve is constant. However,
Ed = 
the elasticity at different points on a linear demand curve t
would be different. Ed > 1

‰ When price is high and quantity is small, the elasticity

Ed = 1
is high. The elasticity becomes smaller as we move down P1
the curve. Ed < 1
Price

Lower Segment Ed = 0
Ep= X
Upper Segment O Quantity Q1 T

16 Business Economics and BCK

ARC-ELASTICITY
‰ When price elasticity is to be found between two Y
D
prices or two points on the demand curve, the
A
question arises as to which price and quantity should P
Arc Elasticity
be taken as base. P1
B

in order to avoid confusion, the averages of the two D

Price
‰
prices and quantities are taken as (i.e. original and
new) base.
‰ The arc elasticity can be found out by using the X
O
formula: We drop the minus sign and use the
Q Q1
Quantity Demanded
absolute value.
Q2-Q1

Ep =
Q2 +Q1  /2
P2-P1
P2 +P1  /2
Q2-Q1 P2 +P1
Ep= ×
Q2 +Q1 P2-P1

Where P1, Q1are the original price and quantity and P2, Q2are the new ones.
‰ The arc elasticity will always lie somewhere (but not necessarily in the middle) between
the point elasticities calculated at the lower and the higher prices.

INTERPRETATION OF THE NUMERICAL VALUES OF ELASTICITY OF

DEMAND
The numerical value of elasticity of demand can assume any value between zero and infinity.
Ep = 0 ‰ If there is no change at all in the quantity demanded Y

when price changes i.e. Perfectly Inelastic Ep = 0

D

‰ Perfectly inelastic demand is as an extreme case of

Price

price insensitivity and is therefore only a theoretical

category with less practical significance.
‰ The vertical demand curve represents perfectly or O Quantity
X

completely inelastic demand

Ep = 1 ‰ If the percentage change in quantity demanded is Y
Ep = 1

equal to the percentage change in price.

D

The demand curve is a rectangular hyperbola.

Price

‰ Also known as Unitary Elastic.

X
O Quantity

Law of Demand and Elasticity of Demand 17

Ep > 1 ‰ When the percentage change in quantity demanded Y

is greater than the percentage change in price. D

Ep > 1

‰ Demand is said to be elastic.

Price
P1

The elastic demand line (demand curve) is fairly

D

flat.
O X
Q Q1
Quantity

Ep < 1 ‰ When the percentage change in quantity demanded Y

is less than the percentage change in price. D Ep < 1

Demand is said to be inelastic.

P
‰

Price
The quantity demanded is relatively insensitive to
P1
‰

price changes.
D

O X
Q Q1

‰ The inelastic demand line (demand curve) is fairly Quantity

steep.
Ep = ∞ ‰ When a ‘small price reduction raises the demand Y
from zero to infinity.
Ep = 
‰ Perfectly or infinitely elastic demand.
P D
‰ As long as the price stays at one particular level any
quantity might be demanded.
‰ If there is a slight increase in price, quantity X
O
demanded fall to zero. Quantity

‰ This type of demand curve is found in a perfectly

competitive market.
‰ The demand curve is horizontal at the price level.

TOTAL OUTLAY METHOD OF CALCULATING PRICE ELASTICITY

The price elasticity of demand for a commodity and the total expenditure or outlay made
on it are significantly related to each other.
As the total expenditure made on a commodity is the total revenue received by the
seller, we can say that the price elasticity and total revenue received are closely related to
each other.
By analysing the changes in total expenditure (or total revenue) in response to a change in
the price of the commodity, we can know the price elasticity of demand for it.

Ep = 1 ‰ When, as a result of the change in price of a good, the total expenditure on

the good or the total revenue received from that good remains the same, the
price elasticity for the good is equal to unity.
‰ This is because the total expenditure made on the good can remain the same only
if the proportional change in quantity demanded is equal to the proportional
change in price.

18 Business Economics and BCK

Ep > 1 ‰ When, as a result of increase in the price of a good, the total expenditure made
on the good or the total revenue received from that good falls or
‰ When as a result of decrease in price, the total expenditure made on the good
or total revenue received from that good increases, we say that price elasticity
of demand is greater than unity.
Ep < 1 ‰ When, as a result of increase in the price of a good, the total expenditure made
on the good or the total revenue received from that good increases or
‰ when as a result of decrease in its price, the total expenditure made on the
good or the total revenue received from that good falls, we say that the price
elasticity of demand is less than unity.
The main drawback of this method is that by using this we can only say whether the demand
for a good is elastic or inelastic; we cannot find out the exact coefficient of price elasticity.

Why should a business firm be concerned about elasticity of demand?

The reason is that the degree of elasticity of demand predicts how changes in the price of
a good will affect the total revenue earned by the producers from the sale of that good.
The total revenue is defined as the total value of sales of a good or service. It is equal to the
price multiplied by the quantity sold.

TOTAL REVENUE
‰ Total revenue (TR) = Price × Quantity sold
‰ Except in the rare case of a good with perfectly elastic or perfectly inelastic demand, when
a seller raises the price of a good, there are two effects which act in opposite directions
on revenue.
¾ Price effect: After a price increase, each unit sold sells at a higher price, which tends
to raise the revenue and vice versa
¾ Quantity effect: After a price increase, fewer units are sold, which tends to lower
the revenue and vice versa.
If the price effect which tends to raise total revenue is the stronger of the two effects, then
total revenue goes up. If the quantity effect, which tends to reduce total revenue, is the
stronger, then total revenue goes down.

Ep = 1 ‰ An increase in price or decrease in price does not change total revenue.

‰ The quantity effect and the price effect exactly balance each other.
Ep > 1 ‰ When, as a result of increase in the price of a good, the total expenditure made
on the good or the total revenue received from that good falls or
‰ When as a result of decrease in price, the total expenditure made on the good
or total revenue received from that good increases, we say that price elasticity
of demand is greater than unity.
Ep < 1 ‰ An increase in price reduces total revenue and a fall in price increases total
revenue.
‰ In this case, the quantity effect is stronger than the price effect.

Law of Demand and Elasticity of Demand 19

The Relationship between Price elasticity and Total Revenue (TR)
Elastic Unitary Elastic Inelastic
Price Increase TR Decreases TR remains same TR Increases
Price Decrease TR Increases TR remains same TR Decreases

Determinants of Price Elasticity of Demand

Following are important determinants of price elasticity:
(a) Availability of substitutes:
 The demand for a commodity with a wide range of substitute products tends to be
more elastic. This is because even a slight increase in its price can prompt buyers to
switch to available substitutes.
 For instance, if the price of Pepsi rises, consumers may choose to purchase Coke as an
alternative, and vice versa.
 As a result, the presence of close substitutes makes the demand for a commodity more
responsive to changes in prices
 On the contrary, commodities that have limited or no substitutes, such as wheat and
salt, generally exhibit less price elasticity of demand. This means that changes in price
have a comparatively smaller impact on the quantity demanded by consumers.
(b) Position of a commodity in the consumer’s budget:
 The greater the proportion of income spent on a commodity; generally the greater
will be its elasticity of demand and vice- versa.
 The demand for goods like common salt, matches, buttons, etc. tend to be highly
inelastic because a household spends only a fraction of their income on each of them.
 On the other hand, demand for goods like rental apartments and clothing tends to be
elastic since households generally spend a good part of their income on them.
 When the good absorbs a significant share of consumers’ income, it is worth their time
and effort to find a way to reduce their demand when the price goes up.
(c) Nature of the need that a commodity satisfies:
 In general, luxury goods are price elastic because one can easily live without a luxury.
In contrast, necessities are price inelastic.
 If it is possible to postpone the consumption of a particular good, such good will have
elastic demand.
 Consumption of necessary goods cannot be postponed and therefore, their demand is
inelastic.
(d) Number of uses to which a commodity can be put:
 The more the possible uses of a commodity, the greater will be its price elasticity and
vice versa.
 When the price of a commodity which has multiple uses decreases, people tend to
extend their consumption to its other uses and vice versa.

20 Business Economics and BCK

(e) Time period:
 The concept of price elasticity of demand is time-dependent, as it is influenced by the
period under consideration, which can range from a day to several years.
 The elasticity of demand varies in direct proportion to the time frame examined.
In the short term, demand tends to be relatively inelastic because consumers face
difficulties in quickly changing their habits or adapting to price changes for a particular
commodity.
 However, in the long run, demand becomes more elastic as consumers have more
flexibility and time to explore alternative options and switch to substitutes when the
price of the given commodity rises.
 In the short term, if the price of petrol increases, consumers may be reluctant to
switch to alternative sources, as it requires significant investments in purchasing
new car. But over a longer period, they have the opportunity to explore options like
EV-Cars, thereby making their demand for petrol more elastic in the long run.
(f) Consumer habits: If a person is a habitual consumer of a commodity, no matter how
much its price change, the demand for the commodity will be inelastic. If buyers have
rigid preferences demand will be less price elastic.
(g) Tied demand: The demand for those goods which are tied to others is normally inelastic
as against those whose demand is of autonomous nature. For example printers and ink
cartridges.
(h) Price Range:
 Goods which are in medium range of price level are more elastic to price change.
 Goods which are in very high price range or in very low price range have inelastic
demand.
(i) Minor complementary items: The demand for cheap, complementary items to be used
together with a costlier product will tend to have an inelastic demand.

TRY YOUR UNDERSTANDING 1.4

1. The minus sign in elasticity of demand indicates
(a) inverse relationship between price & quantity demands
(b) inverse relationship between income & quantity demands
(c) direct relationship between price & quantity demands
(d) None of these
2. What is elasticity of demand in case of necessities & luxuries ?
(a) necessities have elastic & luxuries have inelastic
(b) necessities have inelastic & luxuries have elastic
(c) necessities have zero & luxuries have one
(d) necessities have one & luxuries have zero

Law of Demand and Elasticity of Demand 21

 3. In case of essential goods the elasticity of demand is
(a) infinity (b) high
(c) one (d) zero
4. What is it called when elasticity of demand is one? What shape will the demand curve
take?
(a) unitary elastic; rectangular hyperbole
(b) elastic; downward sloping
(c) elastic; vertical
(d) inelastic; horizontal
5. The formula of arc elasticity demand is

Q2 Q2 Q2 P2
(a) Q + -Q2 ×Q1 + -P2 (b) Q1- +Q2 .P1 + -P2
1
Q1 P1 Q1 P1

Q2 P2
(c) Q1- +Q2 ×P1- +P2 (d) None of these
Q1 P1

6. When price & outlay moves in the same direction, it is case of

(a) unitary elastic demand (b) elastic demand
(c) perfectly elastic demand (d) inelastic demand
7. When the price & outlay move in opposite direction it is case of
(a) unitary elastic demand
(b) elastic demand
(c) perfectly elastic demand
(d) inelastic demand
8. If price of burger rises by 20% & demand falls by 25% then demand for burger is
(a) static (b) perfectly elastic
(c) unitary elastic (d) inelastic
9. If there is no change in quantity demanded to any change in price then elasticity of
demand is & shape of demand curve is
(a) infinity elastic; horizontal demand curve
(b) zero, vertical demand curve
(c) less than one, downward sloping demand curve
(d) zero than one horizontal downward sloping demand curve
10. As the prices of a commodity rises from Rs.10 to Rs.12, its demand falls from 100 units
to 50 units calculate elasticity of demand
(a) 4 (b) 3
(c) 1 (d) 2

22 Business Economics and BCK

11. In a straight line downward sloping demand curve, the elasticity of demand becomes
greater as price
(a) rises (b) zero
(c) falls (d) is unchanged
12. When more substitutes are available elasticity of demand is
(a) more (b) less
(c) infinity (d) None of these

ANSWER
1. (a) 2. (b) 3. (d) 4. (a) 5. (b) 6. (d) 7. (b)
8. (a) 9. (b) 10. (a) 11. (a) 12. (a)

INCOME ELASTICITY OF DEMAND

‰ The income elasticity of demand is a measure of how much the demand for a good is
affected by changes in consumers’ incomes.
‰ Estimates of income elasticity of demand are useful for businesses to predict the possible
growth in sales as the average incomes of consumers grow over time.
‰ Income elasticity of demand is the degree of responsiveness of the quantity demanded of
a good to changes in the income of consumers.
% change in quantity
Ep =
% Change in Income
Or

∆Q Y
E = p
X
Q ∆Y
Ep = 1 If the proportion of income spent on a good remains the same as income increases,
then income elasticity for that good is equal to one.
Ep > 1 ‰ If the proportion of income spent on a good increase as income increases, then
the income elasticity for that good is greater than one.
‰ The demand for such goods increase faster than the rate of increase in income.
‰ If the income elasticity for a good is greater than one, it shows that the good
bulks larger in consumer’s expenditure as he becomes richer. Such goods are
called luxury goods.
Ep < 1 ‰ If the proportion of income spent on a good decrease as income rises, then
income elasticity for the good is positive but less than one.
‰ The demand for income-inelastic goods rises, but substantially slowly compared
to the rate of increase in income.
‰ Necessities such as food and medicines tend to be income- inelastic.
‰ It shows that the good is either relatively less important in the consumer’s eye
or, it is a good which is a necessity.

Law of Demand and Elasticity of Demand 23

‰ Income elasticity of goods reveals a few very important features of demand for the goods
in question.
 If income elasticity is zero, it signifies that the demand for the good is quite unresponsive
to changes in income.
 When income elasticity is greater than zero or positive, then an increase in income
leads to an increase in the demand for the good. This happens in the case of most
of the goods and such goods are called normal goods. For all normal goods, income
elasticity is positive. However, the degree of elasticity varies according to the nature
of commodities.
 When the income elasticity of demand is negative, the good is an inferior good. In
this case, the quantity demanded at any given price decreases as income increases.
The reason is that when income increases, consumers choose to consume superior
substitutes.

CROSS - PRICE ELASTICITY OF DEMAND

‰ The demand for a particular commodity may change due to changes in the prices of
related goods (complementary goods or substitute goods). This type of relationship is
studied under ‘Cross Demand’.
‰ Cross demand refers to the quantities of a commodity or service which will be purchased
with reference to changes in price, not of that particular commodity, but of other inter-
related commodities, other things remaining the same.
‰ Example: if price of pen decreases, then demand for ink rises (Pen and ink are complimentary
goods)
(a) Substitute Goods:
¾ In the case of substitute commodities, the cross Y
demand curve slopes upwards (i.e. positively)
Price of Solar Coffee

showing that more quantities of a commodity, will Substitutes

D
be demanded whenever there is a rise in the price
P1

of a substitute commodity.
P2
¾ Example: When the price of coffee increases, due to the
operation of the law of demand, the demand for coffee D
falls. The consumers will substitute tea in the place of O Q2 Q1
X

coffee. The price of tea is assumed to be constant. Quantity Demanded of Tea

(b) Complementary Goods

Y
¾ A change in the price of a good will have an opposite
Price of Solar Pannels

reaction on the demand for the other commodity D

which is closely related or complementary. P2

¾ Demand Curve of complimentary good is downward

sloping. P1

¾ For instance, an increase in demand for solar panels D

due to reduction in price of panels, it will necessarily O Q2 Q1

X

increase the demand for batteries and vice versa. Quantity of Batteries

24 Business Economics and BCK

‰ The cross-price elasticity of demand between two goods measures the effect of the change
in one good’s price on the quantity demanded of the other good.
‰ It is equal to the percentage change in the quantity demanded of one good divided by the
percentage change in the other good’s price.

% change in quantity of Good X

Ec =
% Change in Price of Good Y
Or

∆Qx Py

E = X
c
Qx ∆Py
‰ In the case of the cross-price elasticity of demand, the sign (plus or minus) is very
important: it tells us whether the two goods are complements or substitutes.
‰ Cross Price Elasticity Of Substitute Goods:
 When two goods X and Y are substitutes, the cross-price elasticity of demand is
positive: a rise in the price of Y increases the demand for X and causes a rightward
shift of the demand curve.
 Value of cross elasticity is a measure of how closely substitutable the two goods are.
Greater the cross elasticity, the closer is the substitute.
(a) If two goods are perfect substitutes for each other, the cross elasticity between
them is infinite.
(b) If two goods are close substitutes, the cross-price elasticity will be positive and
large.
(c) If two goods are not close substitutes, the cross-price elasticity will be positive and
small.
(d) If two goods are totally unrelated, the cross-price elasticity between them is zero.
‰ Cross Price Elasticity Of Complimentary Goods:
 When two goods are complementary (tea and sugar) to each other, the cross elasticity
between them is negative so that a rise in the price of one leads to a fall in the quantity
demanded of the other causing a leftward shift of the demand curve.
 The size of the cross-price elasticity of demand between two complements tells us how
strongly complementary they are:
(a) if the cross-price elasticity is only slightly below zero, they are weak complements;
(b) if it is negative and very high, they are strong complements.
If cross elasticity to change in the price of substitutes is greater than one, the firm
may lose by increasing the prices and gain by reducing the prices of his products.
With proper knowledge of cross elasticity, the firm can plan policies to safeguard
against fluctuating prices of substitutes and complements.

Law of Demand and Elasticity of Demand 25

ADVERTISEMENT ELASTICITY
‰ The advertising elasticity of demand measures the percentage change in demand that
occurs given a one percent change in advertising expenditure.
‰ Advertising elasticity measures the effectiveness of an advertisement campaign in bringing
about new sales.
‰ Advertising elasticity of demand is typically positive.
‰ Higher the value of advertising elasticity greater will be the responsiveness of demand to
change in advertisement.
‰ Advertisement elasticity varies between zero and infinity.

% change in quantity
Ec =
% Change in Spending on Advertisement
Or

E =
∆Qx A
c
X
Qx ∆A

Ea = 0 Demand does not respond at all to increase in advertisement expenditure

Ea > 0 but < 1 Increase in demand is less than proportionate to the increase in
advertisement expenditure
Ea = 1 Demand increase in the same proportion in which advertisement
expenditure increase
Ea > 1 Demand increase at a higher rate than increase in advertisement
expenditure
As far as a business firm is concerned, the measure of advertisement elasticity is useful in
understanding the effectiveness of advertising and in determining the optimum level of
advertisement expenditure.

TRY YOUR UNDERSTANDING 1.5

1. If income of a household rises by 30% and demand falls by 10% then value of income
elasticity of demand is
(a) – 0.33 (b) 0.33
(c) 3 (d) 1
2. What is the relationship between two goods when cross elasticity is positive & when it
is negative ?
(a) substitutes when positive & complements when negative
(b) complements when positive & substitutes when negative
(c) substitutes when positive & no relation when negative
(d) perfect substitutes when positive & perfect complements when negative

26 Business Economics and BCK

 3. Cross elasticity of demand denotes a change in demand for one good due to change in
whose aspects of the other good
(a) quantity (b) Price
(c) quality (d) None of these
4. When elasticity of demand is measured in terms of its substitutes & complements, it is
called
(a) cross elasticity (b) price elasticity
(c) income clasticity (d) elasticity of supply
5. Advertisement elasticity of sales or promotional elasticity of demand is the responsive
of a good demanded to changes in
(a) Price of Commodity
(b) Per Unit advertisement budget
(c) Firms spending on advertising
(d) Firms spending on distribution.
6. Calculate elasticity when price of ball pen falls by 10% then demanded of a ink falls by
10%
(a) 1 (b) –1
(c) 10 (d) cannot calculate
7. As a consumers’ income rises from Rs.3,000 to Rs.3,600, demand rises from 25 units
to 30 units .calculate elasticity of demand
(a) 2.6 (b) 1.5
(c) 2.8 (d) 1
8. Usually, higher the value of advertising elasticity, greater will be the responsiveness of
demand to change in advertisement. Therefore, usually advertising elasticity of demand
is typically
(a) Positive (b) Unitary
(c) Negative (d) Zero
9. Advertisement elasticity of demand values between _________ and _________.
(a) One, infinity
(b) Zero, infinity
(c) Zero, one
(d) (–) Infinity to (+) Infinity

ANSWER
1. (a) 2. (a) 3. (b) 4. (a) 5. (c) 6. (a) 7. (d)
8. (a) 9. (b)

Law of Demand and Elasticity of Demand 27

DEMAND FORECASTING
‰ Forecasting of demand is the art and science of predicting the probable demand for a
product or a service at some future date on the basis of certain past behaviour patterns
of some related events and the prevailing trends at present.
‰ It should be kept in mind that demand forecasting is not simple guessing, but it refers to
estimating demand scientifically and objectively on the basis of certain facts and events
relevant to forecasting.

Usefulness
Demand forecasting plays a crucial role in managerial functions as it reduces uncertainty in
the decision-making process and aids in planning for future production levels. Its significance
can be outlined as follows:
1. Production Planning: Effective demand forecasting is essential for efficient production
planning within an organization. The expansion of production capacity should be aligned
with the anticipated demand for the company’s output. Failing to do so may result in
either overproduction or underproduction, leading to financial losses.
2. Sales Forecasting: Accurate sales forecasting relies heavily on demand forecasting. The
firm’s promotional efforts, such as advertising strategies and pricing decisions, should be
based on a thorough understanding of the expected demand.
3. Business Control: Demand forecasts provide valuable information for budgetary planning
and cost control across various functional areas, including finance and accounting. They
enable businesses to make informed decisions about resource allocation and financial
management.
4. Inventory Control: Demand forecasting plays a vital role in maintaining optimal inventory
levels. By estimating future inventory requirements, such as raw materials, intermediate
goods, semi-finished products, and spare parts, organizations can exercise effective
control over their inventory management, minimizing carrying costs and stockouts.
5. Capital Investments: Capital investments have long-term implications and require careful
consideration. By incorporating demand forecasting, decision-makers can evaluate the
potential returns on capital investments and compare them with current interest rates.
This aids in making informed decisions about allocating resources to profitable investment
opportunities.
In summary, demand forecasting serves as a critical tool for managers, facilitating production
planning, sales forecasting, business control, inventory management, and capital investment
decisions. Its accurate application helps businesses navigate the uncertain environment and
optimize their operations for sustained success

Scope of Forecasting
‰ Demand forecasting can be conducted at the national or international level, depending on
the economic institution’s area of operation.
‰ It can also be focused on a specific product or service provided by a small firm in a local
area.

28 Business Economics and BCK

‰ The scope of the forecasting task is determined by the firm’s current and future area of
operation.
‰ The cost and time required for the forecasting process must be considered in relation to
the benefits gained from the information obtained.
‰ There is a trade-off between the cost of forecasting and the benefits derived from it.

TYPES OF FORECASTS
(i) Macro-level forecasting deals with the general economic environment prevailing in the
economy as measured by the Index of Industrial Production (IIP), national income and
general level of employment etc.
(ii) Industry- level forecasting is concerned with the demand for the industry’s products as
a whole. For example, demand for cement in India.
(iii) Firm- level forecasting refers to forecasting the demand for a particular firm’s product,
say, the demand for ACC cement.
Based on time period, demand forecasts may be short term demand forecasting and long
term demand forecasting.
(i) Short term demand forecasting: It covers a short span of time, depending of the nature
of industry. It is done usually for six months or less than one year and is generally useful
in tactical decisions.
(ii) Long term forecasting: Long term forecast are for longer periods of time, say two to five
years and more. It provides information for major strategic decisions of the firm such
as expansion of plant capacity.

DEMAND DISTINCTIONS
(a) Producer’s goods and Consumer’s goods
 Producer’s goods are those which are used for the production of other goods- either
consumer goods or producer goods themselves. Examples of such goods are machines,
plant and equipments.
 Consumer’s goods are those which are used for final consumption. Examples of
consumer’s goods are readymade clothes, prepared food, residential houses, etc.
(b) Demand for Durable goods and Non-durable goods:
i. Non-Durable Goods:
¾ Non-durable goods are goods that cannot be consumed more than once.
¾ Examples of non-durable producer goods include raw materials, fuel and power,
and packing items.
¾ Examples of non-durable consumer goods include beverages, bread, and milk.
¾ These goods meet only the current demand and are not meant for long-term use.
ii. Durable Goods:
¾ Durable goods are goods that do not quickly wear out, can be consumed multiple
times, and provide utility over a period of time.
Law of Demand and Elasticity of Demand 29
 ¾ Examples of durable consumer goods include cars, refrigerators, and mobile phones.
¾ Examples of durable producer goods include buildings, plants and machinery, and
office furniture.
¾ The demand for durable goods is often derived from other factors or needs.
iii. Semi-Durable Goods: There are also semi-durable goods, such as clothes and umbrellas,
which fall between non-durable and durable goods in terms of their durability and
lifespan.
(c) Derived demand and Autonomous demand
i. Derived Demand:
¾ Derived demand refers to the demand for a commodity that arises because of the
demand for another commodity, known as the “parent product.”
¾ Examples of derived demand include the demand for cement, which is directly
related to building activity.
¾ In general, the demand for producer goods or industrial inputs is considered derived
demand.
¾ Complementary goods also exhibit derived demand, as the demand for one product
is dependent on the demand for another.
ii. Autonomous Demand:
¾ Autonomous demand refers to the demand for a product that is independent of
the demand for other goods.
¾ It arises from the consumer’s innate desire to consume or possess the commodity.
¾ However, determining which products have entirely independent demand is
challenging, as many goods have interdependencies with other products.
(d) Demand for firm’s product and industry demand
i. Industry Demand:
¾ Industry demand refers to the total demand for the products of a specific industry.
¾ It represents the aggregate demand for a particular product across all firms
operating within that industry.
¾ For example, it can refer to the total demand for steel in a country.
ii. Firm’s Product Demand:
¾ Firm’s product demand refers to the demand for the products of a specific firm.
¾ It represents the quantity of products that a firm can sell at a given price over a
specific period of time.
¾ For example, it can refer to the demand for steel produced by the Tata Iron and
Steel Company.

The demand for a firm’s product when expressed as a percentage of industry demand
signifies the market share of the firm.
30 Business Economics and BCK
 (e) Short - run demand and Long-run demand
i. Short-Run Demand:
¾ Short-run demand refers to the immediate reaction of demand to changes in
product price, related commodity prices, income fluctuations, consumer behavior,
and advertising.
¾ It is influenced by the ability of consumers to adjust their consumption patterns
and their susceptibility to new product advertisements.
¾ Short-run demand is characterized by its relatively short time horizon and
immediate responsiveness to various factors affecting demand.
ii. Long-Run Demand:
¾ Long-run demand refers to demand that exists over a more extended period of
time.
¾ Generic goods typically exhibit long-term demand patterns.
¾ Long-term demand is influenced by factors such as long-term income trends,
availability of substitutes, and credit facilities.
¾ It takes into account the adjustments made by the market to changes in pricing,
promotion, or product improvement over time.
¾ For example, if electricity rates are reduced, in the short run, existing users may
increase their use of electric appliances. However, in the long run, more people may
be motivated to purchase and use electric appliances.

