economics notes[1]

8/2/2019 Economics Notes[1]

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UNIT 2

DEMAND ANALYSIS

THE CONCEPT OF DEMAND

Demand is a crucial economic decision variable for the functioning of abusiness enterprise. It reflects the size as well as pattern of market, and

market determines the magnitude of business activities. A study of demand is

imperative for decision takers, as it affects production as well as profit.

Demand-analysis is extensively used in business. Any firms planning

regarding main power utilization, production planning, inventory management,

cost budgeting, market research, pricing decision, advertising budget etc.

need detailed analysis of demand. Demand is the major factor for the survival

of any business. If there is no demand, the out put becomes unwarranted.

DEFINITION

Demand is considered same as want or desire. However, in managerial

economics, demand has a more definite meaning. A good is demanded if it is

useful in satisfying consumers desire. However, if consumer desires a good

but is not able to pay for it, it does not constitute demand. For example, a

beggars desire to buy a car does not mean it is demand, as he is not able to

pay for it. Similarly, a persons desire to have a car, but unwillingness to

purchase it, does not mean demand.

In economics, demand is:

I. Desire for a commodity

II. Ability to pay for the commodity

III. Willingness of consumer to pay for the good

Hence, mere desire is not demand; it has to be backed by ability and

willingness to pay for it. Demand can be defined as quantity of a commodity

that will be purchased at a particular price during a given period or at a pointof time. That is, demand for a good is always stated in terms of price and

time period. A statement that demand for oranges is 200 KG is meaningless.

It should be- demand for oranges is 200 KG by one person at Rs. 10 a KG in

one year.


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TYPES OF DEMAND

When considering demand for a product, one has to be clear about thesources and uses of that product & the market structure. An understanding of

demand at different levels of aggregation is necessary for policy decisions as

well as managerial decision making. Some important classifications are

discussed below:

a) Demand for consumers goods & producers goods : When demand for a

good is for final consumption, it is called consumers demand. Demand

of goods for future production or for producing goods final consumption

is called producers demand. For example: demand for vegetables,

readymade garments, note books etc are those for final consumptionthat is consumer goods demand. Demand for raw materials, machinery

etc. is for production of other goods, therefore called producer goods

demand.

b) Demand for perishable & durable goods : Consumer & producer goods

can be further classified into non durable or single use or perishable

goods, and durable or repeated use goods. Non durable goods usually

meet current demand like milk, fruits, vegetable etc. Durable goods are

used over a period of time and satisfy current demand as well as long

time or future demands, like furniture, automobiles, fans etc. Durablegoods may also call for replacement of old products. The distinction

between durable and non durable goods is important as durable goods

present more complicated problems for demand analysis than non

durables.

c)Autonomous and derived demand: Autonomous demand is that which is

not tied with demand for other goods. Consumer goods have

autonomous demand. Derived demand is that, which is tied with the

purchase of some parent product. Producers goods have derived

demand. Demand for factor inputs depends upon demand for finalproduct. Money has derived demand.

d) Individual demand and market demand: The demand of an individual

consumer for a commodity is called individual demand, while market

demand is the demand of all consumers in the market for a commodity

at a given price. It is the horizontal summation of all individual


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demands. Firms are concerned with market demand for there products

while individuals are concerned with their own demand for different

goods.

e) Firm and industry demand: Most goods are produced by more than one

company or firm, and hence there is a difference between company

(firm) demand and industry demand. Demand facing an individual firm

is called firms demand, while demand faced by an entire industry is

called industry demand. This distinction is necessary as there may be

close substitutes for products of a firm, but there are no close

substitutes for an industry product. For example, a Santro might be a

substitute for an Indica, but not for a bike. Firm demand may be

expressed as percentage of industry demand, called as market share

of the firm.

f) Market segment and total market demand: Demand for certain productscan be studied in totality or by breaking it into different segments

based on classifications like product use, distribution channels, age,

size, income etc. of customer. Segments may differ significantly in

respect of delivery prices, profit margins, seasonal patterns etc. when

such differences are great, demand analysis is done in segments. It is

useful in several problem areas.

