UNIT II

CONSUMER BEHAVIOR AND DEMAND ANALYSIS

Syllabus

Cardinal Utility Approach: Diminishing Marginal Utility, Law of Equi-Marginal Utility. Ordinal Utility Approach:
Indifference curves, Marginal Rate of Substitution, Budget Line and Consumer Equilibrium. Theory of Demand, Law of
Demand, Movement along vs. Shift in Demand Curve, Concept of Measurement of Elasticity of Demand, Factors
Affecting Elasticity of Demand, Income Elasticity of Demand, Cross Elasticity of Demand, Advertising Elasticity of
Demand. Demand Forecasting: Need, Objectives and Methods.

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Utility

Utility means the happiness or satisfaction which you get by consuming a good whether the good is useful or
not. In fact, if a good has an ability to give some satisfaction or happiness to its user, then an economist says
that the good has utility. Utility does not mean the usefulness of a good but it is it’s the capability to satisfy
someone’s need or a want. The world famous painting Mona Lisa by Leonardo da Vinci, has ability to give
happiness to an art lover but the painting cannot be said to be useful to the art lover. Therefore, the painting has
utility but still not useful even for the art lover.

Total Utility

It means number of utilities obtained by consuming all the units of something. In fact, total utility is the
summation of marginal utilities of n units of a good.

Total utility = MU1 + MU2 + MU3 + ⋯ . MUn = ∑ MUi

𝑖=1

Marginal utility

It means the change in total utility when one extra unit of a good is consumed. Mathematically, it is defined as
the ratio of change in the total utility and the change in the quantity. Therefore

∆U Change in the total utility

MU = =
∆Q Change in the quantity

The following schedule shows the calculation of MU from total utility.

Quantity TU MU
(In utils) (In utils)
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2

2
In the language of calculus, if U = f(Q) is a utility function of good x where Q represents its quantity, then marginal utility
is the derivative of utility function with respect to Q. Symbolically,

𝑑𝑈
𝑀𝑈 =
𝑑𝑄

Relationship between total utility and marginal utility

The relationship between the marginal utility and the total utility is:
1. When the marginal utility decreases, then the total utility increases. For example, in the table given
below the last column shows that when the marginal utility (MU) decreases from 10 utils to 0, then the
total utility increases to 30 utils.
2. When the marginal utility is zero, then the total utility attains its maximum value. Referring the
same table we find that when the marginal utility is 0, then the total utility achieves its maximum value
30 utils.
3. When the marginal utility becomes negative, then the total utility declines. For example, when the
marginal utility crosses zero level, then it becomes negative i.e. – 2 utils, then total utility starts to
decline from 30 utils to 28 utils.

Quantity TU MU 32
30
(in utils) (in utils) 28
TU
Total Utility and Marginal Utility

26
0 0 24
22
1 10 10 20
18
2 18 8 16
14
3 24 6 12
10
4 28 4 8
6
5 30 2 4
2
6 30 0 0
-2 0 1 2 3 4 5 6 7 MU 8
7 28 -2 -4
Quantity of X

3
Cardinal utility theory

Economists have tried to understand a consumer’s behavior with the help of various theories or approaches.
Mainly, there are two utility theories i.e. 1) Cardinal Utility Theory and 2) Ordinal Utility Theory. The cardinal
utility theory assumes that utility is a cardinal concept and therefore can be measured in numbers while the
ordinal utility theory assumes that preferences can be ranked/ordered.

Assumption of cardinal utility theory

The assumptions of the cardinal utility theory are as follows.

1. Rational consumer: It means that a consumer always wants to maximize his or her utility for a given
income.
2. Utility is cardinal: It means that utility is a cardinal concept i.e. utility can be measured in numbers.
The measuring unit of utility is util.
3. Marginal utility of money is constant. The marginal utility of money can also be expressed in utils but
remain constant. The marginal utility of money is calculated by the consumer himself or herself.
4. Law of diminishing marginal utility operates well.
5. Utilities are additive: It means the utilities derived from the consumption of n goods can be added.
However, this assumption is not necessary for the cardinal theory.

Law of diminishing marginal utility / Gossen’s first law of utility

The law of diminishing marginal utility states that marginal utility is a decreasing function of the quantity
consumed. In other words, as the consumption of a good is increased from 1 to 2 to 3 to 4 to...to n units, then
the utility derived from the second i.e. MU2 is less than the utility from the first unit i.e. MU1, the utility derived
from the 3rd unit i.e. MU3 is less than the utility from the second unit i.e. MU2, the utility derived from the 4th
unit i.e. MU4 is less than the utility from the 3rd unit i.e. MU3 and finally the utility derived from the nth unit i.e.
MUn is less than the utility derived from the (n-1)th unit i.e. MUn-1. Symbolically,

MU1 > MU2 > MU3 > ⋯ … … … … … > MUn-1 > MUn

The law of diminishing marginal utility makes the marginal utility curve downward sloping. In the following
diagram we have a downward sloping marginal utility curve showing that as the quantity increases, then the
marginal utility keeps on declining. One point must be kept in mind - MU may be positive, zero or even
negative when consumption is compelled.

4
 MU (utils)

0
MU
Quantity of the good

Assumptions of the law of diminishing marginal utility

The law of diminishing marginal utility is based upon the following assumptions:
1. Utility is a cardinal concept i.e. it can be measured in numbers.
2. Marginal utility of money is constant.
3. Consumption should be on continuous basis i.e. there should not be break in consumption.
4. A unit is should be defined properly i.e. if water is being taken, then a unit does not mean a drop rather it
should be a glass of water.
5. Each unit being consumed should be of the same size and quality.
6. Goods are divisible i.e. they can be measured at any point on a number line.
7. Income of the consumer is constant.

Exceptions to the law of diminishing marginal utility

Is the law of diminishing marginal utility always applicable? The answer is NO. There are some exceptions to
the law. These exceptions are as follows:

1. Consumption of initial units

When someone starts to consume something and the first consumed is not in sufficient quantity, then the
second unit will add to the utility more than the first unit.
2. Rare goods especially bearing historical importance
Rare goods mean those goods which are not available in bulk quantity. Historical Coins, paintings etc.
are some examples of rare goods. It has been found that as one gets more and more of rare goods, then
he or she gets more and more utility or satisfaction.
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 3. Addicts of drugs or alcohol
It has been found that the more and more wine a drunkard takes the more utility he obtains.
4. Interesting books, religious books, songs or movies
When we read some interesting books/novels/religious books or listen some melodious songs or watch
fantastic movies, then more consumption (reading/listening/watching etc.) give us more marginal utility.
Therefore, the law does not hold good here. However, the law does not operate up to a certain level of
time and one time will come when the law will start to work.
5. Seekers of spirituality
There is a group of people for whom only spirituality matters. Naaga sadhus, Aghori rishis found in
India are classic examples of such people. In case of such people the law fails because except the things
relating to spirituality do not give them happiness or utility.

CONSUMER EQUILIBRIUM: OPTIMISING/MAXIMISING UTILITY

When a consumer finds that re-distribution of his or her limited income over one or two or more goods will not
add to his or her present total utility, then he or she is said to be in equilibrium. In other words, a consumer is in
equilibrium when he or she maximizes/optimizes his or her utility for a given level of income. Economists study
equilibrium in three cases. These cases are as follows:

I: Consumption of one good

Suppose that Px is the price of a good X and MUx is its marginal utility which is measured in utils. Further
suppose that MUM is constant marginal utility of one rupee which is also measured in utils. When the ratio of
the marginal utility of X and the marginal utility of rupee one is equal to the price of X, then the consumer gets
equilibrium. Symbolically,

MUx
= Px … … … … … … … … … . (1)
MUm

Equation (1) states that when the marginal utility of X per marginal utility of rupee one is equal to the price of
X, then the consumer is in equilibrium.

Rearranging equation (1), we get another version of equilibrium condition i.e.

MUx
= MUm … … … … … … … … (2)
Px

Equation (2) states that when the marginal utility of X per unit of price is equal to the marginal utility of rupee
one, then a consumer is in equilibrium.
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Now if we rearrange again any of the above two equations, then we have another version of equilibrium
condition i.e.

MUx = Px × MUm … … … … … … … (3)

The right hand side of this equation is called weighted marginal utility of rupee one. Equation (3) states that
when the marginal utility of X is equal to the weighted marginal utility of rupee one, then a consumer is in
equilibrium.

