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CHAPTER ONE

INTRODUCTION

Economics is the social science that studies the production, distribution and consumption of

goods and services. The word „economics‟ comes from the Greek word ‘ Oikos’ (house) and

‘nomos’ (law) hence ‘laws of the household’. Economics can alternatively be defined as

follows

Economics; is the social science that is defined as the study of how limited/scarce resources can

best be used to fulfill unlimited human wants. Where the wants and desires of the human beings

are unlimited, the means or resources available for meeting these wants are limited. Therefore,

economics is concerned with understanding the principles and developing the rules that govern

the production and consumption of goods and services in the economy in order to make the best

use of resources. Specifically, economics deals with the understanding and modeling the

behavior of individual consumers and producers as well as the aggregate of all consumers and

producers.

Economics; is a social science which is concerned with the allocation of scarce resources to

provide goods and services which meet the needs and wants of consumers.

Different Economic concepts

1.0 Resource scarcity

The management of society‟s resources is important because resources are scarce. Scarcity

means that society has limited resources and therefore cannot produce all the goods and services

people wish to have (resources are limited in supply/ less than what is required). Just as a

household cannot give every member everything he or she wants, a society cannot give every

individual the highest standard of living to which he or she might aspire. Therefore, economics
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is the study of how society manages its scarce resources. Scarcity of the resources is the main

economic problem. No scarcity no economics. Economics tries to solve the main problem of

scarcity of economic resources. Scarcity of the resources may be due to

i. Limited stock of the resources

ii. Unlimited wants

iii. Alternative use of the resources.

 The problem of scarcity can be solved differently through various economic systems.

These economic systems are Socialist economic system, Capitalist economic system, and

Mixed economic

1.1 Human wants

Human wants are all desires that must be satisfied by using certain goods/services. They differ

in different places and at different times. Human wants differ according to social, physical,

economical and pollical conditions. Therefore, economics is concerned with satisfaction of

human wants which are unlimited under condition of scarce resources.

Attribute of human wants

i. Human wants are unlimited nature

This is the tendency of human being that when he has got one thing, he desires to possess

another and so on. It is for this reason we say human wants are unlimited.

ii. Human wants cannot fully be satisfied because economic resources are scarce.

If the means is available you can only satisfy at a time. For example wants such as food and

water. However, the same want may occur again and again.
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iii. Wants can be satisfied by alternative means.

Wants to some extent are competitive. It is possible to satisfy a given want through the use of

substitute goods. For example, you can either use tea or coffee, coca cola or Pepsi. You choice

may depend on taste, or the money at your disposal

iv. Re-occurrence tendency

some wants satisfied once, are felt again and again. For example, desire for water or new clothes

may arise again and again.

v. Wants vary in urgency and intensity

Though wants may be competitive, they are not generally equally urgent. The intensity of the

particular want may differ from person to person. For example, a person would buy food before

clothes

1.3 Allocation

Since many resources are scarce and the needs are unlimited, a mechanism is needed/ or must

exist to guide the use of the resources. This entails choosing the best alternative which reflect the

real opportunity cost of the resources i.e the cost that which is consistent with individual or

social objectives eg a farmer may decide how much one hectare of land to allocate to maize and

sorghum.

In most societies, resources are allocated not by a single central planner but through the

combined actions of millions of households and firms. Economists therefore study how people

make decisions: how much they work, what they buy, how much they save, and how they invest

their savings. Economists also study how people interact with one another. For instance, they
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examine how the multitude of buyers and sellers of a good together determine the price at which

the good is sold and the quantity that is sold.

1.4 Opportunity cost

The opportunity cost of anything/ any resources is the alternative that has been foregone after

making a certain choice due to the scarcity of the resources. Since people can‟t satisfy all their

wants due to the scarcity of the resources they must therefore choose between one thing and

another thing so that the satisfaction of one want involves sacrificing another want. Likewise,

since supply of factors of production is limited, the production of one thing often involves a

sacrifice of producing another commodity.

Alternatively, Opportunity cost of the resource can also be explained as the return that a

resource can earn when it is put to its best alternative use. for example, a farmer with 100kg of

CAN fertilizer can apply it to one ha of Irish potatoes or one ha of maize. Suppose from maize a

farmer will get an addition of Tsh 20,000 of maize and from potatoes a farmer will get Tsh

35,000 worthy of additional potatoes: if the farmer will decide to apply the fertilizer he/she

forgoe Tsh 20,000 worthy of additional maize, thus the opportunity cost of fertilizer is Tsh

20,000.

1.5 Goals(Ends/objectives)

This represents needs to be satisfied. Since individuals needs or desires appears to be unlimited,

therefore goals compete for scarce resources. Economics helps to choose among competing

alternatives by use of indicators. Example of these indicators includes Prices for consumers and
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producers, the profit motive for producers, and utility incase of consumers. The goals always is

to maximize or to minimize the indicators accordingly.

1.6 Economic problem

Thus, for the problem to become economic at least the following two conditions must be

fulfilled. a) scarcity of the resource should exist b) alternative must exist. For example, if there is

no alternative, therefore, no choice should be done, on other hand if there are alternative but no

scarcity then the resources/goods are free thus the problem is not economic in nature

1.7 Risk and uncertainty:

Risk is the situation where probabilities can be attached to the occurrence of the events. For

example, if drought occurs on average of two years out of five, the probability of drought

occurring is 2/5. Thus, risk describes the entire mechanism by which firm/business managers

make decision with respect to a certain event; according to their attitudes towards risk

entrepreneurs/business managers can be categorized into Risk taker, risk averse and Risk neutral.

Uncertainty is the situation where it‟s not possible to attach probabilities to the occurrence of

events, example of uncertainty are natural hazards, markets fluctuations, state actions and wars.

1.8 Positive and normative economics

Normative economics is concerned with the expression of value judgments by economists, of

what they would like to happen -e.g. what sort of economic society they would like to see in
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operation. The analyst says what ought to be. Economic policies fall under normative economic.

Economist under normative economics advice how the economic should operates, it suggests the

aim and objectives for the economy and points out what ought to be done to achieve them.

Positive economics deals with describing the function of economic units (what is) in terms of

characteristics and nature of relationship for household, firms, markets, and economic systems.

Positive economics is concerned with objective statements about what does happen or what

will happen. A positive approach is more objective, and more scientific, and it is the approach

we shall try to take in our study of economics here. Under is left over r positive economic the

specification of goals or policies is left to decision makers. It serves as the basis for decision

making in normative. Example 2% increase in tax on the rich will raise 5 billion shillings

without reducing their consumption demand. Normative economist may recommend that the

money will best be utilized if it will be allocated to public health canters because it will benefit

the poor who will not afford to go to private hospitals.

1.9 Microeconomics and macroeconomics

Microeconomics 'Micro' comes from the Greek word meaning small, and microeconomics is the

study of individual economic units or particular parts of the economy -e.g. how does an

individual household decide to spend its income? How does an individual firm decide what

volume of output to produce or what products to make? How is the price of an individual product

determined? How are wage levels determined in a particular industry?

macroeconomics 'Macro' comes from the Greek word meaning large, and macroeconomics is

the study of 'global' or collective decisions by individual households or producers. It looks at a

national or international economy as a whole -e.g. total output, income and expenditure,
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unemployment, inflation, interest rates and the balance of international trade etc, and what

economic policies a government can pursue to influence the condition of the national economy

The fundamental questions in economics.

i. What will be produced?

Each society should decide which goods and services should be produced, producing more of

one commodity means sacrificing production of another commodity. Therefore, the firm/society

should make choice on what goods/service to produce with scarce resources available (What to

produce and quantity of it).

ii. How should this product be produced?

After deciding what product to produce and quantity, any producer/firm should make decision

on how to produce the commodity, there are many ways but the firm should choose the least cost

combination of inputs that minimizes cost of production. Least cost combination (LCM) is the

combination of inputs to produce a given level of output at a minimum possible cost

iii. Who gets what?

This is concerned more with the distribution of the returns from factors of production such as

wages, interests, rent, and profit. Distribution is fundamental because it can cause social and

political unrest. Therefore, at the end of production fare distribution should be fairly established.

iv. To whom should the commodity be produced?

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The producers should ask themselves, who should be their potential customers; this is important

because economics is about exchange (demand and market analysis). The producers/firms

should plan for markets strategically.

Market strategy planning means findings attractive opportunities and developing profitable

marketing strategy. A marketing strategy specifies a target market and related market mix.

Target market

The market for all products is not homogenous, there are people with different buying patterns.

These are men, women, children, old, young, sick, religious, education, etc. if the marketer

assumes that there is no significant difference in buying pattern of the people for the product

he/she is selling, such kind of marketing is called Mass marketing. However, if the market

believes that the market ios not homogenous he would divide the market into groups of buyers

with similar buying patterns (homogenous groups) to whom the firm wishes to appeal. Such

process is called market segmentation. Market segmentation is process of dividing the total

market into parts, groups of buyers who have something in common with one another which

cause them to have similar buying pattern. Bases of segmenting the market are based on the three

components of effective demand: people with wants, money to spent (ability) and willingness to

spent.

Market mix

Market mix is the set of controllable variables a firm or company puts together to satisfy the

target market. There are many possible ways to satisfy the needs of the target market. It is useful

to reduce all variables in the market mix into four basic ones: Product, Place, Promotion and
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Price. They are referred to as 4Ps of the market mix. Only when all four elements of market mix

are right and correctly balanced with each other will the customer receive in full measures of the

satisfaction they are seeking. These factors have a common focus on the customer.

Product

Place

Price Promotion

Fig 1.0: An illustration of 4Ps of the market

v. Where to produce?

This question focuses on the location of the firm. The producer should make decision on locating

the firm either near the source of raw materials or near the market.

CHAPTER TWO

THE PRODUCTION THEORY

In this chapter, we shall look at the costs and output decisions of an individual firm. In other

words, we shall look at what the costs of production are for a single firm, and how these are

affected by both short-run and long-run factors.