DEMAND FUNCTION AND DEMAND CURVE

A function explains relationship between two variables. The demand function

for a good is the relation between various amount of commodity that may be

bought and the determinants of those amounts in a given market in a given

period of time.

Thus, demand function shows the various factors on which demand for the

commodity depends.

These determinants of demand are:

I. Price of the commodity. (Px)

II. The prices of related goods substitutes & complements (Py & Pz)

III. Income of consumer. (Y)

IV. Taste and preferences of consumer. (T)

V. Expectations about future prices of commodity. (E)


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The demand function can be represented as

D= F (Px, Py, PZ, Y, T, E)

The impact of these determinants on demand is explained below:-

I. Price of commodity: Generally, as price of a commodity falls, its demandrises and vice versa, showing an inverse relationship.

II. Price of related goods: If the good is a complementary good such as

sugar & tea, pen & refill, bread & butter, etc. then as price of

complementary good rises, demand for commodity declines. However if

the related good is a substitute, like Tea & Coffee, Scooter & Motor

Cycle, then with increase in price of substitute, the quantity demanded

of the commodity increases.

III. Income of a consumer: With an increase in income of consumer, his

purchasing power increases, thus he buys more goods. Similarly, with

less income he buys lesser goods. There is a direct relationship between

income of consumer & demand.

IV. Expectation about future prices: If consumer expects prices of certain

good to rise in near future, he would demand more of it in present, the

demand would increase. On the other hand if he expects price to fall in

near future, he would demand less of the good in present.

V. Tastes & Preferences: The demand for a good that is liked by consumers

is more than the demand for a good that not preferred.

Demand Curve and Schedule

A demand curve and a demand schedule consider only the relationship

between price and quality demanded.

A demand schedule shows the different amounts of quantity demanded at

different levels of price of that commodity. A demand curve is a plot of the

demand schedule. An example is given below:

Demand schedule & curve for Apples

Prices of Apple (Per KG) Quantity demanded (in KG)


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12 1

11 2

10 3

9 4

8 5

7 6

12

11

10

9

8

7

0

1 2 3 4 5 6

The demand curve is seen to be negatively sloped, which shows that the

demand is higher at lower prices & vice versa.

This is the LAW OF DEMAND.

LAW OF DEMAND


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This law explains the general tendency of consumers to buy more of a good at

a lower price and less of it at a higher price. According to the law of demand,

Demand for a good varies inversely with it price. That is, demand for good

increases as its price decreases and it decreases as the price increases.

MOVEMENT ALONG DEMAND CURVE

(Extension & contraction in demand)

When quantity demanded of a commodity falls as a result of rise in price, its

called extension or expansion in demand. If the quantity demanded rises with

a fall in price. Its called contraction in demand.

It can be shown by moving down or up along a demand curve. Example

Price D

P1 A

P2 B

D

O Q1 Q2 Quantity

A movement from A to B indicates an extension in demand from Q1 to Q2

because of fall in price from P1 to P2. Similarly; movement from B to A showscontraction in demand from Q2 to Q1, due to rise in price from P2 to P1.

SHIFT IN THE DEMAND CURVE

(Increase or decrease in demand)


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The factors or determinants of demand other than the price of goods are

assumed to be constant for the period of which demand curve is prepared.

However, if these factors change, a new demand curve would come into

existence, either at a lower level or a higher level.

This is shown below with the help of a diagram:-

Y

Price D D D

D D

D

Quantity Demanded X

It can be seen from the diagram that if there is a change in determinants of

demand other than price, the demand curve shifts towards the left or right

(downward or upward).

Thus if there is a rise in income of consumer: or increase in price of substitute

good, or decrease in price of complementary good, or expectation of futurerise in price: the demand increases, & demand curve shifts form DD to DD.