Example: Suppose a consumer Lara is asked about her utility of rupee one and she replies that its 5 utils.
Therefore, MUM=5 utils. Further suppose that the price of a good is `10 and the marginal utility of different

units of the good are given in the second column the following table. In the above table, for the 3rd unit the MUx
is 50 utils and the weighted marginal utility of rupee one is also 50 utils, therefore equation 3 is satisfied here.
Thus, by consuming 3 units of the good Lara is in equilibrium.

Units MUx (in utils) MUm (in utils) Px (in `) 𝐏x × 𝐌𝐔m

1st 70 5 10 50
2nd 60 5 10 50
3rd 50 5 10 50
4th 40 5 10 50
5th 30 5 10 50
If we plot the data from the above table on a graph, then we get a downward sloping marginal utility curve MU x
and a horizontal line Px X MUm. Both the curves are intersecting when the quantity is 3 units. At the intersection
MUx= Px X MUm. If the consumption is less than 3 units, then MUx > Px X MUm, then Lara can increase her
welfare by increasing consumption and if the consumption is greater than 3 units, MUx< Px X MUm, then Lara
can increase her welfare by decreasing consumption. In this way when MUx= Px X MUm, then the incentive to
go ahead or move backward disappears.

80
MU & weighted MU of

70
60
50 𝑃x × 𝑀𝑈m
money

40
30
𝑀𝑈x
20
10
0
0 1 2 3 4 5 6
Quantity of X

7
II: Consumption of two goods: Law of Equi-marginal utility

Suppose that Px and Py are the prices of two goods X and Y respectively and MUx and MUy are their respective
marginal utilities which are measured in utils. Further suppose that MUM is constant marginal utility of rupee
one which is also measured in utils. Now we know that in case of one good consumption the equilibrium
condition is attained when the ratio of the marginal utility of a good and the marginal utility of rupee one is
equal to the price of the good, therefore,

Equilibrium in case of good X

MUx
= Px … … … … … … … … … . (1)
MUm

Equilibrium in case of good Y

MUy
= Py … … … … … … … … … . (2)
MUm

Dividing equation (1) by equation (2) we get

MUx Px
= … … … … … … … … (3)
MUy Py

This is the required condition of equilibrium when two goods are consumed. Equation (3) states that when the
ratio the marginal utilities of X and Y are equal to their prices ratio, then a consumer is in equilibrium.

Rearranging equation (3) we get another version of the equilibrium condition i.e.

MUx MUy
= … … … … … … . (4)
Px Py

Equation (4) states that when the marginal utility of good X per unit of its price is equal to the marginal utility
of good Y per unit of its price, then a consumer is in in equilibrium. This equation is known as the law of Equi-
marginal utility.

In the following diagram the MUx/Px and MUy/Py curves denote the marginal utilities per unit of the prices of
two goods X and Y respectively. The MUx/Px tells us how much marginal utility is derived by spending rupee
one on X. Similarly, MUy/Py does. Apart, the movement from left to right on the horizontal axis measures the
quantity demanded of X while the movement from right to left measures the quantity demanded of Y. MUx/Px
and MUy/Py curves intersect each other at point E where
MUX MUY
=
PX PY
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Therefore point E is the equilibrium point where OxQ (from left to right) is the quantity demanded of X while
that of Y is OyQ (from right to left).

MUX MUy
Equilibrium Py
PX
Point

MUy
Py
MUX
PX

0x Q 0y
Quantity of X
Quantity of Y

Case 3: Consumption of n goods i.e. more than two goods: Law of Equi-marginal utility

If n goods are consumed, then in equilibrium the ratios of the marginal utilities and their prices are equal.
Symbolically,

MU1 MU2 MU3 MUn

= = = ⋯……….=
P1 P2 P3 Pn

Criticism of the cardinal utility theory

The cardinal utility theory is criticized due to the following reasons:

1. The theory assumes that utility is a cardinal concept i.e. utility can be measured in number but in reality
utility cannot be measured objectively. Utility is a subjective matter not cardinal. Therefore, this
assumption is unrealistic.
2. Generally, the more money a normal person obtains the more marginal utility he obtains but the cardinal
utility theory assumes that the marginal utility of money is constant. This assumption also seems to be
unrealistic.
3. The law of diminishing marginal utility is a psychological law which must be taken as granted.
4. The cardinal utility theory assumes that the marginal utility of money is calculated by the consumer
himself but in practical life this is not an easy task.
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Ordinal utility theory

The ordinal utility theory is based upon the following assumptions:

1. Rational consumer: It means that a consumer always wants to maximize his or her utility for a given
level of income.
2. Utility is ordinal: It means that a consumer can rank or make ordering of his or her preferences for
various market baskets according to the satisfaction/utility of each basket.
3. Consistency in preference: It means that if a consumer prefers market basket A than B at a time, then
he or she will not prefer B than A at other time. Symbolically,
If A ≻ 𝐵, 𝑡ℎ𝑒𝑛 𝐵 ≯ 𝐴
4. Transitivity in preference: It means that if a consumer prefers market basket A than B and B than
market basket C, then he must prefer A than C.
If A ≻ 𝐵 𝑎𝑛𝑑 𝐵 ≻ 𝐶, 𝑡ℎ𝑒𝑛 𝐴 ≻ 𝐶
5. More is better than less: It means that a consumer prefers more quantity of a good than less quantity.

Indifference curve

An indifference curve is a curve showing all those points (or market baskets) giving a consumer equal
satisfaction. In other words, an indifference curve records all those market baskets which are equally capable of
satisfying a consumer. Thus, on an indifference curve the utility level does not change irrespective of the market
baskets being preferred. In the diagram, IC is an indifference curve that shows that market basket A gives the
same satisfaction as market basket B does even A and B have different quantities of two goods x and y.
Mathematically, an indifference curve be defined as a utility function u = f(x, y) of x and y satisfying the
following condition:

𝜕𝑢 𝜕𝑢
𝑑𝑢 = 𝑑𝑥 + 𝑑𝑦 = 0
𝜕𝑥 𝜕𝑦

Qty. Y

A
Y1

B
Y2
IC
0 X1 X2 Qty. X 10
Marginal Rate of Substitution: The slope of an indifference curve

Marginal Rate of Substitution (MRSxy) is the rate at which a consumer is willing to exchange one good y for a
good x. In other words MRSxy tells us that how many units of good y must be given up to obtain one unit extra
of good x. For example, if MRSxy = 5, then it means 5 units of good y must be given up to obtain one unit extra
of good x.

Change in the quantity of Y ∆Y

MRSxy = − =−
Change in the quantity of X ∆X

MRS using calculus

Mathematically, if 𝑢 = 𝑓(𝑥, 𝑦) is a utility function of two variables x and y, then for a given indifference curve
the total differential is zero. Symbolically,

𝜕𝑢 𝜕𝑢
𝑑𝑢 = 𝑑𝑥 + 𝑑𝑦 = 0
𝜕𝑥 𝜕𝑦

Since,

𝜕𝑢 𝜕𝑢
= 𝑀𝑈𝑥 ; = 𝑀𝑈𝑦
𝜕𝑥 𝜕𝑦

Therefore, the total differential is

𝑑𝑢 = 𝑀𝑈𝑥 𝑑𝑥 + 𝑀𝑈𝑥 𝑑𝑦 = 0

Or

𝑑𝑦 𝑀𝑈𝑥
=−
𝑑𝑥 𝑀𝑈𝑦

We know that

𝑑𝑦
Slope of a tangent on a point on a curve = Rate of change of y with respect to 𝑥 =
𝑑𝑥
Therefore,

𝑑𝑦 𝑀𝑈𝑥
𝑀𝑅𝑆xy = =−
𝑑𝑥 𝑀𝑈𝑦

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Properties / assumptions of an indifference curve

1. Downward sloping i.e. the slope of an indifference curve is negative

An indifference curve is assumed to be downward sloping and the reason for being so is very simple
i.e. on a given indifference curve when X increases, then an adjustment in Y is required so that the
utility level on the indifference curve does not change and this adjustment can be made by
sacrificing Y. In this way there is negative relationship between X and Y causing the slope (or MRS)
of an indifference curve to be negative.

An alternative explanation for downward sloping indifference curve is that if an indifference curve is
supposed to be upward sloping, then there would be a logical inconsistency. To understand this,
consider the following diagram in which we have an upward sloping indifference curve IC. There
are two market baskets A and B. Market basket B contains more quantities of each good compared
to A, therefore, B must be preferred to A because this assumed that more is better but since they lie
on the same indifference curve, they must be equally preferred. Is it logical B is preferred to A and it
is equally preferred to A also? No. Therefore, indifference curve is not assumed to be upward
sloping.

