Definitions of Economics:

There are a variety of modern definitions of economics. Some of the differences may reflect
evolving views of the subject itself or different views among economists.
1. J.B. Say (1803), distinguishing the subject from its public-policy uses, defines it as “the
science of production, distribution, and consumption of wealth.”
2. Alfred Marshall provides a still widely cited definition in his textbook Principles of
Economics (1890)
“Political Economy or Economics is a study of mankind in the ordinary business of life; it
examines that part of individual and social action which is most closely connected with the
attainment and with the use of the material requisites of wellbeing. Thus it is on the one side a
study of wealth; and on the other, and more important side, a part of the study of man.”
3. Lionel Robbins (1932) developed implications of what has been termed "perhaps the
most commonly accepted current definition of the subject,
“Economics is a science which studies human behavior as a relationship between ends and scarce
means which have alternative uses.”

Significance/ Importance of Economics:

1. Informative:
it teaches us very interesting and instructive facts about man’s behavior when he is engaged in
economic activity. The inner working of his mind in economic matter revealed to us. We come to
understand the various motives which guide men in economic affairs.
2. Mental training:
It unable us to think clearly and judge correctly and thus affords useful mental exercise. A
careful student of economics can easily see through the game of politician who wants to deceive
the general individuals by making various promises. He will not mislead by cheap newspaper
propaganda.
3. Understand the functioning of economic system:
The study of economics helps us to understand how the complicated economic system of today
functions automatically without any central control. Any economic disturbance somehow tends
to smoothen itself. For ex. If there is shortage of commodity price tends to increase which curtail
the unnecessary demand and it brought down to the level of supply.
4. Teaches mutual dependence:
Economics teaches us the important lesson of the mutual dependence of man on man. We come
to realize how we depend on other for the satisfaction of our wants, and how others depends on
us.
5. Useful citizenship:
The study of economics make us useful and intelligent citizen. Most of the problem today are
fundamentally economic in character. It is only economics that can give us a correct
understanding of the problem of agriculture, industry, trade, transport, ect.
6. Solving problem of poverty:
Finally it is economics that we look up to for solving the problem of poverty. Economics alone
not build a millennium but in that building, but it is an essential tool.
7. Useful for householder:
A householder will arrange his expenditure much better if he has studied economics. He can
prepare a family budget and put his expenditure on a rational manner.
8. Professional value:
The study of economics is very useful in several professions. It is useful to banker, to
businessman, to farmer and to industrialist.

Utility Analysis
Concepts and Measurement:
Utility is the quality of goods and services which satisfy human needs. It is also define as the
want satisfying power of commodity.

Total Utility: It is the summation of all utilities which derives after consumption of all units.

Marginal Utility: it is define as addition in total after consuming an additional unit. And the
formula to calculate it is:

MU= Change in total utility/Change in Quantity consume

Cardinal vs Ordinal Utility

Utility refers to the satisfaction that a consumer obtains from the purchase and use of
commodities and services. According to economics there are two theories that are able to
measure the satisfaction of individuals. These are the cardinal utility theory and the ordinal
utility theory. There are a number of differences between the two in the methodologies that they
use to measure consumption satisfaction.

Cardinal Utility

Cardinal utility states that the satisfaction the consumer derives by consuming goods and
services can be measured with numbers. Cardinal utility is measured in terms of utils (the units
on a scale of utility or satisfaction). According to cardinal utility the goods and services that are
able to derive a higher level of satisfaction to the customer will be assigned higher utils and
goods that result in a lower level of satisfaction will be assigned lower utils. Cardinal utility is a
quantitative method that is used to measure consumption satisfaction.

Ordinal Utility

Ordinal utility states that the satisfaction the consumer derives from the consumption of goods
and services cannot be measured in numbers. Rather, ordinal utility uses a ranking system in
which a ranking is provided to the satisfaction that is derived from consumption. According to
ordinal utility, the goods and services that offer the customer a higher level of satisfaction will be
assigned higher ranks and the opposite for goods and services that offer a lower level of
satisfaction. The goods that offer the highest level of satisfaction in consumption will be
provided the highest rank. Ordinal utility is a qualitative method that is used to measure
consumption satisfaction.

Cardinal vs Ordinal Utility

• Utility refers to the satisfaction that a consumer obtains from the purchase and use of
commodities and services. According to economics there are two theories that are able to
measure the satisfaction of individuals. These are the cardinal utility theory and the ordinal
utility theory.