Production is the process of combining and coordinating materials and forces (inputs) in the

creation of some goods and services (products). Production process involves the transformation

of inputs into outputs. Production function refers to the quantitative description/representation

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of various production possibilities faced by a firm. It is an abstract representation of the

production process that gives the maximum output for any level of inputs.

Q = f(X1, X2)
Production function that relates the level of output to the variable inputs X1 and X2

Production is carried out using the factors of production which must be paid or rewarded for their

use. The cost of production is the cost of the factors that are used.

Factor of production It’s cost

Land rent
Labour wages
Capital interest
Entrepreneurship normal or „pure‟ profit

Firms combine various input resources to produce a given level of output. By varying the

amounts of input used, the level of output can be altered. However not all inputs are equally

flexible. Energy, raw materials, the number of labour hours and so on can be combined with each

other with a great deal of flexibility, but the size of the factory or number of machines cannot be

verified so quickly.

Economist take the view that in the short run some factors of production (or production inputs)

are variable in supply (variable inputs/factors) and so have variable costs. How is the price of an

individual product determined? How are wage levels determined in a particular industry typically

labour is regarded as a variable cost item. On the other hand, some factors of production are

fixed in supply and so have fixed cost item. Fixed factors are the factors whose level does not

change with the level of production. More precisely, fixed costs are those costs which do not

vary directly with output, but which remain constant whether anything is produced or not.

Variable costs are those which do vary directly with the level of output.
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Let us suppose that a firm employs a given amount of capital which is a fixed (invariable) input

in the short run: in other words, it is not possible to obtain extra amounts of capital quickly. The

firm may combine with this capital different amounts of labour, which we assume to be an input

which is variable in the short term. Thus, fixed capital and variable labour can be combined to

produce different levels of output. Here is an illustration of the relationship between the different

definitions of the firm's costs: (the figures used are hypothetical).

Table 2.0: illustration of TC, AC and MC

Units of output Q Total cost TC Average cost (AC) Marginal cost (MC)

1 1.10 1.10

2 1.60 0.80 0.50 (1.60 -1.10)

3 1.75 0.58 0.15 (1.75- 1.60)

4 2.00 0.50 0.25 (2.00 -1.75)

5 2.50 0.50 0.50 (2.50- 2.00)

6 3.12 0.52 0.62 (3.12- 2.50)

7 3.99 0.57 0.87 (3.99- 3.12)

8 5.12 0.64 1.13 (5.12 -3.99)

9 6.30 0.70 1.18 (6.30 -5.12)

10 8.00 0.80 1.70 (8.00- 6.30)

 Total cost (TC) is the sum of variable cost/ labour costs plus fixed/capital costs, since

these are by assumption the only two inputs.

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TC = TFC + TVC

 Average cost (AC) is the cost per unit of output, i.e. AC = TC = TC

output Q

 Marginal cost (MC) is the total cost of producing Qth units of the product. It is the cost

of producing an extra or additional unit of output

ISOQUANT

From the production function, we can derive an isoquant which is the locus of all combination of

inputs say X1 and X2 that produces the same level of outputs Q.

Given Q= f( X1 , X2)

X2(K) a

X1(L)

Figure 2.0; An illustration of Isoquant

Isoquant ab gives all combinations of X1, X2 which yield the same level of output. Isoquant for

the higher level of output is to the right of ab while that of low output is to the left of ab. The

slope of the isoquant is known as Marginal Rate of Technical Substitution MRTS. The MRTS

shows the degree of substitution between two inputs in production.

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dX2 == MRTS
dX1
Whereby X2 is Capital and X1 is Labour.
The MRTS measure how one input substitutes for one another as one moves along an isoquant

to maintain the same level of output production. MRTSX2, X1 is amount by which one input (X1)

must be reduced to maintain the same level of production when the other inputs (X2) is increased

by one unit. When X2 substitute for X1, the isoquant is expressed as MRSx2,x1, to represent that

X2 increasing while X1 is decreasing.

Isoquant Map

An isoquant map is a set of isoquants that shows the maximum attainable output from any given
combination inputs.

Properties of Isoquants

Property 1: An isoquant curve slopes downward, or is negatively sloped.

This means that the same level of production only occurs when increasing units of input are

offset with lesser units of another input factor. This property falls in line with the principal of

Marginal Rate of Technical Substitution (MRTS). As an example, the same level of output could

be achieved by a company when capital inputs increase, but labor inputs decrease.

Property 2: An isoquant curve, is convex to its origin.

This indicates that factors of production may be substituted with one another. The increase in one

factor, however, must still be used in conjunction with the decrease of another input factor.
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Property 3: Isoquant curves cannot be tangent or intersect one another.

Curves that intersect are incorrect and produce results that are invalid, as a common factor

combination on each of the curves will reveal the same level of output, which is not possible.

Property 4: Isoquant curves in the upper portions of the chart yield higher outputs.

This is because, at a higher curve, factors of production are being more heavily employed. Either

more capital or more labor input factors result in a greater level of production.

Property 5: An isoquant curve should not touch the X or Y axis on the graph.

If it does, the rate of technical substitution is void, as it will indicate that one factor is responsible

for producing the given level of output without the involvement of any other input factors.

Relationship Between TPP, APP and MPP

What is the relationship between the TPP, APP and MPP? With APP Sometimes it's helpful to

quantify output per worker or output per unit of capital rather than focusing on the total quantity

of output produced. The average Physical product of labor(APPl) gives a general measure of

output per worker, and it is calculated by dividing total output (q) by the number of workers used

to produce that output (L). Similarly, the average product of capital gives a general measure of

output per unit of capital, and it calculated by dividing total output (q) by the amount of capital

used to produce that output (K).

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The MPP is the amount of physical product that will be produced with the addition of one unit

of a factor of production, other factors being given. The APP is the ratio of the total product to

the total quantity of the variable factor, other factors being given. While TPP This is the

maximum amount of output produced by a certain amount of variable inputs, Total physical

product is the total production of output by a firm based on the quantity of inputs used.

To illustrate the meanings of APP and MPP, let us consider a hypothetical case in which all units

of other factors are constant, and the number of units of one factor is variable. In Table 2.1 the

first column lists the number of units of the variable factor, and the second column the total

physical product produced when these varying units are combined with fixed units of the other

factors. The third column is the APP = total product divided by the number of units of the factor,

i.e., the average physical productivity of a unit of the factor. The fourth column is the MPP = the

difference in total product yielded by adding one more unit of the variable factor, i.e., the total

product of the current row minus the total product of the preceding row:

Table 2.1: illustration of TPP,APP and MPP

UNIT VARIABLE TPP APP MPP

0 0 0 0
1 3 3 3
2 8 4 5
3 15 5 7
4 21 5.2 6.5
5 27.5 5.5 6.5
6 30 5 2.5
7 28 4 -2

In the first place, it is quite clear that no factor will ever be employed in the region where the

MPP is negative. In our example, this occurs where seven units of the factor are being employed.

Six units of the factor, combined with given other factors, produced 30 units of the product. An
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addition of another unit results in a loss of two units of the product. The MPP of the factor when

seven units are employed is -2. Obviously, no factor will ever be employed in this region, and

this holds true whether the factor-owner is also owner of the product, or a capitalist hires the

factor to work on the product. It would be senseless and contrary to the principles of human

action to expend either effort or money on added factors only to have the quantity of the total

product decline.

The Three Stages of Production Function

The classical production function can be divided into three stages based on the efficiency of

resource/inputs utilization.

STAGE I:

 This occurs when MPP is greater than zero,

 MPP is greater than APP and the APP is increasing.

 This means that the efficiency of transforming inputs into output which is measured by

APP is increasing throughout state 1,

 Also, TPP is not at maximum.

STAGE II:

 This Occurs when MPP is greater or equal to zero,

 MPP is less than APP and APP is declining and

 APP is at maximum.
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STAGE III:

 This occurs when MPP IS negative, TPP is declining.

The efficiency of using the variable inputs is measured by APP; When APP attains a a

maximum at the beginning of stage ii, the variable inputs are used most efficiently.

TPP

I II III

APP

MPP X

Fig 2.1: A graphical illustration of three stages of production

Product-Product Relationship
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a) Competitive product: Two products are said to be competitive if the output of one

enterprise cannot be increased unless the output of the other enterprise is decreased

Corns

Soyabeans

Fig 2.3: illustration of competitive product

b) Complimentary products:

Two products are said to be complimentary if the output of one enterprise increase, the

output of the other enterprise increases

Beans

Maize

Fig 2.4: illustration of complimentary product

c) Supplementary product:

Two products are said to be supplementary one can increase the production of one

enterprise without changing the production of the other enterprise.

Crops
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Machine(Tractor)

Fig 2.5: illustration of supplementary products

Joint Product:

These are the product which results from the same production process. The two are combined

into fixed proportions such that one cannot be produced without the other: they may be

consumed as one product though the other joint product may have narrow range of substitution;

example of joint product are skimmed milk and butter, mutton and wool.

mutton

wool

Fig 2.6: illustration of joint products

CHAPTER THREE

THE PRODUCTION POSSIBILITIES FRONTIER (PPF)

Introduction

The production possibilities frontier or the production possibilities curve show the capabilities of
a country. The curve makes some assumptions, like there are that the country only produces two
goods, it has a fixed amount of resources and has a static level of technology.
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A production possibility curve even shows the basic economic problem of a country having
limited resources, facing opportunity costs and scarcity in the economy. The opportunity cost is
the cost of selecting one alternative over another one. The PPF is used to illustrate the trade-offs
that arise from scarcity.

Production possibility frontier (PPF) is the curve which joins all the points showing the

maximum amount of goods and services which the country can produce in a given time with

Limited resources, given a specific state of technology, OR the PPF curve shows the possible

combinations of goods and services available to an economy, given that all productive resources

are fully and efficiently employed.

When the economy is at

 point k, resources are not fully employed and/or they are not used

efficiently.

 Point j is desirable because it yields more of both goods, but not

attainable given the amount of resources available.

 Point h is one of the possible combinations of goods produced when

resources are fully and efficiently employed.