Qty. Y
IC

0 Qty. X

2. Convex to the origin / Diminishing marginal rate of substitution

An indifference curve is convex to the origin. Convexity of an indifference curve means that a
straight line joining any two points on the indifference curve is a set of all those points or market
baskets (excluding the points being joined) which are preferred to all those market baskets lying on
the indifference curve but under the line. The reason of convexity of an indifference is the law of
diminishing marginal utility. In fact, when we prefer the more quantity of X, then Y is sacrificed and
therefore in case of X the marginal utility of X declines due the law of diminishing marginal utility

12
 while that of Y increases due to the same law. That is why, the marginal rate of substitution (MRS)
of an indifference curve is diminishing. The following diagram shows the diminishing MRS.

Qty. Y
A

MRS

B
MRS
C
MRS D

IC

0 Qty. X

3. The higher indifference curve the higher level of satisfaction

In an indifference map (which means a set of indifference curves on the same graph), the
farthest/highest indifference curve gives a consumer the highest satisfaction due the assumption of
ordinal utility theory-more is better. In the following diagram, we have three indifference curves IC1,
IC2 and IC3 and IC3 is the farthest or highest, therefore it gives the highest satisfaction in comparison
of other two indifference curves. Every market basket on a higher indifference curve has more
quantities of two goods than a lower indifference curve.

Qty. Y

IC3
IC2
IC1

0 Qty. X

13
4. Two indifference curves cannot intersect each other
To understand the logic of this property we assume that two indifference curves IC1 and IC2 intersect
at point A as shown in the diagram.

Qty. Y

B
IC1
C IC2

0 Qty. X

Since market baskets A and B fall on the same indifference curve IC1and therefore, A and B are
equally preferred. Symbolically,
A = B……… (1)
Since market baskets A and C fall on the same indifference curve IC2 and therefore, A and C are
equally preferred. Symbolically,
A = C……… (2)
From (1) and (2) we conclude that B and C are equally preferred. Symbolically,
B = C……… (3)
But market basket B falls on a higher indifference curve, therefore, it must be preferred to C.
Symbolically,

𝐵 ≻ 𝐶 … … … . (4)

Is it logical that results (3) and (4) can operate together? No. Therefore, the conclusion is that if
two indifference curves are allowed to intersect, then there would be a logical inconsistency.
Thus, our assumption of intersection of two indifference curves is wrong.

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Exceptional shapes of indifference curve

Perfect substitutes: Straight indifference curve

If x and y are two perfect substitutes, then the MRSxy or MRSyx is constant due to which the indifference curve
is a straight line as shown in the diagram. MRS is constant because a consumer knows that both x and y are
perfect substitutes and due to which if he prefers one more extra unit of x will cause a constant sacrifice of y.

Qty. Y

MRS

MRS

MRS
IC
0 Qty. X

Perfect Complementary goods: L-shaped indifference curve

Two goods are said to be perfect complements when a consumer wants to consume them a specific ratio. In case
of perfect complementary goods an indifference curve is L-shaped. To understand this we take market basket A
consisting of 2 units of good x and 3 units of good y. If the quantity of x is increased from 2 units to 4 units
while the quantity of y is kept constant at 3 to get market basket B, then extra units of x adds nothing to the
utility of the consumer under study. Thus, the utility levels at A and B are the same. Therefore, they must lie on
the same indifference curve IC1. Similarly, if the quantity of y is increased from 3 units to 6 units while the
quantity of x is kept constant at 2 to get market basket C, then extra units y adds nothing to the utility of the
consumer. Thus the utility levels at A and B are the same. Therefore, they must lie on the same indifference
curve IC1. In this way, the indifference curve is right angle at market basket A i.e. L-shaped. The consumer
prefers to consume market basket A in which the ratio of the quantities of x and y is 2:3. If this ratio is
disturbed, then the utility cannot be increased. Utility can be increased by preferring the market basket giving
the same ratio as A does i.e. 2:3. Market basket D on IC2 is such a basket which also yields the same ratio 4:6 =
2:3.

15
 Qty. Y

C D
6 IC2
D

A B
3 IC1

Q
0 2 4 Qty. X

Budget line

A budget line is a line that locates all those market baskets which are affordable and therefore, it helps us in
finding those market baskets which can be and cannot be purchased. Mathematically, a budget line is defined as
follows:
Px Qx + PY Qy = m
Where Px and Py are the per unit prices of two goods X and Y while Qx and Qy are their quantities and m is given
income. Using the mathematics of straight lines we have the following formula of a budget line.
Px
Slope of a budget line = −
Py
In the following diagram we have a budget line BL which shows that all the market baskets on BL are
affordable but those lying beyond it (like D) are not affordable because they will require higher income than m.
All the market baskets lying under a budget line are affordable but in that case there will be saving in the
income given.

Qty. Y

L
0 Qty. X

Note: The inequality given below is called budget region or budget constraint. It gives us the possibility of
saving from the income, but the budget line gives zero possibility of saving.
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Effect of change in income on a budget line while prices of the goods are constant

Case I: Income increases

Keeping other things constant, if the income of a consumer increases, then the budget line shifts parallel
rightward. In the diagram when income is I1, then the budget line is BL but when the income increased to I2,
then the budget line is B’L’.

Qty. Y B’

L L’
0 Qty. X

Case II: Income decreases

Keeping other things constant, if the income of a consumer decrease, then the budget line shifts parallel
leftward. In the diagram when income is I1, then the budget line is BL but when the income decreased to I2, then
the budget line is B’L’.

Qty. Y B

B’

L’ L
0 Qty. X

17
Effect of change in prices of goods on a budget line while income is constant

Case I: Price of good X decreases while the price of Y is unchanged

When the price of X falls, then a consumer can buy more of it and as a result the initial budget line BL rotates
about point B and becomes BL’. Technically, on fall of the price of X, the slope of the budget line increases and
as a result the budget line rotates rightward around point B.

Qty. Y

L L’
0 Qty. X

Case II: Price of good Y decreases while the price of X is unchanged

When the price of Y falls, then a consumer can buy more of it and as a result the initial budget line BL rotates
about point L and becomes B’L. Technically, on fall of the price of Y, the slope of the budget line decreases and
as a result the budget line rotates leftward around point L.

Qty. Y
B’

L
0 Qty. X
Consumer equilibrium: Utility maximising market basket

18
When a consumer finds that re-distribution of his or her limited income over one or two or more goods will not
add to his or her present total utility, then he or she is said to be in equilibrium. In other words, a consumer is in
equilibrium when he or she maximizes/optimizes his or her utility for a given level of income. In ordinal
utility theory a consumer attains equilibrium when a budget line is tangent to an indifference curve.
Technically, a budget line is tangent to an indifference curve when its slope is equal to the slope of an
indifference curve. Thus the equilibrium condition is
Slope of a budget line = Slope of an indifference curve
We know that
Px
Slope of a budget line = −
Py
and
Slope of an indifference curve = −MRS𝑥𝑦 (Marginal Rate of Substiution)

Therefore in equilibrium
Px
− = −MRS𝑥𝑦
Py
Or
Px
= MRS𝑥𝑦
Py
Since,
MUx
MRS𝑥𝑦 =
MUy

Therefore, in equilibrium
Px MUx
=
Py MUy

This is the same result as suggested by the cardinalists. Now, in the following diagram, the budget line BL is
tangent to the indifference curve IC2 at point E and therefore the above condition of equilibrium is satisfied here
and E is the equilibrium point. Let us understand the logic of the above condition. Equilibrium point cannot fall
on indifference curve IC3 because that point will be beyond the budget line even IC3 is the most preferable
indifference curve. Now we consider points A and C lying on the indifference curve IC1. Although, points A
and B are on the budget line and therefore are affordable, yet they cannot be equilibrium because IC 1 is a lower
indifference curve and we already know that the higher indifference curve is preferred. Therefore, the consumer
19
would like to achieve a point on a higher indifference curve like IC2 but it should be in his budget. Now
consider points G and H. These points too are not equilibrium points because they are beyond the budget line.
There is point E only which is in budget as well as on the highest indifference curve IC2.

Qty. Y

B
A

H
IC3
C
IC2
IC1
0 L Qty. X

Price effect, substitution effect, income effect

Price effect is composed of two effects i.e.

