AEC516 - AGRICULTURAL ECONOMICS ANALYSIS I

THE BASIC ECONOMIC FUNCTIONS

Basic Economic Functions of Economics

Economics is the social science that studies how to make decisions in face of resource scarcity
and/or information asymmetry. It focuses on the analysis of individual economic behaviors to
study economic issues. Specifically, it studies economic behavior, economic phenomena, and
how rational economic agents, including individuals, families, firms, institutions, organizations,
and government agencies, make optimal trade-off choices subject to the constraint of limited
resources.

It is actually because of the fundamental inconsistence and conflict between resource scarcity
and individuals’ unlimited desires (or wants) that economics could come into being. The core
idea is that individuals, who are under the basic constraint of limited resources (limited
information, capital, time, capacity and freedom) and driven by unlimited desires, must make
trade-off choices in resource allocation to make the best use of limited resources to maximize the
satisfaction of their needs. Economics occupies the top position among social sciences. As a
discipline of social science, it studies the problem of social choices based on inherent logic
analysis and scientific viewpoints and establishes itself via systematic exploration of the matter
of choice. Such exploration not only involves the building of theory but also provides analytical
tools for the test of economic data.

Differences between Economics and Natural Science

There are three major differences between modern economics and natural science, which make
the study of economics more complex and difficult. They are:

(1) Economics studies human behavior and needs to impose some associated assumptions, while
natural science in general does not involve the behavior of human being. Once individuals are
involved, their behavior is unpredictable without a pre-determined mechanism, making it very
difficult and complicated to deal with.

(2) In the discussion and study of economic problems, descriptive empirical analysis and
normative analysis of value judgment are used.

(3) Society cannot be simply taken for experiment in economics because of the large impacts of
external environment on many economic policies, while this is not a problem in natural science.

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Basic Economic Questions in Economics

There are four basic economic questions that must be answered by any economic system,
regardless of whether it is the planned economy wherein the government plays a decisive role,
the free economy wherein the market plays a decisive role, or the semi-market and semi-planned
mixed economy wherein the state-owned economy plays a leading role.

When it comes to the allocation of resources, all these different types of economic systems face
the following four basic questions:

(1) What should be produced and in what quantity?

(2) How should the product be produced?

(3) For whom should it be produced and how should it be distributed?

(4) Who makes the decision on production?

These four questions must be answered in all economic systems, but different economic
institutional arrangements provide different answers. As such, two basic economic institutional
arrangements have been used to deal with the questions in the real world:

(a) The institutional arrangement of planned economies

All the four questions are answered by the government who determines most economic activities
and monopolizes decision-making processes and all industries. Government makes decisions on
access to market, product types, allocation/distribution of infrastructural investments, individual
job assignment, product price, employment wage, etc. and government bears all the risks
involved in the entire process.

(b). The institutional arrangement of market economies

In this case, most economic activities are organized through free market. The decisions on what
product to produce, how to produce and for whom to produce are mainly made by the firms and
consumers, and the risk is borne by individuals.

While almost every real-world economic system is somewhere in between these two extremes,
the key issue to address is which extreme is in the dominant position. The fundamental flaw of
the planned economic system is that it cannot effectively resolve the problems induced by
information and incentives, which in turn results in inefficient allocation of resources, whereas
free-market economic system can be a good solution to these flaws. This is the fundamental
reason why countries that once adopted planned economic system inevitably failed and why
China carried out market-oriented reforms and wishes to assign a central and decisive role to
market in the issue of resource allocation.
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Hypothesis Vs. Theory

Hypotheses are a set of economic assumptions that have not gone through validation process.
The world is the laboratory for testing the validity or otherwise of all economic hypotheses.

Theory is a validated hypothesis. In other words, when a set of economic assumption has been
subjected to empirical test and they are found to be constant upon several repetitions, they
become a theory. Theories are not often refuted except by superior empirical
discoveries/findings.

Economic Theory

There are two main categories of economic theory according to their functions - Benchmark
Theory and Relatively Realistic Theory

(a). Benchmark economic theory - This provides a benchmark or a reference system. It is

mainly based on assumptions and it is used as a guide

(b). Relatively realistic theory - This one is relatively more realistic economic theories that aim
to solve practical issues so that assumptions are closer to reality. They are usually modifications
to the benchmark theory.