FACTORS AFFECTING DEMAND FOR NON-DURABLE CONSUMER GOODS

There are three basic factors which influence the demand for these goods:
(i) Disposable income: Other things being equal, the demand for a commodity depends upon
the disposable income of the household. Disposable income is found out by deducting
personal taxes from personal income.
(ii) Price: Other things being equal, the demand for a commodity depends upon its own
price and the prices of related goods (its substitutes and complements).
While the demand for a good is inversely related to its own price and the price of its
complements, it is positively related to the price of its substitutes.
(iii) Demography: This involves the characteristics of the population, human as well as non-
human, using the product concerned.

For example, it may pertain to the number and characteristics of children in a study of
demand for toys and characteristics of automobiles in a study of the demand for tyres
or petrol.

Non durables are purchased for current consumption only. From a business firm’s point
of view, demand for non durable goods gets repeated depending on the nature of the
non durable goods. Usually, non durable goods come in wide varieties and there is
competition among the sellers to acquire and retain customer loyalty.

Law of Demand and Elasticity of Demand 31

FACTORS AFFECTING THE DEMAND FOR DURABLE-CONSUMER GOODS
Demand for durable goods has certain special characteristics. Following are the important
factors that affect the demand for durable goods.
‰ Postponement of Replacement: Consumers have the option to delay replacing durable
goods, depending on factors like social status, income level, obsolescence rate, and personal
preferences.
‰ Special Facilities: Durable goods often require specific facilities for their use, such as roads
for automobiles and electricity for appliances like refrigerators and radios. The availability
and growth of these supporting factors impact the demand for durable goods.
‰ Family Characteristics: Since consumer durables are often shared among family members,
purchasing decisions can be influenced by factors such as family income, size, age distribution,
and gender composition. Changes in the number of households should also be considered
when estimating the market size for durable goods.
‰ Replacement Demand: The demand for durable goods includes a significant component
of replacement demand. The more existing durable goods a consumer owns, the greater
the need for replacements. Therefore, factors affecting replacement demand should be
considered when analyzing the demand for durable goods.
‰ Price and Credit Facilities: The demand for consumer durables is influenced by their prices
and the availability of credit facilities that make purchasing them more accessible.

FACTORS AFFECTING THE DEMAND FOR PRODUCER GOODS

‰ Price of Substitutable Factor: An increase in the price of a substitutable factor of production,
like labor, can increase the demand for capital goods.
‰ Price of Complementary Factor: Conversely, an increase in the price of a complementary
factor may decrease the demand for capital goods.
‰ Profit Prospects and Optimism: Higher profit prospects and optimistic expectations of
selling higher output in the future can incentivize firms to invest in capital goods.
‰ Technological Advances: Technological advancements that enhance efficiency, reduce costs,
and increase productivity of capital can positively impact investment in capital goods.
‰ Interest Rates: Lower interest rates can lead to higher investments in capital goods, as
firms have lower opportunity costs for investments and lower borrowing costs.

METHODS OF DEMAND FORECASTING

(a) Survey of Buyers’ Intentions:
 The most direct method of estimating demand in the short run is to ask customers
what they are planning to buy during the forthcoming time period, usually a year.
 This method involves direct interview of potential customers.
 Depending on the purpose, time available and costs to be incurred, the survey may be
conducted by any of the following methods:
32 Business Economics and BCK
 i. Complete enumeration method where nearly all potential customers are
interviewed about their future purchase plans.
ii. Sample survey method under which only a scientifically chosen sample of potential
customers are interviewed.
iii. End–use method, especially used in forecasting demand for inputs, involves
identification of all final users, fixing suitable technical norms of consumption (i.e.
input output ratio) of the product under study, application of the norms to the
desired or targeted levels of output and aggregation.
 Under this method the burden of forecasting is put on the customers.
 This method is useful when bulk of sale is made to industrial producers who generally
have definite future plans. In the case of household customers, this method may not
prove very helpful for several reasons viz. irregularity in customers’ buying intentions,
their inability to foresee their choice when faced with multiple alternatives, and the
possibility that the buyers’ plans may not be real, but only wishful thinking.
(b) Collective Opinion Method:
 Also known as the sales force opinion method or grass roots approach.
 Utilizes the knowledge, experience, and skills of the sales force to forecast future
demand.
 Sales personnel estimate expected sales in their respective territories.
 Salesmen, being close to customers, are believed to have a good understanding of
market reactions.
 Sales estimates from individual salesmen are consolidated to determine the total
estimated sales.
 Estimates are reviewed to eliminate bias and discrepancies.
 Factors like proposed changes in prices, product designs, advertising, competition, and
broader economic changes are considered.
 The final sales forecast is derived after accounting for all relevant factors.
 Strengths and Limitations:
¾ The method is simple and utilizes first-hand information from those directly
involved in sales.
¾ However, it is subjective and susceptible to personal opinions influencing the forecast.
¾ Salesmen may lack awareness of broader economic changes that can impact future
demand.
¾ The method is more suitable for short-term forecasting rather than long-term
analysis.
(c) Expert Opinion Method
 Also known as the Delphi Method, this demand forecasting technique involves soliciting
the views and opinions of specialists, experts, and consultants to estimate future
demand. These experts can be internal, such as executives and sales managers, or
external consultants with expertise in demand forecasting.

Law of Demand and Elasticity of Demand 33

  Key points about the Delphi Method:
1. The Delphi technique, originally developed by Olaf Helmer at the Rand Corporation
in the United States, is employed to gather the opinions of multiple experts
regarding future demand.
2. Experts are provided with relevant information and feedback from other experts
in iterative rounds, and their opinions and comments are solicited until a consensus
or convergence of views is reached.
3. The Delphi Method is considered a time-saving approach to demand forecasting.
(d) Statistical methods: statistical methods have proved to be very useful in forecasting
demand. Forecasts using statistical methods are considered as superior methods because
they are more scientific, reliable and free from subjectivity. The important statistical
methods of demand forecasting are:
i. Trend Projection method:
¾ This method, also known classical method, is considered as a ‘naive’ approach to
demand forecasting.
¾ A firm that has been operating for a significant period of time would have collected
extensive sales data over different time periods.
¾ Arranging this data chronologically creates a “time series” representing the past
pattern of effective demand for a specific product.
¾ Time series data can be analyzed to identify trends and project future demand
patterns.
¾ By examining historical sales patterns, firms can gain insights into the behavior and
potential growth of demand for their product.
¾ The trend projection method assumes that factors responsible for the past trend
in demand will continue to operate.
¾ The popular techniques of trend projection based on time series data are:
A. Graphical Method:
 This method, also known as ‘free hand projection method’ is the simplest and least
expensive.
 This involves plotting of the time series data on a graph paper and fitting a free-hand
curve to it passing through as many points as possible. The direction of the curve shows
the trend.
 The direction of this free hand curve shows the trend.
 The main draw-back of this method is that it may show the trend but the projections
made through this method are not very reliable.
B. Fitting trend equation (Least Square Method):
 The least square method is based on the assumption that the past rate of change of
the variable under study will continue in the future.
 It is a mathematical procedure for fitting a line to a set of observed data points in
such a manner that the sum of the squared differences between the calculated and
observed value is minimised.

34 Business Economics and BCK

  This technique is used to find a trend line which best fit the available data.
 This trend is then used to project the dependant variable in the future.
 This method is very popular because it is simpl, in-expensive and provide fairly reliable
estimates of future demand.
 The major limitation of this method is that it cannot be used where trend is cyclical
with sharp turning points of troughs and peaks. Also, this method cannot be used for
short term forecasts.
ii. Regression analysis:
¾ Under this method, a relationship is established between the quantity demanded
(dependent variable) and the independent variables (explanatory variables) such as
income, price of the good, prices of related goods etc.
¾ Once the relationship is established, we derive regression equation assuming the
relationship to be linear. The equation will be of the form Y = a + bX.
¾ Once the regression equation is derived, the value of Y i.e. quantity demanded can
be estimated for any given value of X.
(e) Controlled Experiments (market experiment method):
 The experimental method involves manipulating specific determinants of demand,
such as price, advertising, etc., while assuming other factors remain constant.
 Experiments can be conducted by varying these determinants across different markets
or over different time periods within the same market.
 The objective is to assess the impact of factors like price, advertising, packaging, etc.,
on sales and record the responses of demand over time.
 The recorded data on the relationship between these determinants and sales can be
used to estimate future demand for the product.
 For example, different prices are associated with different sales levels, and a price-
quantity relationship can be estimated using regression analysis for forecasting purposes.
 It is important to note that market divisions used in experiments should be homogeneous
in terms of income, tastes, and other relevant factors.
 Disadvantages
¾ The method of controlled experiments is used relatively less because this method of
demand forecasting is expensive as well as time consuming.
¾ It is also difficult to determine what conditions should be taken as constant and
what factors should be regarded as variable so as to segregate and measure their
influence on demand.
¾ controlled experiments are risky too because they may lead to unfavourable reactions
from dealers, consumers and competitors.
¾ it is practically difficult to satisfy the condition of homogeneity of markets.
‰ Market experiments can also be replaced by ‘controlled laboratory experiments’ or
‘consumer clinics’ under which consumers are given a specified sum of money and asked
to spend in a store on goods with varying prices , packages, displays etc. The responses of
the consumers are studied and used for demand forecasting.
Law of Demand and Elasticity of Demand 35
(f) Barometric method of forecasting:
 Just as meteorologists use the barometer to forecast weather, the economists use
economic indicators to forecast trends in business activities.
 These indicators help in forecasting the demand prospects of a product, although not
the actual quantity demanded.
 An index of relevant economic indicators is constructed to forecast the likely economic
environment in the near future.
 Types of Economic Indicators:
1. Leading Indicators: These indicators move ahead of other series, providing early signals
of economic trends. Examples include heavy advance orders for capital goods and
an increase in construction permits for new houses, which indicate future economic
prosperity.
2. Coincidental Indicators: Coincidental indicators move up and down simultaneously with
the changes they represent. They offer a snapshot of the current scenario. Examples
include figures on retail sales, the rate of unemployment, and the Index of Industrial
Production (IIP).
3. Lagging Indicators: Lagging indicators follow a change after some time lag. They confirm
past events. For instance, heavy household electrical connections confirm that heavy
construction work was undertaken in the past, but with a time lag.

TRY YOUR UNDERSTANDING 1.6

1. Method of demand forecasting does not include?

(a) Mathematical method (b) Barometric method
(c) Expert opinion method (d) Statistical method
2. Forecasting of demand is the Art and Science of predicting?
(a) Actual demand of a product at same future date
(b) Probable demand in future
(c) Total demand in future
(d) None of these
3. The demand for a commodity that arises because of the demand for same other
commodity (prevent product) is called as
(a) Demand (b) Direct Demand
(c) Derived Demand (d) Implied Demand
4. If the demand for a product is independent of the demand for other goods, then it is
called as
(a) Derived Demand (b) Autonomous Demand
(c) Industry Demand (d) Implied Demand.

36 Business Economics and BCK

 5. Identify Producer’s goods out of following :
(a) Plant and Equipment (b) Readymade clothes
(c) Residential Houses (d) All of the above
6. Which of the following factors affects demand for non-durable con-sumer goods?
(a) Disposable income (b) Price
(c) Demography (d) All of the above.
7. ___________ method of fore-casting includes the methods:
(a) Collective opinion (b) Survey of Buyer’s intentions
(c) Expert Opinion (d) Barometric
8. Which one of the following is the statistical method of demand forecasting?
(a) Trend Projection Method (b) Fitting Equation Method
(c) Regression Analysis (d) All of the above.

ANSWER
1. (a) 2. (b) 3. (c) 4. (b) 5. (a) 6. (d) 7. (b)
8. (d)


Law of Demand and Elasticity of Demand 37

 CHAPTER

Theory of Demand and Supply

™ Unit 1: Law of Demand and Elasticity of Demand
™ Unit 2: Theory of Consumer’s Behaviour –Indifference Curve Approach.
™ Unit 3: Supply and Elasticity of Supply
 UNIT

1
Law of Demand and
Elasticity of Demand

MEANING OF DEMAND
‰ The term ‘demand’ refers to the quantity of a good or service that buyers are willing
and able to purchase at various prices during a given period of time.
‰ The effective demand for a thing depends on
(a) desire
(b) means to purchase and
(c) willingness to use those means for that purchase.
‰ Unless desire is backed by purchasing power or ability to pay and willingness to pay, it
does not constitute demand.

MEANING OF QUANTITY DEMANDED

‰ Quantity demanded is the quantity of a commodity that people are willing to buy at a
particular price at a particular point of time.
‰ Two things are to be noted about the quantity demanded.
(a) The quantity demanded is always expressed at a given price. At different prices
different quantities of a commodity are generally demanded.
(b) The quantity demanded is a flow. We are concerned not with a single isolated purchase,
but with a continuous flow of purchases and we must therefore express demand as
‘so much per period of time’.

WHAT DETERMINES DEMAND?

Demand for a commodity increases or decreases due to a number of factors. The various
factors affecting demand are discussed below:
1. Price of the commodity:
 The good’s own price is a key determinant of its demand.
 Ceteris paribus i.e. Other things being equal, the demand for a commodity is inversely
related to its price.
 It implies that a rise in the price of a commodity leads a fall in the quantity purchased
and vice-versa. This happens because of income and substitution effects.
2. Price of related commodities:
 Related commodities are of two types:
(a) complementary goods and
(b) competing goods or substitutes.
 Complementary goods
¾ Complementary goods and services are those that are bought or consumed
together or simultaneously. Examples are: tea and sugar, automobile and petrol
and pen and ink.
¾ When two commodities are complements, a fall in the price of one (other things
being equal) will cause the demand for the other to rise and vice versa.
¾ There is an inverse relation between the demand for a good and the price of its
complement.
¾ For example, a fall in the price of petrol-driven cars would lead to a rise in the
demand for petrol. There is an inverse relation between the demand for a good
and the price of its complement
 Substitute goods
¾ Two commodities are called competing goods or substitutes when they satisfy
the same want and can be used with ease in place of one another. For example,
tea and coffee, ink pen and ball pen, different brands of toothpaste etc.
¾ When goods are substitutes, a fall in the price of one (ceteris paribus) leads to
a fall in the quantity demanded of its substitutes and vice-versa.
¾ Demand of a commodity is directly related with price of substitute goods.
¾ For example, if price of a substitute good (say, coffee) increases, then demand
for given commodity (say, tea) will rise as tea will become relatively cheaper in
comparison to coffee.
3. Disposable Income of the consumer:
 The purchasing power of a buyer is determined by the level of his disposable income.
Other things being equal, the demand for a commodity depends upon the disposable
income of the potential purchasers.
 Normal Goods: Normal goods are those that are demanded in increasing quantities
as consumers’ income increases. Most goods and services fall under the category of
normal goods. Household furniture, clothing, automobiles, consumer durables and
semi durables etc. fall in this category. When income is reduced (for example due to
recession), demand for normal goods falls.
 Inferior Goods (Also called as Giffen goods) : If any commodity is purchased by a
consumer just because of his low income level, then this commodity is termed as an
inferior commodity for that person. With Increase in income, demand for inferior
goods fall and vice versa.
 As the income level increase and people become richer, there is a relative decline in
the importance of food and other non durable goods in the overall consumption
basket and a rise in the importance of durable goods such as a TV, car, house etc.

32 Business Economics PW
 4. Tastes and preferences of buyers:
 Tastes and preferences of the consumer directly influence the demand for a
commodity.
 Goods which are modern or more in fashion command higher demand than goods
which are of old design or are out of fashion.
 Consumers may perceive a product as obsolete and discard it before it is fully utilised
and then prefer another good which is currently in fashion.
 External effects such as’ demonstration effect’,’ bandwagon effect’, Veblen effect and
‘snob effect’ do play important roles in determining the demand for a product.
 Demonstration effect, a term coined by James Duesenberry, refers to the desire of
people to emulate the consumption behaviour of others. In other words, people buy
or have things because they see that other people are able to have them.
 Bandwagon effect refers to the extent to which the demand for a commodity is
increased due to the fact that others are also consuming the same commodity. It
represents the desire of people to purchase a commodity in order to be fashionable
or stylish or to conform to the people they wish to be associated with.
 Snob effect refers to the extent to which the demand for a consumers’ good is
decreased owing to the fact that others are also consuming the same commodity.
This represents the desire of people to be exclusive; to be different; to dissociate
themselves from the “common herd.” For example, when a product becomes common
among all, some people decrease or altogether stop its consumption.
 ‘Veblen effect’ (named after the American economist Thorstein Veblen) states that
Highly priced goods are consumed by status seeking rich people to satisfy their need
for conspicuous noticeable consumption.
5. Consumers’ Expectations
 Consumers’ expectations regarding future prices, income, supply conditions etc.
influence current demand.
 If the consumers expect increase in future prices, increase in income and shortages
in supply, more quantities will be demanded.
 If they expect a fall in price or fall in income they will postpone their purchases of
nonessential commodities and therefore, the current demand for them will fall.
6. Other factors: Apart from the above factors, the demand for a commodity depends upon
the following factors:
(a) Size of population: Generally, larger the size of population of a country or a region,
larger would be the number of buyers and the quantity demanded in the market
would be higher at every price. The opposite is the case when population is less.
(b) Age Distribution of population:
¾ If a larger proportion of people belong to older age groups relative to younger
age groups, there will be increased demand for geriatric old and weak care
services, spectacles, walking sticks, etc and less demand for children’s books.
¾ Similarly, if the population consists of more of children, demand for toys, baby
foods, toffees, etc. will be more.

Theory of Demand and Supply 33

 (c) The level of National Income and its Distribution:
¾ The level of national income is a crucial determinant of market demand. Higher
the national income, higher will be the demand for all normal goods and services.
¾ If the national income is unevenly distributed [few very rich people while the
majority are very poor], the propensity to consume of the country will be
relatively less and consequently, the demand for consumer goods will be
comparatively less.
¾ However, if the distribution of income is more equal, then the propensity to
consume of the country as a whole will be relatively high indicating higher
demand for goods.
(d) Consumer-credit facility and interest rates:
¾ Availability of credit facilities induces people to purchase more than what their
current incomes permit them.
¾ Low rates of interest encourage people to borrow and therefore demand will be
more and vice versa.
(e) Government policies and regulations:
¾ The governments influence demand through its taxation and subsidy policies.
¾ While taxes increase prices and decrease the quantity demanded, subsidies
decrease the prices and increase the quantity demanded. For example taxes on
luxurious goods and subsidies for solar panels.
¾ Similarly total bans, restrictions and higher taxes may be used by government
to restrict the demand for socially undesirable goods and services.
¾ Government’s policy on international trade also will affect the domestic demand
for goods and services.

TRY YOUR UNDERSTANDING 2.1.1

1. Demand for a commodity refers to
(a) desire for the commodity
(b) need for the commodity
(c) quantity demanded of that commodity
(d) quantity of the commodity demanded at a certain price during any particular period
of time
2. Demand is a
(a) flow concept (b) stock concept
(c) none of these (d) partially a flow concept
3. In economics, demand refers to
(a) quantity demanded at a particular time
(b) quantity demanded backed by ability to pay
(c) quantity demanded for normal & inferior goods
(d) quantity demanded at a specific price during a particular period of time

34 Business Economics PW
 4. When price of z rises it causes an increase in demand for goods X then X & Z are
(a) complementary goods (b) inferior goods
(c) substitute goods (d) necessities
5. When price of z rises then the quantity in demand of goods X reduces. what is the
relationship between X & Z
(a) complementary goods (b) inferior goods
(c) substitute goods (d) necessities
6. The consumer demand those goods which gave
(a) Both positive & negative utility (b) Positive utility
(c) Negative utility (d) None of these

Answer Key
1. (d) 2. (a) 3. (d) 4. (c) 5. (a) 6. (b)

DEMAND FUNCTION
Demand function shows the relationship between quantity demanded for a particular
commodity and the factors influencing it.
It is expressed as: Dx = f (Px, Pr, Y, T, F)
Where,
Dx = Demand for Commodity x; Px = Price of the given Commodity x;
Pr = Prices of Related Goods; Y = Income of the Consumer;
T = Tastes and Preferences; F = Expectation of Change in Price in future.

THE LAW OF DEMAND

‰ As per Prof. Alfred Marshall: “The greater the amount to be sold, the smaller must be
the price at which it is offered in order that it may find purchasers or in other words
the amount demanded increases with a fall in price and diminishes with a rise in price”.
‰ The law of demand states that other things being equal, when the price of a good rises
the quantity demanded of the good will fall.
‰ Thus, there is an inverse relationship between price and quantity demanded, other things
remains constant (i.e. ceteris paribus).
‰ If these factors which determine demand also undergo a change, then the inverse price-
demand relationship may not hold good.
‰ For example, if incomes of consumers increases, then an increase in the price of a
commodity, may not result in a decrease in the quantity demanded of it.
Theory of Demand and Supply 35
 THE DEMAND SCHEDULE
‰ A demand schedule is a table showing the quantities of a good that buyers would choose
to purchase at different prices, per unit of time, with all other variables held constant.
‰ A demand schedule is drawn upon the assumption that all the other influences remain
unchanged.
Price Quantity Demanded
A 5 1
B 4 2
C 3 3
D 2 4
E 1 5

THE DEMAND CURVE

‰ A demand curve is a graphical presentation of the demand schedule.
‰ By convention, the vertical axis of the graph measures the price per unit of the good.
The horizontal axis measures the quantity of the good, which is usually expressed in some
physical measure per time period.
‰ It shows the relationship between the quantities of a good that buyers are willing to buy
and the price of the good.
‰ The negative or downward slope indicates that
Y
the quantity demanded increases as the price
falls (depicting Law Of Demand)
‰ The slope of a demand curve is - ∆P/∆Q (i.e D
Price in `

the change along the vertical axis divided by 1

the change along the horizontal axis). The
negative sign of this slope is consistent with 2
the law of demand. 3
‰ The demand curve for a good does not have 4
to be linear or a straight line; it can be
curvilinear- meaning its slope may vary along 5 D
the curve. If the change in quantity demanded X
O 1 2 3 4 5 Quantity
does not follow a constant proportion, then
Quantity Demanded (in units)
the demand curve will be non linear.

MARKET DEMAND SCHEDULE

‰ Market demand schedule refers to a tabular statement showing various quantities of a
commodity that all the consumers are willing to buy at various levels of price, during a
given period of time.
‰ It is the sum of all individual demand schedules at each and every price.
‰ Market demand schedule can be expressed as: Dm - DA + DB + …….
Where Dm is the market demand and DA + DB + are the individual demands of Household
A, Household B and so on.

36 Business Economics PW
 Market Demand Schedule

Price Individual Demand (in units) Market Demand (in units) {Da + DB)
(Rs.) Household A (DA) Household B (DB)
5 1 2 1+2 = 3
4 2 3 2+3=5
3 3 4 3+4=7
2 4 5 4+5=9
1 5 6 5 + 6 = 11

MARKET DEMAND CURVE

‰ Market demand curve refers to a graphical representation of market demand schedule.
It is obtained by horizontal summation of individual demand curves.
‰ Market demand curve ‘DM’ also slope downwards due to inverse relationship between
price and quantity demanded.
‰ Market Demand Curve is Flatter than individual demand curve, as when price changes
then proportionate change in market demand is more than proportionate change in
individual demand.
Y
Market Demand curve
DM is flatter
5
than DA and DM
Price in `

3
2
1
DA DB DM
X
O 2 4 6 8 10 12
Quantity demanded (in units)

RATIONALE OF THE LAW OF DEMAND (WHY DEMAND CURVE SLOPES

DOWNWARD)
The various reasons for operation of Law of Demand are:
1. Substitution Effect:
 It refers to substituting one commodity in place of other when it becomes relatively
cheaper.
 When price of the given commodity falls (say ball pen), it becomes relatively cheaper
as compared to its substitute (say ink pen) (assuming no change in price of ink pen).
As a result, demand for the given commodity (i.e. ball pen) rises
2. Income Effect:
 It refers to effect on demand when real income of the consumer changes due to
change in price of the given commodity.
Theory of Demand and Supply 37
  When price of the given commodity falls, it increases the purchasing power (real
income) of the consumer. Due to which, he can purchase more of the given commodity
with the same money income.
 For example, Chandu buys 2 ice-creams @ Rs.10 each with his pocket money of
Rs.20. If price of ice cream falls to Rs.5 each, then with the same pocket money,
chandu can buy 4 ice-creams due to an increase in real income.
3. Utility maximising behaviour of Consumers (Law Of Diminishing Marginal Utility):
 According to Marshall, the consumer has diminishing utility for each additional unit of
a commodity and therefore, he will be willing to pay only less for each additional unit.
 A rational consumer will not pay more for lesser satisfaction. He is induced to buy
additional units only when the prices are lower.
4. Arrival of new consumers: When the price of a commodity falls, more consumers start
buying it because some of those who could not afford to buy it earlier may now be able
to buy it. This raises the number of consumers of a commodity at a lower price and
hence the demand for the commodity in question increases.
5. Different uses: Many commodities have multiple uses. When the price of such commodities
are high (or rises) they will be put to limited uses only. If the prices of such commodities
fall, they will be put to more number of uses and therefore their demand will increase.
Example Milk.

EXCEPTIONS TO THE LAW OF DEMAND

The following are the important exceptions to the law of demand:
1. Conspicuous goods (Veblen Effect):
 Articles of prestige value or snob appeal or articles of conspicuous consumption are
used by the rich people as status symbol for enhancing their social prestige such as
diamond, paintings, antiques etc.
 There demand is high at higher prices and if their prices fall, then their demand
will decrease as they are not considered as status symbol goods anymore.
 This was found out by Veblen in his doctrine of “Conspicuous Consumption” and
hence this effect is called Veblen effect or prestige goods effect.
 Veblen effect takes place as some consumers consider that if the commodity is
expensive then it has more utility.
2. Giffen goods:
 Background: Sir Robert Giffen, a Scottish economist and statistician, was surprised
to find out that as the price of bread increased, the British workers purchased more
bread and not less of it. This was something against the law of demand. Why did
this happen? The reason given for this is that, when the price of bread went up, it
caused such a large decline in the purchasing power of the poor people that they
were forced to cut down the consumption of meat and other more expensive foods.
Since bread, even when its price was higher than before, was still the cheapest food
article, people consumed more of it and not less when its price went up.