Similarly, if there is a decrease in income of customer, or decrease in price of

substitute good, or increase in price of complementary good, or expectation of

future decrease in price, then demand decreases & demand curve shifts from

DD to DD towards left.


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UTILITY ANALYSIS

UTILITY

The notion of utility was introduced by British Philosopher Jeremy Bentham in

1780s. The concept was adopted in economics in early 19th century with

works of Stanley Jevons, Alfred Marshall etc. The term utility refers to poweror property of a commodity to satisfy human needs. For example, bread has

the power to satisfy hunger, water has power to quench thirst. All goods that

individuals consume or hold process utility.

Thus, utility is the want satisfying power of a commodity. But it is relative to

a persons need. So in other words, whether a commodity possesses utility

depends upon whether the consumer has need for it. For example, a smoker

does not derive any utility from cigarettes etc. The greater is a consumers

need, greater is the utility derived.

The concept of utility is ethically neutral, that is, there is no good or bad: or

even useful or harmful. Drugs are bad and harmful but they yield utility to

drug takers. This utility is subjective satisfaction obtained by consumer from

consumption of any goods or service. It has a neutral value.

MEASURABILITY OF UTILITY

There are two approaches to measuring utility- cardinal and ordinal

measurement.

1. CARDINAL APPROACH: - This approach was accepted by classical & nonclassical economists. According to this approach utility can be measured

numerically and can also be expressed in terms of money. For example,

it can be said that utility of a, b, c & d commodities is 10, 9, 8 & 7

respectively.

2. ORDINAL APPROACH: - According to this approach, utility is not

quantifiable. It is only an expression of consumers preference for one

commodity over another. That is, a consumer can compare the utility he

derives form different commodities, but he can not give it a particular

numerical value.

CARDINAL APPROCH TO UTILITY ANALYSIS

Under this measure, it is possible to estimate the amount of utility derived

form various units of a commodity in terms of some quantifiable unit.

Economists suggested measurement of utility in terms of money.


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MEASURES OF CARDNAL UTILITY

1) Marginal utility (MU)

Marginal utility is the utility of last unit, or, the addition to total utility by

consumption of the additional unit of commodity. For example, total utility of

consuming ten units of some commodity is total satisfaction those ten unitsprovide. Marginal utility of tenth unit consumed is satisfaction added by

consumption at that unit.

Symbolically:

MU10 = TU10 TU9

Where MU10 = marginal utility of 10th unit

TU10 = Total utility of 10 units

TU9 = Total utility of 9 units

In general: we can say:

MUn = TUn Tun-1

Where n is the number of units for which marginal utility is determined. Also

marginal utility is defined as ratio of extra utility to extra unit of commodity

consumed.

MU = (TU) (Q = units consumed)

Q

2) TOTAL UTILITY (TU)

It represents the sum of all the utilities derived from the total number of unitsconsumed. It is sum of marginal utilities of different units of commodity.

Symbolically:

TUn = MU1 + MU2 + .. MUn

Or:


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TUn = MU

3) AVERAGE UTILITY

It is derived by dividing total utility by the number of units of the commodity

consumed. In terms of symbols: AU= TU/Q

RELATION BETWEEN TU, MU and AU:

This relation can be studied with help of an example, as given below:

Number of

units

Totalutility

marginalutility

Averageutility

1 10 10 10

2 18 18-10=8 18/2=93 24 24-18=6 24/3=8

4 28 28-24=4 28/4=75 30 30-28=2 30/5=66 30 30-30=0 30/6=57 28 28-30=-2 28/7=48 24 24-28=-4 24/8=3

The total utility rises with consumption of additional units of commodity but

the increase is not constant, but falls steadily. That is, the total utility rises at


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a falling rate. When TU reaches a maximum value, marginal utility becomes

zero. Before this point, though marginal utility falls, it remains positive.