Tones of Y Y- Factory goods per year

X- Farm goods per year

800 j

600 h
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500 k

20 60 Tonnes of X

Figure 2.7: Production Possibility Frontier

PPF and Economic Efficiency

A production possibility frontier is used to illustrate the concepts of opportunity cost, trade-offs

and also show the effects of economic growth. Points within the curve show when a country‟s

resources are not being fully utilized. Combinations of the output of consumer and capital goods

lying inside the PPF happen when there are unemployed resources or when resources are used

inefficiently. We could increase total output by moving towards the PPF. Combinations that lie

beyond the PPF are unattainable at the moment. A country would require an increase in factor

resources, an increase in the productivity or an improvement in technology to reach this

combination. Trade between countries allows nations to consume beyond their own PPF

producing more of both goods would represent an improvement in welfare and a gain in what is

called allocative efficiency.

Understanding the Pareto Efficiency

The Pareto Efficiency is a concept named after Italian economist Vilfredo Pareto that measures

the efficiency of the commodity allocation on the PPF. The Pareto Efficiency states that any

point within the PPF curve is considered inefficient because the total output of commodities is

below the output capacity. Conversely, any point outside the PPF curve is considered to be
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impossible because it represents a mix of commodities that will take more resources to produce

than can be obtained.

Trade, Comparative Advantage and Absolute Advantage

Specialization and Comparative Advantage

An economy may be able to produce for itself all of the goods and services it needs to function
using the PPF as a guide, but this may actually lead to an overall inefficient allocation of
resources and hinder future growth – when considering the benefits of trade. Through
specialization, a country can concentrate on the production of just a few things that it can do
best, rather than dividing up its resources among everything. specialization implies that an economy
is producing the goods and services in which it has a comparative advantage

Considering a hypothetical world that has just two countries (Country X and Country Y) and only two
products (cars and cotton). Each country can make cars and/or cotton. Suppose that Country X has very
little fertile land and an abundance of steel available for car production. Country Y, on the other hand, has
an abundance of fertile land but very little steel. If Country Y were to try to produce both cars and cotton,
it would need to divide up its resources, and since it requires a great deal of effort to produce cotton by
irrigating its land, Country X would have to sacrifice producing cars – which it is much more capable of
doing. The opportunity cost of producing both cars and cotton is high for Country X, as it will have to
give up a lot of capital in order to produce both. Similarly, for Country Y, the opportunity cost of
producing both products is high because the effort required to produce cars is far greater than that of
producing cotton.

Each country in our example can produce one of these products more efficiently (at a lower cost) than the
other. We can say that Country X has a comparative advantage over Country Y in the production of cars,
and Country Y has a comparative advantage over Country X in the production of cotton.

Now let's say that both countries (X and Y) decide to specialize in producing the goods with which they
have a comparative advantage. If they then trade the goods that they produce for other goods in which
they don't have a comparative advantage, both countries will be able to enjoy both products at a lower
cost. Furthermore, each country will be exchanging the best product it can make for another good or
service that is the best that the other country can produce so quality improves. Specialization and trade
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also works when several different countries are involved. For example, if Country C specializes in the
production of corn, it can trade its corn for cars from Country X and cotton from Country Y.

Determining how countries exchange goods produced by a comparative advantage ("the best for
the best") is the backbone of international trade theory. This method of exchange via trade is
considered an optimal allocation of resources, whereby national economies, in theory, will no
longer be lacking anything that they need. Like opportunity cost, specialization and comparative
advantage also apply to the way in which individuals interact within an economy.

Absolute Advantage

Sometimes a country or an individual can produce more than another country, even though
countries both have the same amount of inputs. For example, Country X may have a
technological advantage that, with the same amount of inputs (good land, steel, labor), enables
the country to easily manufacture more of both cars and cotton than Country Y. A country that
can produce more of both goods is said to have an absolute advantage. Better access to quality
resources can give a country an absolute advantage as can a higher level of education, skilled
labor, and overall technological advancement. It is not possible, however, for a country to have
an absolute advantage in everything that it produces, so it will always be able to benefit from
trade.

Scarcity and the PPF

To increase the amount of farm goods by10 tons, we must sacrifice 100 tons of factory goods.

The PPF curve is bowed out because resources are not perfectly adaptable to the production of

the two goods. As we increase the production of one good, we sacrifice progressively more of

the other.

800

700
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20 30 X

Fig 2.8: Scarcity and the PPF

Shifting the PPF Curve

To increase the production of one good without decreasing the production of the other, the PPF

curve must shift outward.

 The PPF curve shifts outward as a result of an increase in the economy‟s resources OR

 An increase technological innovation that increases the output obtained from a given

amount of resources. From point k, an additional 200 tons of factory goods or 20 tons of

farm goods are now possible (or any combination in between).

Y-Factory goopds

400 m

200 k h
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X- Farm goods
30 50
Fig2.8: Shifting the PPF Curve

Uses of PPF Curve

1. Resource allocation; the PPF curve helps the society to make good decision on how to
use scarce resources available to produce goods and services that maximizes social
welfare. With the limited resources, the society has to make choice of the combination on
the PPF curve.
2. Identification of the problem of unemployment and underemployment of resources.
When the economy is operating at any point below the PPF curve it implies
underemployment of resources.
3. Identification of the full employment of resources. When the economy is operating at any
point along the PPF curve, it shows the full employment Of resources

CHAPTER THREE

DEMAND AND SUPPLY

INTRODUCTION

Demand
It is important that you should appreciate the concept of demand properly. Demand does not

mean the quantity that potential purchasers wish they could buy. For example, potential

purchasers might desire to have one million units of a good, but there might only be actual

attempts to buy one hundred units at a given price.

Demand is the quantity of a good/commodity buyer is willing and capable to purchase at a going

price at a specific period of time. Therefore, the condition of effective demand entails
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 Willingness,

 ability, to buy effective demand

 specific price,

 specific time

Demand is said to be effective if all the above conditions persist

Distinction between demand schedule, demand curve, and demand function,

Demand schedule

This refers to the list of the variety of quantities of a commodity bought at different prices at

specific periods of time. The demand schedule shows exactly how many units of a good or

service will be bought at each price. It is the underlying data that the demand curve represents.

Demand schedule is a discrete version of a demand function. It specifies a (finite) list of unit

price-quantity demanded pairs

Table 3.0. An illustration of demand schedule

Prices Tshs Quantity kg

200 20

150 40

100 60

50 100

20 150

10 300

The Demand Curve

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The relationship between demand and price can be shown graphically as a demand curve. It

represents the demand schedule graphically. The demand curve of a single consumer is derived

by estimating how much of the good the consumer would demand at various hypothetical market

prices.

A demand curve is a single line that represents the various points on a graph where the price of a good or

service aligns with its quantity. It is a downward curve or line that moves from left to right on a graph,

where the vertical axis represents price and the horizontal axis represents quantity demanded. The

downward shape of a demand curve indicates that, as price decreases, customers will demand more of a

product.

Price

200

150

100

50

20

40 60 100 150 Quantity

 28

Figure 3.0. An illustration of demand curve

The vertical axis is the price axis, measuring the price per unit of the commodity. The horizontal

axis is the quantity axis, measuring the quantity of the good demanded in total by all the

economic actors chosen above. Here, quantity demanded by an economic actor refers to the

quantity that that economic actor is ready, willing, and able to buy. Note that the demand curve

makes sense only ceteris paribus -- all other determinants of demand being kept constant.

Features of demand curve;

 The DC slopes downward from left to right implying that the higher the price the lower
will be the quantity to buy and vice versa
 It has the negative slope due to the inverse relationship between price and quantity
demanded.

Demand curve have a negative slope

Demand curves generally have a negative gradient indicating the inverse relationship between
quantity demanded and price. There are at least three accepted explanations of why demand
curves slope downwards:

1. The law of diminishing marginal utility

2. The income effect
3. The substitution effect
i. Diminishing marginal utility

One of the earliest explanations of the inverse relationship between price and quantity demanded

is the law of diminishing marginal utility. This law suggests that as more of a product is

consumed the marginal (additional) benefit/satisfaction to the consumer falls, hence consumers

are prepared to pay less. This can be explained as follows:

 29

 Most benefit is generated by the first unit of a good consumed because it satisfies all or a

large part of the immediate need or desire.

 A second unit consumed would generate less utility - perhaps even zero, given that the

consumer now has less need or less desire.

 With less benefit/satisfaction derived, the rational consumer is prepared to pay rather less

for the second, and subsequent, units, because the marginal utility falls.

Consider the following figures for utility derived by an individual when consuming bars of

chocolate. While total utility continues to rise from extra consumption, the additional (marginal)

utility from each bar falls. If marginal utility is expressed in a monetary form, the greater the

quantity consumed the less the marginal utility and the less value derived - hence the rational

consumer would be prepared to pay less for that unit.

Table 3.1: illustration of how DMU cause negative demand curve

BARS OF CHOCOLATE TOTAL UTILIRY MARGINAL

UTILITY
1 100
2 190 90
3 270 80
4 340 70
5 400 60
6 450 50
7 490 40
8 520 30
9 540 20

ii. The income effects

The income and substitution effect can also be used to explain why the demand curve slopes

downwards. If we assume that money income is fixed, the income effect suggests that, as the
 30

price of a good falls, real income - that is, what consumers can buy with their money income -

rises and consumers increase their demand. Therefore, as price of the commodity falls, the real

income of the consumer increases then he/she can purchase more units of the commodity with

the same amount of money income.

iii. The substitution effects

In addition, as the price of one good falls, it becomes relatively less expensive. Therefore,

assuming other alternative products stay at the same price, at lower prices the good appears

cheaper, and consumers will switch from the expensive alternative to the relatively cheaper one.

following the gradual fall in price of the commodity, while that of the substitute remains constant

consumers buy more of the commodity and less of the substitute. It is important to remember

that whenever the price of any resource changes it will trigger both an income and a substitution

effect.