Both of the two types of theories are very important and can be used to draw logical conclusions
and make predictions on economic assumptions. The second category of realistic theories is
developed from the continuing revision of the first category of the benchmark theories, thus
making the theoretical system of modern economics complete and close to the real world. The
benchmark theories are built on the economic environment of real market economies and ideal
situations. Though, theoretical results cannot be realized in practice, one cannot deny the fact
that they play an extremely important role in guiding, orientating, and providing benchmarks.
When we study and solve a problem, we need to figure out first what to do and whether it should
be done and then proceed to the question of how to do. Benchmark theories answer what to do,
or provide the direction and goals of improvements towards the ideal situation. Therefore, the
benchmark theory provides necessary standards for judging what is better and whether it is the
right direction.

Roles of Economic Theory

Economic theory has at least three roles, namely:

(i). To provide a benchmark and a reference system to set up goals to create direction for
economic improvements. Through reform and innovation guided by theory, the economy in the
real world becomes increasingly closer to the ideal state;

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(ii). It can be used to learn and understand the real economic world, and to explain economic
phenomena and economic behavior so as to solve real problems, which is the major content of
modern economics, and;

(iii). It can be used to make logically inherent inferences and predictions. Practice is the sole
criteria for testing truth but not the sole criteria for predicting truth. In many cases, problems may
still arise if only existing data are used for economic prediction, so theoretical analysis with
inherent logic is needed.

Key Issues in Microeconomic Theory

Economists usually base the study of economic issues on some key points, constraints, or
principles, namely:

(1) Scarcity of resources – human needs are scarce and infinite, but the resources to meet them
are limited and finite.

(2) Insufficient information and decentralized decision-making system - Only when complete
information is available and is acquired can the outcome of economic decisions be meaningful.

(3) Economic freedom: voluntary cooperation and voluntary exchange – there is need to give
people the freedom of economic choice, which is the most important kind of rights (right to
survival, rights to freedom of choices, and rights to ownership of property.

(4) Decision-making under constraints – these include material constraint, information

constraint, and incentive constraint, which make it difficult for economic agents to achieve their
goals.

(5) Similarity of goals - economic mechanism should solve the problem of conflicts of interest
among individuals or economic units;

(6) Well-defined property rights - Property rights include ownership, right of use, and rights of
decision on owned property.

(7) Equity in opportunity - meaning that there should not be any barrier to hinder individuals
from pursuing their goals based on their capacity, and there should be a starting point of equal
competition for all individual or economic units.

(8) Allocative efficiency of resources - this requires production of products that can best meet the
needs of the consumers.

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 Functions of Microeconomic Theory

Microeconomic theory (or price theory) deals with the economic behavior of individual decision-
making units such as consumers, resource owners, and business firms as well as individual
markets in a free-enterprise economy. This is in contrast with macroeconomic theory, which
studies the aggregate levels of output, national income, employment, and prices for the economy
taken together as whole.

Fig.1: A simple model of the economy

The upper loop in Fig. 1 shows that households purchase goods and services from business
firms. Thus, what is consumption expenditure (a cost) from the point of view of households
represents the income or the money receipts of business firms. On the other hand, the lower loop
shows that business firms purchase the services of economic resources from households. Thus,
what is a cost of production from the point of view of business firms represents money income to
the households.

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 CONSUMER DEMAND THEORY

• Consumer Behaviour is the study of the processes involved when an individual or group
of people purchase, or use selected products or services to satisfy their needs and desires.
• It is a study of how consumers allocate their limited incomes among different goods and
services to maximize their satisfaction/well-being.
• Human as a rational being, often makes decisions to utilise a commodity based on its
ability to maximize utility, whilst expending the minimum effort.
• Utility is the satisfaction a consumer obtains from the consumption of a commodity. Total
utility increases initially as more units of the product is consumed per time; it gets to a
maximum point and then begins to diminish as more units of the product is consumes.
Thus, the extra or marginal utility begins to reduce steadily, gets to zero and then
becomes negative. This is called the principle of diminishing marginal utility.