38 Business Economics PW
  Those goods which are inferior, with no close substitutes easily available and which
occupy a substantial place in consumer’s budget are called ‘Giffen goods’.
 Such goods exhibit direct price-demand relationship.
 All Giffen goods are inferior goods; but all inferior goods are not Giffen goods.
¾ All Giffen goods are inferior goods because all Giffen goods have negative income
effect.
¾ But all inferior goods are not Giffen goods, as all inferior goods do not have
dominating negative income effect, i.e. negative income effect is not stronger
than positive substitution effect in case of all inferior goods.
3. Conspicuous necessities:
 The demand for certain goods is affected by the demonstration effect of the
consumption pattern of a social group to which an individual belongs.
 Due to their constant usage these goods have become necessities of life.
 For example, TVs, refrigerators, coolers, cooking gas etc.
4. Future expectations about prices:
 When the prices show increasing trend, consumers tend to buy larger quantities of
such commodities, expecting that the prices in the future will be still higher and vice
versa.
 For example, when there is wide-spread drought, people expect that prices of food
grains would rise in future. They demand greater quantities of food grains even at
the higher price.
5. Incomplete information and irrational behaviour:
 Consumers have incomplete information and therefore make inconsistent decisions
regarding purchases.
 A household may demand larger quantity of a commodity even at a higher price
because it may be ignorant of the ruling price of the commodity.
 Consumers tend to be irrational and make impulsive purchases without any rational
calculations about the price and usefulness of the product and in such contexts the
law of demand fails.
6. Demand for necessaries:
 The law of demand does not apply much in the case of necessaries of life.
 Irrespective of price changes, people have to consume the minimum quantities of
necessary commodities.
7. Speculative goods: In the speculative market, particularly in the market for stocks and
shares, more will be demanded when the prices are rising and less will be demanded
when prices decline.

TRY YOUR UNDERSTANDING 2.1.2

1. The law of demand refers to relationship between
(a) price of a good & quantity demanded
(b) income & quantity demanded
Theory of Demand and Supply 39
 (c) price of a good & quantity demanded of its substitute
(d) price of a good & quantity demanded of its complementary goods
2. The law of demand assumes that the following is constant
(a) price of related goods (b) income of the consumer
(c) tastes & preferences (d) All the above
3. Market demand is derived from individual demand curve by
(a) vertical summation (b) horizontal summation
(c) Both (a) & (b) (d) None of these

Answer Key
1. (a) 2. (d) 3. (b)

EXPANSION AND CONTRACTION OF DEMAND

(MOVEMENT ALONG THE DEMAND CURVE
OR CHANGE IN QUANTITY DEMANDED)
‰ When quantity demanded of a commodity changes
Y
due to change in price of a commodity (other factors Movement along the
D Demand Curve
remain constant) then it is termed as change in C
quantity demanded. P2
A
Its graphical presentation is expressed as movement P
Price in `

‰
along the demand curve. B
P1
‰ Downward movement represents expansion of
D
demand whereas upward movement represents
contraction of demand. X
O Q2 Q Q1
EXPANSION IN DEMAND Quantity demanded (in units)
It refers to increase in the quantity demanded due
to reduction in the price of commodity, other factors Y
Expansion in Demand
remains constant. D
20 A
‰ It leads to a downward movement along the same
demand curve.
Price in `

‰ Also known as ‘Extension in Demand’ or ‘Increase

in Quantity Demanded’. 15 B

EXPANSION IN DEMAND D
Price (Rs.) Demand (units) X
O 100 150
20 100
Quantity demanded (in units)
15 150

40 Business Economics PW
 CONTRACTION IN DEMAND
It refers to a fall in the quantity demanded due to Y
Expansion in Demand
increase in the price of commodity, other factors D
remaining constant. B
25
‰ It leads to an upward movement along the

Price in `
same demand curve.
‰ Also known as ‘Decrease in Quantity Demanded’. A
20
Price (Rs.) Demand (units)
D
20 100
X
25 70 O 70 100
Quantity demanded (in units)

INCREASE AND DECREASE IN DEMAND (SHIFT IN

DEMAND CURVE OR CHANGE IN DEMAND)
When the demand of a commodity changes due Shift in Demand Curve
‰ Y
to change in any factor other than the own D1
D
price of the commodity, it is known as change D2
in demand.
Price in `

‰ It is graphically expressed as a shift in the P

demand curve.
‰ Rightward Shift Indicated Increase in demand
whereas leftward shift indicates decrease in D1
D
demand. D2
X
O Q2 Q Q1
Quantity Demanded (in units)

INCREASE IN DEMAND Y
Increase in Demand
‰ When demand of a commodity increases D1
due to any factor other than price of a D
commodity then it is termed as increase
in demand. A B
Price in `

20
‰ It leads to a rightward shift of demand
curve.

Price (Rs.) Demand (units)

D1
20 100 D
X
O 100 150
20 150 Quantity Demanded (in units)

Theory of Demand and Supply 41

DECREASE IN DEMAND Y
Decrease in Demand
‰ When demand of a commodity decreases due D
D1
to any factor other than price of a commodity

Price in `
then it is termed as decrease in demand. 20 B A
‰ It leads to a leftward shift of demand curve.
Price (Rs.) Demand (units)

20 100
D
D1
20 70 X
O 70 100
Quantity Demanded (in units)

Reasons for Increase in Demand Reasons for Decrease in Demand

‰ Rise in income, ‰ Fall in income
‰ Rise in the price of a substitute, ‰ Fall in the price of a substitute,
‰ Fall in the price of a complement, ‰ Rise in the price of a complement,
‰ Change in tastes in favour of this commodity, ‰ Change in tastes against this commodity,
‰ An increase in population, and ‰ Decrease in population, and
‰ Redistribution of income to groups who ‰ Redistribution of income away from
favour this commodity groups who favour this commodity.

TRY YOUR UNDERSTANDING 2.1.3

1. When price of a related good or income or taste changes, it brings about
(a) change in quantity demanded (b) change in demand
(c) increase in demand (d) decrease in demand
2. Rise in demand at original price is called
(a) expansion in demand (b) contraction in demand
(c) increase in demand (d)decrease in demand
3. When price of a good changes, it brings about
(a) change in quantity demanded (b) change in demand
(c) expansion in demand (d) contraction in demand

Answer Key
1. (b) 2. (c) 3. (a)

ELASTICITY OF DEMAND
‰ Elasticity of demand is defined as the responsiveness of the quantity demanded of a good
to changes in one of the variables on which demand depends.

42 Business Economics PW
‰ In simple words, elasticity of demand is the percentage change in quantity demanded
divided by the percentage change in one of the variables on which demand depends.
‰ different measures of elasticity are price elasticity, cross elasticity, income elasticity,
advertisement elasticity and elasticity of substitution.

Note: Unless otherwise mentioned, it is price elasticity of demand which is usually

referred to as elasticity of demand.

PRICE ELASTICITY OF DEMAND

‰ Price elasticity of demand measures the sensitivity of quantity demanded to ‘own price’
or the price of the own commodity.
‰ Price elasticity of demand measure the responsiveness of quantity demanded of a
commodity, to a change in Price, assuming all the other factors as constant.
‰ The price elasticity of demand (also referred to as PED) tells us the percentage change
in quantity demanded for each one percent (1%) change in price.

% change in in quantity demanded

Price Elasticity = Ep =
% change in price

Or

Change in quantity / Original Quantity

Ep= X 100
Change in Price / Original Price
Or

Change in quantity Original Price

Ep= ×
Original Quantity Change in Price
Or

∆Q P
Ep= X
Q ∆P
Where
Ep = Price Elasticity
Q = Original Quantity
P = Original Price
∆Q = Change In Quantity
∆P = Change In Price
‰ The greater the value of elasticity, the more sensitive quantity demanded is to price.
‰ The value of price elasticity varies from minus infinity to approach zero.
‰ Since price and quantity are inversely related (with a few exceptions) price elasticity is
negative, but we ignore the negative sign and consider only the numerical value of the
elasticity.
Theory of Demand and Supply 43
 Example: The price of a commodity decreases from Rs 6 to Rs 4 and quantity demanded
of the good increases from 10 units to 15 units. Find the coefficient of price elasticity.
∆Q P
Ep= X
Q ∆P
Ep = (-) 5/10 x 6/2
Ep = (-)1.5

POINT ELASTICITY
‰ The point elasticity of demand is the price elasticity of demand at a particular point on
the demand curve.
‰ The concept of point elasticity is used for measuring price elasticity where the change in
price is infinitesimal (extremely small). Y
‰ Price elasticity is a key element in applying marginal
analysis to determine optimal prices.
‰ Marginal analysis works by evaluating “small” changes t
taken with respect to an initial decision, it is useful to

Pr ice
measure elasticity with respect to an infinitesimally R
small change in price.
‰ Point elasticity makes use of derivative rather than finite
changes in price and quantity.
X
dq p O T
Ep= X Quantity
dp q
‰ Where dq /dp is the derivative of quantity with respect to price at a point on the demand
curve, and p and q are the price and quantity at that point.

GEOMETRIC METHOD (MEASUREMENT OF ELASTICITY

ON A LINEAR DEMAND CURVE)
Y
‰ Elasticity varies along the curve as price and quantity
change. ep = 
‰ The slope of a linear demand curve is constant. t
However, the elasticity at different points on a linear ep > 1
demand curve would be different.
‰ When price is high and quantity is small, the elasticity ep = 1
is high. The elasticity becomes smaller as we move P1
down the curve. ep < 1
Pr ice

Lower Segment
Ep= ep = 0
Upper Segment
O Quantity Q1 X
T

ARC-ELASTICITY
‰ When price elasticity is to be found between two prices or two points on the demand
curve, the question arises as to which price and quantity should be taken as base.
44 Business Economics PW
‰ in order to avoid confusion, the averages of the Y
D
two prices and quantities are taken as (i.e.
original and new) base. A
P
Arc Elasticity
‰ The arc elasticity can be found out by using the
formula: We drop the minus sign and use the B
P1

Price
absolute value. D

Q2-Q1

Ep =
Q2 +Q1  /2
P2-P1
X
P2 +P1  /2 O Q Q1
Quantity Demanded
Q2-Q1 P2 +P1
Ep= ×
Q2 +Q1 P2-P1

Where P1, Q1are the original price and quantity and P2, Q2are the new ones.
‰ The arc elasticity will always lie somewhere (but not necessarily in the middle) between
the point elasticities calculated at the lower and the higher prices.

INTERPRETATION OF THE NUMERICAL VALUES OF

ELASTICITY OF DEMAND
The numerical value of elasticity of demand can assume any value between zero and infinity.

Ep = 0 ‰ If there is no change at all in the quantity Y

demanded when price changes i.e. Perfectly Ep = 0 D
Inelastic
Price

‰ Perfectly inelastic demand is as an extreme case

of price insensitivity and is therefore only a
theoretical category with less practical significance. X
O Quantity
‰ The vertical demand curve represents perfectly
or completely inelastic demand

Ep = 1 ‰ If the percentage change in quantity demanded Y

is equal to the percentage change in price. D Ep = 1
‰ The demand curve is a rectangular hyperbola.
Price

‰ Also known as Unitary Elastic.

X
O Quantity

Theory of Demand and Supply 45

Ep > 1 ‰ When the percentage change in quantity Y
Ep > 1
demanded is greater than the percentage change D
P
in price.

Price
Demand is said to be elastic. P1
‰ D
‰ The elastic demand line (demand curve) is fairly
X
flat. O Q Q1
Quantity

Ep < 1 ‰ When the percentage change in quantity Y Ep < 1

demanded is less than the percentage change in D
price. P

Price
‰ Demand is said to be inelastic.
P1
‰ The quantity demanded is relatively insensitive
D
to price changes.
X
‰ The inelastic demand line (demand curve) is fairly O Q Q1
Quantity
steep.
Ep = ∞ ‰ When a ‘small price reduction raises the demand Y
from zero to infinity. Ep = 
‰ Perfectly or infinitely elastic demand.
P D
‰ As long as the price stays at one particular level
any quantity might be demanded.
If there is a slight increase in price, quantity X
‰ O Quantity
demanded fall to zero.
‰ This type of demand curve is found in a perfectly
competitive market.
‰ The demand curve is horizontal at the price level.

TOTAL OUTLAY METHOD OF CALCULATING PRICE ELASTICITY

The price elasticity of demand for a commodity and the total expenditure or outlay made
on it are significantly related to each other.
As the total expenditure made on a commodity is the total revenue received by the seller, we
can say that the price elasticity and total revenue received are closely related to each other.
By analysing the changes in total expenditure (or total revenue) in response to a change in
the price of the commodity, we can know the price elasticity of demand for it.

Ep = 1 ‰ When, as a result of the change in price of a good, the total expenditure on

the good or the total revenue received from that good remains the same, the
price elasticity for the good is equal to unity.
‰ This is because the total expenditure made on the good can remain the same
only if the proportional change in quantity demanded is equal to the
proportional change in price.

46 Business Economics PW
Ep > 1 ‰ When, as a result of increase in the price of a good, the total expenditure
made on the good or the total revenue received from that good falls or
‰ When as a result of decrease in price, the total expenditure made on the good
or total revenue received from that good increases, we say that price elasticity
of demand is greater than unity.
Ep < 1 ‰ When, as a result of increase in the price of a good, the total expenditure
made on the good or the total revenue received from that good increases or
‰ when as a result of decrease in its price, the total expenditure made on the
good or the total revenue received from that good falls, we say that the price
elasticity of demand is less than unity.

The main drawback of this method is that by using this we can only say whether the demand
for a good is elastic or inelastic; we cannot find out the exact coefficient of price elasticity.

Why should a business firm be concerned about elasticity of demand?

The reason is that the degree of elasticity of demand predicts how changes in the price of
a good will affect the total revenue earned by the producers from the sale of that good.
The total revenue is defined as the total value of sales of a good or service. It is equal to the
price multiplied by the quantity sold.

TOTAL REVENUE
‰ Total revenue (TR) = Price × Quantity sold
‰ Except in the rare case of a good with perfectly elastic or perfectly inelastic demand,
when a seller raises the price of a good, there are two effects which act in opposite
directions on revenue.
 Price effect: After a price increase, each unit sold sells at a higher price, which tends
to raise the revenue and vice versa
 Quantity effect: After a price increase, fewer units are sold, which tends to lower
the revenue and vice versa.
If the price effect which tends to raise total revenue is the stronger of the two effects, then
total revenue goes up. If the quantity effect, which tends to reduce total revenue, is the
stronger, then total revenue goes down.

Ep = 1 ‰ An increase in price or decrease in price does not change total revenue.

‰ The quantity effect and the price effect exactly balance each other.
Ep > 1 ‰ When, as a result of increase in the price of a good, the total expenditure
made on the good or the total revenue received from that good falls or
‰ When as a result of decrease in price, the total expenditure made on the good
or total revenue received from that good increases, we say that price elasticity
of demand is greater than unity.
Ep < 1 ‰ An increase in price reduces total revenue and a fall in price increases total
revenue.
‰ In this case, the quantity effect is stronger than the price effect.

Theory of Demand and Supply 47

The Relationship between Price elasticity and Total Revenue (TR)

Elastic Unitary Elastic Inelastic

Price Increase TR Decreases TR remains same TR Increases
Price Decrease TR Increases TR remains same TR Decreases

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

Following are important determinants of price elasticity:
1. Availability of substitutes:
 The demand for a commodity with a wide range of substitute products tends to be
more elastic. This is because even a slight increase in its price can prompt buyers to
switch to available substitutes.
 For instance, if the price of Pepsi rises, consumers may choose to purchase Coke as
an alternative, and vice versa.
 As a result, the presence of close substitutes makes the demand for a commodity
more responsive to changes in prices
 On the contrary, commodities that have limited or no substitutes, such as wheat
and salt, generally exhibit less price elasticity of demand. This means that changes
in price have a comparatively smaller impact on the quantity demanded by consumers.
2. Position of a commodity in the consumer’s budget:
 The greater the proportion of income spent on a commodity; generally the greater
will be its elasticity of demand and vice- versa.
 The demand for goods like common salt, matches, buttons, etc. tend to be highly
inelastic because a household spends only a fraction of their income on each of them.
 On the other hand, demand for goods like rental apartments and clothing tends to
be elastic since households generally spend a good part of their income on them.
 When the good absorbs a significant share of consumers’ income, it is worth their
time and effort to find a way to reduce their demand when the price goes up.
3. Nature of the need that a commodity satisfies:
 In general, luxury goods are price elastic because one can easily live without a luxury.
In contrast, necessities are price inelastic.
 If it is possible to postpone the consumption of a particular good, such good will have
elastic demand.
 Consumption of necessary goods cannot be postponed and therefore, their demand
is inelastic.
4. Number of uses to which a commodity can be put:
 The more the possible uses of a commodity, the greater will be its price elasticity
and vice versa.
 When the price of a commodity which has multiple uses decreases, people tend to
extend their consumption to its other uses and vice versa.

48 Business Economics PW
 5. Time period:
 The concept of price elasticity of demand is time-dependent, as it is influenced by
the period under consideration, which can range from a day to several years.
 The elasticity of demand varies in direct proportion to the time frame examined. In
the short term, demand tends to be relatively inelastic because consumers face
difficulties in quickly changing their habits or adapting to price changes for a particular
commodity.
 However, in the long run, demand becomes more elastic as consumers have more
flexibility and time to explore alternative options and switch to substitutes when the
price of the given commodity rises.
 In the short term, if the price of petrol increases, consumers may be reluctant to
switch to alternative sources, as it requires significant investments in purchasing new
car. But over a longer period, they have the opportunity to explore options like EV-
Cars, thereby making their demand for petrol more elastic in the long run.
6. Consumer habits: If a person is a habitual consumer of a commodity, no matter how
much its price change, the demand for the commodity will be inelastic. If buyers have
rigid preferences demand will be less price elastic.
7. Tied demand: The demand for those goods which are tied to others is normally inelastic
as against those whose demand is of autonomous nature. For example printers and ink
cartridges.
8. Price Range:
 Goods which are in medium range of price level are more elastic to price change.
 Goods which are in very high price range or in very low price range have inelastic
demand.
9. Minor complementary items: The demand for cheap, complementary items to be used
together with a costlier product will tend to have an inelastic demand.

TRY YOUR UNDERSTANDING 2.1.4

1. The minus sign in elasticity of demand indicates
(a) inverse relationship between price & quantity demands
(b) inverse relationship between income & quantity demands
(c) direct relationship between price & quantity demands
(d) None of these
2. What is elasticity of demand in case of necessities & luxuries ?
(a) necessities have elastic & luxuries have inelastic
(b) necessities have inelastic & luxuries have elastic
(c) necessities have zero & luxuries have one
(d) necessities have one & luxuries have zero
3. In case of essential goods the elasticity of demand is
(a) infinity (b) high (c) one (d) zero
Theory of Demand and Supply 49
4. What is it called when elasticity of demand is one? What shape will the demand curve take?
(a) unitary elastic; rectangular hyperbole
(b) elastic; downward sloping
(c) elastic; vertical
(d) inelastic; horizontal
5. The formula of arc elasticity demand is

Q2 Q2 Q2 P2
(a) Q + -Q2 ×Q1 + -P2 (b) Q1- +Q2 .P1 + -P2
1
Q1 P1 Q1 P1

Q2 P2
(c) Q - +Q2 ×P1- +P2 (d) None of these
1
Q1 P1

6. When price & outlay moves in the same direction, it is case of

(a) unitary elastic demand (b) elastic demand
(c) perfectly elastic demand (d) inelastic demand
7. When the price & outlay move in opposite direction it is case of
(a) unitary elastic demand (b) elastic demand
(c) perfectly elastic demand (d) inelastic demand
8. If price of burger rises by 20% & demand falls by 25% then demand for burger is
(a) static (b) perfectly elastic
(c) unitary elastic (d) inelastic
9. If there is no change in quantity demanded to any change in price then elasticity of
demand is & shape of demand curve is
(a) infinity elastic; horizontal demand curve
(b) zero, vertical demand curve
(c) less than one, downward sloping demand curve
(d) zero than one horizontal downward sloping demand curve
10. As the prices of a commodity rises from Rs.10 to Rs.12, its demand falls from 100 units
to 50 units calculate elasticity of demand
(a) 4 (b) 3 (c) 1 (d) 2
11. In a straight line downward sloping demand curve, the elasticity of demand becomes
greater as price
(a) rises (b) zero (c) falls (d) is unchanged
12. When more substitutes are available elasticity of demand is
(a) more (b) less (c) infinity (d) None of these

Answer Key
1. (a) 2. (b) 3. (d) 4. (a) 5. (b) 6. (d) 7. (b) 8. (a) 9. (b) 10. (a)
11. (a) 12. (a)

50 Business Economics PW
 INCOME ELASTICITY OF DEMAND
‰ The income elasticity of demand is a measure of how much the demand for a good is
affected by changes in consumers’ incomes.
‰ Estimates of income elasticity of demand are useful for businesses to predict the possible
growth in sales as the average incomes of consumers grow over time.
‰ Income elasticity of demand is the degree of responsiveness of the quantity demanded
of a good to changes in the income of consumers.
% Change in Quantity
Ei =
% Change in Income
Or
∆Q Y
Ei = X
Q ∆Y

Ei = 1 If the proportion of income spent on a good remains the same as income increases,
then income elasticity for that good is equal to one.
Ei > 1 ‰ If the proportion of income spent on a good increase as income increases,
then the income elasticity for that good is greater than one.
‰ The demand for such goods increase faster than the rate of increase in income.
‰ If the income elasticity for a good is greater than one, it shows that the good
bulks larger in consumer’s expenditure as he becomes richer. Such goods are
called luxury goods.
Ei < 1 ‰ If the proportion of income spent on a good decrease as income rises, then
income elasticity for the good is positive but less than one.
‰ The demand for income-inelastic goods rises, but substantially slowly
compared to the rate of increase in income.
‰ Necessities such as food and medicines tend to be income- inelastic.
‰ It shows that the good is either relatively less important in the consumer’s
eye or, it is a good which is a necessity.

‰ Income elasticity of goods reveals a few very important features of demand for the goods
in question.
 If income elasticity is zero, it signifies that the demand for the good is quite
unresponsive to changes in income.
 When income elasticity is greater than zero or positive, then an increase in income
leads to an increase in the demand for the good. This happens in the case of most
of the goods and such goods are called normal goods. For all normal goods, income
elasticity is positive. However, the degree of elasticity varies according to the nature
of commodities.
 When the income elasticity of demand is negative, the good is an inferior good. In
this case, the quantity demanded at any given price decreases as income increases.
The reason is that when income increases, consumers choose to consume superior
substitutes.
Theory of Demand and Supply 51
 CROSS - PRICE ELASTICITY OF DEMAND
‰ The demand for a particular commodity may change due to changes in the prices of
related goods (complementary goods or substitute goods). This type of relationship is
studied under ‘Cross Demand’.
‰ Cross demand refers to the quantities of a commodity or service which will be purchased
with reference to changes in price, not of that particular commodity, but of other inter-
related commodities, other things remaining the same.
‰ Example: if price of pen decreases, then demand for ink rises (Pen and ink are
complimentary goods)
(a) Substitute Goods: Y
¾ In the case of substitute commodities, the cross

Price of Solar Coffee

demand curve slopes upwards (i.e. positively) Substitutes
showing that more quantities of a commodity, D
P1
will be demanded whenever there is a rise in
the price of a substitute commodity.
P2
¾ Example: When the price of coffee increases, due
to the operation of the law of demand, the
demand for coffee falls. The consumers will D
substitute tea in the place of coffee. The price of Q2 Q 1 X
O
tea is assumed to be constant. Quantity Demanded of Tea
(b) Complementary Goods
Y
A change in the price of a good will have an

Price of Solar Pannels

¾
opposite reaction on the demand for the other D
commodity which is closely related or P2
complementary.
¾ Demand Cur ve of complimentary good is
P1
downward sloping.
¾ For instance, an increase in demand for solar D
panels due to reduction in price of panels, it will O X
Q2 Q 1
necessarily increase the demand for batteries and
Quantity of Batteries
vice versa.
‰ The cross-price elasticity of demand between two goods measures the effect of the change
in one good’s price on the quantity demanded of the other good.
‰ It is equal to the percentage change in the quantity demanded of one good divided by
the percentage change in the other good’s price.
% change in quantity of Good X
Ec =
% Change in Price of Good Y

Or
∆Qx Py
Ec = X
Qx ∆Py
‰ In the case of the cross-price elasticity of demand, the sign (plus or minus) is very
important: it tells us whether the two goods are complements or substitutes.

52 Business Economics PW
‰ Cross Price Elasticity Of Substitute Goods:
 When two goods X and Y are substitutes, the cross-price elasticity of demand is
positive: a rise in the price of Y increases the demand for X and causes a rightward
shift of the demand curve.
 Value of cross elasticity is a measure of how closely substitutable the two goods are.
Greater the cross elasticity, the closer is the substitute.
(a) If two goods are perfect substitutes for each other, the cross elasticity between
them is infinite.
(b) If two goods are close substitutes, the cross-price elasticity will be positive and
large.
(c) If two goods are not close substitutes, the cross-price elasticity will be positive
and small.
(d) If two goods are totally unrelated, the cross-price elasticity between them is
zero.
‰ Cross Price Elasticity Of Complimentary Goods:
 When two goods are complementary (tea and sugar) to each other, the cross elasticity
between them is negative so that a rise in the price of one leads to a fall in the
quantity demanded of the other causing a leftward shift of the demand curve.
 The size of the cross-price elasticity of demand between two complements tells us
how strongly complementary they are:
(a) if the cross-price elasticity is only slightly below zero, they are weak complements;
(b) if it is negative and very high, they are strong complements.

If cross elasticity to change in the price of substitutes is greater than one, the firm
may lose by increasing the prices and gain by reducing the prices of his products.
With proper knowledge of cross elasticity, the firm can plan policies to safeguard
against fluctuating prices of substitutes and complements.

ADVERTISEMENT ELASTICITY
‰ The advertising elasticity of demand measures the percentage change in demand that
occurs given a one percent change in advertising expenditure.
‰ Advertising elasticity measures the effectiveness of an advertisement campaign in bringing
about new sales.
‰ Advertising elasticity of demand is typically positive.
‰ Higher the value of advertising elasticity greater will be the responsiveness of demand
to change in advertisement.
‰ Advertisement elasticity varies between zero and infinity.
% change in quantity
Ec =
% Change in Spending on Advertisement

Theory of Demand and Supply 53

 Or
∆Qx A
Ea = X
Qx ∆A

Ea = 0 Demand does not respond at all to increase in advertisement expenditure

Ea > 0 but < 1 Increase in demand is less than proportionate to the increase in
advertisement expenditure
Ea = 1 Demand increase in the same proportion in which advertisement
expenditure increase
Ea > 1 Demand increase at a higher rate than increase in advertisement
expenditure

As far as a business firm is concerned, the measure of advertisement elasticity is useful in

understanding the effectiveness of advertising and in determining the optimum level of
advertisement expenditure.