Demand Function

The mathematical function explaining the quantity demanded in terms of its various
determinants, including income and price; thus the algebraic representation of the demand curve.
Individual demand function refers to the functional relationship between individual demand and
the factors affecting individual demand. It is expressed as:
Dx = f (Px, Pr, Y, T, F) Where,

Dx = Demand for Commodity x;

Px = Price of the given Commodity x;

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

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

 31

Demand function shows the relationship between quantity demanded for a particular commodity and the

factors influencing it.

The Law of Demand

The law states that having other factors remain constant, the higher the price of the commodity

the lower the quantity of the commodity demanded and vice versa. This relationship holds true as

long as "all other things being unchanged or constant." That part is so important that economists use

a Latin term to describe it -- ceteris paribus. The "all other things" that need to be equal under ceteris

paribus are the other determinants of demand. These are prices of related goods or services, income,

tastes or preferences, and expectations. For aggregate demand, the number of buyers in the market is also

a determinant. If the other determinants change, then consumers will buy more or less of the product even

though the price remains the same.

Exception of the Law of Demand

There are some instances where the law of demand does not hold true. These are known as

exception of law of demand.

1. The law of demand does not hold true in case of Giffen goods. The rational consumer

will go on decreasing his consumption of such goods as the price falls and vice versa.

Giffen goods named after Sir Robert Giffen, are inferior goods. He observed during

potatoe famine in Ireland in the mid of 1940s, that the poor buy more potatoes as their

price rises. This situation occurs when the price rise drains the income of the peasants

forcing them to become even more reliant on potatoes for food.

 32

2. The law doesn‟t operate due to Veblen effect. This was named after Thorsten Veblen,

explains why the market demand curve exhibit a steeper slope than would otherwise be

predicted and it could even slope upwards in contradiction to the law of demand. The

reason is, as the price the goods or services falls, some consumer perceived that it

reflect a reduction in quality and thus reduce their quantity demanded rather than

increasing their demand for goods.

3. Sometime it happens that when the price of the goods rise, the consumer expects it to

rise further. In that case, he may purchase more units of goods as their price goes on

increasing. For example in the share markets, it is noted that when the price of the

particular share rises, its demand also increases and vice versa.

Change in Quantity Demanded

Change in quantity demanded refers to an increase or decrease in quantity demanded by

consumers due to change in price of the commodity assuming other factors are constant. A

movement along a given demand curve caused by a change in demand price. The only factor that

can cause a change in quantity demanded is price. The demand for a commodity changes due to a

change in price. It is called Extension and contraction of demand. When there is decrease in

price of commodity there is in increase in demand of that commodity. This is called extension of

demand. When there is increase in price of a commodity there is decrease in the demand for that

commodity. This called Contraction of demand. Thus demand varies in opposite direction due to

change in price.

Prices(Tsh)

P2
 33

P1

O Q2 Q1

Fig 3.1: Illustration of change in quantity demanded

As the price of the commodity rises from P1 to P2 the quantity demanded changed/decreased

from Q1 to Q2 . Change in quantity demanded involves the movement along the same demand

curve.

Change in Demand

This involves change in quantity demanded due to change in other factors other than price. These

factors are Income, Price of substitutes, Tastes and fashion, Population, Advertisement, Weather

condition.

Price D2

D1

P1 E E‟

D2

D1
 34

O Q1 Q2 Quantity

Figu3.2: illustration of change in demand

Before change in income at price 0P1 the quantity demanded is 0Q at the demand curve D1D1. As

the income increased the demand has increased to 0Q2. There is a change in equilibrium from E

to E‟.

A shift in the demand curve is when a determinant of demand other than price changes. Here are
just four examples of determinants.

1. Income of the buyers.

2. Consumer trends and tastes.
3. Expectations of future price, supply, needs, etc.
4. The price of related goods. These can be substitutes, such as beef vs. chicken. They can
also be complementary, such as beef and Worcestershire sauce.

Shift in the Demand Curve

The curve shifts to the left if the determinant causes demand to drop. That means less of the good
or service is demanded at every price. For example, when the economy is growing, buyers'
incomes will rise. That means they will buy more of everything, even though the price hasn't
changed. The curve shifts to the right if the determinant causes demand to increase. That means
that more of the goods or services are demanded at every price. Using that same illustration,
when the economy is in a recession, buyers' income drops. They will buy less of everything,
even though the price is the same.

i. Income of the buyers

If the consumer income get raised, you're more likely to buy more of goods, even if their
prices don't change. That shifts the demand curves for both to the right.

ii. Consumer preference/trends

 35

During the fowl pox poultry disease scare, consumers preferred more beef over chicken.
Even though the price of chicken hadn't changed, the quantity demanded was lower at every
price. That shifted the demand curve to the left.

iii. Expectations of future price

When people expect prices to rise in the future, they are more likely to buy more of
commodities now, even if the price hasn't even changed. In other words, they want to stock
up now before prices rise. That shifts the demand curve to the right.

iv. The price of related goods

Beef and chicken are related substitute goods, and if the price of beef rises, you're more likely to
buy more chicken. Even if its price doesn't change. That's how an increase in the price of a
substitute (beef) shifts the demand curve to the right for chicken. The opposite occurs with the
demand for beef packing bags, a complementary product. Its demand curve will shift to the left
as you are less likely to buy it at any price since you have less beef to put it in.

Demand and Household Income

Distinction between Normal, inferior and Giffen goods

Introduction to Engel Curve:

The Engel Curve trace the consumption of a Good X as an individual‟s income changes. Income

is plotted on the y-axis and the quantity of Good X consumed is plotted on the x-axis. The curve

that follows the amount of Good X consumed as income increases plots the Engel Curve.

The slope of the Engel Curve also tells us whether or not the good is a normal good or inferior

good. If the slope of the curve is positive, the good is a normal good because consumption

increases as income is increased. If the slope of the curve is negative, the good is an inferior

good because consumption decreases as income is increased.

Income(Y)
 36

units of quantity demanded (Q)

Fig 3.4: an illustration of an Engel curve

The amount of income that a household earns will affect the demand for a good. As you might

imagine, more income will give households more to spend, and they will want to buy more

goods at existing prices. However, a rise in household income will not increase market demand

for all goods and services. The effect of a rise in income on demand for an individual good will

depend on the nature of the good. Consumer income (Y) is a key determinant of consumer

demand (Qd). The relationship between income and demand can be both direct and inverse.

Normal goods

In the case of normal goods, income and demand are directly related, meaning that an increase in

income will cause demand to rise and a decrease in income causes demand to fall. For example,

luxuries like cars and computers are normal goods for most people. A rise in household income

may increases demand for a good. This is what we might normally expect to happen, and goods

for which demand rises as household income gets bigger are called normal goods. By definition

Normal goods are goods whose quantity demanded Increase as consumer income increases

Inferior goods
 37

In the case of inferior goods income and demand are inversely related, which means that an
increase in income leads to a decrease in demand and a decrease in income leads to an increase
in demand. For example, necessities like beans are often inferior goods.

NOTE: Demand may rise with income up to a certain point but then falls as income rises beyond

that point. Goods whose demand eventually falls as income rises are called inferior goods, e.g.

tripe, cheap wine. By definition Inferior goods are goods whose quantity demanded goes down

as consumer income increases. The reason for falling demand is that as incomes rise, demand

switches to superior products e.g. beef instead of tripe, better quality wines instead of a cheaper

variety.

Quantity
Demanded quantity
demanded

Income income

Normal good inferior good

Fig3.5: illustration of Normal and Inferior Goods

 38

Giffen goods

In economics, a giffen good is an inferior good with the unique characteristic that an increase in price

actually increases the quantity of the good that is demanded. This provides the unusual result of an

upward sloping demand curve. A Giffen good, in economic theory, is a good that is in greater demand as

its price increases. For example, if the price of an essential food staple, such as rice, Increaseses, it may

mean that consumers have less money to buy more expensive foods, so they will actually be forced to buy

more rice. Giffen goods are named after Sir Robert Giffen who wrote that he observed this purchasing

behavior

price

quantity

Fig 3.6: illustration of the Giffen goods

Distinction between Substitutes and complements

A change in the price of one good will not necessarily change the demand for another good. For

example, we would not expect an increase in the price cocoa to affect the demand for motor cars.

However, there are goods for which the market demand is in some way inter- connected. These

interrelated goods are referred to as either substitutes or complements.

Substitute goods
 39

Different goods that, at least partly, satisfy the same needs of the consumers and, therefore, can

be used to replace one another. Price of such goods shows positive cross-elasticity of demand.

Thus, if the price of one good goes up the sales of the other rise, and vice versa. Substitute goods

are goods that are alternatives to each other, so that an increase in demand for one is likely to

cause a decrease in the demand for another, they are goods that provide the same utility to the

consumer. demand from one good to another 'rival' good is substitution.

Py

Qx

Fig 3.7: illustration of Two goods that are substitutes have a positive cross elasticity of

demand: as the price of good Y rises, the demand for good X rises

Examples of substitute goods are:

 tea and coffee;

 different forms of entertainment.

Substitution takes place when the price of one good rises or falls relative to a substitute good.

The cross elasticity of demand for substitute goods is always positive because the demand for

one good increases if the price for the other good increases. For example, if the price of coffee

increases, the quantity demanded for tea (a substitute beverage) increases as consumers switch to

a less expensive yet substitutable alternative

 40

Complements goods

are goods that tend to be bought and used together/jointly, so that an increase in the demand for

one is likely to cause an increase in the demand for the other.

When two goods are complements, they experience joint demand. In economics, a complemety

good or complement is a good with a negative cross elasticity of demand in contrast to

substitute goods which means a good's demand is increased when the price of another good is

decreased. Conversely, the demand for a good is decreased when the price of another good is

increased. If goods A and B are complements, an increase in the price of A will result in a

leftward movement along the demand curve of A and cause the demand curve for B to shift in;

less of each good will be demanded. A decrease in price of A will result in a rightward

movement along the demand curve of A and cause the demand curve B to shift outward; more of

each good will be demanded. Basically, this means that since the demand of one good is linked

to the demand of another good, if a higher quantity is demanded of one good, a higher quantity

will also be demanded of the other, and if a lower quantity is demanded of one good, a lower

quantity will be demanded of the other.