Traditional (or neoclassical) model of consumer behavior

• In the traditional model, it is hypothesized that the consumer has some sense of
preference among ‘a basket of’ commodities and being rational, will attempt to choose
those commodities that will maximise his utility (satisfaction) subject to his budget
constraint.
• The decision-making unit is taken to be the individual consumer, although the analysis
could apply equally to the household, provided the one who controls the purse also acts
rationally to maximize the welfare of the whole household.
• The indifference curve is used in presenting this model. The indifference curve shows
the various combinations of commodity X and Y that yield equal utility (or satisfaction) to
the consumer. This model is adopted for two reasons:
 To represent potentially observable demand patterns for individual consumers over
commodity bundles; and,
 It is symmetric with the production model where isoquants in production/supply theory
take the place of indifference curves in consumption/demand theory.

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Concepts of Consumer Preferences, Choices and Utility

• It is hypothesized that the consumer gains satisfaction, welfare, or utility from the
consumption of a set of commodities and in deciding how much of each good to
purchase, he will aim at achieving the maximum possible level of satisfaction.
• The choice, however, is constrained by the consumer's purchasing power (income level or
budget) and will be influenced by the prices of the available commodities.
• The theory postulates that consumer behaviour will depend on individual preferences,
which may be linked to certain socio-economic factors of the consumer (e.g. age, sex,
education, religion, social class, location, etc.)
• However, the theory does not attempt to explain how consumer’s taste is formed (this is
left to the behavioural scientists) but rather it asserts that at a given point in time,
consumer's taste and preferences can be taken as given/endogenous in the consumption
model.

Preferences

• As noted earlier, it is hypothesized that the consumer seeks to maximize the satisfaction
derived from the consumption of goods and services.
• The precise relationship between the consumers' satisfaction and consumption need not
be specified.
• Consumer theory only requires that a number of general propositions about the nature of
consumer preferences should hold.
These propositions or Axioms of Rational Choice, as they are called, include:

 Completeness: The consumer can compare any two combinations (or bundles) of goods
and decide whether bundle A is preferred to bundle B or bundle B is preferred to bundle
A or that he or she is indifferent between them. By being indifferent, we mean that a
person will be equally satisfied with either basket A or B. Note that these preferences
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 ignore costs. A consumer might prefer A to B but still buys B because it is cheaper (that
is the effect of the budget constraint on his preference for goods).
 Transitivity: The consumer is consistent his or her choices. In particular, if bundle A is
preferred to bundle B and bundle B is preferred to bundle C, then the consumer will
prefer bundle A to bundle C.
 Continuity: If A is preferred to B, then commodities suitably “close to” A must also be
preferred to B. This proposition enables the analysis of individuals’ responses to
relatively small changes in income and prices of related commodities.
Consumer preferences can be illustrated graphically using a device known as an indifference
map (to be discussed later).

Total Utility (TU) and Marginal Utility (MU)

An individual usually demands a particular commodity because of the utility (or satisfaction) he
derives from it. As more of a commodity is consumed per unit time, the total utility (TU)
increases, up to some extent. However, the marginal (extra) utility (MU) derived from the
consumption of an additional unit of the commodity decreases progressively as more of it is
consumed. At some point, the total utility derived from the consumption of the commodity
reaches a maximum and at this point, the marginal utility becomes zero (at the saturation point).
Beyond this point, additional consumption causes the TU to fall and the MU becomes negative.

Table 2. Table of Qx, TUx and MUx

Units of Commodity Total Utility Marginal Utility
(Qx) (TUx) (MUx)
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2

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 Fig. 2: Graph of Total Utility (TU) and Marginal Utility (MU)

Mathematically,

The objective of a rational consumer is to maximize the total utility derived from spending his
limited personal income. He reaches this objective and the consumer is said to be in equilibrium
when he is able to spend his personal income in such a way that the utility of the last Naira spent
on the various commodities is the same. Expressed mathematically:

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subject to the budget constraint that (the customer’s personal income).

THE INDIFFERENCE CURVES (MAP)

A consumer’s tastes and equilibrium can be shown by the indifference curves (map). The
indifference curve shows the various combinations of commodity X and commodity Y which
yield equal utility or satisfaction to the consumer. A higher indifference curve shows a greater
amount of satisfaction, and vice versa. Thus, the indifference curve shows an ordinal, rather than
cardinal measure of utility. More than one indifference curve on the same plane is known as
indifference map.

Activity 3

Table 3 below gives the different combinations of commodities Qx and Qy demanded in a

market. Draw the respective indifferent curves for the schedule.