TRY YOUR UNDERSTANDING 2.1.5

1. If income of a household rises by 30% and demand falls by 10% then value of income
elasticity of demand is
(a) – 0.33 (b) 0.33 (c) 3 (d) 1
2. What is the relationship between two goods when cross elasticity is positive & when it
is negative ?
(a) substitutes when positive & complements when negative
(b) complements when positive & substitutes when negative
(c) substitutes when positive & no relation when negative
(d) perfect substitutes when positive & perfect complements when negative
3. Cross elasticity of demand denotes a change in demand for one good due to change in
whose aspects of the other good
(a) quantity (b) Price (c) quality (d) None of these
4. When elasticity of demand is measured in terms of its substitutes & complements, it is
called
(a) cross elasticity (b) price elasticity
(c) income clasticity (d) elasticity of supply
5. Advertisement elasticity of sales or promotional elasticity of demand is the responsive
of a good demanded to changes in
(a) Price of Commodity (b) Per Unit advertisement budget
(c) Firms spending on advertising (d) Firms spending on distribution.
6. Calculate elasticity when price of ball pen falls by 10% then demanded of a ink falls by
10%
(a) 1 (b) –1 (c) 10 (d) cannot calculate

54 Business Economics PW
 7. As a consumers’ income rises from Rs.3,000 to Rs.3,600, demand rises from 25 units
to 30 units .calculate elasticity of demand
(a) 2.6 (b) 1.5 (c) 2.8 (d) 1
8. Usually, higher the value of advertising elasticity, greater will be the responsiveness of
demand to change in advertisement. Therefore, usually advertising elasticity of demand
is typically
(a) Positive (b) Unitary (c) Negative (d) Zero
9. Advertisement elasticity of demand values between _________ and _________.
(a) One, infinity (b) Zero, infinity
(c) Zero, one (d) (–) Infinity to (+) Infinity

Answer Key
1. (a) 2. (a) 3. (b) 4. (a) 5. (c) 6. (a) 7. (d) 8. (a) 9. (b)

DEMAND FORECASTING
‰ Forecasting of demand is the art and science of predicting the probable demand for a
product or a service at some future date on the basis of certain past behaviour patterns
of some related events and the prevailing trends at present.
‰ It should be kept in mind that demand forecasting is not simple guessing, but it refers
to estimating demand scientifically and objectively on the basis of certain facts and events
relevant to forecasting.

USEFULNESS
Demand forecasting plays a crucial role in managerial functions as it reduces uncertainty in
the decision-making process and aids in planning for future production levels. Its significance
can be outlined as follows:
1. Production Planning: Effective demand forecasting is essential for efficient production
planning within an organization. The expansion of production capacity should be aligned
with the anticipated demand for the company’s output. Failing to do so may result in
either overproduction or underproduction, leading to financial losses.
2. Sales Forecasting: Accurate sales forecasting relies heavily on demand forecasting. The
firm’s promotional efforts, such as advertising strategies and pricing decisions, should be
based on a thorough understanding of the expected demand.
3. Business Control: Demand forecasts provide valuable information for budgetary planning
and cost control across various functional areas, including finance and accounting. They
enable businesses to make informed decisions about resource allocation and financial
management.
4. Inventory Control: Demand forecasting plays a vital role in maintaining optimal inventory
levels. By estimating future inventory requirements, such as raw materials, intermediate
goods, semi-finished products, and spare parts, organizations can exercise effective control
over their inventory management, minimizing carrying costs and stockouts.
Theory of Demand and Supply 55
 5. Capital Investments: Capital investments have long-term implications and require careful
consideration. By incorporating demand forecasting, decision-makers can evaluate the
potential returns on capital investments and compare them with current interest rates.
This aids in making informed decisions about allocating resources to profitable investment
opportunities.

In summary, demand forecasting serves as a critical tool for managers, facilitating production
planning, sales forecasting, business control, inventory management, and capital investment
decisions. Its accurate application helps businesses navigate the uncertain environment and
optimize their operations for sustained success

SCOPE OF FORECASTING
‰ Demand forecasting can be conducted at the national or international level, depending
on the economic institution’s area of operation.
‰ It can also be focused on a specific product or service provided by a small firm in a local
area.
‰ The scope of the forecasting task is determined by the firm’s current and future area of
operation.
‰ The cost and time required for the forecasting process must be considered in relation to
the benefits gained from the information obtained.
‰ There is a trade-off between the cost of forecasting and the benefits derived from it.

TYPES OF FORECASTS
1. Macro-level forecasting deals with the general economic environment prevailing in the
economy as measured by the Index of Industrial Production (IIP), national income and
general level of employment etc.
2. Industry- level forecasting is concerned with the demand for the industry’s products as
a whole. For example, demand for cement in India.
3. Firm- level forecasting refers to forecasting the demand for a particular firm’s product,
say, the demand for ACC cement.

Based on time period, demand forecasts may be short term demand forecasting and long
term demand forecasting.
1. Short term demand forecasting: It covers a short span of time, depending of the nature
of industry. It is done usually for six months or less than one year and is generally useful
in tactical decisions.
2. Long term forecasting: Long term forecast are for longer periods of time, say two to five
years and more. It provides information for major strategic decisions of the firm such
as expansion of plant capacity.

DEMAND DISTINCTIONS
1. Producer’s goods and Consumer’s goods
 Producer’s goods are those which are used for the production of other goods- either
consumer goods or producer goods themselves. Examples of such goods are machines,
plant and equipments.

56 Business Economics PW
  Consumer’s goods are those which are used for final consumption. Examples of
consumer’s goods are readymade clothes, prepared food, residential houses, etc.
2. Demand for Durable goods and Non-durable goods:
(a) Non-Durable Goods:
¾ Non-durable goods are goods that cannot be consumed more than once.
¾ Examples of non-durable producer goods include raw materials, fuel and power,
and packing items.
¾ Examples of non-durable consumer goods include beverages, bread, and milk.
¾ These goods meet only the current demand and are not meant for long-term
use.
(b) Durable Goods:
¾ Durable goods are goods that do not quickly wear out, can be consumed multiple
times, and provide utility over a period of time.
¾ Examples of durable consumer goods include cars, refrigerators, and mobile
phones.
¾ Examples of durable producer goods include buildings, plants and machinery,
and office furniture.
¾ The demand for durable goods is often derived from other factors or needs.
(c) Semi-Durable Goods: There are also semi-durable goods, such as clothes and umbrellas,
which fall between non-durable and durable goods in terms of their durability and
lifespan.
3. Derived demand and Autonomous demand
(a) Derived Demand:
¾ Derived demand refers to the demand for a commodity that arises because of
the demand for another commodity, known as the “parent product.”
¾ Examples of derived demand include the demand for cement, which is directly
related to building activity.
¾ In general, the demand for producer goods or industrial inputs is considered
derived demand.
¾ Complementary goods also exhibit derived demand, as the demand for one
product is dependent on the demand for another.
(b) Autonomous Demand:
¾ Autonomous demand refers to the demand for a product that is independent
of the demand for other goods.
¾ It arises from the consumer’s innate desire to consume or possess the commodity.
¾ However, determining which products have entirely independent demand is
challenging, as many goods have interdependencies with other products.

Theory of Demand and Supply 57

 4. Demand for firm’s product and industry demand
(a) Industry Demand:
¾ Industry demand refers to the total demand for the products of a specific
industry.
¾ It represents the aggregate demand for a particular product across all firms
operating within that industry.
¾ For example, it can refer to the total demand for steel in a country.
(b) Firm’s Product Demand:
¾ Firm’s product demand refers to the demand for the products of a specific firm.
¾ It represents the quantity of products that a firm can sell at a given price over
a specific period of time.
¾ For example, it can refer to the demand for steel produced by the Tata Iron
and Steel Company.
The demand for a firm’s product when expressed as a percentage of industry demand
signifies the market share of the firm.
5. Short - run demand and Long-run demand
(a) Short-Run Demand:
¾ Short-run demand refers to the immediate reaction of demand to changes in
product price, related commodity prices, income fluctuations, consumer behavior,
and advertising.
¾ It is influenced by the ability of consumers to adjust their consumption patterns
and their susceptibility to new product advertisements.
¾ Short-run demand is characterized by its relatively short time horizon and
immediate responsiveness to various factors affecting demand.
(b) Long-Run Demand:
¾ Long-run demand refers to demand that exists over a more extended period
of time.
¾ Generic goods typically exhibit long-term demand patterns.
¾ Long-term demand is influenced by factors such as long-term income trends,
availability of substitutes, and credit facilities.
¾ It takes into account the adjustments made by the market to changes in pricing,
promotion, or product improvement over time.
¾ For example, if electricity rates are reduced, in the short run, existing users
may increase their use of electric appliances. However, in the long run, more
people may be motivated to purchase and use electric appliances.

FACTORS AFFECTING DEMAND FOR

NON-DURABLE CONSUMER GOODS
There are three basic factors which influence the demand for these goods:
1. Disposable income: Other things being equal, the demand for a commodity depends upon
the disposable income of the household. Disposable income is found out by deducting
personal taxes from personal income.

58 Business Economics PW
 2. Price: Other things being equal, the demand for a commodity depends upon its own
price and the prices of related goods (its substitutes and complements).
While the demand for a good is inversely related to its own price and the price of its
complements, it is positively related to the price of its substitutes.
3. Demography: This involves the characteristics of the population, human as well as non-
human, using the product concerned.
For example, it may pertain to the number and characteristics of children in a study of
demand for toys and characteristics of automobiles in a study of the demand for tyres
or petrol.
Non durables are purchased for current consumption only. From a business firm’s point
of view, demand for non durable goods gets repeated depending on the nature of the
non durable goods. Usually, non durable goods come in wide varieties and there is
competition among the sellers to acquire and retain customer loyalty.

FACTORS AFFECTING THE DEMAND FOR

DURABLE-CONSUMER GOODS
Demand for durable goods has certain special characteristics. Following are the important
factors that affect the demand for durable goods.
‰ Postponement of Replacement: Consumers have the option to delay replacing durable
goods, depending on factors like social status, income level, obsolescence rate, and personal
preferences.
‰ Special Facilities: Durable goods often require specific facilities for their use, such as roads
for automobiles and electricity for appliances like refrigerators and radios. The availability
and growth of these supporting factors impact the demand for durable goods.
‰ Family Characteristics: Since consumer durables are often shared among family members,
purchasing decisions can be influenced by factors such as family income, size, age
distribution, and gender composition. Changes in the number of households should also
be considered when estimating the market size for durable goods.
‰ Replacement Demand: The demand for durable goods includes a significant component
of replacement demand. The more existing durable goods a consumer owns, the greater
the need for replacements. Therefore, factors affecting replacement demand should be
considered when analyzing the demand for durable goods.
‰ Price and Credit Facilities: The demand for consumer durables is influenced by their
prices and the availability of credit facilities that make purchasing them more accessible.

FACTORS AFFECTING THE DEMAND FOR PRODUCER GOODS

‰ Price of Substitutable Factor: An increase in the price of a substitutable factor of
production, like labor, can increase the demand for capital goods.
‰ Price of Complementary Factor: Conversely, an increase in the price of a complementary
factor may decrease the demand for capital goods.
‰ Profit Prospects and Optimism: Higher profit prospects and optimistic expectations of
selling higher output in the future can incentivize firms to invest in capital goods.

Theory of Demand and Supply 59

‰ Technological Advances: Technological advancements that enhance efficiency, reduce costs,
and increase productivity of capital can positively impact investment in capital goods.
‰ Interest Rates: Lower interest rates can lead to higher investments in capital goods, as
firms have lower opportunity costs for investments and lower borrowing costs.

METHODS OF DEMAND FORECASTING

1. Survey of Buyers’ Intentions:
 The most direct method of estimating demand in the short run is to ask customers
what they are planning to buy during the forthcoming time period, usually a year.
 This method involves direct interview of potential customers.
 Depending on the purpose, time available and costs to be incurred, the survey may
be conducted by any of the following methods:
(a) Complete enumeration method where nearly all potential customers are interviewed
about their future purchase plans.
(b) Sample survey method under which only a scientifically chosen sample of potential
customers are interviewed.
(c) End–use method, especially used in forecasting demand for inputs, involves
identification of all final users, fixing suitable technical norms of consumption (i.e.
input output ratio) of the product under study, application of the norms to the
desired or targeted levels of output and aggregation.
 Under this method the burden of forecasting is put on the customers.
 This method is useful when bulk of sale is made to industrial producers who generally
have definite future plans. In the case of household customers, this method may not
prove very helpful for several reasons viz. irregularity in customers’ buying intentions,
their inability to foresee their choice when faced with multiple alternatives, and the
possibility that the buyers’ plans may not be real, but only wishful thinking.
2. Collective Opinion Method:
 Also known as the sales force opinion method or grass roots approach.
 Utilizes the knowledge, experience, and skills of the sales force to forecast future
demand.
 Sales personnel estimate expected sales in their respective territories.
 Salesmen, being close to customers, are believed to have a good understanding of
market reactions.
 Sales estimates from individual salesmen are consolidated to determine the total
estimated sales.
 Estimates are reviewed to eliminate bias and discrepancies.
 Factors like proposed changes in prices, product designs, advertising, competition,
and broader economic changes are considered.
 The final sales forecast is derived after accounting for all relevant factors.
 Strengths and Limitations:
¾ The method is simple and utilizes first-hand information from those directly
involved in sales.

60 Business Economics PW
 ¾ However, it is subjective and susceptible to personal opinions influencing the
forecast.
¾ Salesmen may lack awareness of broader economic changes that can impact
future demand.
¾ The method is more suitable for short-term forecasting rather than long-term
analysis.
3. Expert Opinion Method
 Also known as the Delphi Method, this demand forecasting technique involves soliciting
the views and opinions of specialists, experts, and consultants to estimate future
demand. These experts can be internal, such as executives and sales managers, or
external consultants with expertise in demand forecasting.
 Key points about the Delphi Method:
(a) The Delphi technique, originally developed by Olaf Helmer at the Rand Corporation
in the United States, is employed to gather the opinions of multiple experts
regarding future demand.
(b) Experts are provided with relevant information and feedback from other experts
in iterative rounds, and their opinions and comments are solicited until a consensus
or convergence of views is reached.
(c) The Delphi Method is considered a time-saving approach to demand forecasting.
4. Statistical methods: statistical methods have proved to be very useful in forecasting
demand. Forecasts using statistical methods are considered as superior methods because
they are more scientific, reliable and free from subjectivity. The important statistical
methods of demand forecasting are:
(a) Trend Projection method:
¾ This method, also known classical method, is considered as a ‘naive’ approach
to demand forecasting.
¾ A firm that has been operating for a significant period of time would have
collected extensive sales data over different time periods.
¾ Arranging this data chronologically creates a “time series” representing the past
pattern of effective demand for a specific product.
¾ Time series data can be analyzed to identify trends and project future demand
patterns.
¾ By examining historical sales patterns, firms can gain insights into the behavior
and potential growth of demand for their product.
¾ The trend projection method assumes that factors responsible for the past trend
in demand will continue to operate.
¾ The popular techniques of trend projection based on time series data are:
(b) Graphical Method:
¾ This method, also known as ‘free hand projection method’ is the simplest and
least expensive.

Theory of Demand and Supply 61

 ¾ This involves plotting of the time series data on a graph paper and fitting a
free-hand curve to it passing through as many points as possible. The direction
of the curve shows the trend.
¾ The direction of this free hand curve shows the trend.
¾ The main draw-back of this method is that it may show the trend but the
projections made through this method are not very reliable.
(c) Fitting trend equation (Least Square Method):
¾ The least square method is based on the assumption that the past rate of change
of the variable under study will continue in the future.
¾ It is a mathematical procedure for fitting a line to a set of observed data points
in such a manner that the sum of the squared differences between the calculated
and observed value is minimised.
¾ This technique is used to find a trend line which best fit the available data.
¾ This trend is then used to project the dependant variable in the future.
¾ This method is very popular because it is simpl, in-expensive and provide fairly
reliable estimates of future demand.
¾ The major limitation of this method is that it cannot be used where trend is
cyclical with sharp turning points of troughs and peaks. Also, this method cannot
be used for short term forecasts.
(d) Regression analysis:
¾ Under this method, a relationship is established between the quantity demanded
(dependent variable) and the independent variables (explanatory variables) such
as income, price of the good, prices of related goods etc.
¾ Once the relationship is established, we derive regression equation assuming the
relationship to be linear. The equation will be of the form Y = a + bX.
¾ Once the regression equation is derived, the value of Y i.e. quantity demanded
can be estimated for any given value of X.
5. Controlled Experiments (market experiment method):
 The experimental method involves manipulating specific determinants of demand,
such as price, advertising, etc., while assuming other factors remain constant.
 Experiments can be conducted by varying these determinants across different markets
or over different time periods within the same market.
 The objective is to assess the impact of factors like price, advertising, packaging, etc.,
on sales and record the responses of demand over time.
 The recorded data on the relationship between these determinants and sales can be
used to estimate future demand for the product.
 For example, different prices are associated with different sales levels, and a price-
quantity relationship can be estimated using regression analysis for forecasting
purposes.
 It is important to note that market divisions used in experiments should be
homogeneous in terms of income, tastes, and other relevant factors.

62 Business Economics PW
  Disadvantages
¾ The method of controlled experiments is used relatively less because this method
of demand forecasting is expensive as well as time consuming.
¾ It is also difficult to determine what conditions should be taken as constant and
what factors should be regarded as variable so as to segregate and measure their
influence on demand.
¾ controlled experiments are risky too because they may lead to unfavourable
reactions from dealers, consumers and competitors.
¾ it is practically difficult to satisfy the condition of homogeneity of markets.
¾ Market experiments can also be replaced by ‘controlled laboratory experiments’
or ‘consumer clinics’ under which consumers are given a specified sum of money
and asked to spend in a store on goods with varying prices , packages, displays
etc. The responses of the consumers are studied and used for demand forecasting.
6. Barometric method of forecasting:
 Just as meteorologists use the barometer to forecast weather, the economists use
economic indicators to forecast trends in business activities.
 These indicators help in forecasting the demand prospects of a product, although
not the actual quantity demanded.
 An index of relevant economic indicators is constructed to forecast the likely economic
environment in the near future.
 Types of Economic Indicators:
(a) Leading Indicators: These indicators move ahead of other series, providing early
signals of economic trends. Examples include heavy advance orders for capital
goods and an increase in construction permits for new houses, which indicate
future economic prosperity.
(b) Coincidental Indicators: Coincidental indicators move up and down simultaneously
with the changes they represent. They offer a snapshot of the current scenario.
Examples include figures on retail sales, the rate of unemployment, and the
Index of Industrial Production (IIP).
(c) Lagging Indicators: Lagging indicators follow a change after some time lag. They
confirm past events. For instance, heavy household electrical connections confirm
that heavy construction work was undertaken in the past, but with a time lag.

TRY YOUR UNDERSTANDING 2.1.6

1. Method of demand forecasting does not include?
(a) Mathematical method (b) Barometric method
(c) Expert opinion method (d) Statistical method
2. Forecasting of demand is the Art and Science of predicting?
(a) Actual demand of a product at same future date
(b) Probable demand in future
(c) Total demand in future
(d) None of these
Theory of Demand and Supply 63
3. The demand for a commodity that arises because of the demand for some other commodity
(prevent product) is called as
(a) Demand (b) Direct Demand
(c) Derived Demand (d) Implied Demand
4. If the demand for a product is independent of the demand for other goods, then it is
called as
(a) Derived Demand (b) Autonomous Demand
(c) Industry Demand (d) Implied Demand.
5. Identify Producer’s goods out of following :
(a) Plant and Equipment (b) Readymade clothes
(c) Residential Houses (d) All of the above
6. Which of the following factors affects demand for non-durable con sumer goods?
(a) Disposable income (b) Price
(c) Demography (d) All of the above.
7. ___________ method of fore-casting includes the methods:
(a) Collective opinion (b) Survey of Buyer’s intentions
(c) Expert Opinion (d) Barometric
8. Which one of the following is the statistical method of demand forecasting?
(a) Trend Projection Method (b) Fitting Equation Method
(c) Regression Analysis (d) All of the above.

Answer Key
1. (d) 2. (a) 3. (c) 4. (b) 5. (a) 6. (d) 7. (b) 8. (d)



64 Business Economics PW
 UNIT

2
Theory of Consumer’s
Behaviour

‰ In economics, the term ‘want’ refers to a wish, desire or motive to own or/and use goods
and services that give satisfaction.
‰ Wants may arise due to physical, psychological or social factors.
‰ Since the resources are limited, we need to make a choice between the urgent wants
and the not so urgent wants.
1. All wants of human beings exhibit some characteristic features.
2. Wants are unlimited in number. All wants cannot be satisfied.
3. Wants differ in intensity. Some are urgent ,others are less intensely felt.
4. Each want is satiable (able to be met).
5. Wants are competitive. They compete each other for satisfaction because resources
are scarce in relation to wants.
6. Wants are complementary. Some wants can be satisfied only by using more than one
good or group of goods.
7. A particular want may be satisfied in alternative ways 8. Wants are subjective and
relative. 9. Wants vary with time, place, and person.
8. Some wants recur again whereas others do not occur again and again.
9. Wants may become habits and customs.
10. Wants are affected by income, taste, fashion, advertisements and social norms and
customs.

CLASSIFICATION OF WANTS
In Economics, wants are classified into three categories, viz., necessaries, comforts and luxuries.
1. Necessaries: Necessaries are those which are essential for living. Necessaries are further
sub-divided into
(a) Necessaries for life: Necessaries for life are things necessary to meet the minimum
physiological needs for the maintenance of life such as minimum amount of food,
clothing and shelter.
(b) Necessaries for efficiency: Man requires something more than the necessities of life to
maintain longevity, energy and efficiency of work, such as nourishing food, adequate
clothing, clean water, comfortable dwelling, education, recreation etc.
 (c) Conventional necessaries: Conventional necessaries arise either due to pressure of habit
or due to compelling social customs and conventions. They are not necessary either
for existence or for efficiency.
2. Comforts: While necessaries make life possible comforts make life comfortable and
satisfying. Comforts are less urgent than necessaries. Tasty and wholesome food, good
house, clothes that suit different occasions, audio-visual and labour saving equipments
etc. make life more comfortable.
3. Luxuries: Luxuries are those wants which are superfluous and expensive. They are not
essential for living. Items such as expensive clothing, exclusive vintage cars, classy furniture
and goods used for vanity etc. fall under this category.

WHAT IS UTILITY?
‰ Utility refers to want satisfying power of a commodity.
‰ The utility of a consumer is a measure of the satisfaction that the consumer expects to
obtain from consumption of goods and services when he spends money on a stock of
commodity which has the capacity to satisfy his want.
‰ A commodity has utility for a consumer even when it is not consumed.
‰ Utility is a subjective and relative entity and varies from person to person.
‰ A commodity has different levels of utility for the same person at different places or at
different points of time.
‰ Utility is not the same thing as usefulness.
‰ In Economics, the concept of utility is ethically neutral. Even harmful things like liquor
may be said to have utility because people want them.

THE MARGINAL UTILITY ANALYSIS

‰ The marginal utility theory, formulated by Alfred Marshall, a British economist, seeks
to explain how a consumer chooses to spend his income on different goods and services
so as to maximize his utility (i.e. how consumer reaches the equilibrium).
‰ Total Utility
 Total utility refers to the total satisfaction obtained from the consumption of all
possible units of a commodity.
 Total utility is the sum of marginal utilities derived from the consumption of different
units i.e.
TU = MU1 + MU2 +.....+ MUn
Where
MU1, MU2,.....,MUn etc are marginal utilities of the successive units of a commodity.
‰ Marginal Utility (MU)
Marginal utility is the additional utility derived from the consumption of one additional
unit of the given commodity.
MUn = TUn - TUn-1
Where,
MUn is the marginal utility of the nth unit.

66 Business Economics PW
 TUn is the total utility of the nth unit, Maximum TU

Total Utility from Ice Cream

and Y
TUn-1 is the total utility of the (n-1) th TU
unit. 50
MU is the change in TU when one more 40
unit is consumed. However, when change (A
)
30
in units consumed is more than one,
then MU can also be calculated as: 20

Change in Total Utility 10

MU =
Change in number of Units AQ X
O 1 2 3 4 5 6
Y Units of Ice Cream
∆TU

Marginal Utility of Ice Cream

=
∆Q

20
Ice-creams Marginal Total Utility
Consumed Utility (MU) (TU) 16

(B ) 12
1 20 20
8
2 16 36
4 Zero MU
3 10 46
X
4 4 50 O 1 2 3 4 5 6
–ve MU
–4 Units of Ice Cream
5 0 50 MU Curve
–8
6 -6 44 Y‘

ASSUMPTIONS OF MARGINAL UTILITY ANALYSIS

Theory of Consumer Behavior (Utility Theory) Assumptions:

1. Rationality: Consumers are rational and seek to maximize satisfaction from their limited
income.
2. Cardinal Measurability of Utility: Utility is a measurable and quantifiable concept, often
expressed in cardinal numbers or units.
3. Money as a Measuring Rod of Utility: The amount of money a consumer is willing to pay
for a good reflects the utility derived from that good.
4. Other Factors Constant: The theory assumes that factors such as price, tastes, preferences,
income, habits, temperament, and fashion remain constant.
5. Continuity in Consumption: Consumption occurs without time gaps or intervals between
units of consumption.
6. Homogeneity of Units: The units of the commodity consumed are assumed to be identical
or homogeneous in nature.

Theory of Demand and Supply 67

 7. Standard Units: Consumption is based on standard units of the commodity, and the
commodity should be divisible.
8. Constancy of Marginal Utility of Money: The marginal utility of money remains constant
when spending on a good, facilitating utility measurement in monetary terms.
9. Independent Utility: The theory assumes that the total utility derived from a collection
of goods is the sum of the separate utilities of each good, ignoring complementarity
between goods.