• Cardinal utility states that the satisfaction that the consumer derives by consuming goods and
services can be measured with numbers.

• Ordinal utility states that the satisfaction that the consumer derives from the consumption of
goods and services cannot be measured in numbers. Rather, ordinal utility uses a ranking system
in which a ranking is provided to the satisfaction that is derived from consumption.

• While cardinal utility is a quantitative measure, ordinal utility is a qualitative measure.

• In cardinal utility, it is assumed that consumers derive satisfaction through consumption of one
good at a time. However, in ordinal utility it is assumed that a consumer may derive satisfaction
from the consumption of a combination of goods and services, which will then be ranked
according to preference.

Law of Diminishing Marginal Utility:

Definition of the Law:
"Other things remaining the same when a person takes successive units of a commodity, the
marginal utility diminishes constantly". – Dr. Alfred Marshall

The marginal utility of a commodity diminishes at the consumer gets larger quantities of it.
Marginal utility is the change in the total utility resulting from one unit change in the
consumption.

Assumptions:
Following are the assumptions of the law of diminishing marginal utility.

1. The utility is measurable and a person can express the utility derived from a commodity
in qualitative terms such as 2 units, 4 units and 7 units etc.
2. A rational consumer aims at the maximization of his utility.
3. A commodity is being taken continuously.
4. There should be proper units of a good consumed by the consumer.
5. The taste of the consumer remains same during the consumption for the successive units
of commodity.
 6. Income of the consumer remains constant during the operation of the law of diminishing
marginal utility.

Explanation With Schedule and Diagram:

We assume that a man is very thirsty. He takes the glasses of water successively. The marginal
utility of the successive glasses of water decreases, ultimately, he reaches the point of satiety.
After this point the marginal utility becomes negative, if he is forced further to take a glass of
water. The behavior of the consumer is indicated in the following schedule:

Units of commodity Marginal utility Total utility

1st glass 10 10
2nd glass 8 18
3rd glass 6 24
4th glass 4 28
5th glass 2 30
6th glass 0 30
7th glass -2 28

On taking the 1st glass of water, the consumer gets 10 units of utility, because he is very thirsty.
When he takes 2nd glass of water, his marginal utility goes down to 8 units because his thirst has
been partly satisfied. This process continues until the marginal utility drops down to zero which
is the saturation point. By taking the seventh glass of water, the marginal utility becomes
negative because the thirst of the consumer has already been fully satisfied.

The law of diminishing marginal utility can be explained by the following diagram drawn with
the help of above schedule:

In the above figure, the marginal utility of different glasses of water is measured on the y-axis
and the units (glasses of water) on X-axis. With the help of the schedule, the points A, B, C, D,
E, F and G are derived by the different combinations of units of the commodity (glasses of
water) and the marginal utility gained by different units of commodity. By joining these points,
we get the marginal utility curve. The marginal utility curve has the downward negative slope. It
intersects the X-axis at the point of 6th unit of the commodity. At this point "F" the marginal
utility becomes zero. When the MU curve goes beyond this point, the MU becomes negative.

Law of Equi Marginal Utility:

The law of equi marginal utility was presented in 19th century by an Australian economists H.
H. Gossen. It is also known as law of maximum satisfaction or law of substitution or Gossen's
second law. A consumer has number of wants. He tries to spend limited income on different
things in such a way that marginal utility of all things is equal. When he buys several things with
given money income he equalizes marginal utilities of all such things. The law of equi marginal
utility is an extension of the law of diminishing marginal utility. The consumer can get maximum
utility by allocating income among commodities in such a way that last rupee spent on each item
provides the same marginal utility.

Definition:
"A person can get maximum utility with his given income when it is spent on different
commodities in such a way that the marginal utility of money spent on each item is equal".

It is clear that consumer can get maximum utility from the expenditure of his limited income. He
should purchase such amount of each commodity that the last unit of money spend on each item
provides same marginal utility.

Assumptions of the Law of Equi Marginal Utility:

1. There is no change in the prices of the goods.
2. The income of consumer is fixed.
3. Consumer has perfect knowledge of utility obtained from goods.
4. Consumer is rational who seek maximum satisfaction.
5. The utility is measurable in cardinal terms.
6. Consumer has many wants.
7. The goods have substitutes.