1. Substitution Effect
It means replacing a good with its substitute good when the price of the good replaced increases. So,
when the price of a good X rises, then this is replaced by its substitute good Y because Y becomes now
relatively cheaper. In this way, the demand for X falls and the demand for Y rises.
2. Income Effect
It means increase in ability to buy more units of a good due to decline in the price of a good. One point
is very important here i.e. the income effect is strong when the good concerned exhausts a major portion
of consumer’s income.

Separation of substitution effect, income effect from price effect

Normal Good
Normal good is a good in case of which the substitution effect and the income effect move in the same direction
such that the price effect is positive.

In order to separate the substitution effect and the income effect from the price effect we use here the Hicksian
approach. In the diagram point E is initial equilibrium point when the budget line BL is tangent to indifference
curve IC1. At point E quantity purchased of X is X1. Suppose the price of X falls, then the budget line rotates
20
about point B and becomes BL’ which is tangent to a new indifference curve IC 2 at point F. Therefore point F is
new equilibrium point where the quantity purchased is X2. The movement from point E to F is called the price
effect. To isolate the substitution effect and the income effect from the price effect we draw a hypothetical
budget line RT such that this is parallel to the budget line BL’ and tangent to initial indifference curve IC 1 at
point S. At point S the quantity is X3. The benefit of drawing this hypothetical budget line is that it
hypothetically withdraws the purchasing power of the consumer increased due to the fall in the price of X. The
movement from point E to S is called the substitution effect while the movement from point S to F is called the
income effect. One point should be noticed here is that the substitution effect, the income effect both are
positive and therefore the price effect is also positive.

Qty. Y

E
F
S
IC2

L IC1 L’
0 X1 X3 X2 T Qty. X
SE IE

PE

Inferior Good

A good is said to be inferior good when there is negative relationship between the income of a consumer and the
quantity demanded. More technically, when the substitution effect offsets the income effect such that the price
effect remains positive, the good is called an inferior good.

In order to decompose the substitution effect and the income effect from the price effect we use here the
Hicksian approach. In the diagram point E is initial equilibrium point when the budget line BL is tangent to
indifference curve IC1. At point E quantity purchased of good X is X1. Suppose the price of X falls, then the
budget line rotates about point B and becomes BL’ which is tangent to a new indifference curve IC 2 at point F.
Therefore point F is new equilibrium point where the quantity purchased is X2. The movement from point E to
F is called the price effect. To isolate the substitution effect and the income effect from the price effect we draw
a hypothetical budget line RT such that this is parallel to the budget line BL’ and tangent to initial indifference
21
curve IC1 at point S. At point S the quantity is X3. The benefit of drawing this hypothetical budget line is that it
hypothetically withdraws the purchasing power of the consumer increased due to the fall in the price of X. The
movement from point E to S is called the substitution effect while the movement from point S to F is called the
income effect. One point must be noted here that the income effect is negative while the substitution effect is
positive, however, the substitution effect outweighs the income effect and therefore the price effect remains
positive.

Qty. Y

R F
E
IC2
S

IC1

L L’
0 X1 X3 X2 T Qty. X
IE
SE
PE

Giffen Good

A Giffen good is a special case of an inferior good. If the income effect offsets the substitution effect, then the
good is said to be a Giffen good. The most famous example of a Giffen good is the potato during the Irish
potato famine of the 19th century.

In order to decompose the substitution effect and the income effect from the price effect we use here the
Hicksian approach. In the diagram point E is initial equilibrium point when the budget line BL is tangent to
indifference curve IC1. At point E quantity purchased of good X is X1. Suppose the price of X falls, then the
budget line rotates about point B and becomes BL’ which is tangent to a new indifference curve IC 2 at point F.
Therefore point F is new equilibrium point where the quantity purchased is X2. The movement from point E to
F is called the price effect. To isolate the substitution effect and the income effect from the price effect we draw
a hypothetical budget line RT such that this is parallel to the budget line BL’ and tangent to initial indifference
curve IC1 at point S. At point S the quantity is X3. The benefit of drawing this hypothetical budget line is that it
hypothetically withdraws the purchasing power of the consumer increased due to the fall in the price of X. The
movement from point E to S is called the substitution effect while the movement from point S to F is called the
22
income effect. One point should be noticed here is that the substitution effect is positive but, the income effect is
negative and the income effect outweighs the substitution effect and therefore the price effect is negative.

Qty. Y

B
F
IC2
R

E
S
IC1
L L’
0 X2 X1 X3 L T Qty. X
SE
IE
PE

Derivation of a demand curve

Normal Good
A good is said to be normal good when there is positive relationship between the income of a consumer and the
quantity demanded. In order to derive a demand curve of a normal good X, we have two diagrams. In the upper
diagram, E is initial equilibrium point when the budget line BL is tangent to indifference curve IC1. At point E
the quantity of X is X1 at price P1. Corresponding to point E we have a point G in the lower diagram.

Qty. Y
23
 B

E
F
PCC
IC2

L IC1 L’

Price of X

D
P1 G

P2 H

0 X1 X2 Qty. X

Suppose the price of X falls from P1 to P2in the lower diagram, then the budget line rotates about point B and
becomes BL’ which is tangent to a new indifference curve IC2 at point F where the quantity purchased is X2in
the upper diagram. Corresponding to point F we have H in the lower diagram. Joining points G and H we get a
downward sloping demand curve, DD. Apart in case of a normal the price consumption curve1 is downward
sloping as shown in the upper diagram.

1Price consumption curve: When the price a good increases or decreases, then the consumer equilibrium point
changes. A price consumption curve shows the effect of price change on consumer equilibrium and this is
drawn by joining all the consumer points resulting at different prices. In the upper diagram when we join the
consumer equilibrium points E and F, then we get a downward sloping price consumption curve.

Inferior Good
A good is said to be inferior good when there is negative relationship between the income of a consumer and
the quantity demanded. More technically, when the substitution effect offsets the income effect such that the
24
price effect remains positive, the good is called an inferior good. The demand curve of an inferior good with
respect to its price is downward sloping. In order to derive a demand curve of a normal good X we have two
diagrams. In the upper diagram, E is initial equilibrium point when the budget line BL is tangent to indifference
curve IC1. At point E the quantity purchased of X is X1 at price P1. Corresponding to point E we have a point G
in the lower diagram.

Qty. Y

PCC
F
E
IC2

L IC1 L’
0 Qty. X
Price of X

D
P1 G

P2 H

0 X1 X2 Qty. X

Suppose the price of X falls from P1 to P2in the lower diagram, then the budget line rotates about point B and
becomes BL’ which is tangent to a new indifference curve IC2 at point F where the quantity purchased is X2in
the upper diagram. Corresponding to point F we have H in the lower diagram. Joining points G and H we get a
downward sloping demand curve DD. Apart, in case of an inferior good the price consumption curve (PCC) is
upward sloping as shown in the upper diagram.

Giffen Good
A Giffen good is a special case of an inferior good. If the income effect offsets the substitution effect, then the
good is said to be Giffen good. The most famous example of a Giffen good is the potato during the Irish potato
25
famine of the 19th century. The demand curve of a Giffen good in respect of its price is upward sloping. Thus, a
Giffen good is an exception the law of demand. In order to derive a demand curve of a Giffen good X we have
two diagrams. In the upper diagram, E is initial equilibrium point when the budget line BL is tangent to
indifference curve IC1. At point E the quantity purchased of X is X1 at price P1. Corresponding to point E we
have a point G in the lower diagram.

Qty. Y

B PCC

IC2

IC1 L’
L
0 Qty. X
Price of X

P1 G

H
P2

0 X2 X1 Qty. X

Suppose the price of X falls from P1 to P2in the lower diagram, then the budget line rotates about point B and
becomes BL’ which is tangent to a new indifference curve IC2 at point F where the quantity purchased is X2in
the upper diagram. Corresponding to point F we have H in the lower diagram. Joining points G and H we get an
upward sloping demand curve DD. Apart, in case of a Giffen good the price consumption curve (PCC) is
backward bending as shown in the upper diagram.

Demand

26
A desire to have a good is called demand if the following two conditions are satisfied: 1) the consumer must
have necessary money to buy the good and 2) he or she must be willing to spend his or her money on that good.

Thus, if a person desires to have a Samsung Galaxy mobile phone costing ` 30,000 but he does not have

sufficient money to buy it or he has sufficient money but he does not want to spend on the mobile phone, then
his desire is just desire not demand.