THE LAW OF DIMINISHING MARGINAL UTILITY

‰ The law of diminishing marginal utility states that each successive unit of a good or
service consumed adds less to total utility than the previous unit.
‰ As consumer consumes more and more units of a good, the intensity of his want for the
good goes on decreasing and a point is reached where the consumer no longer wants it.
‰ It is to be noted that it is the marginal utility and not the total utility which declines
with the increase in the consumption of a good.
Units of Ice Cream Total Utility (in utils) Marginal Utility (in utils)
1 20 20
2 36 16
3 46 10
4 50 4
5 50 0
(Point of Satiety)
6 44 -6
Law of Diminishing Marginal Utility
Y
MU Curve slopes downwards,
Marginal Utility of Ice Cream

indicating decrease in satisfaction

20 A with each successive ice cream
16 B
12
C Zero MU
8 (Point of safety)
D
4
E
O X
1 2 3 45 6
–4 –ve MU
–8 MU

Y‘

SOME FACTS ABOUT LAW OF DIMINISHING

MARGINAL UTILITY
This law was given by prof. Alfred marshall

68 Business Economics PW
 RELATIONSHIPS BETWEEN TOTAL
UTILITY AND MARGINAL UTILITY
Maximum TU
1. Total utility rises as long as MU is

Total Utility from Ice Cream

Y
positive, but at a diminishing rate
because MU is diminishing. TU
50
2. Marginal utility diminishes throughout.
40
3. When marginal utility is zero, the total (A)
utility is maximum. It is the satiation 30
point. 20
4. When marginal utility is negative, total
10
utility is diminishing.
5. MU is the rate of change of total utility X
O 1 2 3 4 5 6
or it is the slope of TU curve. Y Units of Ice Cream

Marginal Utility of Ice Cream

6. MU can be positive, zero or negative.

Chocolate Total Marginal 20

Consumption Utility Utility 16
1 20 20 (B ) 12

2 34 14 8
4 Zero MU
3 45 11
X
4 50 5 O 1 2 3 4 5 6
–ve MU
–4 Units of Ice Cream
5 50 0 MU Curve
–8
6 46 -4 Y‘

LIMITATIONS AND EXCEPTIONS OF THE LAW OF

DIMINISHING MARGINAL UTILITY
1. Utility is not in fact independent. The shape of the utility curve may be affected by the
presence or absence of articles which are substitutes or complements. The utility obtained
from tea may be seriously affected if no sugar is available and the utility of bottled soft
drinks will be affected by the availability of fresh juice.
2. The law may not apply in the following situations:
(a) The law may not apply in the case of prestigious goods and articles like gold, cash,
diamonds etc. where a greater quantity may increase the utility rather than diminish it.
(b) The law also may not hold well in the case of hobbies, rare collections etc where, with
every addition to the collection, the marginal utility will go on rising. Similarly, people
who seek greater knowledge and information will be more satisfied with every
additional information secured by them.
Theory of Demand and Supply 69
 (c) The law may not be operating in cases such as creative art, painting, music, poetry
etc as more of these would generate greater satisfaction.
(d) The law does not hold good in the case of habit forming commodities like alcohol,
cigarettes, and computer games etc. because those who are habituated into these
may experience increasing utility with every additional intake.
(e) The law also fails in the case of people with miserly behaviour as accumulation of
every additional unit of money would give them greater levels of satisfaction.

TRY YOUR UNDERSTANDING 2.2.1

1. MU is calculated as
(a) TUn – TUn–1 (b) TUn–1 – TUn

TUn TUn − 1
(c) (d)
TUn − 1 TUn

2. When there is no consumption, what value TU & MU takes ?

(a) TU is zero & MU is positive (b) TU is zero & MU is falling
(c) TU is zero & MU is maximum (d) TU is none & MU is above
3. Which of the following is not the characteristic of wants of human beings?
(a) Wants are unlimited
(b) Wants are subjective & relative
(c) Wants are affected by income, taste, fashion, advertisements and social customs
(d) Wants do not vary with time, place & person.
4. Wants arise from multiple causes including
(a) Natural instincts
(b) Social obligations
(c) Individual’s economic & social status
(d) All of the above
5. Marginal Utility Analysis has been propounded by:
(a) Marshall (b) Hicks (c) Allen (d) Hicks & Allen
6. Alfred Marshall was a economist.
(a) British (b) American (c) European (d) Asian
7. Which of the following relation is true with MU?
(a) When MU is positive, Total utility rises at a diminishing rate
(b) When marginal utility is zero, total utility is maximum
(c) When marginal utility is negative, total utility is diminishing
(d) All of the above
8. Total utility is maximum when:
(a) Marginal utility is zero. (b) Marginal utility is at its highest point.
(c) Marginal utility is negative. (d) None of the above.

70 Business Economics PW
 9. ____________ is the additional made to total utility by the consumption of an additional
unit of a commodity.
(a) Marginal Utility (b) Average Utility
(c) Total utility (d) Incremental Marginal Utility
10. When economists speak of the utily of a certain good, they are referring to:
(a) The demand for the good.
(b) The usefulness of the good in consumption.
(c) The expected satisfaction derived from consuming the good.
(d) The rate at which consumers are willing to exchange one good for another.

Answer Key
1. (a) 2. (c) 3. (d) 4. (d) 5. (a) 6. (d) 7. (d) 8. (a) 9. (a) 10. (c)

CONSUMER EQUILIBRIUM
Consumer’s Equilibrium refers to the situation when a consumer is having maximum satisfaction
with limited income and has no tendency to change his way of existing expenditure.
‰ The consumer has to pay a price for each unit of a commodity and cannot consume an
unlimited quantity.
‰ According to the Law of Diminishing Marginal Utility (DMU), the utility derived from
each additional unit of a commodity decreases.
‰ As the consumer purchases more units, their income decreases.
‰ The rational consumer seeks to balance expenditure to achieve maximum satisfaction
with minimum expenditure.
‰ This balance, known as equilibrium, is reached when the consumer optimizes their
consumption to achieve the highest level of satisfaction given their income and the
diminishing utility of additional units.
‰ Once equilibrium is achieved, there is no incentive to change the quantity of the commodity
purchased.

CONSUMER EQUILIBRIUM IN SINGLE COMMODITY CASE

‰ A consumer reaches equilibrium when they purchase the quantity of a commodity that
provides maximum satisfaction.
‰ The number of units consumed depends on two factors: the price of the commodity and
the expected utility (marginal utility) from each additional unit.
‰ To determine the equilibrium point, the consumer compares the price of the commodity
with its utility or satisfaction.
‰ As a rational consumer, equilibrium is achieved when the marginal utility derived from
the last unit consumed is equal to the price paid for the commodity.
‰ Marginal utility is measured in utils, while price is measured in monetary units (money).
‰ To effectively compare marginal utility and price, it is necessary to express marginal
utility in terms of money.
Theory of Demand and Supply 71
‰ This allows for a direct comparison between the satisfaction derived from each additional
unit (measured in utils) and the cost of the commodity (measured in money units).
Marginal Utility in utils
Marginal Utility in terms of Money =
Marginal Utility of one rupee MUm ( )
‰ Since utility is subjective and varies from person to person, it is assumed that each
consumer defines their own marginal utility (MU) of one rupee.

EQUILIBRIUM CONDITION
A consumer of a single commodity (let’s say commodity X) is in equilibrium when the marginal
utility (MUX) derived from consuming one more unit of the commodity is equal to the price
(Px) paid for that commodity, i.e., MUX = Px.
‰ If the marginal utility (MUX) is greater than the price (Px), the consumer is not in equilibrium.
In this case, the consumer continues to buy more units of the commodity because the benefits
derived from each additional unit

MU and Price of commodity (int `)

exceed the cost. However, as the Y
Consumer’s Equilibrium in case
consumer buys more, the marginal
of singal commodity (x)
utility falls due to the law of diminishing
marginal utility. The consumer reaches 20
equilibrium when the marginal utility Consumer’s Equilibrium (MUX = PX)
16
becomes equal to the price, achieving
maximum benefits. 12
PX
Similarly, if the marginal utility (MUX) 8 E
‰ Zero MU
is less than the price (Px), the consumer 4 (Point of safety)
is also not in equilibrium. In this situation, X
the consumer needs to reduce the O 1 2 3 45 6
–4 –ve MU
consumption of commodity X to increase
overall satisfaction until the marginal –8 MUX
utility becomes equal to the price. Y‘
Units of Price (Px) Marginal utility Marginal utility in Rs. Difference MUX and
X (utils) (MUX) 1 util = Rs.1 Px
1 10 20 20 x 1 = 20 20-10= 10
2 10 16 16 x1 = 16 16-10 = 6
3 10 10 10 x 1 = 10 10-10 = 0
4 10 4 4x1=4 4-10 = -6
‰ Consumer’s Equilibrium in case of Single Commodity

CONSUMER EQUILIBRIUM IN TWO COMMODITY CASE

(LAW OF EQUI-MARGINAL UTILITY)
In reality, a consumer spends his income on more than one good. In such cases, consumer
equilibrium is explained with the law of Equi-Marginal utility. According to this law, the
consumer will be in equilibrium when he is spending his money on different goods and services
72 Business Economics PW
in such a way that the marginal utility of each good is proportional to its price and the last
rupee spent on each commodity yields him equal marginal utility.
The law states that the consumer is said to be at equilibrium, when the following condition
is met:
MUx MUy
MUm = =
Px Py

Or
MUx Px
MUm = =
MUy Py

Or
MU P
        x = x
MUy Py

TRY YOUR UNDERSTANDING 2.2.2

1. Consumer’s equilibrium condition is written as

MUx MUy MUx MUy

(a) = (b) <
Px Py Px Py

MUx MUy
(c) > (d) None of these
Px Py

2. ____________ is a situation where a consumer is spending his income in such a way that he
is getting maximum satisfaction and has no tendency to change.
(a) Equilibrium (b) Consumers satisfaction
(c) Consumers equilibrium (d) None

Answer Key
1. (a) 2. (c)

CONSUMER SURPLUS
The concept of consumer surplus was propounded by Alfred Marshall.
Consumer surplus is defined as the difference between the total amount that consumers are
willing and able to pay for a good or service (indicated by the demand curve) and the total
amount that they actually do pay (i.e. the market price).
Marshall defined the concept of consumer surplus as the “excess of the price which a consumer
would be willing to pay rather than go without a thing over that which he actually does pay”,
is called consumers surplus.”

Theory of Demand and Supply 73

consumer surplus = what a consumer is ready to pay - what he actually pays.
= Sum of MU – (Price x Units Purchased)
= Total Utility – Total Amount Spent
The concept of consumer surplus is derived from the law of diminishing marginal utility.
The price is the same for all units of the good he purchases, he gets extra utility for all units
consumed by him except for the one at the margin. This extra utility or extra surplus for the
consumer is called consumer surplus.

MEASUREMENT OF CONSUMER SURPLUS

Y
Units Marginal Price Consumer D

Price & Marginal Utility

Consumed Utility Surplus
1 30 20 10
2 28 20 8 R
P
3 25 20 5
4 22 20 2 D1
5 20 20 0 MU
O Q X
125 100 25
Amount of commodity
Applications of consumer surplus:

1. Business decision-making: Understanding consumer surplus helps businesses assess the

welfare gained by different customer segments. Consumers perceiving higher surplus are
more likely to become repeat customers, impacting business success.

2. Pricing strategies: Knowledge of consumer surplus aids managers in setting prices.

By identifying consumer groups with different demand elasticity and their
willingness to pay higher prices, firms can employ price discrimination for increased
profitability.

3. Cost-benefit analysis: Large-scale investment decisions consider consumer surplus to

assess project benefits. The extent of consumer surplus generated can influence investment
choices and resource allocation.

4. Pricing adjustments: Consumer surplus informs firms considering price increases.

Customers experiencing low surplus may be less willing to purchase products at higher
prices, potentially leading to reduced sales.

5. Taxation decisions: Consumer surplus guides finance ministers in determining taxable

products and tax rates. Commodity taxes are often imposed on products with high
consumer surplus, as the impact on citizen welfare is relatively minimal.

LIMITATIONS OF CONSUMER SURPLUS

It is often argued that this concept of consumer surplus is hypothetical and illusory. In real
life, the surplus satisfaction cannot be measured accurately.
74 Business Economics PW
 1. Consumer surplus cannot be measured precisely - because it is difficult to measure the
marginal utilities of different units of a commodity consumed by a person.
2. In the case of necessaries, the marginal utilities of the earlier units are infinitely large.
In such case the consumer surplus is always infinite.
3. The consumer surplus derived from a commodity is affected by the availability of
substitutes.
4. There is no simple rule for deriving the utility scale of articles which are used for their
prestige value (e.g., diamonds).
5. Consumer surplus cannot be measured in terms of money because the marginal utility
of money changes as purchases are made and the consumer’s stock of money diminishes.
(Marshall assumed that the marginal utility of money remains constant. But this
assumption is unrealistic).
6. The concept can be accepted only if it is assumed that utility can be measured in terms
of money or otherwise. Many modern economists believe that this cannot be done.

TRY YOUR UNDERSTANDING 2.2.3

1. The concept of Consumer’s Surplus was propounded by
(a) Alfred Marshall
(b) Hicks & Allen
(c) J. B. Say
(d) None of these
2. If a Consumer gets more utility from a commodity, he would be willing to pay a higher
price and vice versa. This extra satisfaction which consumer gets from the purchase of
goods is called as
(a) Producer’s Supply
(b) Consumer’s Surplus
(c) Extra Utility
(d) Excess Marginal Utility
3. Which of the following statement is incorrect as regards Consumer’s Surplus?
(a) It can be measured in money
(b) It cannot be measured precisely
(c) It is affected by a variability of substitutes
(d) It is ahways infinite for necessaries.
4. By consumer surplus, economists mean
(a) The area inside the budget line.
(b) The area between the average revenue and marginal revenue curves
(c) The difference between the maxi-mum amount a person is willing to pay for a good
and its market price.
(d) None of the above.
Theory of Demand and Supply 75
 5. In the diagram given below, the shaded portion represents. Y
(a) Price above which there is no demand for the commodity.
(b) Monopoly price of the commodity. D
(c) Consumer surplus.
(d) None of the above.
P

Price
6. Consumer surplus is more in case of
(a) Luxury
D
(b) Necessity
(c) Semi luxurious goods O X
Quantity Demanded
(d) All the above

Answer Key
1. (a) 2. (b) 3. (a) 4. (c) 5. (c) 6. (b)

INDIFFERENCE CURVE ANALYSIS (ORDINAL UTILITY

APPROACH OR HICKSIAN ANALYSIS)
J.R. Hicks and R.G.D. Allen, made significant contributions to the understanding and
development of indifference curve analysis.
‰ Modern economists reject the idea of a “cardinal measure of utility.”
‰ They argue that utility is a psychological concept and cannot be precisely measured in
absolute terms.
‰ Instead, economists believe that consumers can rank different combinations of goods and
services based on their preferences.
An indifference curve represents a graphical depiction of different combinations of two goods
where a consumer is equally satisfied or indifferent.

INDIFFERENCE SCHEDULE Y
Indifference Curve
Combination of Apples Apples Bananas
and Bananas (A) (B)
15 P(1A + 15B)
P 1 15
Bananas (B)

12 Q(2A + 10B)
Q 2 10
9
R(3A + 6B)
R 3 6 6
S(4A + 3B)
3 T(5A + 1B)
S 4 3
IC1
1 2 3 4 5 X
O
T 5 1
Apples (A)

76 Business Economics PW
 ASSUMPTIONS UNDERLYING INDIFFERENCE
CURVE APPROACH
1. Knowledge of Tastes and Preferences: Consumers are assumed to possess complete
knowledge of their own tastes and preferences, as well as comprehensive information
about the economic environment in which they operate.
2. Rationality: Consumers are assumed to be rational and tend to make choices that lead
to increased satisfaction. They aim to select consumption bundles that are more preferred
over those that are less preferred.
3. Ordinal Utility: The indifference curve analysis assumes that utility can only be ranked
in order of preference. Consumers can compare and rank different combinations of goods
based on the satisfaction they provide. However, they cannot express the magnitude of
preference quantitatively between different combinations.
4. Transitivity: Consumer choices are assumed to be transitive. If a consumer prefers
combination A to combination B, and combination B to combination C, then it is implied
that the consumer also prefers combination A to combination C. This assumption ensures
a consistent consumption pattern.
5. Non-Satiation: The assumption of non-satiation suggests that consumers always prefer
more of a good to less. If one combination of goods has more of each commodity compared
to another combination, the consumer is assumed to prefer the combination with more
goods.

MARGINAL RATE OF SUBSTITUTION (MRS)

The Marginal Rate of Substitution (MRS) represents the rate at which two commodities
can be exchanged or substituted while maintaining the consumer’s overall satisfaction at a
constant level.
MRS between Apple and Banana
Combination Apples (A) Banana (B) MRSAB
P 1 15 -
Q 2 10 5B : 1A
R 3 6 4B : 1A
S 4 3 3B : 1A
T 5 1 2B : 1A
Y MRS Between Apple and Banana
P(1A + 15B) IC1 is convex shaped due
15

12 5B{ to diminishing MRS

Bananas (B)

Q(2A + 10B)
9 4B { R(3A + 6B)
6
3B{ S(4A + 3B)
3
2B { T(5A + 1B)
1B{ IC1
X
O 1 2 3 4 5
Apples (A)
Theory of Demand and Supply 77
The Marginal Rate of Substitution (MRS) diminishes due to the principle of diminishing
marginal utility.
As the consumer consumes more of one good and less of the other, the MRS measures the
amount of the second good the consumer is willing to give up to obtain an additional unit of
the first good while still maintaining the same level of satisfaction.
Initially, when the consumer has a higher quantity of the second good, they are willing to
give up more units of it to obtain an extra unit of the first good.
However, as they consume more of the first good and less of the second, the consumer’s
willingness to trade decreases, resulting in a diminishing MRS.
In other words, the consumer becomes less willing to sacrifice the second good as they already
have an increasing quantity of the first good. This decreasing willingness to substitute goods
leads to a diminishing Marginal Rate of Substitution.
MRS between 2 points is also the slope of indifference curve between these 2 points.

MONOTONIC PREFERENCE
‰ Monotonic preferences indicate that a rational consumer consistently prefers more of a
commodity due to the higher satisfaction it provides.
‰ It means that as consumption increases, total utility also increases.
‰ A consumer’s preferences are considered monotonic when they prefer a bundle that has
more of at least one good and no less of the other good compared to another bundle.
‰ Monotonic preferences imply a consistent desire for greater quantities of goods and
services to maximize utility.

INDIFFERENCE MAP
‰ An indifference curve map is a collection of indifference curves in which each curve
corresponds to a different level of satisfaction.
‰ Moving upward and to the right from one indifference curve to the next represents an
increase in utility, and moving down and to the left represents a decrease.
‰ An indifference curve map thus depicts the complete Y
Indifference Map
picture of consumer tastes and preferences.
‰ Higher indifference curves indicate higher levels of
Commodity Y

satisfaction for individuals. This is because a higher

indifference curve represents a larger bundle of
goods, implying a greater quantity of goods and A B
P
therefore more utility. This relationship holds true IC3
due to the assumption of monotonic preferences, IC2
where individuals consistently prefer larger IC1
x
quantities of goods to increase their overall O R S
Commodity X
satisfaction.

78 Business Economics PW
 PROPERTIES OF INDIFFERENCE CURVES
The following are the main characteristics or properties of indifference curves:

1. Indifference curves slope downward to the right: This property implies that the two
commodities can be substituted for each other and when the amount of one good in the
combination is increased, the amount of the other good is reduced. This is essential if the
level of satisfaction is to remain the same on an indifference curve.

2. Indifference curves are always convex to the origin: An

indifference curve is convex to the origin because of Y
diminishing MRS. MRS declines continuously because of the
law of diminishing marginal utility.

Good Y
Exception
(a) When two goods are perfect substitutes of each other,
the consumer is completely indifferent as to which to
consume and is willing to exchange one unit of X for
one unit of Y. His indifference curves for these two goods
O x
are therefore straight, parallel lines with a Good X
constant slope along the curve, or the
Y
indifference curve has a constant MRS.
(b) When two goods are perfect complementary
goods (i.e. Printer & Cartridge), the indifference
Good Y

curve will consist of two straight lines with a

right angle bent which is convex to the origin,
or in other words, it will be L shaped. B
Y2 l2
Avery interesting fact about this is that in
the case of perfect complements, the Y A C
1
l1
marginal rate of substitution is undefined
X
because an individual’s preferences do not O X3
Good X
allow any substitution between goods.
Y
3. Indifference curves can never intersect each
other: No two indifference curves will intersect
each other although it is not necessary that
they are parallel to each other. In case of
intersection the relationship becomes logically A
Good Y

absurd because it would show that higher and

C
lower levels are equal, which is not possible.
IC2
4. A higher indifference curve represents a higher B
level of satisfaction than the lower indifference IC1
curve: This is because combinations lying on a
x
higher indifference curve contain more of either O Good X
Theory of Demand and Supply 79
 one or both goods and more goods are preferred Y
to less of them.
5. Indifference curve will not touch either axes: As per
indifference curve, the consumer is considering
different combination of two commodities.

Good Y
 if an indifference curve touches the Y-axis, it
indicates that the consumption of the commodity
on the X-axis is zero.
 Similarly, if an indifference curve touches the
X-axis, it suggests that the consumption of the
commodity on the Y-axis is zero.
IC1
Therefore, according to this analysis, an indifference x
O
curve is never supposed to touch any of the axes. Good X

THE BUDGET LINE

A budget line is a graphical representation that shows the various combinations of two goods
that can be purchased by a consumer, given their income and the prices of the goods.
It shows the affordability of different combinations, where the total cost of each combination
is equal to the consumer’s income.
A consumer can purchase only those combinations Y
(bundles) of goods, which cost less than or equal to his
10 B M
income. PY
9
Algebraically, we can write the budget constraint for Budget line equation
8
two goods X and Y as: PXX + PYY = M
7
PXQX + PYQY ≤ B 6
Chocolate

+H
5
Where PX and PY are the prices of goods X and Y and
QX and QY are the quantities of goods X and Y chosen 4
3
and B is the total money available to the consumer. +K
2 M
The following table shows the combinations of Ice cream 1 L PX
and chocolates a consumer can buy spending the entire x
O 1 2 3 4 5
fixed money income of Rs.100, with the prices Rs 20 Ice Cream
and Rs.10 respectively.
Ice-cream Chocolate
A 0 10
B 1 8
C 2 6
D 3 4
E 4 2
F 5 0

80 Business Economics PW
It should be noted that any point outside the given price line, say H, will be beyond the reach
of the consumer and any combination lying within the line, say K, shows under spending by
the consumer.
The slope of the budget line is determined by the relative prices of the two goods. It is equal
to ‘Price Ratio’ of two goods. i.e. PX /PY i.e. It measures the rate at which the consumer can
trade one good for the other.

SLOPE OF THE BUDGET LINE

The slope of a curve is calculated as a change in variable on the vertical or Y-axis divided by
change in variable on the horizontal or X-axis
Units of Chocolate willing to Sacrifice
Slope of Budget Line =
Units of Ice-cream willing to Gain

Price Ratio or Marginal Rate of Exchange (MRE)

Price Ratio is the price of commodity on the X-axis divided by the price of commodity Y-axis.

Price Ratio =
( ) = PX
Price of X PX
Price of Y (PY ) PY

PROPERTIES OF BUDGET LINE

1. Negative Slope of the Budget Line: The budget line exhibits a downward slope, indicating
that an increase in the quantity of one good can be attained by reducing the quantity
of the other good. This relationship occurs due to the finite income and the relative prices
of the goods.
2. Constant Price Ratio and Straight Budget Line: The slope of the budget line is determined
by the price ratio between the two goods. Since the price ratio remains constant, the
budget line appears as a straight line in the graph.

SHIFT IN BUDGET LINE

1. Effect of a Change in the Income of Consumer: If there is change in income of consumer
and prices of goods remain constant then, budget line will shift. When income increases
then, budget line will shift rightward as more bundles of goods can be purchased now
and vice versa.

2. Effect of a change in prices of commodities:

(a) Change in prices of both commodities: when price of both the commodities fall, then
budget line will shift to right and vice versa.
(b) Change in price of commodity on X-Axis: In this case budget line on X axis will either
shift to right (decrease in price) or to left (increase in price) but the new budget line
meets the Y Axis at same point.
(c) Change in price of commodity on Y-Axis: In this case budget line on Y axis will either
shift to upward (decrease in price) or to downward (increase in price) but the new
budget line meets the X Axis at same point.
Theory of Demand and Supply 81
 CONSUMER EQUILIBRIUM
A consumer is in equilibrium when he is deriving maximum possible satisfaction from the
goods and therefore is in no position to rearrange his purchases of goods. We assume that:
1. The consumer has a given indifference map which shows his scale of preferences for
various combinations of two goods X and Y.
2. He has a fixed money income which he has to spend wholly on goods X and Y.
3. Prices of goods X and Y are given and are fixed.
4. All goods are homogeneous and divisible, and
5. The consumer acts ‘rationally’ and maximizes his satisfaction.
According to an indifference map, a higher indifference curve represents a greater level of
satisfaction compared to any lower indifference curve. As a result, consumers always aim
to be on the highest attainable indifference curve while considering their budget constraint.

CONDITIONS OF CONSUMER’S EQUILIBRIUM

To be at equilibrium following 2 conditions must be fulfilled:

1. MRSXY = Ratio of prices

 Slope of indifference curve must be equals to slope of budget line.
 In the context of two goods, X and Y,
Consumer’s Equilibrium
the first condition states that the Y Indifference Curve approach
Marginal Rate of Substitution (MRS)
between X and Y should be equal to Consumer’s is at equilibrium
B F at point E, When budget line
the ratio of their prices.
Commodity Y

AB is just tangent to IC2

 If the MRSXY is greater than the price
ratio, it indicates that the consumer H
E
is willing to give up more units of Y N
IC3
to obtain an additional unit of X IC2
compared to the market requirement. G IC1
This encourages the consumer to x
O M A
purchase more of X. Consequently, the Commodity X
MRS decreases and continues to
decrease until it becomes equal to the price ratio, establishing equilibrium.
 On the other hand, if the MRSXY is lower than the price ratio, it suggests that the
consumer is willing to give up fewer units of Y to obtain an extra unit of X compared
to the market requirement. This motivates the consumer to buy less of X and more
of Y. As a result, the MRS increases until it becomes equal to the price ratio, leading
to the establishment of equilibrium.
2. The indifference curve must be convex to the origin at the point of equilibrium i.e. MRS
must be diminishing.
The indifference curve analysis is superior to utility analysis:
(a) It dispenses with the assumption of measurability of utility
(b) It studies more than one commodity at a time

82 Business Economics PW
 (c) It does not assume constancy of marginal utility of money
(d) It segregates income effect from substitution effect.

TRY YOUR UNDERSTANDING 2.2.4

1. Which assumptions implies the consumer aims at utility maximixation?
(a) a rationality (b) ordinality
(c) cardinality (d) None of these
2. When indifferent curve is straight downward sloping line, the two goods are
(a) substitutes (b) complements
(c) perfect substitutes (d) perfect complements
3. L-shaped indifference curve exist in case two goods are
(a) substitutes (b) complements
(c) perfect substitutes (d) perfect complements
4. If MRS was increasing, what shape will indifference curve take ?
(a) horizontal (b) vertical
(c) concave (d) rising
5. At the point of consumer’s equilibrium indifference curve & budget curve are
(a) passing through each other (b) intersecting
(c) tangent (d) not tangent to each other
6. Which one is not an assumption of the theory of demand based on analysis of indifference
curves?
(a) Given scale of preferences as between different combinations of two goods.
(b) Diminishing marginal rate of substitution.
(c) Constant marginal utility of money.
(d) Consumers would always prefer more of a particular good to less of it, other things
remaining the same.
7. Which of the following is not the property of indifference curve?
(a) Slopes downwards to the right
(b) Always corrvex to the origin
(c) Intersects each other
(d) Will not touch either of the axes
8. A point below the budget line of a consumer
(a) Represents a combination of goods which costs the whole of consumer’s income.
(b) Represents a combination of goods which costs less than the consumer’s income.
(c) Represents a combination of goods which is unattainable to the consumer given his/
her money income.
(d) Represents a combination of goods which costs more than the consumers income.