Indifference Curve I Indifference Curve II Indifference Curve III

Qx Qy Qx Qy Qx Qy
1 10 3 10 5 12
2 5 4 7 6 9
3 3 5 5 7 7
4 2.3 6 4.2 8 6.2
5 1.7 7 3.5 9 5.5
6 1.2 8 3.2 10 5
7 0.8 9 3 11 4.9
8 0.5 10 2.9 12
9 0.3
10 0.2

Activity required: Plot the indifference table below as indifference curves

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 Fig.3. Indifference curves I, II, and III

Characteristics of the indifference curve

Indifference curves exhibit three basic characteristics, namely:

- They are negatively sloped (since consuming more of Y necessitates consumption of less
of X to remain on the same level of satisfaction, as we are dealing with scarce/economic
goods)

- They are convex to the origin (since it exhibits diminishing MRTSxy).

- They cannot intercept.

Marginal Rate of Technical Substitution (MRTS)

The marginal rate of technical substitution of commodity Y for commodity X (MRTS xy) refers to
the amount of commodity Y that a consumer is willing to give up in order to gain one additional
unit of commodity X (and still remain on the same indifference curve). As a consumer moves
down an indifference curve, the MRTS xy diminishes. MRTSxy represents the slope of the
indifference curve. That is, .

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Table 4. The indifference curve and marginal rate of technical substitution (MRTSxy)

Indifference Curve I Indifference Curve II Indifference Curve III

Qx Qy MRTSxy Qx Qy MRTSxy Qx Qy MRTSxy
1 10 - 3 10 - 5 12 -
(point
A)
2 5 (point 5 4 7 3 6 9 3
B)
3 3 (point 2 5 5 2 7 7 2
C)
4 2.3 0.7 6 4.2 0.8 8 6.2 0.8
5 1.7 0.6 7 3.5 0.7 9 5.5 0.7
6 1.2 0.5 8 3.2 0.3 10 5 0.3
7 0.8 0.4 9 3 0.2 11 4.9 0.2
8 0.5 0.3 10 2.9 0.1 12 0.1
9 0.3 0.2
10 0.2 0.1

In moving from point A to point B on the indifference curve I in Table 4, the consumer gives up
5 units of commodity Y in exchange for one additional unit of commodity X. thus, the MRTS xy =
5. Also, from point B to point C, on the same indifference curve, the MRTS xy = 2. On moving
down the indifference curve, the consumer is willing to give up less and less of commodity Y in
order to gain each additional unit of commodity X (i.e., the MRTS xy diminishes). This is so
because the less of Y and the more of X the consumer has (i.e, the lower the point on the
indifference curve), the more valuable is each remaining unit of Y an the less valuable is each
additional unit of X to the consumer. Therefore, the individual is willing to give up less and less
of Y to get each additional unit of X, and the MRTSxy diminishes.

Practice question 1: What is the difference between MRTSxy and TUx?

Answer:

The MRTSxy measures the amount of commodity Y that a consumer is willing to give up in order
to gain one additional unit of commodity X (and still remain on the same indifference curve).
That is, .

The MUx measures the change in total utility a consumer receives when he consumes one

additional unit of commodity X. That is,

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 THE BUDGET CONSTRAINT LINE

The budget constraint line shows all the different combinations of two commodities that a
consumer can purchase, given his money income and the prices of the two commodities.

Fig. 4. Graph of the budget constraint line

Assuming that Px = Py = N1, and a consumer’s money income is N100 per period of time and
that he spends all of it on commodities X and Y. The budget line for this commodity is given by
line KL in the figure. If all the income is spent on Y, he could purchase 100 units of Y and none
of X (at point K), and if all the income is spent on X, he could purchase 100 units of X and none
of Y (at point L). Budget line KL shows all the various combinations of X and Y that the
consumer can purchase given his income (N100) and the prices of X and Y (i.e., P x and Py).
Since the consumer is spending all of his income on X and Y, it therefore holds that:

PxQx + PyQy = M (= N100)

Following the straight line equation, the general form of the budget constraint line, following the

straight line equation, is given as:

where is the intercept and is the slope.

Supposing Px = N1 and Py = N2 and budget M = N100, and he still spends all on X and Y, line
KL shows all the various combinations of X and Y that the consumer can purchase given his
income. For each unit of Y the consumer gives up, he can buy 2 units of X. Therefore, the
consumer can buy 100X and 0Y, 80X and 10Y, 60X and 20Y, …0X and 50Y.