After the point when TU is maximum, an increase in consumption results in

falling TU, and MU becomes negative.

AU is always positive & its curve remains above x-axis, downward sloping likethe MU curve.

LAW OF DIMIISHING MARGINAL UTILITY

The law of diminishing marginal utility states that- The utility that a consumer

derives from the consumption of an additional unit of a commodity keeps

decreasing with every increase in the stock of the commodity which he

already has.

The law means that as one gets more & more units of the same commodity,

the utility from each successive unit goes on decreasing. This is because the

more we get of one thing, the intensity of our desire to have more of it falls.

Assumptions to the law

1) Rationality: The consumer is assumed to be rational. He aims at

maximization of utility subject to the constraint imposed by his given

income.

2) Cardinal measurement of utility: Utility is assumed to be measurable

and can be quantified. It can be added, subtracted, multiplied & divided

3) Continuity: The consumption process is assumed to be continuous, that

is, there is no time gap between consumption of two successive units of

commodity.

4) Homogeneity: The commodity is homogenous, that is, all units

consumed are same quantitatively & qualitatively.

5) Independence of utilities: Utilities of different commodities are

independent of one another. Utility derived from consumption of one

good does not depend upon consumption of other goods.

6) Constancy: The personal, social & mental conditions of consumer are

assumed to be constant. Also his income, tastes, fashion, & habits

remain same.

7) Marginal utility of money is assumed to be constant.


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CONSUMER EQUILIBRIUM: LAW OF EQUIMARGINAL UTILITY

A consumer spends his income on many goods & services. The aim of the

consumer is to maximize utility derived from the various goods he has

consumed, so he has to distribute his income in a way that he is in

equilibrium, at a point of maximum utility is derived. Let us assume two goods

A & B Let the price of A be PA & price of B be PB.

Then, the principle of equi-marginal utility states that consumer would be in

equilibrium (i.e. Maximum utility) when he allocates his expenditure on various

goods he consumes such that the utility of last rupee spent on each good is

equal.

From law of diminishing marginal utility, it can be derived that consumer is in

equilibrium when the quantity of commodity is purchased in such a way that

MU derived from it is equal to the price paid for it multiplied by marginal utility

of money (assumed to be constant)

MUA = PA * MUM___________(1)

MUB = PB * MUM___________(2)

MUM = MUA &

PA

MUM = MUB

PB

Where MUM = marginal utility of money

Dividing (1) by (2)

MUA = PA or

MUB PB

MUA = MUB

PA PB

It can be seen that consumer is in equilibrium when MU of money to the

consumer is equal to ratios of marginal utilities of commodities with respect to

their prices.

ORDINAL APPROACH TO UTILITY ANALYSIS


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Since it was seen that cardinal measurement of utility is not realistic, a new

approach was introduced by Edgeworth (1881) and Vilfred Pareto (1906).

Under this approach, a consumer is able to rate various combinations of goods

and services in order of his preference for them. He can indicate whether he

prefers one commodity bundle to another or whether he is indifferent between

them. In case he is indifferent, it means he has equal preference for bothcommodity bundles. This is called the indifference curve analysis.

INDIFFERNCE CURVE

An indifference curve shows the various alternative combinations of goods

which provide some level of satisfaction to the consumer.

One indifference curve shows one particular level of satisfaction. Below is a

representation of an indifference schedule, which enlists all such combinations

of two goods in a tabular form that give exactly the same total satisfaction to

the consumer. An indifference curve for the two goods is then plotted.

Combination Units of X plus Units of Y

A 1 + 64

B 2 + 48

C 3 + 36

D 4 + 25

E 5 + 15

F 6 + 8

The consumer is indifferent towards its combinations A,B,C,D,E, and F. the

consumer has no special inclination for any one combination. Plotting these

values of combinations, taking units of goods X on X- axis and units of good Y

o Y axis give its indifference curve IC.