Explanation With Schedule and Diagram:

The law of substitution can be explained with the help of an example. Suppose consumer has
sixty rupees that he wants to spend on apples and bananas in order to obtain maximum total
utility. The following table shows marginal utility (MU) of spending additional rupees of income
on apples and bananas:

Money (Units) MU of apples MU of bananas

1 10 8
2 9 7
 3 8 6
4 7 5
5 6 4
6 5 3
     

The above schedule shows that consumer can spend six rupees in different ways:

1. 1Rs on apples and 5 Rs on bananas. The total utility he can get  is:
[(10) + (8+7+6+5+4)] = 40.
2. Rs 2 on apples and Rs 4 on bananas. The total utility he can get is:
[(10+9) + (8+7+6+5)] = 45.
3. Rs 3 on apples and Rs 3 on bananas. The total utility he can get is:
[(10+9+8) + (8+7+6)] = 48.
4. Rs 4 on apples and Rs 2 on bananas. This way the total utility is:
[(10+9+8+7) + (8+7)] = 49.
5. Rs 5 on apples and Rs 1 on bananas. The total utility he can get is:
[(10+9+8+7+6) + (8)] = 48.

Total total utility for consumer is 49 utils that is the highest obtainable with expenditure of Rs 4
on apples and Rs 2 on bananas. Here the condition MU of apple = MU of banana i.e 7 = 7 is also
satisfied.

The same information can be used for graphical presentation of this law:

The diagram shows that consumer has income of six dollars. He wants to spend this money on
apples and bananas in such a way that there is maximum satisfaction to the consumer.
Indifference Curve Analysis: Concept, Assumption and
Properties
In microeconomics, indifference curve is an important tool of analysis in the study of consumer
behavior.

The concept of indifference curve analysis was first propounded by British economist Francis
Ysidro Edgeworth and was put into use by Italian economist Vilfredo Pareto during the early 20th
century. However, it was brought into extensive use by economists J.R. Hicks and R.G.D Allen.
Hicks and Allen criticized Marshallian cardinal approach of utility and developed indifference
curve theory of consumer’s demand. Thus, this theory is also known as ordinal approach.

Indifference curve
An indifference curve is a curve of all combinations of two goods which yield the same level of
satisfaction (utility) to the consumers.

Since any combination of the two goods on an indifference curve gives equal level of
satisfaction, the consumer is indifferent to any combination he consumes. Thus, an indifference
curve is also known as ‘equal satisfaction curve’ or ‘iso-utility curve’.

On a graph, an indifference curve is a link between the combinations of quantities which the
consumer regards to yield equal utility. Simply, an indifference curve is a graphical
representation of indifference schedule.

The table given below is an example of indifference schedule and the graph that follows is the
illustration of that schedule.

Table: Indifference schedule

Combination Mangoes Oranges
A 1 14
B 2 9
C 3 6
D 4 4
E 5 2.5

Figure: Graphical representation of indifference curve

Assumptions of indifference curve
The indifference curve theory is based on few assumptions. These assumptions are

Two commodities

It is assumed that the consumer has fixed amount of money, all of which is to be spent only on
two goods. It is also assumed that prices of both the commodities are constant.

Non satiety

Satiety means saturation. And, indifference curve theory assumes that the consumer has not
reached the point of satiety. It implies that the consumer still has the willingness to consume
more of both the goods. The consumer always tends to move to a higher indifference curve
seeking for higher satisfaction.

Ordinal utility

According to this theory, utility is a psychological phenomenon and thus it is unquantifiable.

However, the theory assumes that a consumer can express utility in terms of rank. Consumer can
rank his/her preferences on the basis of satisfaction yielded from each combination of goods.

Diminishing marginal rate of substitution

Marginal rate of substitution may be defined as the amount of a commodity that a consumer is
willing to trade off for another commodity, as long as the second commodity provides same level
of utility as the first one.

And, diminishing marginal rate of substitution states that the rate by which a person substitutes X
for Y diminishes more and more with each successive substitution of X for Y.

As indifference curve theory is based on the concept of diminishing marginal rate of substitution,

an indifference curve is convex to the origin.
Rational consumers

According to this theory, a consumer always behaves in a rational manner, i.e. a consumer
always aims to maximize his total satisfaction or total utility.

Properties of indifference curve

There are four basic properties of an indifference curve. These properties are

1. Indifference curve slope downwards to right

An indifference curve can neither be horizontal line nor an upward sloping curve. This is an
important feature of an indifference curve.

When a consumer wants to have more of a commodity, he/she will have to give up some of the
other commodity, given that the consumer remains on the same level of utility at constant
income. As a result, the indifference curve slopes downward from left to right.