Py

Qx
 41

Fig 3.8: Complementary goods exhibit a negative cross elasticity of demand: as the price of good Y

rises, the demand for good X falls.

Examples of complements are:

 cups and saucers;

 bread and butter;

 motor cars and motor spares.

Alternatively, the cross elasticity of demand for complementary goods is negative. As the price

for one goods increases, an item closely associated with that item and necessary for its

consumption decreases because the demand for the main good has also dropped. For example, if

the price of motor cars increases, the quantity demanded for motor spares falls.

Price Elasticity of Demand

Price elasticity is a measure of the responsiveness of the quantity demanded to a change in

price. It is calculated as the percentage change in quantity demanded to a percentage change in

price. When quantity demanded is very responsive to a change in price we say demand is elastic;

when quantity demanded is not very responsive to a change, we say that demand is inelastic. The

following figure illustrates the most extreme cases: perfectly elastic demand ( at a higher price,

quantity demanded decreases to zero) and perfectly inelastic demand ( a change in price has no

effect on quantity demanded

P P D2

Ed=0
 42

D1; Ed=∞

Q Q

Fig3.9: Perfect elastic demand Fig 3.10: Perfect inelastic demand

NOTE: The implication of a perfectly inelastic demand is that price does not matter; the consumer would purchase

the same amount of a good or service no matter how its price changes. A diabetic‟s demand for insulin has a demand

curve that is almost vertical. A perfectly elastic demand curve is horizontal at the market price. These firms under

perfect elasticity must “take it or leave it,” meaning that they either accept the market price or choose not to sell

their product. At a higher price, the company will not have any sales because there are too many competitors

offering the same product at a lower price. At the market or lower price, the company will sell everything

If the price elasticity of demand is equal to

0 = demand is perfectly inelastic (i.e., demand does not change when price changes).

<1= Values between zero and one indicate that demand is inelastic (this occurs when

the percent change in demand is less than the percent change in price).

=1: When price elasticity of demand equals one, demand is unit elastic (the percent

change in demand is equal to the percent change in price).

>1= Finally, if the value is greater than one, demand is perfectly elastic (demand is

affected to a greater degree by changes in price).

Factors Influencing Price Elasticity of Demand

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Nature of Goods:

Refers to one of the most important factors of determining the price elasticity of demand. In
economics goods are classified into three categories, namely, necessities (or essential goods),
comforts, and luxuries. Generally, the demand essential goods, such as salt, sugar, match boxes,
and soap, is relatively inelastic (less than unity) or perfectly inelastic.

 This implies that consumers purchase the same quantity of these goods, regardless of
increase or decrease in their prices. Moreover, the consumption of necessities cannot be
postponed; therefore, the demand for necessities is inelastic.
 On the other hand, price elasticity of demand for luxury goods, such as car, air
conditioners, and expensive jewellery, is highly elastic. Any change in the prices of
luxury goods cause a major a change in their demand.
 In addition, the price elasticity of demand for comforts, such as milk fan (cold room), and
coolers, is equal to unity. Therefore, we can say that demand for comforts is more elastic
as compared to necessities and less elastic than luxury goods.

Number of Uses of a Good:

Helps in determining the price elasticity of a good. The demand for multi-use goods is more
elastic as compared to single-use goods. When the price of a multi-use good decreases,
consumers would increase its consumption. Therefore, the percentage change in the demand for
multi-use goods is more with respect to percentage change in their prices. For example

 if, electricity can be used for a number of purposes, such as lighting, cooking, and various
commercial and industrial purposes. If the price of electricity decreases, consumers may
increase its usage for various other purposes.
 Similarly, if the price of milk decreases, consumers may increase its consumption by
using it for various purposes, such as butter, cream, and ghee. In such a case, the demand
for milk would be highly elastic. On the contrary, if the price for these goods increases,
there use would be restricted to urgent purposes only.
 44

Distribution of Income:

Acts as a crucial factor in influencing the price elasticity of demand. If a consumer has high
income, then the demand for products consumed by him/her would be inelastic. For example,

 An increase in prices of any product would not affect the demand for products consumed
by a millionaire.
 On the other hand, demand for products consumed by lower or middle-income consumers
would be highly sensitive to change in the price e.g the price of mobile phones increases,
then the demand for mobile phones would be inelastic in high income group, whereas it
would be highly elastic in lower and middle income group consumers.

Level of Price:

Refers to the fact that demand for high-priced goods, such as

 Expensive gold and diamond jewellery and imported cars, is inelastic. The change in the
price of these goods produces a very small change in their demand.
 Similarly, the demand for low-priced goods, such as cheap potatoes and match boxes, is
also inelastic.

Apart from this, the demand for medium-priced goods that are neither very costly nor very low
cost is elastic. The demand for medium-priced goods is very sensitive to change in their prices.

Availability of Substitutes:

Influences the elasticity of demand to a larger extent. The main reason for change in the

elasticity of demand with change in price of some goods is the availability of their competing

substitutes. The larger the number of close substitutes of a good available in the market, greater

the elasticity for that good. For example, tea and coffee are close substitutes. When the price of a

commodity rises, the people would shift their preference to substitute commodities and demand the

substitutes with the hope that the price of substitutes will not rise.
 45

Complementary Goods

Refer to the fact that the demand for complementary goods is relatively inelastic. The

complementary goods, pen and ink and car and petrol, are consumed jointly. Therefore, the rise

in price of one good would not affect its demand, until there is change in the price of its

complementary good. For example, if the price of petrol rises, then its demand would not

contract immediately until the price of car increases.

Types of Price Elasticity

a) Elastic demand; Price elasticity is said to be elastic if a small change in price of the commodity will bring

in a larger than proportionate change in quantity demanded of the commodity. Numerically >1

Price D

P2

P1

0 Q1 Q2 Quantity

Fig3.11: elastic demand

This means that a commodity with elastic demand are more sensitive to price changes,eg a small

increase in price leads to a large change in quantity demanded example are luxury goods ie TVs.

b) Inelastic Demand; Price elasticity is said to be inelastic when a change in price bigger change in price

brings a small change in quantity demanded. This means they are less sensitive to price changes. All

necessity goods i.e foods, clothes are price inelastic.

c) Unitary elastic; a proportionate change in price brings in an equal proportionate change in quantity

demand

Price D Price
 46

P1 P1

P2 D P2 D

0 q1 q2 quantity 0 q1 q2 quantity

Fig3.12 Inelastic demand Fig3.13: unitary elastic

Calculation of price elasticity of demand is given by the formula below as

Pe % Change in quantity demanded

% Change in price of the commodity
Elasticity is always negative due to the inverse relationship between price and quantity
demanded.
Example
If, for example, a 20% increase in the price of a product causes a 10% fall in the Quantity
demanded, the price elasticity of demand will be:

Pe = 10% = -0.5
20%

That means a unit change in price decrease the quantity demanded by 0.5 units.
Example 2:
If price of the commodity is 5 Tsh per unit and demand is 10 units, and price fall to 4 Tsh per
unit and demand increased to 12 units, therefore price elasticity will be as follows,
Ep = % Change in quantity demanded
% Change in price of the commodity

20/-20= -1
Therefore, the price elasticity is -1
 47

Income Elasticity of Demand

Income elasticity is the responsiveness of demand to change in income of the consumer. It is
obtained by dividing the proportionate change in demand by the proportionate change in income.
Income elasticity is always positive.

EI = % Change in quantity demanded

% Change in income of the consumer
In economics, income elasticity of demand measures the responsiveness of the quantity demanded for a
Commodity to a change in the income of the consumer demanding the commodity, ceteris paribus. It is
calculated as the ratio of the percentage change in quantity demanded to the percentage change in
income.

Example 1.

if in response to a 10% increase in income, the quantity demanded for a good increased by 20%, the
income elasticity of demand would be 20%/10% = 2.

Example 2

When the income of a certain consumer is Tsh 1000, his demand for sugar is 5 units, after one
year his income increased to Tsh 1200, and his demand for sugar increased to 7 units. Calculate
his income elasticity.

EI = 40/20 +2

Therefore, the income elasticity for sugar is +2

With income elasticity, you may end up with

 A negative income elasticity.

A negative income elasticity of demand is associated with inferior goods where an increase
in income will lead to a fall in the demand and may lead to changes to more luxurious
substitutes.

 A positive income elasticity.

 48

A positive income elasticity of demand is associated with normal goods where an increase in
income will lead to a rise in demand. If income elasticity of demand of a commodity is less than
1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a
superior good.

 Normal necessities have an income elasticity of demand of between 0 and +1 for

example, if income increases by 20% and the demand for fresh salt increases by
8% then the income elasticity is +0.4. Demand is rising less than
proportionately to income.
 Luxury goods and services have an income elasticity of demand > +1 i.e.
demand rises more than proportionate to a change in income – for example a
16% increase in income might lead to a 20% rise in the demand for new car
models. The income elasticity of demand in this example is +1.25

 A zero-income elasticity.

A zero-income elasticity of demand occurs when an increase in income is not associated with a
change in the demand of a good. These would be sticky goods.

Cross Elasticity of Demand

Cross elasticity of demand is an economic concept that measures the responsiveness in the quantity

demand of one good when a change in price takes place in another good. Also called cross price elasticity

of demand, this measurement is calculated by taking the percentage change in the quantity demanded of

one good and dividing it by the percentage change in price of the other good. Cross elasticity is the

ratio at which demand for any commodity change due to change in the price of any substitute

commodity.

Calculating cross elasticity, you may end up with Items with a coefficient of 0 implying

unrelated items, and the goods are independent of each other. Items may be weak substitutes, in

which the two products have a positive but low cross elasticity of demand. This is often the case
 49

for different product substitutes, such as tea versus coffee. Items that are strong substitutes have

a higher cross elasticity of demand

Example:

Price of coffee is Tsh 100 per unit and demand for tea at its own price is 100 units. If price of
coffee raised to Tsh 120 per unit, as a result of this demand of tea increased to 150 units,
calculate the cross elasticity :

EC = % Change in quantity demanded for tea

% Change in price of the commodity of coffee

50/20= +2.5

Cross elasticity = +2.5

Application of price elasticities

The concept of price elasticity of demand has a significant contribution in the field of industry,
trade, and commerce. The price elasticity of demand not only enables an organization to analyze
economic problems, but also helps in solving managerial problems, not related to pricing
decisions. The importance of price elasticity of demand is explained in the following points:

i. Pricing Decisions

Refer to one of the major role of price elasticity of demand. The price elasticity of demand helps
an organization to determine the price of its products in various circumstances.