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Practice Question 3: What do you understand by the term ‘budget constraint’? Using the
hypothetical example of commodities A and B, briefly explain the influence of budget constraint
and commodity prices on the preferences and choices of a consumer.

Answer:

Budget constraint simply means that a consumer is only able to purchase commodities within the
limits of his/her personal income.

A consumer may actually prefer commodity A to commodity B. However, given the prices of A
and B, the consumer may eventually choose to purchase B if it is cheaper than A. Therefore,
budget constraints alter the choices of a consumer beyond his/her preferences.

Utility Maximization and Consumer Equilibrium

A consumer is in equilibrium when, given his personal income and price constraints, the
consumer maximizes the total utility or satisfaction from his or her expenditures. In other words,
a consumer is in equilibrium when, given his budget line, the person reaches the highest possible
indifference curve.

Fig. 5. Graph of the equilibrium position

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A consumer is at equilibrium consumption position when the budget line is at tangent to the
highest possible indifference curve (point E on Fig.2.2). The consumer would love to attain
indifference curve III but cannot. The individual could also consume on point N or point R on
indifference curve I but doing so would not maximize his satisfaction from the expenditures,
indifference curve II is the highest the individual can reach given his level of income and
commodity prices by choosing commodities Qy(E) and Qx(E). NB: at point E, the slope of the
budget line equals the slope of indifference curve II. Therefore,

at point E,

A consumer maximizes the total utility (or satisfaction) obtained from spending his/her income
(and is said to be at equilibrium) when the marginal utility of the last Naira spent on each
commodity is the same. That is, the equilibrium condition for utility maximization is stated as
follow:

Marginal utility of the last Naira spent on each commodity

at the point where P1Q1 + P2Q2 = M

Ordinarily, the consumer will wish to choose the consumption combination (say Q 1 and Q2) that
will maximize (yield) the highest possible level of satisfaction to him. This is the level of
commodities Q1 and Q2 associated with the highest attainable indifference curve. Thus, the point
of tangency between the highest attainable indifference curve and the budget line defines the
optimal consumption combination level (Q*1 and Q*2). Hence, a consumer is at equilibrium at
the point where the slope of the indifference curve is equal to the slope of the budget line.

that is, at the point where

Consumer Demand Theory with Calculus

Starting with the utility function U= U(X,Y), where X and Y refers, respectively, to the quantities
of commodities X and Y, the derivation of the expression for the slope of the indifference curve
using calculus goes thus:

Taking the total differential and setting it equal to zero (since utility remains unchanged along a
given indifference curve), we can get:

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Thus, the expression for the absolute slope of the indifference curve is

Combining the utility function U= U(X,Y) and the budget constraint PxX + PyY = M, the
equilibrium condition can be derived thus:

We start by forming function V, which incorporates the utility function to be mximised subject to
the budget constraint set equals zero, and get

where is the Langragian multiplier. Taking the first partial derivative of V w.r.t X and Y and
setting them equal to zero, we get

and

Dividing the first by the second equation, we get

Consumer’s Surplus

Consumer’s surplus refers to the difference between what the consumer is willing to pay to
purchase a given quantity of a commodity and what he actually pays for them. Consumer’s
surplus arises because the consumer actually pays for all units of the commodity the price he is
just willing to pay for the last unit purchased, even though the MU on earlier units is greater.
Consumer surplus can be measured by the area under the consumer’s demand curve and above
the commodity price.

The Law of Diminishing Marginal Utility

As an individual consumes more units of a commodity per time, the total utility (TU) he receives
first begins to increase. However, as he continues to consume more and more units of the
commodity, his TU keeps increasing until he gets to a point when his TU reaches a maximum
level and then it stops to increase any further. This is called the point of saturation. If the
consumer continues to consume the commodity beyond this point, his TU begins to fall and thus,
the extra utility he obtains from each additional unit of consumption (MU) begins to fall.
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Note that: MU is positive but declining as long as TU is increasing. MU = 0 at the point of
saturation (where TU is maximum and is neither rising nor falling). Beyond the saturation point,
TU is falling and MU is negative.

Practice Question 2:

(i). Determine the MU for the table below.

(ii). Plot the TU and MU graph

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(iii). Determine the consumer’s saturation point for commodity Y.