Theory of Demand and Supply 83

9. ____________ is a curve which represents all those combinations of two goods which give
same satisfaction to the consumer.
(a) Indifference Curve (b) Iso-utility curve
(c) Equal-Utility Curve (d) All of the above
10. ____________ represents a collection of many indifference curves where each curve represents
a certain level of satisfaction.
(a) Indifference Group (b) Indifference Map
(c) Indifference Aggregate (d) Market Map
11. When the consumer has more and more unit of food, he is prepared to give up less and
less units of clothing. It is due to ____________.
(a) Falling MRS (b) Rising MRS
(c) Constant MRS (d) None of the above.
12. Which one of the following Statement is incorrect about Indifference Curve?
(a) Always Convex to the origin
(b) Never intersects each other
(c) Higher Curve represents higher level of satisfaction.
(d) It may touch X axis but never Y axis.
13. A higher indifference curve shows a higher level of satisfaction than a lower one. Therefore,
a consumer, in his attempt to mavimize satisfaction will toy to reach the possible
indifference curve.
(a) Highest (b) Lowest
(c) Any of (a) or (b) (d) None of these
14. The Slope of Indifference curve is
(a) Marginal Rate of Substitution (b) Minimal Rate of Substitution
(c) Average Rate of Substitution (d) Total Rate of Substitution
15. The slope of the ‘Price line’ indicates the ratio between ____________ of the two goods.
(a) Prices (b) Quantities demanded
(c) Quantities Sold (d) Marginal Utility

Answer Key
1. (a) 2. (c) 3. (d) 4. (c) 5. (c) 6. (c) 7. (c) 8. (b) 9. (d) 10. (b)
11. (a) 12. (d) 13. (a) 14. (a) 15. (a)



84 Business Economics PW
 UNIT

3 Supply and Elasticity of Supply

‰ The term ‘supply’ refers to the amount of a good or service that the producers are willing
and able to offer to the market at various prices during a given period of time.
‰ Three important points apply to supply:
(a) Supply refers to what a firm offer for sale in the market, not necessarily to what
they succeed in selling. What is offered may not get sold.
(b) Supply requires both willingness and ability to supply. Production cost is often the
primary influence on ability.
(c) Supply is a flow. Supply is identified for a specified time period. The quantity supplied
is ‘so much’ per unit of time, per day, per week, or per year.

DETERMINANTS OF SUPPLY
Price is an important consideration in determining the willingness and desire to part with
commodities, there are many other factors which determine the supply of a product or a
service. These are discussed below:
1. Price of the good:
 Other things being equal, the higher the price of own a good the greater the quantity
of it that will be supplied. This is because goods and services are produced by the
firm in order to earn profits and, ceteris paribus, profits rise if the price of its product
rises.
2. Prices of related goods:
 If the prices of other goods rise, they become relatively more profitable to the firm
to produce and sell than the good in question. When a seller can get a higher price
for a good, producing and selling it becomes more profitable. Producers will allocate
more resources towards its production even by drawing resources from other goods
they produce.
 For example, a rise in the price of comic books will encourage publishers to shift
resources out of the production of other books (such as novels) and use them in the
production of comic books.
3. Prices of factors of production:
 The cost of producing a commodity is determined by the prices of the factors of
production or inputs involved, such as labor, capital, and raw materials. When the
prices of these factors increase, it leads to higher production costs, which in turn
reduces profitability for the seller. Consequently, the seller tends to decrease the
 supply of the commodity. Conversely, if the prices of factors of production or inputs
decrease, the cost of production falls, resulting in higher profit margins and an
increase in the supply of the commodity.
 For example, let’s consider a clothing manufacturer. If the price of cotton, a key raw
material, rises significantly, it directly affects the cost of producing garments. As a
result, the manufacturer’s profitability decreases. To mitigate this, the manufacturer
may reduce the supply of clothing items or increase their prices to maintain
profitability.
4. State of technology:
 The supply of a particular product depends upon the state of technology also. The
use of new technology in an industry (such as automation) increases production
efficiency and reduces production costs.
 Inventions and innovations tend to make it possible to produce more or better goods
with the same resources, and thus they tend to increase the quantity supplied of
some products and to reduce the quantity supplied of products that are displaced.
 Availability of spare production capacity and the ease with which factor substitution
can be made and the cost of such substitution also determine supply.
5. Government Policy (Taxes & Subsidies)
 An increase in taxes raises the overall cost of production, resulting in a decrease in
the supply of goods or services due to reduced profit margins. Conversely, tax
concessions and subsidies have the opposite effect, increasing the supply of goods as
they make it more financially beneficial for firms to engage in production.
 For instance, if the government imposes higher taxes on a particular industry, such
as the automotive sector, the cost of production for automobile manufacturers will
rise. This increase in costs reduces the profit margin for these manufacturers, leading
them to decrease the supply of vehicles in the market.
6. Nature of competition and size of industry: Under competitive conditions, supply will be
more than that under monopolized conditions.
7. Expectations: Choices of firms in respect of selling the product now or later depends on
expectations of future prices. Sellers compare current prices with future prices. An increase
in the anticipated future price of a good or service reduces its supply today; and if sellers
expect a fall in prices in future, more will be supplied now.
8. Number of sellers: If there are large number of firms in the market, supply will be more.
Besides, entry of new firms, either domestic or foreign, causes the industry supply curve
to shift rightwards.
9. Other Factors: The quantity supplied of a good also depends upon government’s industrial
and foreign policies, goals of the firm, infrastructural facilities, natural factors such as
weather, floods, earthquake and man- made factors such as war, labour strikes, communal
riots etc.

86 Business Economics PW
 THE LAW OF SUPPLY
The law of supply can be stated as, Other things remaining constant, the quantity of a good
produced and offered for sale will increase as the price of the good rises and decrease as the
price falls.
This law is based upon common sense, because the higher the price of the good, the greater
the profits that can be earned and thus greater the incentive to produce the good and offer
it for sale.

CHANGE IN QUANTITY SUPPLIED VS CHANGE IN SUPPLY

1. Change in Quantity Supplied refers to a change in the supply of a commodity that occurs
solely due to a change in its own price. For instance, if the supply of Close-Up toothpaste
changes in response to a change in its own price, it is considered a change in quantity
supplied.
2. Change in Supply refers to a change in the supply of a commodity that is caused by
factors other than its price. These factors may include changes in the price of related
goods, advancements in technology, or alterations in taxation policies. For example, if
the supply of Close-Up toothpaste changes due to a shift in the price of other goods,
advancements in toothpaste manufacturing technology, or a change in taxation policy,
it is referred to as a change in supply.

SUPPLY SCHEDULE
A supply schedule is a table or tabular statement that presents the quantities of a commodity
that are supplied at different price levels over a specified period of time.

SUPPLY CURVE
It is a graphical representation of the supply schedule, showing the various quantities of a
commodity that producers are willing to supply at different price levels, assuming no changes
in other factors.
Y
Price (Rs.) Quantity supplied of
good (units) Individiual supply curve SS
1 5 5
E
4
Price in `

2 10 D
3 15 3 C

4 20 2 B
5 25 1
A

X
O 5 10 15 20 25

Theory of Demand and Supply 87

 SLOPE OF SUPPLY CURVE
The slope of a curve is determined by calculating the change in the variable on the y-axis
divided by t h e change in the variable on the x-axis. Therefore, the slope of the supply curve is
calculated by dividing the change in price (ΔP) by the change in quantity (ΔQ).

MARKET SUPPLY SCHEDULE

In mathematical terms, the slope of the supply curve can be represented as:
Slope of Supply Curve = (ΔP) / (ΔQ)

MARKET SUPPLY SCHEDULE

‰ A market supply schedule is a table that shows the quantities of a commodity that all
producers in a market are willing to sell at different price levels during a specific time
period.
‰ It is derived by aggregating the individual supply schedules of all producers in the market.
‰ The market supply schedule is expressed as: Sm = SA + SB + ... where Sm represents the
market supply, and SA, SB, and so on represent the individual supplies of each supplier.

MARKET SUPPLY CURVE

The market supply curve is a graphical representation that shows the relationship between
the price of a commodity and the total quantity supplied by all producers in the market.
‰ It is derived by horizontally adding or summing up the individual supply curves of each
producer. Y
Market supply curve
Price Individual Supply Market Supply
(Rs.) Px (units) (units) (SA + SA SB SM
5
SB}
Price in `

4
SA SB
1 5 10 5 + 10 = 15 3
2 10 20 10 + 20 = 30 2
3 15 25 15 + 25 = 40
1
4 20 35 20 + 35 = 55
5 25 40 25 + 40 = 65 X
O 10 20 30 40 50
Quantity Supplied (in units)

Market Supply Curve is Flatter

The market supply curve is typically flatter compared to individual supply curves. This
occurs because changes in price result in a proportionately greater change in market supply
compared to the proportionate change in individual supplies.

88 Business Economics PW
 Y
MOVEMENTS ON THE
S
SUPPLY CURVE – INCREASE Movement along
OR DECREASE IN THE supply curve

QUANTITY SUPPLIED P1 B

Price in `
When the quantity supplied of a commodity
changes solely due to a change in its own P A
price, while other factors remain constant, P2
it is referred to as a ‘change in quantity C
supplied’. Graphically, this change is S
represented as a movement along the same X
supply curve. This movement can either O O2 O O1
Quantity
be downward, indicating a contraction in Quantity Supplied (in units)
supply, or upward, indicating an expansion
in supply, along the existing supply curve. Y
S
SHIFTS IN SUPPLY CURVE – Increase in supply S1

INCREASE OR DECREASE
Price in `

IN SUPPLY 20

Rightward Shift In Supply Curve (Increase in

Supply): When the supply curve bodily shifts
towards the right as a result of a change in S
one of the factors that influence the quantity S1
supplied other than the commodity’s own
price, we say there is an increase in supply. X
O 100 150 Quantity
When the supply curve shifts to the right,
Quantity Supplied (in units)
more is offered for sale at each price.

Price (in Rs.) Quantity (in units) Y

S1
20 100
Decrease in supply S
25 150

Leftward Shift (Decrease in Supply):

Price in `

When the factors other than price change 20

and cause the supply curve to shift to the
left, we call it decrease in supply. When
the supply curve shifts to the left, less
quantity is offered for sale at each price. S1
Price (in Rs.) Quantity (in units) S

20 100
X
25 70 O 70 100 Quantity
Quantity Supplied (in units)

Theory of Demand and Supply 89

 ELASTICITY OF SUPPLY
The elasticity of supply is defined as the responsiveness of the quantity supplied of a good to
a change in its price. Elasticity of supply is measured by dividing the percentage change in
quantity supplied of a good by the percentage change in its price i.e.,

(Percentage change in quantity supplied)

Es =
(Percentage change in Price)

Or

(Change in quantity supplied)

(quantity supplied)
Es =
(Change in price)
Price
Or

∆P P
Es = x
∆Q Q
Where,
q denotes original quantity supplied.
∆q denotes change in quantity supplied.
p denotes original price.
∆p denotes change in price.

TRY YOUR UNDERSTANDING 2.3.1

1. Supply is the:
(a) Limited resources that are avail-ab le with the seller.
(b) Cost of producing a good.
(c) Entire relationship between the quantity supplied and the price of good.
(d) Willingness to produce a good if the techno logy to produce it becomes available.
2. The quantity supplied of a good or service is the amount that ______________
(a) Is actually bought during a given time period at a given price.
(b) Producers wish they could sell at a higher price.
(c) Producers plan to sell during a given time period at a given price.
(d) People are willing to buy during a given time period at a given price.
3. In a very short period, the supply:
(a) Can be changed. (b) Cannot be changed.
(c) Can be increased. (d) None of the above.

90 Business Economics PW
 4. Which of the following statement is correct?
(a) Supply is inversely related to its cost of production
(b) Price and quantity demand of a goods have direct relationship
(c) Taxes and subsidy has no impact on the supply of the product
(d) Seasonal changes have no impact on the supply of the commodity
5. Which of the following is a factor determining the supply?
(a) Price of the good (b) Price of related goods
(c) Price of factor of Production (d) All of the above.
6. Other things being equal,the ___________ the relative price of a good the __________ the
quantity of it that will be supplied.
(a) Higher, Lesser (b) Higher, Greater
(c) Lower,Lower (d) None of these
7. According to law of supply, change in supply is related to?
(a) Price of goods (b) Price of related goods
(c) Factors of production (d) None of the above
8. The supply curve for perishable commodities is _____________________ .
(a) Elastic (b) Inelastic
(c) perfectly elastic (d) perfectly inelastic
9. When supply price increase in the short run, the profit of the producer ______________ .
(a) Increases (b) Decreases
(c) Remains constant (d) Decreases marginally Answer:
10. Contraction of supply is the result of:
(a) Decrease in the number of pro-ducers.
(b) Decrease in the price of the good concerned.
(c) Increase in the prices of other goods.
(d) Decrease in the outlay of sellers. Answer:
11. When the supply of a good increase as a result of an increase in _________ its price,then it
is an increase in and there is a upward _____________ the supply curve.
(a) Quantity Supplied, movement on
(b) Quantity Supplied, Shift of
(c) Supply, movement on
(d) Supply, Shift of Answer:
12. Movements on the supply curve may be due to:
(a) Change in price of goods
(b) Change in price of related goods
(c) Change in technology
(d) None of the above. Answer:

Theory of Demand and Supply 91

13. Contraction of supply implies ______________ .
(a) Decrease in cost of production
(b) Decrease in price of the good concerned
(c) Decrease in price of related good
(d) Increase in price of the good concerned Answer:
14. When supply curve moves to the left, it means
(a) Smaller supply at a given price.
(b) Larger supply at a given price.
(c) Constant supply at a lower price.
(d) None of the above.
15. When the supply curve shifts to the left or right, it is called as respectively. ___________or
___________ in supply,
(a) Decrease, Decrease(b)Decreases, Increase
(c) Increase, Increase (d)Increase, Decrease.

Answer Key
1. (c) 2. (c) 3. (b) 4. (a) 5. (d) 6. (b) 7. (a) 8. (d) 9. (a) 10. (b)
11. (a) 12. (b) 13. (b) 14. (a) 15. (b)

TYPES OF SUPPLY ELASTICITY

1. Perfectly inelastic supply
Y S
 If as a result of a change in price, the quantity
supplied of a good remains unchanged, we say that ES = 0
the elasticity of supply is zero or the good has P1
perfectly inelastic supply (Es = 0.).
Price

 Supply curve is Vertical (i.e. Parallel to Y axis) P

2. Relatively less-elastic supply

S X
 If as a result of a change in the price of a good its O Q
supply changes less than proportionately, we say Quantity Supplied (in units)
that the supply of the good is relatively less elastic
or elasticity of supply is less than one. Y
 In this case, the coefficient of elasticity falls in the range ES < 0 S
0 < Es < 1 P1
Price

 The percentage change in quantity is less than the P

P
percentage change in price. Q
S
 In other words, the quantity is not very responsive to X
price. O Q Q1
Quantity Supplied

92 Business Economics PW
 Highly Elastic Supply
3. Relatively greater-elastic supply
‰ If elasticity of supply is greater than one i.e., when the Y SS
quantity supplied of a good changes substantially in ES > 0
P1

Price in `
response to a small change in the price of the good we
say that supply is relatively elastic.
P
‰ The percentage change in quantity is greater than the
percentage change in price.
The coefficient of elasticity falls in the range 1 < E < ∞. X
‰ O Q Q1
4. Unit-elastic Quantity Supplied (in units)
‰ In this case, the coefficient of elasticity is one.(Es = 1). Y
‰ If the relative change in the quantity supplied is exactly
ES = 0
equal to the relative change in the price, the supply is said S
P1
to be unitary elastic. P

Price
‰ The percentage change in quantity is equal to the percentage P
change in price. S Q
Unit elasticity is essentially a dividing line or boundary S
‰ X
between the elastic and inelastic ranges. O Q Q1
Quantity Supplied
5. Perfectly elastic supply
Y
‰ At the opposite extreme of zero elasticity supply is perfectly
elastic. ES = 
S S
This occurs as the price elasticity of supply approaches infinity P

Price
‰
and the supply curve becomes horizontal.
‰ Elasticity of supply is said to be infinite (E = ∞)or perfectly X
O Q Q1
elastic when nothing is supplied at a lower price and an
Quantity Supplied
infinitesimally small change in price results in an infinitely
large change in quantity supplied indicating that producers
will supply any quantity demanded at that price.

‰ In some cases, the elasticity of supply is not constant but

varies over the supply curve.
‰ In the case of an industry with limited capacity for
production. For low levels of quantity supplied, firms Y
respond substantially to changes in price. P4
‰ When there is a small rise in price from P1 to P2 ,the E<1
P3
q u a n t i t y supplied increases more than proportionately
Price

( Q 1 to Q2).
‰ In this region, firms have idle capacity and therefore when P2 E>1
price rises, they respond by increase in quantity supplied P1
using the idle capacity available.
X
‰ Once fir ms reach their full capacity, further increase in O Q1Q2 Q3Q4
production is possible only by building new plants and Quantity Supplied
incurring expenses towards this.
‰ To induce firms to increase output, price must rise
substantially (P3 to P4) and supply becomes less elastic.

Theory of Demand and Supply 93

 MEASUREMENT OF SUPPLY-ELASTICITY
1. Percentage / Proportionate Method: According to this method elasticity of supply is calculated
by dividing a % or proportionate c h a n g e in supply with the % or proportionate change in
price.

Percentage change in quantity supplied

Es =
Percentage change in Price
2. Point elasticity:
 The elasticity of supply can be considered with reference to a given point on the
supply curve or between two points on the supply curve. When elasticity is measured
at a given point on the supply curve, it is called point elasticity.
 Point-elasticity of supply can be measured with the help of the following formula:

∆Q P
Es = ×
∆P Q

3. Arc Elasticity: In situations where there is a relatively larger price change and we need
to measure elasticity over a range or arc, rather than at a specific point, we utilize the
concept of arc elasticity. Arc elasticity involves calculating the average of the two prices
and quantities, both original and new, to determine the elasticity of demand or supply
over the specified range.
Q2 – Q1 P2 + P1
Es = ×
Q2 + Q1 P2 − P1
Where P1 Q1 are original price and quantity and P2 Q2 are new price and quantity
supplied.

DETERMINANTS OF ELASTICITY OF SUPPLY

Following are the general determinants of elasticity of supply:
1. If increase in production causes substantial increase in costs, producers will have less
incentive to increase quantity supplied in response to increase in price and therefore,
price elasticity of supply would be less. If there are constant costs or negligible rise in
costs as output increases, supply will be elastic.
Similarly, Products that involve more complex production processes or require relatively
longer time to produce exhibit lower elasticity of supply. For example the supply of
aircrafts and cruise ships is less elastic compared to supply of motor bikes
2. The longer the period of time, the more responsive the quantity supplied to changes in
price and the greater the supply elasticity. A shorter time period does not allow sellers
sufficient time to find resources and alternatives and to adjust their production decisions
to changes in price. In the long run, firms can build new plants or new firms may be
able to enter the market and increase the supply.
3. Supply is more elastic when there is large number of producers and there is high degree
of competition among them. Supply elasticity is also higher when there are fewer barriers
of entry into the market.

94 Business Economics PW
 4. Supply will be elastic if firms are not working to full capacity. If spare production capacity
is available with the firms, they can increase output without a rise in costs. The greater
the spare capacity available, the greater will be the elasticity of supply.
5. If key raw materials and inputs are easily and cheaply available, then supply will be
elastic. If drawing productive resources into the industry is easier, the supply curve is
more elastic. In case it is difficult to procure resources economically, the cost of production
increases and supply will become less elastic.
6. If firms have adequate stocks of raw materials, components and finished products, they
will be able to respond with higher supply as price rises. Generally, those commodities
which can be easily and inexpensively stored without losing value may have elastic supply.
7. The ease and cost of factor substitution influence price elasticity of supply. Commonly
available and easily substituted factors allow for quick production response to price
changes. Scarcity of specialized materials or labor with longer training periods reduces Quantity 19
supply elasticity. For example, physicians in healthcare industry and chartered accountants
Demand
in accounting service.
8. If both capital and labour are occupationally mobile, then the elasticity of supply for a E
product is higher than if capital and labour cannot be easily switched. For example, a
printing press can easily switch between printing magazines and greeting cards. Similarly Supply
falling prices of a particular vegetable encourage farmers to switch to the production of
another. Products which are more continuously produced have greater supply elasticity
than those which are produced infrequently.
(a) Expectations about future prices also affect elasticity of supply. Expectation of
substantial rise in prices in future will make the sellers respond less to a current rise
in price.

EQUILIBRIUM PRICE
‰ The equilibrium price in a market is determined by the intersection between demand
and supply. It is also called the market equilibrium.
‰ At this price, the amount that the buyers want to buy is equal to the amount that sellers
want to sell.
‰ The competitive market equilibrium represents the ‘unique’ point at which both consumers
and suppliers are satisfied with price and quantity.
‰ Equilibrium price is also called market clearing price.
‰ The determination of market price is the central theme of micro economic analysis.
Hence, micro-economic theory is also called price theory
price

Price Demand Supply Impact On Price

Supply
5 6 31 Downward
4 12 25 Downward
E
3 19 19 Equilibrium 3
2 25 12 Upward
Demand
1 31 6 Upward
O 19 Quantity

Theory of Demand and Supply 95

 MARKET EQUILIBRIUM AND SOCIAL EFFICIENCY
‰ Social efficiency represents the net gains to society from
Y
all exchanges that are made in a particular market. It
consists of two components: consumer surplus and
producer surplus.
S
consumer surplus is a measure of consumer welfare

price
‰
whereas Producer surplus is the benefit derived by Consumer
surplus
producers from the sale of a unit above and beyond P
Producer
their cost of producing that unit. surplus
‰ Producer surplus can be calculated as the area above D
the supply curve and below the market price.
O Q X
‰ It represents the additional revenue or profit that Quantity Exchanged
producers gain when the market price exceeds their
production costs.

TRY YOUR UNDERSTANDING 2.3.2

1. Elasticity of supply refers to the degree of responsiveness of supply of a good to changes

in its:
(a) Deand. (b) Price.
(c) Cost of production. (d) State of technology.
2. The elastic ity of supply is defined as the _______
(a) Responsiveness of the quantity supplied of a good to a change in its price.
(b) Responsiveness of the quan-,tity supplied of a good without change in its price.
(c) Responsiveness of the quantity demanded of a good to a change in its price.
(d) Responsiveness of the quantity demanded of a good without change in its price.

3. When price of a commodity Rises from 200 to ‘{ 300 and Quantity supply increases
from 2,000 to 5,000 units find elasticity of supply?
(a) 3.0 (b) 2.5 (c) 0.3 (d) 3.5

4. If price of computers increases by 10% and supply increases by 25%. The elasticity of
supply is :
(a) 2.5 (b) 0.4 (c) (-) 2.5 (d) (-) 0.4

5. The Price of Commodity X in-creased from ‘{ 2,000 per unit to ‘{ 2,100 per unit and
consequently the quantity supplied rises from 2,500 units to 3,000 units. The Elasticity
of supply will be
(a) 2 (b) 4 (c) .25 (d) 0
6. Perishable commodities will have _______
(a) Perfectly elastic curve (b) Perfectly inelastic curve
(c) Elastic (d) Inelastic

96 Business Economics PW
 7. A vert ical supply curve parallel to Y axis implies that the elasticity of supply is:
(a) Zero (b) Infinity
(c) Equalto one (d) Greater than zero but less than infinity
8. A horizontal supply curve parallelto the quantity axis implies that the elasticity of supply
is:
(a) Zero. (b) Infinite.
(c) Equal to one. (d) Greater than zero but less than one.
9. When the supply of a product is perfectly inelastic then the curve will be
(a) Parallel to Y - axis (b) Parallel to X - axis
(c) At the angle of 45° (d) Sloping upwards
10. The cross elasticity between Rye bread and Whole Wheat bread is expected to be:
(a) Positive (b) Negative (c) Zero (d) Can’t say
11. Equilibrium refers to a market situation where quantity demand is to quantity supplied.
(a) Equal (b) Less than or Equal
(c) More than (d) More than or equal
12. The equilibrium price is deter-mined by the inter-section between and
It is also called as the equilibrium.
(a) Demand, Supply, Static (b) Demand Supply, Dynamic
(c) Supply, Demand, Partial (d) Demand, Supply, Market
13. Suppose the price of movies seen at a theater rise from Rs.120 per person to Rs.200
per person .The theater manager observes that the rise in price causes attendance at a
given movie to fall from 300 persons to 200 persons .What is the price elasticity of
demand for movies ?
(a) 0.5 (b) 0.8 (c) 1 (d) 1.2
14. A discount store has a special offer on CD’s .It reduces their from Rs.150 to Rs.100.
Suppose the store manager observes that the quantity demanded increases from 700
CD’s to 1,300 CD’s .What is the price elasticity of demand for CD’s ?
(a) 0.8 (b) 1 (c) 1.25 (d) 1.5

Answer Key
1. (b) 2. (a) 3. (a) 4. (a) 5. (b) 6. (b) 7. (a) 8. (b) 9. (a) 10. (a)
11. (a) 12. (d) 13. (b) 14. (d)

Important Economist name in the chapter (1) Substitution Effect

Hicks and Allen (2) Indifference curve analysis
James Dusesenberry Demonstration Effect
Thorstein Veblen (1) Veblen Effect
(2) Conspicuous Consumption
Robert Giffen Giffen Goods
Olaf Helmer Delphi Technique

Theory of Demand and Supply 97

 EXERCISE
1. Demand for a commodity refers to:
(a) desire backed by ability to pay for the commodity.
(b) need for the commodity and willingness to pay for it
(c) the quantity demanded of that commodity at acertain price.
(d) the quantity of the commodity demanded at a certain price during any particular
period of time.
2. Contraction of demand is the result of :
(a) decrease in the number of consumers.
(b) increase in the price of the good concerned.
(c) increase in the prices of other goods.
(d) decrease in the income of purchasers.
3. All but one of the following are assumed to remain the same while drawing an individual’s
demand curve for a commodity. Which one is it?
(a) The preference of the individual.
(b) His monetary income.
(c) Price of the commodity
(d) Price of related goods.
4. Which of the following pairs of goods is an example of substitutes?
(a) Tea and sugar. (b) Tea and coffee.
(c) Pen and ink. (d) Shirt and trousers.
5. In the case of a straight line demand curve meeting the two axes, the price-elasticity of
demand at the mid-point of the line would be :
(a) 0 (b) 1 (c) 1.5 (d) 2
6. The Law of Demand, assuming other things to remain constant, establishes the relationship
between:
(a) income of the consumer and the quantity of a good demanded by him.
(b) price of a good and the quantity demanded.
(c) price of a good and the demand for its substitute.
(d) quantity demanded of a good and the relative prices of its complementary goods.
7. Identify the factor which generally keeps the price-elasticity of demand for a good low:
(a) Variety of uses for that good.
(b) Very low price of a commodity
(c) Close substitutes for that good.
(d) High proportion of the consumer’s income spent on it.