Quantity demanded

Quantity demanded means the number of units of a good which a consumer is ready to buy at a particular price

per unit of time. For example if a consumer is ready to buy 30 units of a good at ` 40 per unit per month, then

the quantity demanded per month for the good at a particular price `40 per unit is 30 units.

Demand schedule and its types

A demand schedule is a table showing various quantities of a good at various prices. There are two types of demand
schedules:

1. Individual Demand Schedule or Individual demand

It shows various quantities demanded by an individual at various prices. Suppose there is a consumer

Sam who is ready to buy 5 units, 4 units, 3 units, 2 units and 1unit of a good at the per unit prices of ` 1 ,

`2 , ` 3, ` 4 and ` 5 respectively. This information is shown in the following table which is named as the

demand schedule of Sam (an individual) for the good.

Price per kg Quantity of apples

1 5
2 4
3 3
4 2
5 1

2. Market Demand Schedule or Market demand

27
 It shows various quantities demanded by a market at various prices. Suppose there are three consumers
in the market of a good- Gaurav, Ram and Vijay. The quantities demanded by each of them at various
prices are shown by the columns 2, 3 and 4. While the last columns shows the horizontal summation of
the quantities demanded at a price. This table is named as the market demand schedule because it shows
the quantities demanded by all the consumers in a market at different prices.

Price per kg Gaurav Ram Vijay Market demand

1 5 6 4 15
2 4 5 3
(5)=(2)+(3)+(4)
12
(1)
3 3 4 2 9
4 2 3 1 6
5 1 2 0 3

Meaning of a demand curve and its types

A demand curve is a graphical display of a demand schedule. It shows various quantities of a good at various prices. In
fact a demand curve is a graphical representation of a demand schedule. A demand curve is of two types:

1. Individual Demand Curve

It shows various quantities demanded of a good by an individual at various prices. Suppose there is a consumer

Sam who is ready to buy 5 units, 4 units, 3 units, 2 units and 1unit of a good at the per unit prices of ` 1 , `2 , ` 3, `

4 and ` 5 respectively. This information is shown through the following curve which is named as the demand

curve of Sam (an individual) for the good.

4
Price

0
0 1 2 3 4 5 6
Quantity of good x

28
 2. Market Demand Curve

It shows various quantities demanded of a good by a market at various prices. Suppose at prices ` 1 , ` 2 , ` 3, ` 4

and ` 5 the quantities demanded by all the consumers in the market are 15 units, 12 units, 9 kg, 6 units and 3 units

respectively. When these data are plotted on a graph paper, then we get the following market demand curve.

16
15
14
13
12
11
10
9
Price

8
7
6
5
4
3
2
1
0
0 1 2 3 4 5 6
Quantity of good x

Law of demand

The law of demand, also known as the first law of purchase, means the behavior of a consumer of buying
lower quantity of a good when its price increases or buying higher quantity when its price decreases keeping
other factors constant. In other words, lower units of a good are demanded when its price increases or more
units are demanded when its price decreases provided other things are constant. Thus, the law of demand
establishes a negative relationship between price and the quantity demanded.
In order to understand the demand law we consider the following demand schedule. In the schedule when the
price of a good rises from 1 to 2 to 3 to 4 to 5, then the quantity demanded falls from 5 to 4 to 3 to 2 to 1
respectively. Therefore, there is a negative relationship between the price and the quantity demanded.

Price of the good Quantity demanded

1 5
2 4
3 3
4 2
5 1

When the data of the above schedule are plotted on a graph paper, then we get a downward sloping straight line DD which
is known as demand curve. Thus, the demand law states that the slope of a demand curve is negative.
29
 6

Price
3

0
0 1 2 3 4 5 6
Quantity of good x

Mathematical definition of the demand law

Suppose that Q = 𝑓(P) is a demand function where Q is quantity demanded and P is the price of a good. Then
as per the demand law, the derivative of Qwith respect to price is negative i.e.
𝑑𝑄
<0
𝑑𝑃

Rationale of the law of demand / Reason of the law of demand / Logic of the law of demand

Economists have attempted to answer the question i.e. why does the demand law exist? Or why is there a
negative relationship between the price and the quantity demanded of a good. Below is the list of explanations
presented by economists.

1. The law of diminishing marginal utility and the equilibrium

In the following diagram, MU curve is downward sloping due to the law of diminishing marginal utility.
At point A the consumer is in equilibrium because price P1 is equal to MU1 and the quantity demanded
is Q1. Suppose, the price falls to P2 causing the equilibrium point to disturb and then to attain
equilibrium position again our consumer would seek the marginal utility equal to P 2. This can be done
by demanding Q2 units and new equilibrium point will be B. One point must be noted here that in
moving from point A to B the consumer has increased the quantity demanded from Q1 to Q2 when price
falls from P1 to P2 and this movement is nothing but the demand law. Thus the conclusion is that the
equilibrium condition and the law of diminishing marginal utility curve explain the law of demand i.e. if
the marginal utility curve were upward sloping instead of downward, then demand would not have
30
 increased rather fallen when price falls. Thus, the entire game behind the law of demand is of the law of
diminishing marginal utility and equilibrium condition.

Price

P1 A

P2 B

MU

0 Q1 Q2 Qty.

2. Modern View
Modern economists hold the substitution and the income effects are responsible for the operation of the
law of demand.

a. Substitution Effect
It means replacing a good with its substitute good when the price of the good replaced increases.
So, when the price of a good X rises, then this is replaced by its substitute good Y because Y
becomes now relatively cheaper. In this way, the demand for X falls and the demand for Y rises.

b. Income Effect
It means increase in ability to buy more units of a good due to decline in the price of a good. One
point is very important here i.e. the income effect is strong when the good concerned exhausts a
major portion of consumer’s income.

Factors affecting demand or determinants of demand

There are many determinants of demand. The main determiners are as follows:

1. Price of the good itself

The law of demand states about the effect of change in the price of a good over its quantity demanded
while keeping all other factors affecting demand constant. The law states that there is negative
relationship between the price and the quantity demanded for a good and therefore, when the price of a
good goes up, the quantity demanded falls down provided other things remain unchanged.

31
2. Prices of related goods
Related goods are those goods which affect the demand for each other. There are two types of related
goods:

a. Substitute good / Competitive good

Two goods are said to be substitute goods when one of them can be used in place of the other. Since,
Frooti can be used in place of Slice or Maaza, Laptop can be used in place of a desktop computer,
Discovery channel can be watched in place of National Geographic Channel, Metro rail can be used
in place of a DTC bus and many more such cases can be added to the list, therefore they are
substitute goods. The price of a substitute good affects the quantity demanded for its related good
because when the price of a good increases, then its substitute good becomes relatively cheaper,
therefore a consumer switches to the substitute good. As a result, the increase in the price of a good
causes the quantity demanded for the substitute good to rise.

b. Complementary good
Two goods are said to be complementary goods when one of them cannot perform without using the
other good. Further, complementary goods are used in a fixed ratio. Since, a computer hardware
cannot be used without installing software, a car cannot be driven without fueling it with
diesel/petrol/CNG, a mobile handset cannot be used without inserting a SIM card and so on and
therefore they are complementary goods. The price of a good affects the quantity demanded of its
complementary good because when the price of a good increases, then using it becomes expensive,
therefore a consumer decides to buy less of it and the quantity demanded for its Complementary
good declines because there is no use the Complementary good without the other good. As a result,
an increase in the price of a good causes the quantity demanded of the Complementary good to fall.

c. Income of the consumer

a. Normal Good

Other things remaining the same, a good is called normal good when the income effect is positive
i.e. there is a positive relationship between the quantity demanded and consumer’s income. In
other words, a normal good is the one when consumer’s increases and the quantity demanded
also increases while keeping the other factors constant. Clothing is one of the best examples of
normal goods.

32
 b. Inferior Good
Other things remaining the same, a good is called inferior good when the income effect is
negative i.e. there is a negative relationship between the quantity demanded and consumer’s
income. In other words, an inferior good is the one when consumer’s increases and the quantity
demanded decreases while keeping the other factors constant. In other words, an inferior good is
the one when consumer’s increases and the quantity demanded for the good decreases. Biri is an
inferior good in comparison to Cigarette, Bajra is an inferior good in comparison to Wheat.

c. Tastes and Preferences:

Tastes and preferences of consumers also affect the demand for a good. Tastes and preferences are
psychological topics and they depend upon various factors like religion, fashion or trend, the income
class of the consumer etc. Any change in such factors affect the demand.