Qy 0 1 2 3 4 5 6 7 8 9 10
TUy 0 13 24 34 42 49 55 58 60 60 55

Practice question 3: Why is water, which is essential to life, so cheap while diamonds, which
are not essential to life, so expensive?

Answer:

Since water is essential to life, the TU received from water exceeds the TU received from
diamonds. However, the price we are willing to pay for a commodity depends on the MU and not
on TU. That is, since we consume so much water, the MU of the last unit of water consumed is
very low. Therefore, we are willing to pay only a very low price for this last unit of water
consumed. Since all the units of water consumed are identical, we pay the same low price on all
the other units of water consumed.

THEORY OF CONSUMPTION

The Income-Consumption (IC) curve and the Engel curve

When we keep consumer’s taste and the prices of commodity X and Y constant but the
consumer’s money income (M) varies, we derive the consumer’s IC curve and the Engel curve.
The Engel curve is obtained when we draw a line to join all the loci of points of equilibrium that

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result when the consumer’s income (M) is varied but tastes and prices of the commodities are
held constant.

(Fig. 5 Graphical derivation of the Engel curve)

The consumer reaches equilibrium at point F (on the indifference curve I), point E (indifference
curve II) and point S (indifference curve III). By joining the points of consumer equilibrium F-E-
S, we get the IC curve.

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 (Fig. 6. Graph of the Engel curve)

NB: The Engel curve looks exactly like the commodity supply curve.

Since the Engel curve is positively sloped, the income elasticity of demand >0 and
commodity X is a normal good. When the Engel curve is negatively sloped, <0 and the
commodity is an inferior good. Furthermore, when the tangent to the Engel curve at a particular
point is positively sloped and it cuts the income axis, >1 and the commodity is a luxury at that
point. If the tangent to the Engel curve at a particular point is positively sloped and it cuts the
quantity axis, 0< <1 (value ranges between 0 and 1) and the commodity is a necessity at that
point.

Practice Question 4: For the income-quantity table below, (a) sketch the Engel curve and (b).
determine if the commodity is a necessity, a luxury, a normal, or an inferior good at points A, B,
D, F, H, and L.

Point A B C D F G H L
Income 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000
(M)( N)
Quantity 100 200 300 350 380 390 350 250
(Kg)

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 (Fig. 7. Engel graph of practice question 4)

At A and B, the tangent to the Engel curve is positively sloped and cuts the income axis.
Therefore, >1 and the commodity is a luxury at those points. At points D and F, the tangent
to the Engel curve is positively sloped and cuts the quantity axis, and thus, 0< <1 and the
commodity is a necessity at those points. At points H and L, the tangent to the Engel curve is
negatively sloped and the commodity is an inferior good at those points.

THE PRICE-CONSUMPTION (PC) CURVE AND THE CONSUMER’S DEMAND

CURVE

By changing the price of X while keeping constant the price of Y and the consumer’s tastes and
money income, we can derive the consumer’s price-consumption (PC) curve for commodity X.
The price-consumption (PC) curve for commodity X is the locus of points of consumer
equilibrium resulting when only the price of X is varied, and other factors kept constant. The
consumer’s demand curve for commodity X shows the amount of X that the consumer is willing
to purchase at various prices of X, ceteris paribus.

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When the slope of the price-consumption (PC) curve is positive, then the price elasticity of
demand, is inelastic. When the slope is zero, then is unitary price-elastic. When the slope
is negative, then the price elasticity of demand, is price-elastic.

Where price elasticity of demand

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The basic price-consumption relationships in the consumer theory

• A consumer's demand for a commodity is the amount of it which the consumer is willing
and able to buy, under given conditions, per unit of time, in a specified market, and at
specified prices. (Nb: demand is not the same as desire or need).

• The economic analysis of demand is concerned with actual market behaviour.

• Willingness to purchase the commodity is a necessary condition; the sufficient condition

is that the potential consumer must also have the ability to purchase (i.e. pay for) the
commodity. This distinction is particularly important when the analysis concerns the
demand for food and the design of food policy.

• Traditional economic theory suggests that, given the consumer's tastes and preferences,
the demand for a commodity will be determined by:

 the price of the commodity

 the prices of other related commodities (substitutes, compliments, etc), and

 the consumer's level of income.

CONSUMER DEMAND AND MARKET DEMAND

Demand function: A technical relationship between quantity and price of a commodity.