Such situations are as follows:

a. Monopoly Price Discrimination:

Refers to a situation when different prices are charged from different consumers. For example,

charges more prices from consumers whose demand for products is inelastic. This implies high
 50

prices are charged from consumers whose demand does not change with change in the price of

products. On the other hand, a monopolist charges less prices from consumers whose demand is

elastic.

For example, the demand for electricity for domestic users is inelastic; therefore, the

price of domestic electricity is high, whereas the demand for industrial electricity is

inelastic. This is because the use of electricity for industrial purposes can be replaced

with other fuels.

b. Price with without substitutes

Firms utilize cross elasticity of demand to establish prices to sell their goods. Products with no

substitutes have the ability to be sold at higher prices, because there is no cross elasticity of

demand to consider. However, incremental price changes to goods with substitutes are analyzed

to determine the appropriate level of demand desired and the associated price of the good.

c. Price with complimentary goods

With complementary goods, their prices are strategically priced based on cross elasticity of

demand. For example, cars may be sold at a loss with the understanding that the demand for

future complementary goods, such as cars spears should increase.

ii. Formulation of Government Policies:

This is another important significance of the concept of price elasticity of demand. The

government takes into consideration the price elasticity of demand while planning taxes. For
 51

example, tax on products having elastic demand generate less revenue for the government as the

taxes increase the price of products, which results in decrease in demand. On the contrary, a high

rate of tax is levied on products having inelastic demand. Apart from this, the government also

considers the price elasticity of demand before implementing any price control policy.

iii. Wage Bargaining

The bargaining power of the trade unions in raising the wages of a group of labour in a particular industry

also depends, among other things, on the elasticity of demand for their services to the employer. A trade

union usually succeeds in raising wages when the demand for the services of labour to the employer is

inelastic: because, in such a case the employer cannot easily dispense with their services. On the other

hand, it may not succeed when demand for labour is elastic.

iv. Effects of Changes in Price Upon Demand:

The concept is very useful to study the reactions of the demand for a commodity to the changes
in its price. If the demand is elastic, a small change in the price brings about a considerable
change in the quantity demanded, but in the case of inelastic demand this consequential change
in demand is relatively small. So, the concept is relevant to the decisions relating to business
pricing and profits.

SUPPLY

Supply is the amount of commodities sold in the market at various levels of prices at specific periods of

time, or is the amount of the commodities that firms are willing and able to sell in the market at specific

levels of price and period of time. The relationship between quantity supplied and prices establishes the

law of supply.
 52

The law of supply states that, having other factors remained constant the higher the price of the

commodity the greater the quantity that will be supplied.

Supply schedule

Supply schedule is a table that shows how much product a supplier will have to produce to meet

consumer demand at a specified price. A supply schedule is a chart or table that tells how many "units" of

something producers will make based on the current market price of a unit

Table 3.2: an illustration of supply schedule

Price Supply (Units)

20 10

25 20

30 30

35 40

40 50

45 60

50 70

Supply curve

The supply curve represents the direct relationship between price and quantity. The supply curve
is simply the supply schedule plotted on a graph. The graph has two axes. The vertical axis is
price. The horizontal axis is output. In general, a supply curve slopes upward, from the lower left
-- low price, low output -- to the upper right -- high price, high output. The point where the
supply and demand curves for a product intersect represents "equilibrium," the price at which
 53

the number of units consumers want to buy equals the number producers want to make. Using
the above supply schedule to represent the supply curve

60
50
50 45
40
40 35
30
prices

30 25
20
20

10

0
0 10 20 30 40 50 60 70 80
supply

Fig 3.13: an illustration of supply curve

Change in quantity supplied

This is a movement along a given supply curve caused by a change in supply price. The only

factor that can cause a change in quantity supplied is price. change in quantity supplied is a

change in the specific quantity of a commodity that producers/firms are willing and able to

produce and offer for sell. It is illustrated by a movement along a given supply curve. In fact, the

only way to induce a change in quantity supplied is with a change in the price. Anything else,

everything else, causes a change in supply. As the supply price induces a change in the quantity

supplied and a movement along the supply curve, the five supply determinants (resource prices,

production technology, other prices, sellers' expectations, and number of sellers) should remain

unchanged.
 54

Since Price is an important factor of changing the quantity supplied by a seller, then When the price of a

commodity increases its quantity supplied also increases and this is called the extension of supply. In

opposite process, when the price of commodity decreases, the quantity supplied of it also decreases it is

called the contraction of supply. It leads to the law of supply.

Figure3. 14: an illustration of contraction and extension of supply

Factors influencing supply

i. Cost of production

There are various production costs involved in the production of commodities. These may
include wages, price of raw materials and rents. When production cost is low, it cost less to
produce therefore more can be produced and supplied.

ii. Climatic conditions

If climatic condition is favorable, production will increase and a result of this supply will
increase as well.

iii. Technology
 55

New inventions may improve production methods and reduces the production costs. Also more
can be produced in less time, and this again result in increase in supply.

iv. Infrastructures

If means of transport and communication are adequate and well developed, it will be possible to

move commodities from one place to another hence increase in supply.

v. Taxation

When taxes are levied at higher rates, supply fall because increase in taxes , is equivalent to the

increase in the costs of production. On other hands when taxes are reduced will stimulates

supply of goods and services.

vi. Political factor

During peace and security, supply rises because production is encouraged.

Market Equilibrium

Equilibrium price and quantity

Market equilibrium is a market state where the supply in the market is equal to the demand in the

market. It is the situation where by no agent want to change her decision and all decisions are

compatible. The equilibrium price is the price of a good or service when the supply of it is equal to the

demand for it in the market. If a market is at equilibrium, the price will not change unless an external

factor changes the supply or demand, which results in a disruption of the equilibrium. The equilibrium in

a market occurs where the quantity supplied in that market is equal to the quantity demanded in that

market. This is the price at which the quantity supplied is equal to the quantity demanded. At
 56

equilibrium market clears. The quantity sold at equilibrium is known as equilibrium quantity and

the price is equilibrium price.

Table 3.3: An illustration of market equilibrium

PRICE DEMAND (Units) SUPPLY (Units)

100 20 110

80 40 100

60 60 90

50 80 80

30 100 60

10 110 40

Distinction between surplus and deficit

Sometimes the market is not in equilibrium-that is quantity supplied doesn't equal quantity
demanded. When this occurs, there is either excess supply or excess demand.

A Market Surplus occurs when there is excess supply- that is quantity supplied is greater than
quantity demanded. producers are not able to sell all their goods. This will induce them to lower
their price to get rid of their inventories/stock. In order to stay competitive many firms will
lower their prices thus lowering the market price for the product. In response to the lower price,
consumers will increase their quantity demanded, moving the market toward an equilibrium
price and quantity. In this situation, excess supply has exerted downward pressure on
the price of the product.

A Market Shortage occurs when there is excess demand- that is quantity demanded is greater
than quantity supplied. Are not able to buy as much of a good as they would like. In response to
the demand of the consumers, producers will raise the price of their product they are willing to
 57

supply. The increase in price will be too much for some consumers and they will no longer
demand the product. equilibrium will be reached.

Price

D S

P2

Surplus

PE d=s

P1 deficit/shortage

S D

O Q1 QE Q2 Quantity

Fig 3.15: an illustration of market equilibrium

When price rises from equilibrium price Pe to a higher new price P2, then the quantity demanded

decreases from equilibrium quantity QE to low quantity Q1. While the higher price stimulates

more supply and this cause an increase in quantity supplied from QE to Q2. At this higher price

there is more supply than demand, the situation is referred to as excess supply/surplus.

When price falls from PE to P1 , the lower the price the higher the quantity demanded, this lower

price increase demand from QE to Q2, Simultaneously this discourage producers to supply more
 58

quantities, quantity supplied decrease from QE to Q1. At this lower price, there is greater demand

than supply and the situation is referred to as excess demand or area of shortage supply.

Price Floor; this is the minimum price fixed by the government above equilibrium price (by

intervention) to protect/encourage the suppliers and producers to produce and supply more.

Taking the above figure into consideration the price floor can be P2.

Price Ceilings: this is the maximum price set by the government below the equilibrium price (by

intervention) to protect and stimulate the consumers to buy and consumes more of the

commodity. Taking the above figure into consideration the price floor can be P1.

Example; from the following demand and supply functions find an equilibrium price and

quantity. Demand function Qd = 26-6p supply function Qs =16 + 4p

Solution; At equilibrium Qd = Qs

26-6p = 16 + 4p

Collect together like terms 26-16 = 4p +6p

10=10p

Divide both sides by 10 P=1 this is equilibrium price

Substitute this in the equation to get equilibrium quantity

26-6p= 16+4p but p=1

26-6= 16+4

20=20 this is equilibrium quantity

 59

Chapter Four

Consumer Behavior

Introduction
consumer behavior is the study of how the consumers, make purchase decisions and what are the

underlying factors that influence such decisions. The Consumer Behavior is the observational

activity conducted to study the behavior of the consumers in the marketplace from the time they

enter the market and initiate the buying decision till the final purchase is made.