98 Business Economics PW
 8. Identify the coefficient of price-elasticity of demand when the percentage increase in
the quantity of a good demanded is smaller than the percentage fall in its price:
(a) Equal to one. (b) Greater than one.
(c) Less than one. (d) Zero.
9. In the case of an inferior good, the income elasticity of demand is:
(a) positive. (b) Zero. (c) Negative. (d) infinite.
10. If the demand for a good is inelastic, an increase in its price will cause the total expenditure
of the consumers of the good to:
(a) Remain the same. (b) Increase.
(c) Decrease. (d) Any of these.
11. If regardless of changes in its price, the quantity demanded of a good remains unchanged,
then the demand curve for the good will be:
(a) horizontal. (b) Vertical.
(c) positively sloped. (d) negatively sloped.
12. Suppose the price of Pepsi increases, we will expect the demand curve of Coca Cola to:
(a) Shift towards left since these are substitutes
(b) Shift towards right since these are substitutes
(c) Remain at the same level
(d) None of the above
13. All of the following are determinants of demand except:
(a) Tastes and preferences. (b) Quantity supplied.
(c) Income of the consumer (d) Price of related goods.
14. A movement along the demand curve for soft drinks is best described as :
(a) An increase in demand.
(b) A decrease in demand.
(c) A change in quantity demanded.
(d) A change in demand.
15. If the price of Pepsi decreases relative to the price of Coke and 7-UP, the demand for :
(a) Coke will decrease . (b) 7-Up will decrease.
(c) Coke and 7-UP will increase. (d) Coke and 7-Up will decrease.
16. If a good is a luxury, its income elasticity of demand is:
(a) Positive and less than 1. (b) Negative but greater than -1.
(c) Positive and greater than 1. (d) Zero.
17. The price of hot dogs increases by 22% and the quantity of hot dogs demanded falls by
25%. This indicates that demand for hot dogs is :
(a) Elastic. (b) Inelastic.
(c) Unitarily elastic. (d) Perfectly elastic.

Theory of Demand and Supply 99

18. If the quantity demanded of mutton increases by 5% when the price of chicken increases
by 20%, the cross-price elasticity of demand between mutton and chicken is
(a) -0.25 (b) 0.25 (c) -4 (d) 4
19. Given the following four possibilities, which one results in an increase in total consumer
expenditure?
(a) Demand is unitary elastic and price falls.
(b) Demand is elastic and price rises.
(c) Demand is inelastic and price falls.
(d) Demand is inelastic and prices rises.
20. Which of the following statements about price elasticity of supply is correct?
(a) Price elasticity of supply is a measure of how much the quantity supplied of a good
responds to a change in the price of that good
(b) Price elasticity of supply is computed as the percentage change in quantity supplied
divided by the percentage change in price
(c) Price elasticity of supply in the long run would be different from that of the short
run
(d) All the above
21. Which of the following is an incorrect statement?
(a) When goods are substitutes, a fall in the price of one (ceteris paribus) leads to a fall
in the quantity demanded of its substitutes.
(b) When commodities are complements, a fall in the price of one (other things being
equal) will cause the demand of the other to rise
(c) As the income of the consumer increases, the demand for the commodity increases
always and vice versa.
(d) When a commodity becomes fashionable people prefer to buy it and therefore its
demand increases
22. Suppose the price of movies seen at a theatre rises from Rs 120 per person to Rs 200
per person. The theatre manager observes that the rise in price causes attendance at a
given movie to fall from 300 persons to 200 persons. What is the price elasticity of
demand for movies? (Use Arc Elasticity Method)
(a) .5 (b) .8 (c) 1.0 (d) 1.2
23. Suppose a department store has a sale on its silverware. If the price of a plate-setting
is reduced from Rs 300 to Rs 200 and the quantity demanded increases from 3,000
plate-settings to 5,000 plate-settings, what is the price elasticity of demand for
silverware? (Use Arc Elasticity Method)
(a) .8 (b) 1.0 (c) 1.25 (d) 1.50
24. When the numerical value of cross elasticity between two goods is very high, it means
(a) The goods are perfect complements and therefore have to be used together
(b) The goods are perfect substitutes and can be used with ease in place of one another
(c) There is a high degree of substitutability between the two goods
(d) The goods are neutral and therefore cannot be considered as substitutes

100 Business Economics PW

25. If the local pizzeria raises the price of a medium pizza from ` 60 to ` 100 and quantity
demanded falls from 700 pizzas a night to 100 pizzas a night, the price elasticity of
demand for pizzas is : (Use Arc Elasticity Method)
(a) .67 (b) 1.5 (c) 2.0 (d) 3.0
26. If electricity demand is inelastic, and electricity charges increase, which of the following
is likely to occur?
(a) Quantity demanded will fall by a relatively large amount.
(b) Quantity demanded will fall by a relatively small amount.
(c) Quantity demanded will rise in the short run, but fall in the long run.
(d) Quantity demanded will fall in the short run, but rise in the long run.
27. Suppose the demand for meals at a medium-priced restaurant is elastic. If the management
of the restaurant is considering raising prices, it can expect a relatively:
(a) Large fall in quantity demanded.
(b) Large fall in demand.
(c) Small fall in quantity demanded.
(d) Small fall in demand.
28. Point elasticity is useful for which of the following situations?
(a) The bookstore is considering doubling the price of notebooks.
(b) A restaurant is considering lowering the price of its most expensive dishes by 50
percent.
(c) An auto producer is interested in determining the response of consumers to the price
of cars being lowered by Rs 100.
(d) None of the above.
29. A decrease in price will result in an increase in total revenue if :
(a) The percentage change in quantity demanded in less than the percentage change in
price.
(b) The percentage change in quantity demanded is greater than the percentage change
in price.
(c) Demand is inelastic.
(d) The consumer is operating along a linear demand curve at a point at which the price
is very low and the quantity demanded is very high.
30. An increase in price will result in an increase in total revenue if :
(a) The percentage change in quantity demanded is less than the percentage change in
price.
(b) The percentage change in quantity demanded is greater than the percentage change
in price.
(c) Demand is elastic.
(d) The consumer is operating along a linear demand curve at a point at which the price
is very high and the quantity demanded is very low.

Theory of Demand and Supply 101

31. Demand for a good will tend to be more elastic if it exhibits which of the following
characteristics?
(a) It represents a small part of the consumer’s income.
(b) The good has many substitutes available.
(c) It is a necessity (as opposed to a luxury).
(d) There is little time for the consumer to adjust to the price change.
32. Demand for a good will tend to be more inelastic if it exhibits which of the following
characteristics?
(a) The good has many substitutes.
(b) The good is a luxury (as opposed to a necessity).
(c) The good is a small part of the consumer’s income.
(d) There is a great deal of time for the consumer to adjust to the change in prices.
33. Suppose a consumer’s income increases from `30,000 to `36,000. As a result, the
consumer increases her purchases of compact discs (CDs) from 25 CDs to 30 CDs. What
is the consumer’s income elasticity of demand for CDs? (Use Arc Elasticity Method)
(a) 0.5 (b) 1.0 (c) 1.5 (d) 2.0
34. Total utility is maximum when :
(a) Marginal utility is zero. (b) Marginal utility is at its highest point.
(c) Marginal utility is negative (d) None of the above
35. Which one is not an assumption of the theory of demand based on analysis of indifference
curves?
(a) Given scale of preferences as between different combinations of two goods.
(b) Diminishing marginal rate of substitution.
(c) Diminishing marginal utility of money
(d) Consumers would always prefer more of a particular good to less of it, other things
remaining the same.
36. An indifference curve slopes down towards right since more of one commodity and less
of another result in:
(a) Same level of satisfaction. (b) Greater satisfaction.
(c) Maximum satisfaction. (d) Any of the above
37. Suppose that workers in a steel plant managed to force a significant increase in their
wage package. How would the new wage contract be likely to affect the market supply
of steel, other things remaining the same?
(a) Supply curve will shift to the left.
(b) Supply curve will shift to the right.
(c) Supply will not shift, but the quantity of cars produced per month will decrease.
(d) Supply will not shift, but the quantity of cars produced per month will increase.

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38. Which of the following statements is incorrect?
(a) An indifference curve must be downward-sloping to the right.
(b) Convexity of a curve implies that the slope of the curve diminishes as one moves from
left to right.
(c) The income elasticity for inferior goods to a consumer is positive
(d) The total effect of a change in the price of a good on its quantity demanded is called
the price effect.
39. The successive units of stamps collected by a little boy give him greater and greater
satisfaction. This is a clear case of
(a) Operation of the law of demand.
(b) Consumer surplus enjoyed in hobbies and rare collections
(c) Exception to the law of diminishing utility.
(d) None of the above
40. What will happen in the rice market if buyers are expecting higher rice prices in the
near future?
(a) The demand for rice will increase and the demand curve will shift to the right
(b) The demand for rice will decrease and the demand curve will shift to the left
(c) The demand for rice will be unaffected as it is a necessity
(d) The demand for wheat will increase and the demand curve will shift to the right
41. In the case of a Giffen good, the demand curve will usually be :
(a) horizontal. (b) downward-sloping to the right.
(c) vertical. (d) upward-sloping to the right.
42. By consumer surplus, economists mean
(a) The area inside the budget line above the price of the commodity
(b) The area between the average revenue and marginal revenue curves.
(c) The difference between the maximum amount a person is willing to pay for a good
and its market price.
(d) The difference between the market price and the supply curve
43. Which of the following is a property of an indifference curve?
(a) It is convex to the origin due to diminishing marginal rate of substitution
(b) The marginal rate of substitution is constant as you move along an indifference curve.
(c) Marginal utility is constant as you move along an indifference curve.
(d) Total utility is greatest where the budget line line cuts the indifference curve.
44. When economists speak of the utility of a certain good, they are referring to
(a) The demand for the good.
(b) The usefulness of the good in consumption.
(c) The expected satisfaction derived from consuming the good.
(d) The rate at which consumers are willing to exchange one good for another.

Theory of Demand and Supply 103

45. A vertical supply curve parallel to Y axis implies that the elasticity of supply is :
(a) Zero (b) Infinity
(c) Equal to one (d) Greater than zero but less than infinity.
46. For a normal good with a downward sloping demand curve:
(a) The price elasticity of demand is negative; the income elasticity of demand is negative.
(b) The price elasticity of demand is positive; the income elasticity of demand is negative.
(c) The price elasticity of demand is positive; the income elasticity of demand is positive.
(d) The price elasticity of demand is negative; the income elasticity of demand is positive.
47. An increase in the supply of a good is caused by :
(a) Improvements in its production technology
(b) Fall in the prices of other goods which can be produced using the same inputs .
(c) Fall in the prices of factors of production used in its production .
(d) all of the above.
48. Elasticity of supply refers to the degree of responsiveness of supply of a good to changes
in its:
(a) Demand. (b) Price.
(c) Cost of production. (d) State of technology.
49. A horizontal supply curve parallel to the quantity axis implies that the elasticity of supply is:
(a) Zero. (b) Infinite.
(c) Equal to one. (d) Greater than zero but less than one.
50. Contraction of supply is the result of :
(a) Decrease in the number of producers.
(b) Decrease in the price of the good concerned.
(c) Increase in the prices of other goods.
(d) Decrease in the outlay of sellers.
51. Conspicuous goods are also known as
(a) Prestige goods (b) Snob goods
(c) Veblen goods (d) All of the above
52. The quantity purchased remains constant irrespective of the change in income. This is
known as
(a) negative income elasticity of demand
(b) income elasticity of demand less than one
(c) zero income elasticity of demand
(d) income elasticity of demand is greater than one
53. As income increases, the consumer will go in for superior goods and consequently the
demand for inferior goods will fall. This means inferior goods have
(a) income elasticity of demand less than one
(b) negative income elasticity of demand

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 (c) zero income elasticity of demand
(d) unitary income elasticity of demand
54. When income increases the money spent on necessaries of life may not increase in the
same proportion, This means
(a) income elasticity of demand is zero
(b) income elasticity of demand is one
(c) income elasticity of demand is greater than one
(d) income elasticity of demand is less than one
55. The luxury goods like jewellery and fancy articles will have
(a) low income elasticity of demand
(b) high income elasticity of demand
(c) zero income elasticity of demand
(d) none of the above
56. A good which cannot be consumed more than once is known as
(a) Durable good (b) Non-durable good
(c) Producer good (d) None of the above
57. A relative price is
(a) price expressed in terms of money
(b) what you get paid for babysitting your cousin
(c) the ratio of one money price to another
(d) equal to a money price
58. A point below the budget line of a consumer
(a) Represents a combination of goods which costs the whole of consumer’s income
(b) Represents a combination of goods which costs less than the consumer’s income
(c) Represents a combination of goods which is unattainable to the consumer given his/
her money income
(d) Represents a combination of goods which costs more than the consumers’ income
59. Demand is the
(a) the desire for a commodity given its price and those of related commodities
(b) the entire relationship between the quantity demanded and the price of a good other
things remaining the same
(c) willingness to pay for a good if income is larger enough
(d) ability to pay for a good
60. Suppose potatoes have (-).0.4 as income elasticity. We can say from the data given that:
(a) Potatoes are superior goods.
(b) Potatoes are necessities.
(c) Potatoes are inferior goods.
(d) There is a need to increase the income of consumers so that they can purchase
potatoes.
Theory of Demand and Supply 105
61. The price of tomatoes increases and people buy tomato puree. You infer that tomato
puree and tomatoes are
(a) Normal goods (b) Complements
(c) Substitutes (d) Inferior goods
62. Chicken and fish are substitutes. If the price of chicken increases, the demand for fish will
(a) Increase or decrease but the demand curve for chicken will not change
(b) Increase and the demand curve for fish will shift rightwards.
(c) Not change but there will be a movement along the demand curve for fish.
(d) Decrease and the demand curve for fish will shift leftwards.

63. Potato chips and popcorn are substitutes. A rise in the price of potato chips will _______
the demand for popcorn and the quantity of popcorn sold will _______
(a) increase; increase(b)increase; decrease
(c) decrease; decrease(d)decrease; increase

64. If the price of orange Juice increases, the demand for apple Juice will _______.
(a) increase because they are substitutes
(b) decrease because they are substitutes
(c) remain the same because real income is increased
(d) decrease as real income decreases
65. An increase in the demand for computers, other things remaining same, will:
(a) Increase the number of computers bought.
(b) Decrease the price but increase the number of computers bought.
(c) Increase the price of computers.
(d) Increase the price and number of computers bought.
66. When total demand for a commodity whose price has fallen increases, it is due to:
(a) Income effect. (b) Substitution effect
(c) Complementary effect (d) Price effect
67. With a fall in the price of a commodity:
(a) Consumer’s real income increases
(b) Consumer’s real income decreases
(c) There is no change in the real income of the consumer
(d) None of the above
68. With an increase in the price of diamond, the quantity demanded also increases. This is
because it is a:
(a) Substitute good (b) Complementary good
(c) Conspicuous good (d) None of the above
69. An example of goods that exhibit direct price-demand relationship is
(a) Giffen goods (b) Complementary goods
(c) Substitute goods (d) None of the above

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70. In Economics, when demand for a commodity increases with a fall in its price it is known
as:
(a) Contraction of demand (b) Expansion of demand
(c) No change in demand (d) None of the above
71. The quantity supplied of a good or service is the amount that
(a) is actually bought during a given time period at a given price
(b) producers wish they could sell at a higher price
(c) producers plan to sell during a given time period at a given price
(d) people are willing to buy during a given time period at a given price
72. Supply is the
(a) limited resources that are available with the seller
(b) cost of producing a good
(c) entire relationship between the quantity supplied and the price of good.
(d) Willingness to produce a good if the technology to produce it becomes available
73. In the book market, the supply of books will decrease if any of the following occurs except
(a) a decrease in the number of book publishers
(b) a decrease in the price of the book
(c) an increase in the future expected price of the book
(d) an increase in the price of paper used.
74. If price of computers increases by 10% and supply increases by 25%. The elasticity of
supply is :
(a) 2.5 (b) 0.4 (c) (-) 2.5 (d) (-) 0.4
75. An increase in the number of sellers of bikes will increase the
(a) The price of a bike(b)Demand for bikes
(c) The supply of bikes (d)Demand for helmets
76. If the supply of bottled water decreases, other things remaining the same, the equilibrium
price _______ and the equilibrium quantity _______
(a) increases ; decreases (b) decreases; increases
(c) decreases; decreases (d) increases; increases
77. A decrease in the demand for cameras, other things remaining the same will
(a) Increase the number of cameras bought
(b) Decrease the price but increase the number of cameras bought
(c) Decrease in quantity of camera demanded
(d) Decrease the price and decrease in the number of cameras bought.
78. Which of the following statements about inferior goods is/are false?
(i) Inferior goods are those that we will never buy, no matter how cheap they are.
(ii) Inferior goods are those that we buy more of, if we become poorer.

Theory of Demand and Supply 107

 (iii) Inferior goods are those that we buy more of, if we become richer.
(a) (i) and (iii) only. (b) (i) only.
(c) (iii) only. (d) (i), (ii), and (iii)
79. Comforts lie between
(a) inferior goods and necessaries
(b) luxuries and inferior goods
(c) necessaries and luxuries
(d) none of the above
80. In a very short period, the supply
(a) can be changed (b) can not be changed
(c) can be increased(d) none of the above
81. When supply curve moves to the left, it means
(a) lesser quantity is supplied at a given price
(b) larger quantity is supplied at a given price
(c) prices have fallen and quantity is supplied at a lower price
(d) none of the above
82. When supply curve moves to right, it means
(a) supply increases and more quantity is supplied at a given price
(b) supply decreases and less quantity is supplied at a given price
(c) supply remains constant at a given price
(d) none of the above
83. The elasticity of supply is defined as the
(a) responsiveness of the quantity supplied of a good to a change in its price
(b) responsiveness of the quantity supplied of a good without change in its price
(c) responsiveness of the quantity demanded of a good to a change in its price
(d) responsiveness of the quantity demanded of a good without change in its price
84. Elasticity of supply is measured by dividing the percentage change in quantity supplied
of a good by _______
(a) Percentage change in income
(b) Percentage change in quantity demanded of goods
(c) Percentage change in price
(d) Percentage change in taste and preference
85. Elasticity of supply is zero means
(a) perfectly inelastic supply
(b) perfectly elastic supply
(c) imperfectly elastic supply
(d) none of the above

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86. Elasticity of supply is greater than one when
(a) Proportionate change in quantity supplied is more than the proportionate change in
price.
(b) Proportionate change in price is greater than the proportionate change in quantity
supplied.
(c) change in price and quantity supplied are equal
(d) None of the above
87. If the quantity supplied is exactly equal to the relative change in price then the elasticity
of supply is
(a) Less than one (b) Greater than one
(c) One (d) None of the above
88. The price of a commodity decreases from Rs 6 to Rs 4 and the quantity demanded of
the good increases from 10 units to 15 units, find the coefficient of price elasticity.
(a) 1.5 (b) 2.5 (c) -1.5 (d) 0.5
89. The supply function is given as Q = -100 + 10P. Find the elasticity using point method,
when price is ` 15.
(a) 4 (b) -3 (c) -5 (d) 3
90. The figure below shows the budget constraint of a consumer with an income of `900/-
to spend on two commodities, namely ice cream and chocolates.
Y
90
Quantity of
Chocolates

0 45 X
Cups of Ice cream

The prices of these two commodities respectively are:

(a) Rs. 10 and Rs 20 (b) Rs 20 and Rs. 10
(c) Rs. 10 and Rs 5 (d) Any of the above
91. ‘No matter what the price of coffee is, Arjun always spend a total of exactly 100 per
week on coffee.’ The statement implies that:
(a) Arjun is very fond of coffee and therefore he has an inelastic demand for coffee
(b) Arjun has elastic demand for coffee
(c) Arjun’s demand for coffee is relatively less elastic
(d) Arjun’s demand for coffee is unit elastic

Theory of Demand and Supply 109

92. A firm learns that the own price elasticity of a product it manufactures is 3.5. What
would be the correct action for this firm to take if it wishes to raise its total revenue?
(a) Lower the price because demand for the good is elastic.
(b) Raise the price because demand for the product is inelastic.
(c) Raise the price because demand is elastic.
(d) We need information in order to answer this question.
93. At higher prices people demand more of certain goods not for their worth but for their
prestige value – This is called
(a) Veblen effect (b) Giffens paradox
(c) Speculative effect (d) None of the above
94. If the price of air-conditioner increases from `30,000 to `30,010 and resultant change
in demand is negligible, we use the measure of _______ to measure elasticity.
(a) Point elasticity of demand since it is a small change
(b) Arc elasticity of demand since it is a small change
(c) Price elasticity based on average prices method
(d) Any of the above
95. Given the following four possibilities, which one will result in an increase in total
expenditure of the consumer?
(a) Demand is unit elastic and price rises
(b) Demand is elastic and price rises
(c) Demand is inelastic and price falls
(d) demand is inelastic and price rises
96. The supply curve shifts to the right because of _______
(a) improved technology
(b) increased price of factors of production
(c) increased excise duty
(d) all of the above
97. Which of the following statements is correct?
(a) When the price falls the quantity demanded falls
(b) Seasonal changes do not affect the supply of a commodity
(c) Taxes and subsidies do not influence the supply of the commodity
(d) With lower cost, it is profitable to supply more of the commodity.
98. If the demand is more than supply, then the pressure on price will be
(a) Upward (b) Downward
(c) Constant (d) None of the above
99. The supply curve for highly perishable commodities during very short period is generally
_______
(a) Elastic (b) Inelastic
(c) Perfectly elastic (d) Perfectly inelastic
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100. Supply is a ___________ concept.
(a) Stock (b) Flow and stock
(c) Flow (d) None of the above
101. The cross elasticity between Rye bread and Whole Wheat bread is expected to be:
(a) Positive (b) Negative
(c) Zero (d) Can’t say
102. The cross elasticity between personal computers and soft wares is:
(a) Positive (b) Zero
(c) Negative (d) One
103. The cross elasticity between Bread and DVDs is:
(a) Positive (b) Negative
(c) Zero (d) One
104. Which of the following statements is correct?
(a) With the help of statistical tools, the demand can be forecasted with perfect
accuracy
(b) The more the number of substitutes of a commodity, the more elastic is the demand.
(c) Demand for butter is perfectly elastic.
(d) Gold jewellery will have negative income elasticity.
105. Suppose the income elasticity of education in private school in India is 3.6. What does
this indicate:
(a) Private school education is highly wanted by rich
(b) Private school education is a necessity.
(c) Private school education is a luxury.
(d) We should have more private schools.
106. If the organizers of an upcoming cricket match decide to increase the ticket price in
order to raise its revenues, what they have learned from past experience is;
(a) The percentage increase in ticket rates will be always equal the percentage decrease
in tickets sold
(b) The percentage increase in ticket rates will be always greater than the percentage
decrease in tickets sold
(c) The percentage increase in ticket rates will be less than the percentage decrease
in tickets sold
(d) (a) and (c) above are true
107. Data on production of vegetables for the past two years showed that, despite stable
prices, there is a substantial decline in output of cabbage leading to lower supply into
the market. Which of the following can possibly be the reason?
(a) An increase in the price of cauliflower which is equally preferred by consumers
(b) Announcement of a subsidy by government on vegetable production
(c) More farmers producing cabbage and the increasing competition among them
(d) A substantial decrease in the price of capsicum

Theory of Demand and Supply 111

108. The following diagram shows the relationship between price of Good X and quantity
demanded of Good Y. What we infer from the diagram is ;
Y

Price of Good X
D

X
0 Quantity demanded of Good Y

(a) Good X and Good Y are perfect complements

(b) Good X and Good Y are perfect substitutes
(c) Good X and Good Y are remote substitutes
(d) Good X and Good Y are close substitutes
109. The diagram given below shows
Y

D1
D2
Price

D1
D2
0 X
Q1 Q
(a) A change in demand which may be caused by a rise in income and the good is a
normal good
(b) A shift of demand curve caused by a fall in the price of a complementary good
(c) A change in demand which is caused by a rise in income and the good is an inferior
good
(d) A shift of demand curve caused by a rise in the price of a substitute and the good
is a normal good.

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110. Which of the following alternatives would be true if the event presented in the following
diagram occurs?
Y

S1

Price
P

S1

0 X
Q1 Q
Quantity

(a) A fall in wage costs of the firm along with a fall in consumer incomes
(b) A shortage of raw materials and consequent increase in raw material price
(c) An increase in subsidy by the government and a reduction in taxes
(d) Decrease in the market price of the commodity in question
111. The demand curve of a normal good has shifted to the right. Which of the four events
would have caused the shift?
(a) A fall in the price of a substitute with the price of the good unchanged
(b) A fall in the nominal income of the consumer and a fall in the price of the normal
good
(c) A fall in the price of a complementary good with the price of the normal good
unchanged
(d) A fall in the price of the normal good, other things remaining the same
112. If roller- coaster ride is a function of amusement park visit, then, if the price of
amusement park entry falls
(a) The demand for roller- coaster rides will rise and the demand curve will shift to
right
(b) The demand for roller coaster ride cannot be predicted as it depends on the tastes
of consumers for the ride
(c) There will be an expansion in the demand for roller coaster drive as it complementary
(d) None of the above

Theory of Demand and Supply 113

113. If a short run supply curve is plotted for the following table which presents price and
quantity of fighter aircrafts, what will be its shape?

Price in millions of $ Number of Aircrafts

124 28
140 28
150 28
160 28
175 28
(a) Horizontal straight line parallel to the quantity axis
(b) Steeply rising with elasticity less than one
(c) Vertical straight line parallel to Y axis
(d) A perfectly elastic supply curve
114. The average income of residents of two cities A and B and the corresponding change
in demand for two goods is given in the following table. Which of the following statements
is true?

City %Increase In Income % change in demand for Good X % change in demand for Good Y
A 12 6.5 - 2.3
B 9 5.6 1.6
(a) Both goods are normal goods in both cities A and B
(b) Good X is a normal good in both cities ; good Y is an inferior good in city A
(c) Good X is a normal good in both cities ; good Y is an inferior good in city B
(d) Need more information to make an accurate comment
Refer to the figure below. Answer questions 115 and 116
115. If this consumer is spending her entire income and consuming at point B, what advise
will you give her?
Y

P
B
Good Y

IC3
K IC2

IC1
0 X
Good X L

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 (a) No advise needed ,as she is maximizing her utility at B
(b) Consume more of Good X and less of Good Y
(c) Consume more of X and and less of Y and reach point K
(d) Consumer same quantity of Good Y and more of Good X
116. Which of the following statements is true about this consumer?
(a) The consumer is not maximizing her utility at point K
(b) The consumer is spending her entire income on both goods
(c) The consumer gets equal pleasure at points B and K
(d) All the above
Refer to the figure below. Answer questions 117 and 118
117. The effect on consumer surplus of a fall in price from E to F is
Y

P R
Price

C
G

D
0 X
Q Q1
Quantity

(a) A decrease in consumer surplus by EFGR

(b) A decrease in consumer surplus by AER
(c) A decrease in consumer surplus by EFCR
(d) None of The above
118. When price rises from F to E, the increase in revenue earned by the seller is
(a) Equivalent to area EFGR (b) Equivalent to area EFCR
(c) Equivalent to area AER (d) None of the above
119. How would that budget line be affected if the price of both goods fell?
(a) The budget line would not shift.
(b) The new budget line must be parallel to the old budget line.
(c) The budget line must be shifting to the left
(d) The new budget line will have the same slope as the original so long as the prices
of both goods change in the same proportion.