Substitute goods

Two goods are said to be substitute goods when one of them can be used in place of the other. Since, Frooti can
be used in place of Slice or Maaza, Laptop can be used in place of a desktop computer, Discovery channel can
be watched in place of National Geographic Channel, Metro rail can be used in place of a DTC bus and many
more can be added to the list, therefore they are substitute goods. The price of a substitute good affects the
quantity demanded for its related good because when the price of a good increases, then its substitute good
becomes relatively cheaper, therefore a consumer switches to the substitute good. As a result, an increase in
the price of a good causes the quantity demanded of the substitute good to rise.

Effect of rise in the price of a good on the quantity demanded of its substitute good

We take two goods Frooti and Slice. We know that both are mango drinks and can be used in place of other and
therefore they are substitute goods. When the price of Frooti is P1, then the quantity demanded for Slice is Q1.
This is shown by point A. Suppose the price of Frooti rises to P2, then a consumer knows that Slice gives the
same satisfaction as Frooti does, therefore he or she would like to switch to Slice. As a result, the quantity
demanded for Slice rises to Q2. This is shown by point B. By joining points A and B we get the demand curve
of Slice with respect to the price of Frooti. This demand curve (denoted by d) is upward sloping.

Price of Frooti

d
B
P2
33
 P1 A

0 Q1 Q2
Quantity demanded of Slice

Effect of fall in the price of a good on the quantity demanded of its substitute good

We take two goods Frooti and Slice. We know that both are mango drinks and can be used in place of other and therefore
they are substitute goods. When the price of Frooti is P1, then the quantity demanded for Slice is Q1. This is shown by
point A. Suppose, the price of Frooti falls to P2, then a consumer knows that Frooti gives the same satisfaction as Slice
does, therefore he or she would like to switch to Frooti. As a result, the quantity demanded for Slice falls to Q 2. This is
shown by point B. By joining points A and B we get the demand curve of Slice with respect to the price of Frooti. This
demand curve (denoted by d) is upward sloping.

Price of Frooti

d
A
P1

B
P2

0 Q2 Q1
Quantity demanded of Slice

Complementary goods

Two goods are said to be complementary goods when one of them cannot perform without using the other good.
Since, a computer hardware cannot be used without installing software, a car cannot be driven without fueling it
with diesel/petrol/CNG, a mobile handset cannot be used without inserting a SIM card and so on and therefore
they are complementary goods. The price of complementary good affects the quantity demanded for a good
because when the price of a good increases, then using it becomes expensive, therefore a consumer decides to
buy less of it and the quantity demanded for its complementary good declines because there is no use the
complementary good without the other good. As a result, the increase in the price of a good causes the
quantity demanded for the Complementary good to fall.

34
Effect of increase in the price of a good on the quantity demanded of its complementary good

We take two goods a Lenovo computer and an operating system Windows 10. We know that without an
operating system a computer cannot work, therefore these two goods are Complementary goods. Now, when the
price of a Lenovo computer is P1, then the quantity demanded for a particular operating system, say, Windows
10 is Q1 and this is shown by point A. Suppose the price of the computer rises to P2, then operating the
computer is now expensive than before and Windows 10 alone has no use, therefore the quantity demanded for
Windows 10 falls to Q2 and this is shown by point B. Joining points A and B with get the demand curve of
Windows 10 with respect to the price of its Complementary good Lenovo computer. This demand curve
denoted by d is downward sloping.

Price of a Lenovo
computer

P2 B

P1 A

0 Q2 Q1
Quantity demanded of Windows 10

Effect of fall in the price of a good on the quantity demanded for its complementary good
We take two goods a Lenovo laptop and an operating system, say, Windows 10. . We know that without an
operating system a computer cannot work, therefore these two goods are Complementary goods. Now, when the
price of a Lenovo laptop is P1, then the quantity demanded of the operating system is Q1 and this is shown by
point A. Suppose the price of the laptop falls to P2, then purchasing the laptop is now cheaper than before and
therefore the quantity demanded of Lenovo rises but it would need Windows 10 as well and therefore the
quantity demanded of Windows 10 also rises to Q2 and this is shown by point B. By joining points A and B
with get the demand curve of Windows 10 with respect to the price of its Complementary good Lenovo
computer. This demand curve denoted by d is downward sloping.
Price of a Lenovo
computer
A
P1

B
P2

0 Q1 Q2
Quantity demanded of Windows 10

35
Normal good

Other things remaining the same, a good is called normal good when the income effect is positive i.e. there is a
positive relationship between the quantity demanded and consumer’s income. In other words, a normal good is
the one when consumer’s increases and the quantity demanded also increases while keeping the other factors
constant. Clothing is one of the best examples of normal goods. The relationship between the income and the
quantity demanded for a normal good can be understood through the following diagram. When the income is I1,
then the quantity demanded is Q1. This is shown by point A. Suppose, the income increases to I2, then the
quantity demanded also increases to Q2. This is shown by point B. By joining points A and B we get an
upward sloping demand curve d with respect to income. This curve is also known as Engel’s curve.

Income

d
B
I2

I2 A

Positive income effect

0 Q1 Q2
Quantity demanded

Inferior goods

Other things remaining the same, a good is called inferior good when the income effect is negative i.e. there is
a negative relationship between the quantity demanded and consumer’s income. In other words, an inferior
good is the one when consumer’s increases and the quantity demanded decreases while keeping the other
factors constant. In other words, an inferior good is the one when consumer’s increases and the quantity
demanded for the good decreases. Biri is an inferior good in comparison to Cigarette, Bajra is an inferior good
in comparison to Wheat. The relationship between the income and the quantity demanded for a normal good can
be understood through the following diagram. When the income is I1, then the quantity demanded is Q1. This is
shown by point A. Suppose, the income increases to I2, then the quantity demanded decreases to Q2. This is
shown by point B. By joining points A and B we get a downward sloping demand curve d with respect to
income. This curve is also known as Engel’s curve.

Income
36
 I2 B

I1 A

d Negative income effect

0 Q2 Q1
Quantity demanded

Differences between a normal good and an inferior good

S.No. Basis Normal good Inferior good

1 Meaning A good is called normal good when A good is called inferior good when there is
there is positive relationship between negative relationship between the consumer’s
the consumer’s income and the quantity income and the quantity demanded. Bajra in
demanded. Clothing is an example. comparison to Wheat is an example.

2 Direction of The income effect is positive. The income effect is negative.

income effect
3 Demand
curve with The demand curve is upward sloping. The demand curve is downward sloping.
respect to
income
4 Relation with A normal good can never be a Giffen An inferior good turns into a Giffen good when the
Giffen good good. income effect is stronger than the substitution
effect.

Are all demand curves downward sloping?

All demand curves are not downward sloping. There are some cases where the existence of the law of demand is
questioned. These cases are known as the exceptions to the law of demand. These exceptions are as follows:

1. Giffen goods

37
 Giffen goods are named after Robert Giffen who discovered these goods. A Giffen good is a special
type of an inferior good, therefore all inferior goods are not Giffen goods. The most famous example of
a Giffen good is the potato during the Irish potato famine of the 19th century. A Giffen good exhausts
a major portion of a consumer’s income i.e. when its price increases, then the income effect is stronger
than the substitution effect which causes the demand curve upward sloping.

2. Veblen goods
These goods are named after an American economist Thorstein Bunde Veblen. Veblen goods are
those goods which are bought to create or enhance prestige or social status and therefore they are also
known as status symbol goods. The more expensive the good is, the higher the prestige or social status
its buyer feels. Ornaments made of gold, silver, platinum, diamonds etc., luxurious cars like BMW,
Mercedes-Benz, I-Phone of Apple Inc., are some examples of Veblen goods.

3. Bandwagon effect
Bandwagon effect simply means people do something because others are doing so. It has been
observed in lots of cases that demand for a good has increased even at higher prices just because others
are demanding it.

4. Situations of war, riots, drought, natural attacks

In the situations of war, riots, drought, natural attacks like earth quake, flood, tsunami etc. people
behave abnormally. For example: If a country is suffering from a civil war, then its people would be
forced to buy more even at higher prices because they may anticipate that the war would not stop in
near future and a shortage or black marketing may arise.

5. The common law of business balance or ignorance

There is a group of consumers who think that if a good is expensive, then this is a qualitative good and
if a good is not expensive, then producers may have compromised with its quality. Therefore a
consumer from this group buys more of a good even at high price and the demand law does not hold
good here.