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0

10

2030

40

50

60

70

0 2 4 6 8

Commodity X

Comm

odityY

A consumer may have a large number of indifference curve, representing a

different level of utility derived thus, if one draw a large number of

indifference curve together, each showing a different level of satisfaction weget and indifference map as shown below.

Y

Units of Y

IC4

IC3

IC2

IC1

Units of X

In this diagram, IC1, IC2, IC3, & IC4 represent different levels of satisfaction

received from combination of two commodities X & Y.

ASSUMPTIONS OF INDIFFERENCE CURVE ANALYSIS

1) Ordinal utility: It is assumed that utility can be measured not in

numerical figures, but in ordinal measures, that is, consumer can

arrange combinations of two goods in ascending or descending order of

preference.

IC


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2) Non-satiety: The consumer has not reached the point of saturation in

consumption of any good. He always wants to buy more of commodities

to reach higher indifference curves.

3) Two commodities: It is assumed that consumer has a fixed amount of

money which he spends entirely on two commodities only, given

constant prices of both commodities.

4) Rationality: The consumer is assumed to be rational and he seeks to

maximize his satisfaction. He has full knowledge of market conditions

and is consistent in his choice, if he chooses combination A in one

situation and not B, then he always chooses A instead of B when both

are available.

5) Transitivity: It is assumed that consumers choices are transitive: that is

if there are 3 commodity bundles A B and C and he prefers A to B

and prefers B to C, then he prefers A to C.

6) Diminishing marginal rate of substitution: It means if more of X is

consumed, to remain at same satisfaction level, some of Y has to be

given up. As consumer buys more & more of X, he is ready to give up

lesser & lesser of Y.

PROPERTIES OF INDIFFERENCE CURVE

1) Indifference curves slope downward from left to right and thus, have a

negative slope, showing that if there is increase in amount of onecommodity, then there is decrease in amount of the other one.

2) Indifference curves are convex to the origin.

3) Two indifference curves cannot touch or intersect as each curve

represents a different level of satisfaction.

4) Higher indifference curve represent higher level of satisfaction.

5) Indifference curves need not be parallel to each other.

Budget line

A consumer cannot decide to buy a particular combination of goods only on

the basis of indifference curves, as these curves do not show which

combination will give him the best for his money. Besides the preference

pattern of consumer, two other factors that lead to choosing a particular


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combination are: income of consumer and prices of the commodities. This

information is given by the budget line of the consumer.

The budget line shows all combinations of two commodities that a consumer

can buy spending his entire income for given prices of two commodities.

For example, a consumer with total income of Rs.100 can buy 50 units of X atprice Rs. 2 per unit of X: and he can buy 25 units of Y at price Rs. 4 per unit of

Y.

This is show as follows:

0

5

10

15

20

25

30

0 10 20 30 40 50 60

Commodity X

Com

modityY

In the figure: AB is the budget line. All points on AB show various combinations

of X & Y that consumer can buy given his income & prices of X & Y.

CONSUMER EQUILIBRIUM

An indifference map shows the tastes and preferences of the consumer

independently of market conditions with regard to two goods. On the other

hand, budget line shows the purchasing power or opportunities open to the

consumer in the market, given his income and prices of commodities. Both

these instruments are important to determine what the consumer actually

does in the market, that is, how the consumer spends his money for two goods

maximizing his satisfaction.

To get consumers equilibrium (which occurs at highest level of satisfaction

possible given his income), we superimpose the budget line and indifferencemap. The consumer would prefer to be on the highest indifference curve

possible reachable by his budget line to maximize his satisfaction. In the below

figure, the equilibrium is graphically represented. AB is the budget line. The

consumer may choose any combination of commodity X and commodity Y on

the budget line. Three indifference curves IC1, IC2, IC3 are shown in the figure.