Importance of Consumer Behavior

1. It is beneficial for the marketer to study the behavior of the consumers in order to make
better strategic marketing decisions. If the marketer has complete knowledge about the
consumer‟s likings or disliking, then he can predict the response of the potential
customers towards his goods. Therefore, studying the consumer behavior before and
during purchase helps in production scheduling, designing, pricing, positioning,
segmentation, advertising and other promotional activities.
2. Studying of consumer behavior is equally important for the non-profit organizations such
as governmental agencies, hospitals, NGO‟s, charitable organizations. For example, the
polio campaigns can be designed for the vulnerable sections of the society who cannot
afford the basic livelihood.
 60

3. The Government also studies the consumer behavior to provide them with the necessary
goods and services, understanding the potential future problems, such as pollution, anti-
plastic drive, etc.
4. For legislation, it is again essential to understand the consumer behavior, then only the
protective measures against the consumer exploitation can be taken. Such as mandatory
information on the packaging related to manufacturing date, expiry date, terms of use,
etc.
5. The understanding of a behavior of a consumer is necessary before the launch of the
demarketing strategies. For example, motives, attitude, behavior of the customers behind
the purchase of injurious products Viz. Cigarettes, Tobacco, etc. should be properly
understood.

Factors Influencing Consumer Behavior

These are some of the underlying factors that influence the consumer behavior, and the marketer
must keep these in mind, so that appropriate strategic marketing decision is made.

Psychological: The human psychology plays a crucial role in designing the consumer‟s
preferences and likes or dislikes for a particular product and services. Some of the important
psychological factors are: Motivation, Perception Learning Attitudes and Beliefs

Social Factors: The human beings live in a complex social environment wherein they are
surrounded by several people who have different buying behaviors. Since the man is a social
animal who likes to be acceptable by all tries to imitate the behaviors that are socially
acceptable. Hence, the social factors influence the buying behavior of an individual to a great
extent. Some of the social factors are: Family, Reference Groups, Roles and status

Cultural Factors: It is believed that an individual learns the set of values, perceptions,
behaviors, and preferences at a very early stage of his childhood from the people especially, the
family and the other key institutions which were around during his developmental stage. Thus,
the behavioral patterns are developed from the culture where he or she is brought up.
 61

Personal Factors: There are several factors personal to the individuals that influence their
buying decisions. Some of them are: Age, Income, Occupation, Lifestyle

Economic Factors: The last but not the least is the economic factors which have a significant
influence on the buying decision of an individual. These are: Personal Income, Family Income,
Income Expectations, Liquid Assets of the Consumer, Savings

In this section, we look at how consumers make economic choices, so that we can then go on to

examine how those choices interact together in economic markets. A key concept in the study of

consumer behavior is utility.

Different concepts governing consumer behavior

Utility

We have already seen that a primary focus of economics is to understand behavior given the

problem of scarcity: the problem of fulfilling the unlimited wants of humankind with limited or

scarce resources. Because of scarcity, economies need to allocate their resources in such a way

that everything ends up where it ought to. Underlying the laws of demand and supply is the

concept of utility, which represents the satisfaction, advantage, pleasure, or fulfillment a person

gains from obtaining or consuming a good or service. Therefore, Utility is the word used to

describe the pleasure, satisfaction or benefit derived by a person from the consumption of goods

OR Utility is the usefulness, benefit or satisfaction derived from the consumption of goods and

services.

Total utility
 62

This is the total satisfaction derived from the consumption of various units of goods and services
is called total utility. Every unit of a commodity has its marginal utility (a utility derived from
the consumption of an additional unit), and the total utility is the summation of all these
individual marginal utilities. Suppose a consumer consumes four units of commodity X at a point
of time and derives utilities from the successive consumption of units as u1, u2, u3, u4, then the
total utility from the consumption of commodity X can be measured as follows:

Ux = u1+u2+u3+u4

If the consumer consumes ‘n’ number of commodities, then the utility derived from the
consumption of each commodity, let‟s say, X, Y and Z are Ux, Uy, Uz. The total utility is the sum
of utilities of each individual commodity and hence is measured as:

TUn = Ux + Uy +Uz

Therefore, total utility is then the total satisfaction that a person derives from spending his income

and consuming goods.

Marginal utility

Marginal utility is the additional satisfaction a consumer gains from consuming one more unit of
a good or service. Marginal utility is an important economic concept because economists use it to
determine how much of an item a consumer will buy. Positive marginal utility is when the
consumption of an additional item increases the total utility. Negative marginal utility is when
the consumption of an additional item decreases the total utility. Economists use the concept of
marginal utility to measure happiness and pleasure, and how that affects consumer decision
making.

If someone eats six apples and then eats a seventh, total utility refers to the satisfaction he

derives from all seven apples together, while marginal utility refers to the additional

satisfaction from eating the seventh apple, having already eaten six.
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Table 4.1: an illustration of marginal utility

Quantity Total utility Marginal utility

consumed (MU)
1 10
2 24 14
3 40 16
4 52 12
5 61 9
6 68 7
7 72 4
8 72 0

Ways of measuring utility

It's difficult to measure a qualitative concept such as utility, but economists try to quantify it in

two different ways: cardinal utility and ordinal utility. Both of these values are imperfect, but

they provide an important foundation for studying consumer choice. In economics, utility simply

means the satisfaction that a consumer experiences from a product or service. Utility is an

important factor in decision-making and product choice. Utility varies among consumers for the

same product

Cardinal approach

This approach assumes that utility can be measured. Under this approach some economists

suggested that utility is additive and can be measured in monetary units, by the amount the

money the consumer is willing to sacrifice for another unit of the commodity. It is expressed as a

quantity measured in hypothetical units which called utils. If a consumer imagines that one

mango has 8 utils and an apple 4 utils, it implies that the utility of mango is twice than of an

apple. The consumption theory is based on the notion that consumer aims at maximizing his

utility, and thus, all his actions and doings are directed towards the utility maximization. The

consumption theory seeks to find out the answers to the following questions:
 64

i. How does a consumer decide on the optimum quantity of a commodity

that he/she wishes to consume?

ii. How consumers allocate their disposable incomes between several

commodities of consumption, such that utility is maximized?

Assumptions under cardinal approach

The cardinal utility approach used in analyzing the consumer behavior depends on the following
assumptions to find answers to the above-stated questions:

1. Rationality: The consumer is rational, that he aims at maximizing his utility subject to

his constrained income. It is assumed that the consumers are rational, and they satisfy

their wants in the order of their preference. This means they will purchase those

commodities first which yields the highest utility and then the second highest and so on.

2. Constrained/Limited Resources (Money): The consumer has limited money to spend

on the purchase of goods and services and thus this makes the consumer buy those
commodities first which is a necessity.
3. Maximize Satisfaction: Every consumer aims at maximizing his/her satisfaction for the
amount of money he/she spends on the goods and services.
4. Utility is cardinally Measurable: It is assumed that the utility is measurable, and the
utility derived from one unit of the commodity is equal to the amount of money, which a
consumer is ready to pay for it, i.e. 1 Util = 1 unit of money.
5. Diminishing Marginal Utility: This means, with the increased consumption of a
commodity, the utility derived from each successive unit decline. This law holds true for
the theory of consumer behavior.
6. Marginal Utility of Money is Constant: It is assumed that the marginal utility of money
remains constant irrespective of the level of a consumer‟s income. i.e change in the total
satisfaction derived from money that results from one unit of change in the quantity of
money.
 65

7. The total utility of the basket of goods depends on the quantities of individual
commodities in the basket

UT = f ( X1,X2,X3,……….Xn)

The law of Diminishing marginal utility

As more and more of goods are consumed, the process of consumption at some point yields smaller and

smaller additions to the utility. The utility gained from successive units of the commodity

diminishes. In other words, the marginal utility of the commodity diminishes as more of the

commodity is consumed.

The formula for marginal utility is given by

MU = change in total utility

change in quantity consumed

Table 4.2: illustration of MU

Quantity of commodity X total utility/week Marginal Utility
0 0 -
1 40 40
2 60 20
3 70 10
4 65 -5

Assumptions of the law of diminishing marginal utility

i. homogeneity

Assumes that there must be a standard for the unit of a consumer good. For example, a cup of
coffee, a glass of milk, and a plate of food.

ii. Consistency in consumer’s tastes:

 66

Equality in consumer preference should persist. Implies that the tastes and preferences of
consumers must remain same during the consumption period. If the tastes of consumers change,
the law may not hold.

iii. Continuity in consumption:

Implies that the consumption of a good should be continuous. In other words, this assumption
states that the time interval between the consumption of units must be short.

iv. Reasonability:

Implies that the units of goods should be of standard size. For instance, it should be a glass of
water rather than a spoon of water. If the size of a good is too small or large as compared to the
standard size, the law may not hold.

v. Rationality:

Requires that the behavior and mental condition of the consumer should be normal during
consumption period.

Consumer problem

When consumers make choices about the quantity of goods and services to consume, it is presumed that

their objective is to maximize total utility. In maximizing total utility, the consumer faces a number of

constraints, the most important of which are the consumer's income and the prices of the goods and

services that the consumer wishes to consume. The consumer's effort to maximize total utility, subject to

these constraints, is referred to as the consumer's problem.

Consumer Equilibrium Using Cardinal Approach

 67

The solution to the consumer's problem, which entails decisions about how much the consumer

will consume of a number of goods and services, is referred to as consumer Consumer

equilibrium (Maximum satisfaction)

An important question to ask is at what levels of consuming different goods will the consumer

achieve maximum satisfaction (equlibrium)? Beginning with a simple model of a single

commodity x. under this condition the consumer is in equilibrium when the Marginal utility of x

(MUx) is equated to the market price of x.

MUx = Px consumer equilibrium

If the MUx is greater than its price the consumer will increase his wellbeing by

purchasing more units of the commodity x, but if the MUx is less than its price then the

consumer will increase his satisfaction by cutting down the quantity of x and keeping part

of his income unspent.