Movement along a demand curve / increase and decrease in quantity demanded

38
Movement along a demand curve means downward or upward movement of the consumer equilibrium point on
the same demand curve for a good due to decrease or increase in the price of the good itself provided other
things are kept constant. There are two types of movement along a demand curve.

1. Extension in demand or Increase in the quantity demanded

Ceteris paribus, when a consumer increases the quantity demanded because of the fall in the price of the
good itself, then this is known as extension in demand. The equilibrium point of the consumer moves
downward on the same demand curve. In the diagram, we have a demand curve d showing the initial
consumer equilibrium point A at which price is P1 and quantity demanded Q1. Suppose, price falls from
P1 to P2, then by reason of the law of demand quantity demanded increases from Q1 to Q2. As a result
new equilibrium point is B. The movement from A to B is known as extension in demand.

Price

P1 A

P2 B

0 Q1 Q2 Qty.

2. Contraction in demand or Decrease in the quantity demanded

Ceteris paribus, when a consumer decreases the quantity demanded because of the rise in the price of
the good itself, then this is known as contraction in demand. The equilibrium point of the consumer
moves upward on the same demand curve. In the diagram, we have a demand curve d showing the initial
consumer equilibrium point A at which price is P1 and quantity demanded Q1. Suppose, price rises from
P1 to P2, then by reason of the law of demand quantity demanded decrease from Q1 to Q2. As a result
new equilibrium point is B. The movement from A to B is known as contraction in demand.

Price

P2 B

P1 A

0 Q2 Q1 Qty.

39
Change in demand / Shift in demand curve

When a consumer increases or decreases quantity demanded because of a factor other than the price of the good
itself, then this is known as shift in demand. There are two types of changes in demand.

1. Increase in demand

When quantity demanded increases due to other factors not price, then this is known as increase in
demand and it causes the demand curve to shift rightward. In the figure, it can be noticed that initial
demand curve is d1 and at price P the equilibrium point is A where the quantity demanded is Q1.
Suppose, due to some reasons (discussed below) the quantity demanded increases to Q2 while price
remains at P, then the equilibrium point A shifts to B on the new demand curve d 2. This shifting from A
to B is called increase in demand or rightward shift in demand.

Price

A B
P

d1 d2

0 Q1 Q2 Qty.

Reasons for increase in demand

a. Increase in income of the consumer due to promotion, new job, gifts, profits, transfer payments
etc.
b. Increase in the price of the substitute good.
c. Fall in the price of the Complementary good.
d. Positive change in tastes and preferences due to some reasons.
e. Some announcements like media news/scientific research etc. causing the demand to rise. For
example, a scientific research concluding that carrot prevents the chances of cancer, it may
increase the demand for carrots.
f. Increase in the number of buyers or increase in the population.

40
 2. Decrease in demand

When quantity demanded decreases due to other factors not price, then this is known as decrease in
demand and it causes the demand curve to shift leftward. In the figure, it can be noticed that initial
demand curve is d1 and at price P the equilibrium point is A where the quantity demanded is Q1.
Suppose, due to some reasons (discussed below) the quantity demanded decreases to Q2 while price
remains at P, then the equilibrium point A shifts to B on the new demand curve d2. This shifting from A
to B is called increase in demand or leftward shift in demand.

Price

B A
P

d2 d1

0 Q2 Q1 Qty.

Reasons for decrease in demand

a. Decrease in income of the consumer due to demotion, loosing job, losses etc.
b. Decrease in the price of the substitute good.
c. Increase in the price of the Complementary good.
d. Negative change in tastes and preferences due to some reasons.
e. Some announcements like media news/scientific research etc. causing the demand to fall. The case of
Maggi is a latest and classic example of this. The demand for Maggi decreased dramatically
when the media reports showed that FSSAI (Food Safety and Standards Authority of India)
found that Maggi noodles are unsafe and hazardous for human consumption.
f. Decrease in the number of buyers or decrease in the population.

Differences between extension in demand and increase in demand

S.No. Basis Extension in demand Increase in demand

1 Meaning
41
 When there is rise in the quantity When there is rise in the quantity demanded
demanded due to fall in the price of due to factors other than the price of the good
the good itself while other factors itself, then this is known as increase in
remaining the same, then this is demand.
known as extension in demand.

2 Causes Fall in the price of the good itself. 1. Increase in income of the consumer due
to promotion, new job, gifts, profits,
transfer payments etc.
2. Increase in the price of the substitute
good.
3. Fall in the price of the Complementary
good.
4. Positive change in tastes and
preferences due to some reasons like
age factor.
5. Some announcements like media
news/scientific research etc. causing the
demand to rise. For example, a
scientific research concluding that
carrot prevents the chances cancer, it
may increase the demand for carrots.
6. Increase in the number of buyers or
increase in the population.

3
The consumer equilibrium point shifts The consumer equilibrium point shifts
Effect on
consumer downward on the same demand curve rightward from point A on the demand curve
equilibrium
from point A to point B on the same D1D1 to point B on demand curve D2D2 as
demand curve DD as shown in the shown in the diagram.
diagram.

42
 Price
D Price

D1 D2
A
P1

A B
B 𝑃̅
P2

00Q1 Q2 Qty. Q1 Q2 Qty. X D1 D2

00 Q1Q
Q21 Qty.
Q2 Qty. X

Differences between contraction in demand and decrease in demand

S.No. Basis Contraction in demand Decrease in demand

1 Meaning When there is fall in the quantity When there is fall in the quantity demanded due
demanded due to rise in the price of to factors other than the price of the good itself,
the good itself while other factors then this is known as decrease in demand.
remaining the same, then this is
known as contraction in demand.

2 Causes Fall in the price of the good itself. 1. Decrease in income of the consumer due
to demotion, loosing job, losses etc.
2. Decrease in the price of the substitute
good.
3. Increase in the price of the
Complementary good.
4. Negative change in tastes and
preferences due to some reasons like age
factor.
5. Some announcements like media
news/scientific research etc. causing the
demand to fall. The case of Maggi is a

43
 latest and classic example of this. The
demand for Maggi decreased
dramatically when the media reports
showed that FSSAI (Food Safety and
Standards Authority of India) found that
Maggi noodles are unsafe and hazardous
for human consumption.
6. Decrease in the number of buyers or
decrease in the population.

3 Effect on The consumer equilibrium point The consumer equilibrium point shifts leftward
consumer
equilibrium shifts upward on the same demand from point A on the demand curve D1D1 to point
curve from point A to point B on the B on demand curve D2D2 as shown in the figure.
same demand curve DD as shown in
the figure.

Price
Price
D D2 D1

B
A
PP12 B A
𝑃̅

PP21 AB

D2 D1
D
0 Q2 Q1 Qty. X
00Q1 Q2 Qty.Q2 Q1 Qty. X

Price elasticity of demand

Price elasticity of demand means the degree of sensitivity of the demand for a good when its price changes. In
other words, price elasticity of demand is a numerical measurement of the effect of change in the price of a
good on its quantity demanded. Mathematically, price elasticity of demand means the ratio of percentage
change in the quantity demanded for a good and the percentage change in the price. Therefore,

44
 Percentage change in the quantity demanded for a good
ed =
Percentage change in the price of the good

∆Q P1
= ×
∆P Q1
Where
∆Q = Change in the quntity demanded = Q2 − Q1 ; Q2 = New quantity and Q1 = Old quantity

∆P = Change in the price = P2 − P1 ; P2 = New price and P1 = Old price

Various methods to calculate price elasticity of demand

The methods to calculate price elasticity of demand are as follows:

1. Total expenditure method.

2. Percentage or proportion method.
3. Point elasticity method.
4. Arc method.

Method 1

Total Expenditure Method / Total Outlay Method

Total expenditure is defined as the product of the quantity purchased and the price. Under this method, the
movement of the total expenditure incurred on a good is observed to estimate the elasticity. Leibhafasky has
suggested the following formula to calculate elasticity:
1 ∆E
ed = 1 − ( )
Q1 ∆P
Where ∆E = Change in expenditure ; ∆P = Change in price and Q1 = initial quantity demanded
As per this method there are three cases i.e.

1. Inelastic demand
When the increase in the price causes the total expenditure to increase or the decrease in the price
causes the total expenditure to decrease, then the elasticity is less than one and the demand is said to be
inelastic. Therefore, when there is positive relationship between the price and the total expenditure, then
there is inelastic demand and the degree of elasticity is less than one.