However, consumer can not purchase any combination of X and Y that lies on

A

B


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IC3, as it is out of reach of his budget line. Also, he would not choose a

combination below his budget satisfaction. Thus, in any case, equilibrium must

lie on budget line. But, C and D points will not give maximum possible

satisfaction as they lie on a lower indifference curve IC1, and it is possible to

reach a combination of commodities on a higher indifference curve IC2 with

the same money income.

IC2 is the highest indifference curve that consumer can reach given his budget

constraint. The budget line touches IC2 at point E, which is the point of

consumers equilibrium. At this point, consumer buys OM amount of X and ON

amount of Y.

Given the budget line, consumer attains equilibrium at a point where the

budget line is tangential to an indifference curve.

PRICE EFFECT

If price of one of the commodities changes, while other things like income

remain constant, the consumers equilibrium will shift to a new budget line.

With a change in price of good X, the consumers purchasing power in terms ofX changes. Thus, if price of X falls, consumer can buy more of X with the same

income, and therefore, budget line shifts towards the right on X- axis. But

starting point of budget line on Y-axis remains same, as there is no change in

price of Y.

The price effect is discussed in the figure given below.

O

A

B

C

D IC1

E

IC2

IC3

M

N

Commodity X

Commodity Y


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In the figure, initial consumer equilibrium is at point E, where original budget

line AB, touches indifference curve IC1. Now, if price of commodity X falls, the

budget line shifts from AB1 to AB2 (as consumer can buy more of X with same

budget). The new budget line is tangent to higher indifference curve IC2 at

point E2. The new equilibrium of consumer is at point E2, which is to the right of

E1. His level of satisfaction has increased as a result of fall in price of X.

If price of X falls further, the budget line will shift to the right again, to AB3,

which is tangent to an even higher indifference curve IC3, at point E3.

When all these equilibrium points are joined together, we get price

consumption curve.

The price consumption curve measures the price effect, which is the effect of

changes in price of one commodity on the consumers demand for this

commodity, while price of other commodity & consumers income is constant.

PCC is the price consumption curve.

DERIVATION OF DEMAND CURVE FROM PRICE EFFECT

A demand curve depicting the relationship between price and quantity

demanded can be derived from the price consumption curve.

In the figure quantity of commodity X is taken along the X-axis and income of

consumer is taken on Y-axis, (in this case Rs. 60). As price of commodity

falls, the budget line shifts to the right. Thus, new equilibrium point is to right

O

A

E1

O

B3

B2

B1

E3

PCC

E2

IC2

IC3

IC1

Commodity X

Commodity Y


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of previous equilibrium. If price of X falls from Rs. 3 to Rs. 2 to Rs. 1.5, he gets

a series of equilibrium point E1, E2, E3 on budget lines AB1, AB2 and AB3. The

consumer can purchase at most 20, 30 and 40 units of X respectively. By

joining E1, E2, and E3, we get the price consumption curve.

In the lower panel of the diagram, the demand curve can be derived using the

upper panel. The lower panel also measures quantity of commodity X on the

X- axis, but measures price of X on the Y-axis. Each point on price

consumption curve PCC shows a particular quantity of commodity X,

corresponding to some price of the commodity X.


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To derive demand curve from PCC, Consider equilibriums point E, on budget

line AB1. The quantity demanded at this point is OQ1. Price of X for this budget

line is equal to money income divided by number of units of X that can be

bought with this income.

Price= Rs. 60/20= Rs. 3. At E1 he buys Q1 amount of X.

Now; Price OP & quantity OQ, become point R or demand curve in lower panel.

Similarly from point E2; quantity demanded of X is OQ2, and price is equal to

money income divided by total units that can be bought with given budget

line, i.e., price = 60/30 = 2Rs.

Also, at point E3: OQ3 units of commodity are demanded at price = 60/40 =

1.5Rs. These combinations of quantity of X demanded & price of X are shown

as points S & T on the lower panel. Joining R, S & T gives us the demand curve.

INCOME EFFECT

If the income of consumer changes, his equilibrium will also change, given the

prices of commodities X & Y are constant. That is, with a change in consumers

income, his budget line would shift, resulting in a new equilibrium point with a

new indifference curve.