Theory of Demand and Supply 115

120. During a recession, economies experience increased unemployment and a reduced level
of income. How would a recession likely to affect the market demand for new cars?
(a) Demand curve will shift to the right.
(b) Demand curve will shift to the left.
(c) Demand will not shift, but the quantity of cars sold per month will decrease.
(d) Demand will not shift, but the quantity of cars sold per month will increase.

Answer Key
1. (d) 2. (b) 3. (c) 4. (b) 5. (b) 6. (b) 7. (b) 8. (c)
9. (c) 10. (b) 11. (b) 12. (b) 13. (b) 14. (c) 15. (d) 16. (c)
17. (a) 18. (b) 19. (d) 20. (d) 21. (c) 22. (b) 23. (c) 24. (c)
25. (d) 26. (b) 27. (a) 28. (c) 29. (b) 30. (a) 31. (b) 32. (c)
33. (b) 34. (a) 35. (c) 36. (a) 37. (a) 38. (c) 39. (c) 40. (a)
41. (d) 42. (c) 43. (a) 44. (c) 45. (a) 46. (d) 47. (d) 48. (b)
49. (b) 50. (b) 51. (d) 52. (c) 53. (b) 54. (d) 55. (b) 56. (b)
57. (c) 58. (b) 59. (b) 60. (c) 61. (c) 62. (b) 63. (a) 64. (a)
65. (d) 66. (d) 67. (a) 68. (c) 69. (a) 70. (b) 71. (c) 72. (c)
73. (b) 74. (a) 75. (c) 76. (a) 77. (c) 78. (a) 79. (c) 80. (b)
81. (a) 82. (a) 83. (a) 84. (c) 85. (a) 86. (a) 87. (c) 88. (a)
89. (d) 90. (b) 91. (d) 92. (a) 93. (a) 94. (a) 95. (d) 96 (a)
97. (d) 98. (a) 99. (d) 100. (c) 101 (a) 102 (c) 103. (c) 104 (b)
105 (c) 106. (b) 107 (a) 108. (d) 109 (c) 110 (b) 111 (c) 112 (a)
113 (c) 114 (b) 115 (b) 116 (d) 117 (d) 118 (a) 119 (d) 120 (b)



116 Business Economics PW

 UNIT
Supply and Elasticity of
3 Supply

‰ The term ‘supply’ refers to the amount of a good or service that the producers are willing
and able to offer to the market at various prices during a given period of time.
‰ Three important points apply to supply:
(i) Supply refers to what a firm offer for sale in the market, not necessarily to what
they succeed in selling. What is offered may not get sold.
(ii) Supply requires both willingness and ability to supply. Production cost is often the
primary influence on ability.
(iii) Supply is a flow. Supply is identified for a specified time period. The quantity supplied
is ‘so much’ per unit of time, per day, per week, or per year.

DETERMINANTS OF SUPPLY
Price is an important consideration in determining the willingness and desire to part with
commodities, there are many other factors which determine the supply of a product or a service.
T h e s e are discussed below:
(a) Price of the good:
 Other things being equal, the higher the relative price of a good the greater the quantity
of it t h a t will be supplied. This is because goods and services are produced by the firm
in order to e a r n profits and, ceteris paribus, profits rise if the price of its product rises.
(b) Prices of related goods:
 If the prices of other goods rise, they become relatively more profitable to the firm to
produce and sell than the good in question. When a seller can get a higher price for a
good, producing and selling it becomes more profitable. Producers will allocate more
resources towards its production even by drawing resources from other goods they
produce.
 For example, a rise in the price of comic books will encourage publishers to shift
resources out of the production of other books (such as novels) and use them in the
production of comic books.
(c) Prices of factors of production:
 The cost of producing a commodity is determined by the prices of the factors of
production or inputs involved, such as labor, capital, and raw materials. When the
prices of these factors increase, it leads to higher production costs, which in turn
 reduces profitability for the seller. Consequently, the seller tends to decrease the supply
of the commodity. Conversely, if the prices of factors of production or inputs decrease,
the cost of production falls, resulting in higher profit margins and an increase in the
supply of the commodity.
 For example, let’s consider a clothing manufacturer. If the price of cotton, a key raw
material, rises significantly, it directly affects the cost of producing garments. As a
result, the manufacturer’s profitability decreases. To mitigate this, the manufacturer
may reduce the supply of clothing items or increase their prices to maintain profitability.
(d) State of technology:
 The supply of a particular product depends upon the state of technology also. The use
of new technology in an industry (such as automation) increases production efficiency
and reduces production costs.
 Inventions and innovations tend to make it possible to produce more or better goods
with the same resources, and thus they tend to increase the quantity supplied of some
products and to reduce the quantity supplied of products that are displaced.
 Availability of spare production capacity and the ease with which factor substitution
can be made and the cost of such substitution also determine supply.
(e) Government Policy (Taxes & Subsidies)
 An increase in taxes raises the overall cost of production, resulting in a decrease in the
supply of goods or services due to reduced profit margins. Conversely, tax concessions
and subsidies have the opposite effect, increasing the supply of goods as they make it
more financially beneficial for firms to engage in production.
 For instance, if the government imposes higher taxes on a particular industry, such as
the automotive sector, the cost of production for automobile manufacturers will rise.
This increase in costs reduces the profit margin for these manufacturers, leading them
to decrease the supply of vehicles in the market.
(f) Nature of competition and size of industry: Under competitive conditions, supply will be
more than that under monopolized conditions.
(g) Expectations: Choices of firms in respect of selling the product now or later depends
on expectations of future prices. Sellers compare current prices with future prices. An
increase in the anticipated future price of a good or service reduces its supply today; and
if sellers expect a fall in prices in future, more will be supplied now.
(h) Number of sellers: If there are large number of firms in the market, supply will be more.
Besides, entry of new f i r m s , either domestic or foreign, causes the industry supply curve
to shift rightwards.
(i) Other Factors: The quantity supplied of a good also depends upon government’s industrial
and foreign policies, goals of the firm, infrastructural facilities, natural factors such as
weather, floods, earthquake and man- made factors such as war, labour strikes, communal
riots etc.

2 Business Economics and BCK

THE LAW OF SUPPLY
The law of supply can be stated as: Other things remaining constant, the quantity of a good
produced and offered for sale will increase as the price of the good rises and decrease as the
price falls.
This law is based upon common sense, because the higher the price of the good, the
greater the profits that can be earned and thus greater the incentive to produce the good
and offer it for sale.

CHANGE IN QUANTITY SUPPLIED VS CHANGE IN SUPPLY

1. Change in Quantity Supplied refers to a change in the supply of a commodity that occurs
solely due to a change in its own price. For instance, if the supply of Close-Up toothpaste
changes in response to a change in its own price, it is considered a change in quantity
supplied.
2. Change in Supply refers to a change in the supply of a commodity that is caused by
factors other than its price. These factors may include changes in the price of related
goods, advancements in technology, or alterations in taxation policies. For example, if
the supply of Close-Up toothpaste changes due to a shift in the price of other goods,
advancements in toothpaste manufacturing technology, or a change in taxation policy,
it is referred to as a change in supply.

SUPPLY SCHEDULE
A supply schedule is a table or tabular statement that presents the quantities of a commodity
that a r e supplied at different price levels over a specified period of time.

SUPPLY CURVE
It is a graphical representation of the supply schedule, showing the various quantities of a
commodity that producers are willing to supply at different price levels, assuming no changes
in other factors.
Y
Price (Rs.) Quantity supplied of
Individiual supply curve
good (units)
SS
5
E
Price in `

1 5 4 D
2 10 3 C
2
3 15 B
1
A
4 20
X
5 25 O 5 10 15 20 25

Supply and Elasticity of Supply 3

SLOPE OF SUPPLY CURVE
The slope of a curve is determined by calculating the change in the variable on the y-axis
divided by t h e change in the variable on the x-axis. Therefore, the slope of the supply curve is
calculated by dividing the change in price (ΔP) by the change in quantity (ΔQ).

MARKET SUPPLY SCHEDULE

In mathematical terms, the slope of the supply curve can be represented as:
Slope of Supply Curve = (ΔP) / (ΔQ)

MARKET SUPPLY SCHEDULE

‰ A market supply schedule is a table that shows the quantities of a commodity that all
producers in a market are willing to sell at different price levels during a specific time
period.
‰ It is derived by aggregating the individual supply schedules of all producers in the market.
‰ The market supply schedule is expressed as: Sm = SA + SB + ... where Sm represents the
market supply, and SA, SB, and so on represent the individual supplies of each supplier.

MARKET SUPPLY CURVE

The market supply curve is a graphical representation that shows the relationship between
the price of a commodity and the total quantity supplied by all producers in the market.
‰ It is derived by horizontally adding or summing up the individual supply curves of each
producer.
Y
Price Individual Supply Market Supply Market supply curve
(Rs.) Px (units) (units) (SA + SA SB SM
5
SB}
Price in `

4
SA SB
1 5 10 5 + 10 = 15 3

2 10 20 10 + 20 = 30 2

3 15 25 15 + 25 = 40 1
4 20 35 20 + 35 = 55 X
5 25 40 25 + 40 = 65 O 10 20 30 40 50
Quantity Supplied (in units)

Market Supply Curve is Flatter

The market supply curve is typically flatter compared to individual supply curves. This
occurs because changes in price result in a proportionately greater change in market supply
compared to the proportionate change in individual supplies.

4 Business Economics and BCK

MOVEMENTS ON THE SUPPLY CURVE – INCREASE OR DECREASE IN
THE QUANTITY SUPPLIED
When the quantity supplied of a commodity changes solely due to a change in its own price,
while other factors remain constant, it is referred to as a ‘change in quantity supplied’.
Graphically, this change is represented as a movement along the same supply curve. This
movement can either be downward, indicating a contraction in supply, or upward, indicating
an expansion in supply, along the existing supply curve.

Y
S
Movement along
Price in `

supply curve
P1 B

P A
P2
C
S
X
O O2 O O1 Quantity
Quantity Supplied (in units)

SHIFTS IN SUPPLY CURVE – INCREASE OR DECREASE IN SUPPLY

Rightward Shift In Supply Curve (Increase in Supply): When Y
S
the supply curve bodily shifts towards the right as a result Increase in supply S1
of a change in one of the factors that influence the quantity
Price in `

supplied other than the commodity’s own price, we say 20

there is an increase in supply. When the supply curve shifts
to the right, more is offered for sale at each price.
S
S1
Price (in Rs.) Quantity (in units)
X
20 100 O 100 150 Quantity
Quantity Supplied (in units)
25 150
Y
Leftward Shift (Decrease in Supply): When the factors S1
Decrease in supply S
other than price change and cause the supply curve to
Price in `

shift to the left, we call it decrease in supply. When the

20
supply curve shifts to the left, less quantity is offered for
sale at each price.
S1
Price (in Rs.) Quantity (in units) S

20 100 O 70 100 Quantity

X

25 70 Quantity Supplied (in units)

Supply and Elasticity of Supply 5

ELASTICITY OF SUPPLY
The elasticity of supply is defined as the responsiveness of the quantity supplied of a good to
a change in its price. Elasticity of supply is measured by dividing the percentage change in
quantity supplied of a good by the percentage change in its price i.e.,

(Percentage change in quantity supplied)

Es =
(Percentage change in Price)

Or

(Change in quantity supplied)

(quantity supplied)
Es =
(Change in price)
Price
Or

∆P P
Es = x
∆Q Q
Where,
q denotes original quantity supplied.
∆q denotes change in quantity supplied.
p denotes original price.
∆p denotes change in price.

TRY YOUR UNDERSTANDING 1.1

1. Supply is the:
(a) Limited resources that are avail-ab le with the seller.
(b) Cost of producing a good.
(c) Entire relationship between the quantity supplied and the price of good.
(d) Willingness to produce a good if the techno logy to produce it becomes available.
2. The quantity supplied of a good or service is the amount that ______________
(a) Is actually bought during a given time period at a given price.
(b) Producers wish they could sell at a higher price.
(c) Producers plan to sell during a given time period at a given price.
(d) People are willing to buy during a given time period at a given price.
3. In a very short period, the supply:
(a) Can be changed. (b) Cannot be changed.
(c) Can be increased. (d) None of the above.

6 Business Economics and BCK

 4. Which of the following statement is correct?
(a) Supply is inversely related to its cost of production
(b) Price and quantity demand of a goods have direct relationship
(c) Taxes and subsidy has no impact on the supply of the product
(d) Seasonal changes have no impact on the supply of the commodity
5. Which of the following is a factor determining the supply?
(a) Price of the good (b) Price of related goods
(c) Price of factor of Production (d) All of the above.
6. Other things being equal,the ___________ the relative price of a good the __________ the
quantity of it that will be supplied.
(a) Higher, Lesser (b) Higher, Greater
(c) Lower,Lower (d) None of these
7. According to law of supply, change in supply is related to?
(a) Price of goods (b) Price of related goods
(c) Factors of production (d) None of the above
8. The supply curve for perishable commodities is _____________________ .
(a) Elastic (b) Inelastic
(c) perfectly elastic (d) perfectly inelastic
9. When supply price increase in the short run, the profit of the producer ______________ .
(a) Increases (b) Decreases
(c) Remains constant (d) Decreases marginally Answer:
10. Contraction of supply is the result of:
(a) Decrease in the number of pro-ducers.
(b) Decrease in the price of the good concerned.
(c) Increase in the prices of other goods.
(d) Decrease in the outlay of sellers. Answer:
11. When the supply of a good increase as a result of an increase in _________ its price,then it
is an increase in and there is a upward _____________ the supply curve.
(a) Quantity Supplied, movement on
(b) Quantity Supplied, Shift of
(c) Supply, movement on
(d) Supply, Shift of Answer:
12. Movements on the supply curve may be due to:
(a) Change in price of goods
(b) Change in price of related goods
(c) Change in technology
(d) None of the above. Answer:
Supply and Elasticity of Supply 7
13. Contraction of supply implies ______________ .
(a) Decrease in cost of production
(b) Decrease in price of the good concerned
(c) Decrease in price of related good
(d) Increase in price of the good concerned Answer:
14. When supply curve moves to the left, it means
(a) Smaller supply at a given price.
(b) Larger supply at a given price.
(c) Constant supply at a lower price.
(d) None of the above.
15. When the supply curve shifts to the left or right, it is called as respectively. ___________or
___________ in supply,
(a) Decrease, Decrease (b) Decreases, Increase
(c) Increase, Increase (d) Increase, Decrease.

ANSWER
1. (c) 2. (c) 3. (b) 4. (a) 5. (d) 6. (b) 7. (a)
8. (d) 9. (a) 10. (b) 11. (a) 12. (a) 13. (b) 14. (a)
15. (b)

TYPES OF SUPPLY ELASTICITY

1. Perfectly inelastic supply Y S
 If as a result of a change in price, the quantity supplied ES = 0
of a good remains unchanged, we say that the elasticity P1

of supply is zero or the good has perfectly inelastic supply

Price

(Es = 0.). P

 Supply curve is Vertical (i.e. Parallel to Y axis) S

X
2. Relatively less-elastic supply O Q
Quantity Supplied (in units)
 If as a result of a change in the price of a good its supply
changes less than proportionately, we say that the supply Y
of the good is relatively less elastic or elasticity of supply S
ES < 1
is less than one. P1

 In this case, the coefficient of elasticity falls in the range

Price

P
0 < Es < 1 P
Q
 The percentage change in quantity is less than the
S
X
percentage change in price. O Q Q1
Quantity Supplied
 In other words, the quantity is not very responsive to
price.

8 Business Economics and BCK

 3. Relatively greater-elastic supply
‰ If elasticity of supply is greater than one i.e., when the
Y
Highly Elastic Supply SS
quantity supplied of a good changes substantially in ES > 1
response to a small change in the price of the good we P1

Price in `
say that supply is relatively elastic.
‰ The percentage change in quantity is greater than the P

percentage change in price.

‰ The coefficient of elasticity falls in the range 1 < E < ∞. O Q Q1
X

4. Unit-elastic Quantity Supplied (in units)

‰ In this case, the coefficient of elasticity is one.(Es = 1).

Y
‰ If the relative change in the quantity supplied is exactly
equal to the relative change in the price, the supply is ES = 1
S
said to be unitary elastic. P1
P

Price
‰ The percentage change in quantity is equal to the
P
percentage change in price. Q
S
‰ Unit elasticity is essentially a dividing line or boundary S
X
between the elastic and inelastic ranges. O Q Q1
Quantity Supplied
5. Perfectly elastic supply
‰ At the opposite extreme of zero elasticity supply is Y

perfectly elastic. E =

Price
S

‰ This occurs as the price elasticity of supply approaches P

S
S
infinity and the supply curve becomes horizontal.
‰ Elasticity of supply is said to be infinite (E = ∞)or perfectly X
elastic when nothing is supplied at a lower price and O Q Q 1

Quantity Supplied
an infinitesimally small change in price results in an
infinitely large change in quantity supplied indicating
that producers will supply any quantity demanded at that price.

‰ In some cases, the elasticity of supply is not constant but

varies over the supply curve.
‰ In the case of an industry with limited capacity for
production. For low levels of quantity supplied, firms
respond substantially to changes in price.
‰ When there is a small rise in price from P1 to P2 ,the
q u a n t i t y supplied increases more than proportionately
( Q 1 to Q2).
‰ In this region, firms have idle capacity and therefore when
price rises, they respond by increase in quantity supplied
using the idle capacity available.
‰ Once fir ms reach their full capacity, further increase in
production is possible only by building new plants and
incurring expenses towards this.
‰ To induce firms to increase output, price must rise
substantially (P3 to P4) and supply becomes less elastic.

Supply and Elasticity of Supply 9

MEASUREMENT OF SUPPLY-ELASTICITY
(a) Percentage / Proportionate Method: According to this method elasticity of supply is
calculated by dividing a % or proportionate c h a n g e in supply with the % or proportionate
change in price.
Percentage change in quantity supplied

Es =
Percentage change in Price

(b) Point elasticity:

 The elasticity of supply can be considered with reference to a given point on the supply
curve or between two points on the supply curve. When elasticity is measured at a
given point on the supply curve, it is called point elasticity.
 Point-elasticity of supply can be measured with the help of the following formula:

∆Q P
Es = ×
∆P Q

(c) Arc Elasticity: In situations where there is a relatively larger price change and we need
to measure elasticity over a range or arc, rather than at a specific point, we utilize the
concept of arc elasticity. Arc elasticity involves calculating the average of the two prices
and quantities, both original and new, to determine the elasticity of demand or supply
over the specified range.
Q2 – Q1 P2 – P1
Es = ×
Q2 + Q1 P2 + P1

Where P1 Q1 are original price and quantity and P2 Q2 are new price and quantity
supplied.

DETERMINANTS OF ELASTICITY OF SUPPLY

Following are the general determinants of elasticity of supply:
(a) If increase in production causes substantial increase in costs, producers will have less
incentive to increase quantity supplied in response to increase in price and therefore,
price elasticity of supply would be less. If there are constant costs or negligible rise in
costs as output increases, supply will be elastic.

Similarly, Products that involve more complex production processes or require relatively
longer time to produce exhibit lower elasticity of supply. For example the supply of
aircrafts and cruise ships is less elastic compared to supply of motor bikes
(b) The longer the period of time, the more responsive the quantity supplied to changes in
price and the greater the supply elasticity. A shorter time period does not allow sellers
sufficient time to find resources and alternatives and to adjust their production decisions
to changes in price. In the long run, firms can build new plants or new firms may be
able to enter the market and increase the supply.
(c) Supply is more elastic when there is large number of producers and there is high degree
of competition among them. Supply elasticity is also higher when there are fewer barriers
of entry into the market.
10 Business Economics and BCK
(d) Supply will be elastic if firms are not working to full capacity. If spare production
capacity is available with the firms, they can increase output without a rise in costs. The
greater the spare capacity available, the greater will be the elasticity of supply.
(e) If key raw materials and inputs are easily and cheaply available, then supply will be
elastic. If drawing productive resources into the industry is easier, the supply curve
is more elastic. In case it is difficult to procure resources economically, the cost of
production increases and supply will become less elastic.
(f) If firms have adequate stocks of raw materials, components and finished products, they
will be able to respond with higher supply as price rises. Generally, those commodities
which can be easily and inexpensively stored without losing value may have elastic supply.
(g) The ease and cost of factor substitution influence price elasticity of supply. Commonly
available and easily substituted factors allow for quick production response to price changes.
Scarcity of specialized materials or labor with longer training periods reduces supply Quantity
elasticity. For example, physicians in healthcare industry and chartered accountants in
accounting service.
Demand

(h) If both capital and labour are occupationally mobile, then the elasticity of supply for a
product is higher than if capital and labour cannot be easily switched. For example, a
printing press can easily switch between printing magazines and greeting cards. Similarly
falling prices of a particular vegetable encourage farmers to switch to the production of Supply
another. Products which are more continuously produced have greater supply elasticity
than those which are produced infrequently.
(i) Expectations about future prices also affect elasticity of supply. Expectation of
substantial rise in prices in future will make the sellers respond less to a current rise
in price.

EQUILIBRIUM PRICE
‰ The equilibrium price in a market is determined by the intersection between demand
and supply. It is also called the market equilibrium.
‰ At this price, the amount that the buyers want to buy is equal to the amount that sellers
want to sell.
‰ The competitive market equilibrium represents the ‘unique’ point at which both consumers
and suppliers are satisfied with price and quantity.
‰ Equilibrium price is also called market clearing price.
‰ The determination of market price is the central theme of micro economic analysis.
Hence, micro-economic theory is also called price theory
price

Price Demand Supply Impact On Price

Supply
5 6 31 Downward
4 12 25 Downward E
3 19 19 Equilibrium
3

2 25 12 Upward
Demand
1 31 6 Upward
O 19 Quantity

Supply and Elasticity of Supply 11

MARKET EQUILIBRIUM AND SOCIAL EFFICIENCY
‰ Social efficiency represents the net gains to society from all exchanges that are made
in a particular market. It consists of two components: Y
consumer surplus and producer surplus.
‰ consumer surplus is a measure of consumer welfare
whereas Producer surplus is the benefit derived by S

price
producers from the sale of a unit above and beyond Consumer

their cost of producing that unit.

surplus
P
Producer
‰ Producer surplus can be calculated as the area above surplus
the supply curve and below the market price. D
‰ It represents the additional revenue or profit that O Q X
producers gain when the market price exceeds their Quantity Exchanged
production costs.

TRY YOUR UNDERSTANDING 1.2

1. Elasticity of supply refers to the degree of responsiveness of supply of a good to changes
in its:
(a) Demand. (b) Price.
(c) Cost of production. (d) State of technology.
2. The elastic ity of supply is defined as the _______
(a) Responsiveness of the quantity supplied of a good to a change in its price.
(b) Responsiveness of the quan-,tity supplied of a good without change in its price.
(c) Responsiveness of the quantity demanded of a good to a change in its price.
(d) Responsiveness of the quantity demanded of a good without change in its price.
3. When price of a commodity Rises from 200 to ‘{ 300 and Quantity supply increases
from 2,000 to 5,000 units find elasticity of supply?
(a) 3.0 (b) 2.5
(c) 0.3 (d) 3.5
4. If price of computers increases by 10% and supply increases by 25%. The elasticity of
supply is :
(a) 2.5 (b) 0.4
(c) (-) 2.5 (d) (-) 0.4
5. The Price of Commodity X in-creased from ‘{ 2,000 per unit to ‘{ 2,100 per unit and
consequently the quantity supplied rises from 2,500 units to 3,000 units. The Elasticity
of supply will be
(a) 2 (b) 4
(c) .25 (d) 0

12 Business Economics and BCK

 6. Perishable commodities will have _______
(a) Perfectly elastic curve (b) Perfectly inelastic curve
(c) Elastic (d) Inelastic
7. A vert ical supply curve parallel to Y axis implies that the elasticity of supply is:
(a) Zero (b) Infinity
(c) Equalto one (d) Greater than zero but less than infinity
8. A horizontal supply curve parallelto the quantity axis implies that the elasticity of supply
is:
(a) Zero. (b) Infinite.
(c) Equal to one. (d) Greater than zero but less than one.
9. When the supply of a product is perfectly inelastic then the curve will be
(a) Parallel to Y - axis (b) Parallel to X - axis
(c) At the angle of 45° (d) Sloping upwards
10. The cross elasticity between Rye bread and Whole Wheat bread is expected to be:
(a) Positive (b) Negative
(c) Zero (d) Can’t say
11. Equilibrium refers to a market situation where quantity demand is to quantity supplied.
(a) Equal (b) Less than or Equal
(c) More than (d) More than or equal
12. The equilibrium price is deter-mined by the inter-section between and It is also called
as the equilibrium.
(a) Demand, Supply, Static (b) Demand Supply, Dynamic
(c) Supply, Demand, Partial (d) Demand, Supply, Market
13. Suppose the price of movies seen at a theater rise from Rs.120 per person to Rs.200
per person .The theater manager observes that the rise in price causes attendance at
a given movie to fall from 300 persons to 200 persons .What is the price elasticity of
demand for movies ?
(a) 0.5 (b) 0.8
(c) 1 (d) 1.2
14. A discount store has a special offer on CD’s .It reduces their from Rs.150 to Rs.100.
Suppose the store manager observes that the quantity demanded increases from 700
CD’s to 1,300 CD’s .What is the price elasticity of demand for CD’s ?
(a) 0.8 (b) 1
(c) 1.25 (d) 1.5

ANSWER
1. (b) 2. (a) 3. (a) 4. (a) 5. (b) 6. (b) 7. (a)
8. (b) 9. (a) 10. (a) 11. (a) 12. (d) 13. (b) 14. (d)

Supply and Elasticity of Supply 13

Important Economist name in the chapter (1) Substitution Effect
Hicks and Allen (2) Indifference curve analysis
James Dusesenberry Demonstration Effect
Thorstein Veblen (1) Veblen Effect
(2) Conspicuous Consumption
Robert Giffen Giffen Goods
Olaf Helmer Delphi Technique


14 Business Economics and BCK