The demand schedule for an individual specifies the units of a good or service the individual is
willing to purchase at alternative prices during a specified period of time. The individual must
not only show willing to buy must also display the ability to pay for those commodities.
Therefore, effective demand must be backed up with the willingness and ability to pay for a
commodity/service. The relationship between price and quantity demanded is inverse. When
plotted on a graph, the inverse relationship between price and quantity demanded appears as a
negatively sloped demand curve.

A market demand schedule specifies the units of a good or service all individuals in the market
are willing and able to purchase at any particular time. The market demand schedule reflects the
collective wants of people in a market area and is the sum of the quantities demanded (Q d) by the
individuals at alternative prices (P). Therefore, the demand function holds thus:

(given the consumer’s taste)

where:

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Qd = quantity demanded of a good

P1, P2,…, Pn = Prices of the n consumers of goods in the market

M = Consumer’s income.

NB: We can actually have an individual demand function and market demand function.

The Demand Schedule

A demand schedule is a table giving the quantity of a commodity purchased at the respective
prices at a given period of time. When this schedule is made for individual buyers in the market,
it is an individual demand schedule but when it is done for the entire consumers in the market, it
is called market demand schedule. The table below gives the alternative prices (P) and the
quantity of commodity (Q) demanded at each price by each one of a total of 1000 buyers in a given
market.

Individual Demand Market Demand Schedule

Schedule
Price (P) Quantity Demanded (q) by Quantity Demanded (Q) by
(N per unit) one individual the 1000 buyers in the market
(Units/month) (Units/month)
5 35 35,000
4 45 45,000
3 60 60,000
2 80 80,000
1 11 11,000
Individual demand schedule and market demand schedule of commodity q

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 The demand curve

More quantities of the commodity are purchased at lower prices because of substitution effect
and income effect.

When a commodity’s price falls, an individual normally purchases more units of this good or
service since he is likely to substitute it for the other goods whose price has remained unchanged
(substitution effect). Also, when a commodity’s price falls, the purchasing power of an individual
with a given income increases, allowing for ability to buy more quantities of the product ( income
effect).

Factors affecting quantity demanded

i. Price of the commodity or service

ii. Income of the consumer

iii. Taste of the consumer

iv. Weather or climate condition

v. Availability of other substitutes\

vi. Technological changes or advancement

Change in quantity demanded Vs. Change in demand

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As we have noted, the market demand curve depicts the relationship between consumption of a
particular good and its own price, all other determinants of demand being held constant. In
mathematical notation, the market demand curve for good Qd can be represented as:

A change in the commodity’s price will induce a movement along the market demand curve. A
shift in the demand curve, on the other hand, will occur if one or more of the other determinants
of the demand function changes.

A rightward shift in the demand curve (D 1 to D2) would induce a higher level of consumption
(e.g, for butter as a product)s. This shift could be caused, for example, by:

(a). An increase in per caput income, assuming butter is a normal good

(b). An increase in the price of a substitute, say margarine. As the price of margarine rises,
consumers reduce their consumption of margarine and increase their purchases of (relatively less
expensive) butter

(c). A decrease in the price of a complement. If butter is used as a spread for bread then as the
bread price falls, consumers are induced to buy more bread and with it, more butter.

Graphical illustrations here

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 MEASUREMENT OF ELASTICITIES OF DEMAND

Economists use the concept of price elasticity of a product or service to measure sensitivity of
quantity demanded. Elasticity is a measure of the proportional change in the quantity demanded
as a result of a proportional change in another quantity.

Price elasticity of demand

It is a measure of the degree of responsiveness in the quantity of a commodity demanded as

a result of changes in the commodity price. Algebraically, elasticity of demand is the ratio of
the percentage change in quantity to the percentage change in price. It is normally expressed as a
fraction:

Demand is said to be elastic if > 1; inelastic if < 1, and unitary elastic if = 1.

Types of elasticity of demand

(a). Own (price) elasticity of demand ( )

The own price elasticity of demand measures the sensitivity of the demand of a good (Qi) to
changes in its (own) price (Pi), ceteris paribus. Symbolically, it is defined as:

= (or ) for an infinitesimal change

varies between 0 and (i.e. 0< < )

= 0 if the quantity demanded does not change at all with a change in commodity price. The
larger the value of elasticity, the larger the percentage change in in quantity demanded for a
given percentage change in price.