The effect of change in consumers income on his total satisfaction or

purchase of the two commodities given prices of the two commodities,

preferences & taste of consumer remaining constant, is called income effect.

In the figure given below, the consumer is in equilibrium at E1, where original

budget Line AB, is tangent to indifference curve IC1. At this point, consumer

buys OX1 of good X and OY1 of good Y. When money income of consumer

increases, budget line will shift upward, and will be parallel to original budget

line A1 B1. With increased income consumer would be able to choose a

combination of X & Y on a higher indifference curve IC2. The new budget line

A2 B2 touches IC2 at E2 which is the new equilibrium point. At this point

consumer buys OX2 of X and OY2 amount of Y.

If income of consumer increases further, the budget line will shift upward

again, to new line A3 B3, parallel to previous budget lines. The consumer in

now in equilibrium at E3, where A3 B3 touches higher indifference curves IC3.


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The curve obtained by connecting successive consumers equilibrium points

(E1, E2, E3) at various curves of the consumers income is known as the incomeconsumption curve (ICC), while other things remain unchanged.

The ICC traces out income effect of the change in money income of consumer.

BREAK UP OF PRICE EFFECT INTO INCOME EFFECT AND SUBSTITUTION

EFFECT

Whenever price of a commodity falls (price of other commodity & income

remaining the same), the consumer substitutes this commodity for the other

one so as to maintain original standard of living. This is known as substitution

effect. Thus, substitution effect can be defined as change in consumption oftwo commodities as a result of change in their relative prices (given constant

income), so that consumer is also to maintain original standard of living by

remaining on the same indifference curve.

Whenever the price of a commodity changes; the real income of the consumer

changes. That is, even though his monetary income remains fixed, his

purchasing power changes, shown as a change in real income. As a result, the

consumer is able to rearrange his purchase. This shows that income effect

exists as an element of price effect. Also, a consumer substitutes a relatively

expensive commodity for a relatively cheaper one. Thus substitution effect isalso present in price effect.

Thus, price effect is broken up into income effect and substitution effect. This

is shown by two methods: - Hicksian approach and Slutsky approach.

BREAK UP OF PRICE EFFECT UNDER HICKSIAN APPROACH:-

J.R. Hicks defined original standard of living in terms of level of satisfaction.

According to him, when relative prices of two commodities change, the

consumers real income purchasing power is altered in a way that he remains

on the same satisfaction level, that is, at the same indifference curve.

Consider two commodities tea and coffee. Tea is shown on X-axis and coffee is

shown on y- axis. The initial budget line is tangent to indifference curve IC1 at

point E. The consumer purchase OX1 quantity of Tea and OY1 quantity of

coffee. Now, if price of Tea falls, the consumers real income or purchasing

power increases. With decline in price, the consumer equilibrium shifts to point


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F, where the new budget line is tangent to higher indifference curve IC2. The

movement from point E to F is called price effect. At the new equilibrium point,

the consumer purchases OX2 of Tea, i.e., increases consumption of tea by

X1X2. This price effect can be broken into substitution effect and income effect.

Now, due to fall in price, consumers real income is increased. To bring

consumer back to original satisfaction level, the real income has to be brought

back to the original level. Thus, we assume that some income in terms of tea

& some income in terms of coffee is taken away from the consumer. This is

shown in the graph by a parallel downward shift in the new budget line AB, till

it becomes tangent to the original indifference curve IC1. The purpose of this

shift is to maintain the initial satisfaction level of the consumer. In the figure,

the compensating budget line is CD, tangent to IC1 at point G. The movement

from E to G shows the substitution effect in terms of Hicks. As tea is cheaper,

consumer demands more of tea & less of coffee. The quantity of tea

demanded rises form OX1 to OX3, while quantity demanded of coffee reducesfrom OY1 to OY2.