45
 2. Unit elastic demand
When increase or decrease in the price does not affect the total expenditure, then there is unit elastic
demand and the degree of the elasticity is one.

3. Elastic demand
When the increase in the price causes the total expenditure to decrease or the decrease in the price
causes the total expenditure to increase, then the elasticity is greater than one and the demand is said to
be elastic. Therefore, when there is negative relationship between the price and the total expenditure,
then there is elastic demand and the degree of elasticity is greater than one.

The above three cases have been summarized in the following schedule.
Price Quantity Total Movement of Elasticity
` purchased Expenditure Total
` expenditure
1 10 10
2 9 18 Total expenditure Inelastic demand
3 8 24 increases when
4 7 28 price increases
5 6 30 Total expenditure Unit elastic
6 5 30 does not change demand
7 4 28 Total expenditure
8 3 24 decreases when Elastic demand
9 2 18 price increases
10 1 10

Method 2
Percentage method or Proportionate method
According to this method price elasticity is defined as the ratio of the percentage change in the quantity
demanded and the percentage change in the price. Therefore,

Percentage change in the quantity demanded for a good

ed =
Percentage change in the price of the good

∆Q P1
= ×
∆P Q1
Where:
∆Q = Change in the quntity demanded = Q2 − Q1 ; Q2 = New quantity and Q1 = Old quantity

∆P = Change in the price = P2 − P1 ; P2 = New price and P1 = Old price

46
According to this method there are 5 degrees of price elasticity of demand.

1. Perfect inelastic demand i.e. ed = 0

When the percentage change in the quantity demanded is zero irrespective of the percentage change
in the price, then there is perfect inelastic demand. In this case the demand curve DD is parallel to
the Y-axis as shown in the figure. This is an extreme case. In this case, it can be said that demand
for a good is completely insensitive to the changes in the price.

Price D

D
0 Q
Qty. demanded

2. Inelastic demand i.e. ed < 1

When the percentage change in the quantity demanded is less than the percentage change in the
price, then there is inelastic demand. In this case the demand curve DD is steeper as shown in the
figure. In this case it can be said that the demand is not highly sensitive to the price changes.

Price
D

P2

P1

0 Q 1 Q2
Qty. demanded

3. Unit elastic demand i.e. ed = 1

When the percentage change in the quantity demanded is equal to the percentage change in the
price, then there is unit elastic demand. In this case the demand curve DD is shown the figure.

47
 Price
D
P2

P1
D

0 Q1 Q2
Qty. demanded

4. Elastic demand i.e. ed > 1

When the percentage change in the quantity demanded is greater than the percentage change in the
price, then there is elastic demand. In this case the demand curve DD is flatter as shown in the
figure. In this case it can be said that demand is highly sensitive to the price changes.

Price

D
P2

P1 D

0 Q1 Q2
Qty. demanded

5. Perfect elastic demand i.e. ed = ∞

When a minor/small change in the price causes the quantity demanded to change infinitely, then
there is perfect elastic demand. In this case the demand curve DD is parallel to the X-axis as shown
in the figure. This is an extreme case.

Price

D D
P

0 Q1 Q2
Qty. demanded

48
Method 3

Point elasticity method or geometrical method

Under this method elasticity is calculated at a particular point on a given demand curve. Suppose we have a
straight demand curve with 5 points on it as shown in the figure below. Then according to this method elasticity
at each point can be calculated using the following formula:

lower segment with reference to a point

ed =
Upper segment with reference to the point

Price
A
B

E
0 Qty. demanded

Applying the above formula we have the following results

Point A

Elasticity at this point is infinite because the upper segment is infinity.

Point B

Elasticity at this point is greater than one because the lower segment is greater than the upper segment.

Point C

Elasticity at this point is equal to one because the lower segment is equal to the upper segment.

Point D

Elasticity at this point is less than one because the lower segment is less the upper segment.

Point E

Elasticity at this point is zero because the upper segment is zero.

49
Method 4
Arc method of price elasticity of demand
Or
Mid-point formula of price elasticity of demand
Arc method is a refined version of the percentage method of price elasticity of demand. According to the arc
method the formula to calculate price elasticity of demand (ed) is as follows:

∆Q (P1 + P0)/2
ed = − ×
∆ P (Q1 + Q0)/2
Or
∆Q (P1 + P0)
ed = − ×
∆ P (Q1 + Q0)

Where
∆Q = Change in quantity demanded
∆P = Change in price
P0, P1 = Initial price and later price respectively
Q0, Q1 = Initial quantity and later quantity respectively

The above formula is called mid-point formula of price elasticity of demand. In fact, this formula is used when
the change in price and quantity demanded is significant while the formula of percentage method is used
when the change in price and quantity demanded is not significant.

Factors affecting price elasticity of demand

Factors affecting price elasticity of demand are as follows:

1. Price of a good itself

When there is high price, then the elasticity of demand is also higher. Therefore, expensive goods have
higher elasticity and cheap goods have lower elasticity.
2. Essentiality of goods
The elasticity of demand of essential goods like salt, water, wheat, rice etc. is lower while the elasticity
of demand of non-essential goods like jewellery, luxurious cars is higher.

50
 3. Availability of substitutes
If a good has many substitute goods, then the elasticity of demand is higher. The goods having no
substitute goods have lower elasticity of demand.
4. Alternative uses of a good
If a good has various uses like milk which can be used for drinking; making tea, coffee, sweets, curd
etc., then the elasticity is higher. Thus, as the number of uses of a good increases, then elasticity of
demand also increases.
5. Postponement of use
If the consumption of a good can be postponed to future, then the elasticity of demand must be higher
and if the consumption cannot be postponed, then the elasticity must be lower.

6. Habit of a consumer
If the habit of a consumer for a good is strong, then the elasticity of demand must be lower and if the
habit is weak, then the elasticity is higher. For example in case of a drunk the elasticity of demand of
liquor is lower.
7. Expenditure and Income ratio
If the ratio of the expenditure incurred on a good and the income of a consumer is lower, then the
elasticity of demand is also lower. If the ratio is higher, then the elasticity is also higher.
8. Time
In short run the elasticity of demand is found to be lower while in long run this is found to be higher.

Cross Elasticity of Demand

Cross Elasticity of demand (generally denoted by CXY) means the ratio of the percentage change in the quantity
demanded of a good X and the percentage change in the price of good Y. Therefore,

Percentage change in the quantity demanded for good X

CXY =
Percentage change in the price of good Y

∆QX PY
CXY = ×
∆ PY QX

51
Where
∆QX = Change in the quantity of good X
∆PY = Change in the price of good Y
PY = Initial price of good Y
QX = Initial quantity of good X

Significance of Cross elasticity of demand tells us how much the demand for a good X responds when the
price of its related good Y is changed.

Important points
1. If CXY > 0 𝑖. 𝑒. 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦, then it means that X and Y are substitute goods.
2. If CXY = 0 𝑖. 𝑒. 𝑧𝑒𝑟𝑜 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦, then it means that X and Y are unrelated goods.

Income Elasticity of Demand

Income Elasticity of demand (generally denoted by IX) means the ratio of the percentage change in the quantity
demanded of a good X and the percentage change in the income of the consumer. Therefore,

Percentage change in the quantity demanded for good X

CXY =
Percentage change in the income

∆QX I
CXY = ×
∆ I QX
Where
∆QX = Change in the quantity of good X
∆I = Change in the income
I = Initial income
QX = Initial quantity of good X

Significance of income elasticity of demand tells us how much the demand for a good X responds when the
income of the consumer is changed.

52
Important points
1. If 0 < IX < 1 , then the good is a necessary good.
2. If IX > 1, then the good is a luxury good.
3. If IX < 0, then the good is an inferior good.

Advertising Elasticity of Demand

Advertising Elasticity of demand (generally denoted by AX) means the ratio of the percentage change in the
quantity demanded of a good X and the percentage change in the expenditure on advertising. Therefore,
Percentage change in the quantity demanded for good X
CXY =
Percentage change in the expenditure on advertising

∆QX A
CXY = ×
∆ A QX

Where
∆QX = Change in the quantity of good X
∆A = Change in the expenditure on advertising
A
= Initial expnenditure on advertising
QX
= Initial quantity of good X

Significance of advertising elasticity of demand tells us how much the demand for a good X responds when
the expenditure on advertising is changed.

53