Type and interpretation of (own) price elasticity and its effect on total revenue from quantity sold

S/No. Value of Interpretation Terminology Effect of Price

elasticity ( ) (P) changes on
Total Revenue
(TR)
i. =0 Quantity demanded does not Perfectly If P increases,
change as price changes inelastic TR increases

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 If P decreases,
TR decreases
ii. 0 > >1 Quantity changes by a small Inelastic demand If P increases,
% than price TR increases

If P decreases,
TR decreases
iii. =1 Quantity changes by the Unitary -
same % as price elasticity
iv. 0> > Quantity changes by a larger Elastic demand If P increases,
% than price TR decreases
If P decreases,
TR increases
v. = Consumers will purchase all Perfectly elastic If P increases,
they can at a particular price TR decreases
but none of the product at a
If P decreases,
higher price
TR increases

Factors affecting the price elasticity of demand

i). Availability of substitutes (demand for a commodity is more elastic if there are close
substitutes)

ii). The proportion of income spent on a particular product (the higher the share of the
consumer’s budget/income a commodity takes, the more responsive to price changes (elastic) the
consumer will be.

iii). The number of uses a commodity is put (for composite goods that have many several uses,
they are relatively more responsive to price changes (i.e. more elastic)

iv). The degree of commodity aggregation (i.e. how widely or narrowly the commodity is
define). Commodity aggregation reduces the number of substitutes and increases the budget
share of the commodities. E.g. the demand for chocolate is expected to be more price elastic than
the demand for beverages, which in turn will be more price elastic that the demand for all
categories of foods.

Example

For the market demand schedule in the Table below, find the (own) price elasticity of demand
for a movement from (i). points B to D (ii). points D to B (iii). Midway between B and D (iv). points
D to G.

Point A B C D F G H
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Px 6 5 4 3 2 1 0

Qx 0 20,000 40,000 60,000 80,000 100,000 120,000

Solution

(i). From point B to D: =5

(ii). From point D to B: =1

(iii). At the point mid-way (i.e. at C): = 2

(iv). From point D to G: =1

(b). Cross price elasticity of demand

The cross price elasticity of demand of a product is the degree of responsiveness in the quantity
demanded of commodity B as a result of changes in the price of commodity A, ceteris paribus.

is negative for complimentary goods and positive for goods that are substitutes.

Example:

The prices and quantities demanded of tea (X), coffee (Y) an lemon (Z) before and after a price
change regime in a market is given in the table below.

Commodity Before After

Price (N/cup) Quantity Price (N/cup) Quantity
(unit/week) (unit/week)
Tea (X) 20 40 20 50 (with coffee)
35 (with lemon)
Coffee (Y) 40 50 60 30
Lemon (Z) 10 20 20 15
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Find the:

(i). cross elasticity of demand between tea and coffee and describe the kind of commodities they
are

(ii). cross elasticity of demand between tea and lemon and describe the relationship between both
commodities

Solution:

(i). is calculated to be +0.5. Therefore, tea and coffee are substitutes

(ii) is calculated to be -0.125. Therefore, tea and lemon are compliments

(c). Income elasticity of demand

Income elasticity of demand is a measure of the degree of responsiveness of quantity of a

commodity demanded to changes in the customer’s income.

i). is positive for normal goods (as income increases, the quantity consumed increases)

ii). is negative for inferior goods (as income increases, the quantity consumed decreases)

Example

The table below shows the quantity of meat a family of four would purchase per year at various
income levels. (a). Find the income elasticity of demand of this family for meat between the
various successive levels of the family’s income (b). Over what range of income is meat a
luxury, a necessity, or an inferior good for this family? (c). Plot on a graph the income-quantity
relationship, i.e. the Engel curve (income on the Y-axis and quantity on the X-axis).

Problem and Solution (in bolden portion of the table)

Point Income (M) Quantity (Q) % in M % in Q Type of

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 ($/annum) (Kg/annum) good
A 4,000 100 - - - -
B 6,000 200 50 100 2 Luxury
C 8,000 300 33.33 50 1.50 Luxury
D 10,000 350 25 16.67 0.67 Necessity
E 12,000 380 20 8.57 0.43 Necessity
F 14,000 390 16.67 2.63 0.16 Necessity
G 16,000 350 14.28 -10.26 -0.72 Inferior
H 18,000 250 12.50 -28.57 -2.29 Inferior

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