In the model of more than one commodity, consumer equilibrium will be

Let MUx = Px ------------(1)

MUy = Py ------------(2)

Divide eqn (1) by (2)

MUx = MUy
Px = Py consumer equilibrium

Determination of consumer equilibrium

Consider the simple case of a consumer who cares about consuming only two goods: good 1 and
good 2. This consumer knows the prices of goods 1 and 2 and has a fixed income or budget that
can be used to purchase quantities of goods 1 and 2. The consumer will purchase quantities of
 68

goods 1 and 2 so as to completely exhaust the budget for such purchases. The actual quantities
purchased of each good are determined by the condition for consumer equilibrium, which is

This condition states that the marginal utility per dollar spent on good 1 must equal the marginal
utility per dollar spent on good 2. If, for example, the marginal utility per dollar spent on good 1
were higher than the marginal utility per dollar spent on good 2, then it would make sense for the
consumer to purchase more of good 1 rather than purchasing any more of good 2. After
purchasing more and more of good 1, the marginal utility of good 1 will eventually fall due to
the law of diminishing marginal utility, so that the marginal utility per dollar spent on good 1
will eventually equal that of good 2. Of course, the amount purchased of goods 1 and 2 cannot be
limitless and will depend not only on the marginal utilities per dollar spent, but also on the
consumer's budget.

An example.

To illustrate how the consumer equilibrium condition determines the quantity of goods X
and Y that the consumer demands, suppose that the price of good X is Tsh 2 per unit and
the price of good Y is Tsh1 per unit. Suppose also that the consumer has a budget of
Tsh5. The marginal utility ( MU) that the consumer receives from consuming 1 to 4 units
of goods X and Y is reported in Table 4.3 . Here, marginal utility is measured in fictional
units called utils, which serve to quantify the consumer's additional utility or satisfaction
from consuming different quantities of goods X and Y. The larger the number of utils, the
greater is the consumer's marginal utility from consuming that unit of the good. Table
also reports the ratio of the consumer's marginal utility to the price of each good. For
example, the consumer receives 24 utils from consuming the first unit of good X, and the
price of good X is Tsh2. Hence, the ratio of the marginal utility of the first unit of good 1
to the price of good X is 12.
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Table 4.3: An illustration of consumer equilibrium

units of good MU of MUx/Px units of MU MUy/Py

X X good Y of Y
1 24 12 1 9 9
2 18 9 2 8 8
3 12 6 3 5 5
4 6 3 4 1 1

The consumer equilibrium is found by comparing the marginal utility per sh spent (the

ratio of the marginal utility to the price of a good) for goods X and Y, subject to the

constraint that the consumer does not exceed her budget of Tsh5. The marginal utility per

sh spent on the first unit of good X is greater than the marginal utility per sh spent on the

first unit of good Y(12 utils > 9 utils). Because the price of good X is Tsh 2 per unit, the

consumer can afford to purchase this first unit of good X, and so she does. She now has

Tsh 5 − Tsh 2 = Tsh 3 remaining in her budget. The consumer's next step is to compare

the marginal utility per Tsh spent on the second unit of good X with marginal utility per

Tsh spent on the first unit of good Y. Because these ratios are both equal to 9 utils, the

consumer is indifferent between purchasing the second unit of good X and first unit of

good Y, so she purchases both. She can afford to do so because the second unit of good X

costs Tsh 2 and the first unit of good Y costs Tsh 1, for a total of Tsh3. At this point, the

consumer has exhausted her budget of Tsh 5 and has arrived at the consumer equilibrium,

where the marginal utilities per sh spent are equal. The consumer's equilibrium choice is

to purchase 2 units of good X and 1 unit of good Y.

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Ordinal approach;

The ordinal approach had a view that utility cannot be measured cardinally, but an individual

consumer can rank bundles of goods in order of preference.

Assumptions

I. Rationality

consumer prefer more than less (maximize utility). Implies that a consumer is a rational being and

aims at maximizing the total satisfaction given the income and prices of goods and services.

II. Utility Is ordinal

consumer can rank his preference (order of various basket of goods ) according to the

satisfaction of each bundle. Assumes that utility is expressible only in ordinal terms. This implies that a

consumer is only able to express his/her preference for goods.

III. Consistent and transitivity of choice. A>B and B>C

Implies that consumer choices are assumed to be transitive and consistent. The transitivity of
choice means that if a consumer prefers A to B and B to C, he/she would prefer A to C. On the
other hand, the consistency of choice means that if a consumer prefers A to B in one period, he
or she cannot prefer B to A in another period.

Consumer Equilibrium Under Ordinal Utility Approach

To understand how the consumer reaches his equilibrium using the ordinal approach we need to
understand the following terms:

 Indifference curve: The indifference curve shows the different combinations of two
substitutes (goods) that yield the same level of satisfaction (utility) to the consumer. This
means that the consumer is indifferent towards the consumption of two goods which are
closely related to each other.

Good y a
 71

b Indifferent curve

Good x

Fig4.1: an illustration of indifferent curve

Moving along indifferent curve ab the consumer maintain same level of utility.
Indifference curve is defined as the locus of points on the graph each representing a different
combination of two substitute goods, which yield the same utility or level of satisfaction to a
consumer. The combinations of goods give equal satisfaction to a consumer. Therefore, a
consumer is indifferent between any two combinations of two goods when it comes to making a
choice between them. This curve is also called as iso-utility curve or equal utility curve.
Therefore, this is the curve that join together all the different combinations of two goods
which yield the same utility to the consumer

 Indifference Map: The indifference map contains different indifference curves showing
the combinations of different quantities of two substitute goods on the basis of the
consumer preferences. The consumer can make different combinations of goods by
consuming less of one commodity or the other in such a way that all the combinations
yield the same level of satisfaction.

Good y

10 a I3

4 b I2

I1 X

3 6
 72

Fig4.2: an illustration of indifferent curve Map

Along indifferent curve I1 the consumers derive the same level of utility by consuming different

combinations of commodity Y and x. Point a (3, 10) and point b(6,4) both have the same utility

level tom the consumer. Indifferent curve I1, I2 and I3 constitute what called indifferent curve

map. Indifferent curve I3 is more preferred than indifferent curve I2, and I2is more preferred than

I1.

 Marginal Rate of Substitution (MRS): The marginal rate of substitution defines the rate
at which one commodity is substituted for another in such a way that the total utility
(satisfaction) remains the same.
 Budget Line: As per the properties of the indifference curve, higher the indifference
curve on the indifference map, the higher is the utility derived from the consumption.
Thus, the consumer tries to reach to the highest possible indifference curve with two
strong constraints: limited income and market price of goods and services. Since the
amount of income in hand decides how high consumer can reach on his indifference map
acts as a budgetary constraint. Therefore, the budget line represents the different quantity
combinations of available commodities that a consumer can purchase given his level of

Determination of Consumer Equilibrium Under Ordinal Approach

The first order condition, the consumer reaches his equilibrium in the same manner as he does
under the cardinal approach of the two-commodity model. It is expressed as:

By implication,

Thus, the necessary condition of the cardinal approach to consumer equilibrium can be written
as:
 73

The first order condition is necessary but not

sufficient. Thus, the second order or supplementary condition requires that the necessary
condition must be accomplished at the highest possible indifference curve on the indifference
map.

IC3

QY E

IC2

IC1 X

O B
QX

Fig4.3: an illustration consumer equilibrium under ordinal school

In the figure above, there are three indifference curves, Viz. IC1, IC2, and IC3 presenting a
hypothetical indifference map of the consumer. AB is the hypothetical budget line. At point „E‟,
the indifference curve IC2 and Budget line AB intersect and hence, therefore, the slope of IC2 =
 74

AB. At this point, both the necessary condition and the supplementary condition get fulfilled,
and hence, the consumer attains equilibrium at point „E‟.

Thus, the slope of the indifference curve can be written as:

The slope of budget line is given as:

In the figure above, at point „E‟, MRS x, y = Px /Py and hence the consumer is said to have
attained equilibrium at this point. The IC2 is tangent with the budget line AB, which shows that
the consumer has reached to the highest possible indifference curve for a given level of his
income and the market price of goods and services. Thus, at point „E‟ consumer consumes
quantity OQx of X and OQy of Y, which yields him the maximum utility or satisfaction

Characteristics of indifferent curve

Indifferent curve can never intersect.

If, the combinations B and C will give equal satisfaction to the consumer; both being on the same
indifference curve I2. If combination A is equal to combination C in terms of satisfaction, and
combination B is equal to combination C, it follows that the combination A will be equivalent to
B in terms of satisfaction. But a glance at Fig.4.4 will show that this is absurd conclusion since
combination B contains more of good Y than combination B, while the amount of good X is the
same in both the combinations.
 75

Good Y

I2

A I1 good X

Fig 4.4: Indifferent Curves Cannot Intersect

The individual is indifferent between ac along curve I1 but also he should be indifferent

at bc along curve I2, but this would be irrational because B contain more units/quantities

of commodity Y than A all with the same quantity of commodity X, therefore to be

consistent with rationality, indifferent curves cannot intersect each other.

Indifferent curve slopes downward from left to right

This property follows from assumption I. Indifference curve being downward sloping means that

when the amount of one good in the combination is increased, the amount of the other good is

reduced. This must be so if the level of satisfaction is to remain the same on an indifference

curve.

Y
 76

Fig 4.4: Indifferent Curves sloping downward from left to right

When a consumer is consuming both commodity Y and X, he intends to derive the same level of

utility from any combination of the two commodities consumed. Moving along indifferent curve

I, as he consumes more of X, less of Y is consumed retaining same level of utility.

Indifferent curves are convex to the origin

This property of indifference curves follows from assumption that the marginal rate of
substitution of X for Y (MRSxy) diminishes as more and more of X is substituted for Y.

Fig 4.5; convexity of indifferent curve X

As more units of Y are given up, larger quantities of X are consumed to have same utility
 77

A higher indifference curve represents a higher level of satisfaction than a lower indifference
curve:

The last property of indifference curve is that a higher indifference curve will represent a higher
level of satisfaction than a lower indifference curve. In other words, the combinations which lie
on a higher indifference curve will be preferred to the combinations which lie on a lower
indifference curve. Combination Q on the higher indifference curve C2 will give a consumer
more satisfaction than combination S on the lower indifference curves C1 because the
combination Q

good Y

Q C2

S C1

Good X

Fig 4.6: indifferent curve with higher satisfaction

contains more of both goods X and Y than the combination S. Hence the consumer must
prefer Q to S. We therefore, conclude that a higher indifference curve represents a higher
level of satisfaction and combinations on it will be preferred to the combinations on a
lower indifference curve