To differentiate the income effect from price effect the amount of money

assumed to be taken away from the consumer is now assumed to be given

back to him, so that he is back from point G on IC1 to point F on IC2. Thus, the

consumer has higher purchasing power. The movement from G to F is due to

increase in income, and hence shows the income effect.

It can be said that the move from E to F happened in two stages, that is, first,

due to substitution effect, equilibrium moves from E to G on the same

indifference curve, and then due to income effect, equilibrium shifts from G to

F. Thus price effect is a sum of income effect & substitution effect.


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Price effect (P.E.) = X1X2 (E to F)

Substitution effect (S.E.) = X1X3 (E to CT)

Income effect (I.E.) = X2X3 (CT to F)

X1X2 = X1X3 + X2X3

P.E. = S.E. + I.E.

ELASTICITY OF DEMAND

The concept of elasticity shows the relation of one variable with respect to a

change in other variable, on which it depends.

Thus, elasticity of demand in general explains the magnitude of impact of the

changes in factors influencing demand on the quantity demanded. Thus,

elasticity of demand is the ratio of change in quantity demanded to thechange in factors affecting demand. These factors may be price of a

commodity, income of the consumer, price of related commodities,

advertisement expenditure etc.

The concept of elasticity tells not only that demand is responsive to changes in

price of commodity, but also shows the degree of responsiveness of demand

to such changes in price.

When we consider responsiveness of demand to a change in price of

commodity purchased, it is called price elasticity of demand. Similarly, we

have income elasticity which measures responsiveness of demand with

respect to change in income of consumer, and cross elasticity measuring

responsiveness of demand with respect to change in price of related goods.

Price elasticity of demand is the most commonly discussed type of demand

elasticity. An example is given below.

The figure shows two demand curves DD and DD. Let DD be the demand for

wheat in Delhi and DD be the demand for wheat in Chennai. At Rs. 40 per kg,

demand for wheat in Delhi as well as Chennai is 25kg per house hold per

month.

If the price of wheat falls to Rs 30 in both cities, the demand for wheat in Delhi

rises to 30 kg per household per month, while in Chennai the demand rises to

35kg per household per month. This shows that demand for wheat is more

elastic in Chennai as compared to Delhi.


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TYPES OF DEMAND CURVE ON BASIS OF ELASTICITY

Depending upon the change in price of the commodity consumed, the demand

curves can be classified in 5 types based on price elasticity of demand.

1. Perfectly elastic demand curve:

It is situation where with any change in price, the demand for the

commodity disappears, that is the demand is affected very highly. This

can be shown by a horizontal straight line parallel to the x-axis.

At any price higher or lower than OP, there is no demand for the commodity.

This is a hypothetical situation, not seen in real life.

2. Perfectly inelastic demand curve:


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In this case there is no responsiveness of demand with change in price, that is,

the elasticity of demand is zero, with any change in price the quantity

demanded remains same. It is shown by a vertical straight line parallel to Y

axis.

At any price, the demand remains same. This is also a hypothetical situation

not observed in reality.

3. Unitary Elastic Demand Curve:

In this case, demand varies proportionately with change in price, that is, the

quantity demanded changes in proportion to change in price. This is shown by

a straight line with unit slope.

In this case, a unitary change in price means a unitary change in quantity

demanded. This is a more realistic situation as compared to the above two.

4. Highly elastic demand curve:


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This is a situation where demand is very responsive to change in price.

That is, with a small change in price, the quantity demanded changes

very much. It is shown by a straight line with a blunt slope.

Here, a small change in price givers rise to a large change in quantity

demanded. This is a very realistic situation.

5. Highly inelastic demand curve:

In such a situation, demand is not much responsive to a change in price. That

is, with a huge change in price, the quantity demanded does not change

much. This is shown by a straight line with a steep curve.


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This is also a case which is quite realistic. A small change in quantity

demanded is brought about by a large change in price.

economics notes[1]

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