In the above diagram, IC is an indifference curve, and A and B are two points which represent
combination of goods yielding same level of satisfaction.

We can see that when X1 amount of commodity X was consumed, Y1 amount of commodity Y
was also consumed. When the consumer increased the consumption of commodity X to X2, the
amount of commodity Y fell to Y2. And, thus the curve is sloping downward from left to right.

2. Indifference curve is convex to the origin

As mentioned previously, the concept of indifference curve is based on the properties of

diminishing marginal rate of substitution.

According to diminishing marginal rate of substitution, the rate of substitution of commodity X

for Y decreases more and more with each successive substitution of X for Y.

Also, two goods can never perfectly substitute each other. Therefore, the rate of decrease in a
commodity cannot be equal to the rate of increase in another commodity.
Table: Indifference schedule
Combination Commodity X Commodity Y
A 1 12
B 2 8
C 3 5
D 4 3
E 5 2

The above table represents various combination of commodity X and commodity Y that gives a
man same level of utility. When the man takes 12 units of commodity Y, he consumes 1 unit of
X every day. When he started consuming two units of commodity X a day, his consumption of
commodity Y dropped to 8 units a day. In the same way, we can see other combinations as 3 of
commodity X + 5 of commodity Y, 4 of Com X + 3 of Com Y and 5 of Com X + 2 of Com Y.

We can clearly see that the rate of decrease in consumption of Commodity Y is not the same as
rate of increase in consumption of Commodity X. Similarly, rate of decrease in consumption of
Commodity Y has gradually decreased even with constant increase in consumption of
Commodity X.

Thus, indifference curve is always convex (neither concave nor straight).

3. Indifference curve cannot intersect each other

Each indifference curve is a representation of particular level of satisfaction.

The level of satisfaction of consumer for any given combination of two commodities is same for
a consumer throughout the curve. Thus, indifference curves cannot intersect each other.

The following diagram will help you understand this property clearer.
In the above image, IC1 and IC2 are two indifference curves and C is the point where both the
curves intersect.

According to indifference curve theory, satisfaction at point C = satisfaction at point A

Also, satisfaction at point C = satisfaction at point B
But, satisfaction at point B ≠ satisfaction at point A.

Therefore, two indifference curves cannot intersect. Yet, two indifference curves need not be
parallel to each other.

4. Higher indifference curve represents higher level of satisfaction

Higher the indifference curves, higher will be the level of satisfaction. This means, any
combination of two goods on the higher curve give higher level of satisfaction to the consumer
than the combination of goods on the lower curve.

In the above figure, IC1 and IC2 are two indifference curves, and IC2 is higher than IC1. We can
also see that Q is a point on IC2 and S is a point on IC2.

Combination at point Q contains more of both the goods (X and Y) than that of the combination
at point S. We know that total utility of commodity tends to increase with increase in stock of the
commodity. Thus, utility at point Q is greater than utility at point S, i.e. satisfaction yielded
from higher curve is greater than satisfaction yielded from lower curve.
 5. In between two indifference curves no of indifference curve can be formed:
In the given diagram of an indifference curve we can able to see that for same two commodities X and Y
number of indifference are formed it is because consumer give the preference to the various combinations
of X and Y according to their level of income. If level of income of the consumer is high he able to prefer
the combination of upper indifference curve and whose level of income comparatively low than he have
to prefer the combination of lower indifference curve. As the level of income of every individual is
different and therefore number of indifference curve can be formed for same two commodities.

6. An indifference curve never intersects or touches either axis:

As it is shown on the given diagram if an indifference curve intersects of touch to either axis one
commodity become zero but indifference curve always represent combinations of two commodities
therefore an indifference curve never intersect or touch to either axis.

7. An indifference curves not necessarily become parallel to each other:

Two indifference curves become parallel to each other when the marginal rate of substitution of one curve
is equally match with other. But the marginal rate of substitution for same two commodities vary
consumer to consumer and in that case two indifference curve not become parallel to each other.
What is demand?
1. Demand is an economic principle referring to a consumer's desire to purchase goods and
services and willingness to pay a price for a specific good or service.

2. Demand is that quantity of goods and services which consumer desire to as well as able
to purchase at various level of prices during certain period of time.

1. Desire to purchase

2. Able to purchase

3. Price

4. Time period

DETERMINANTS OF DEMEND
Following are the determinants of demand for a product:

i. Price of a Product or Service:

Affects the demand of a product to a large extent. There is an inverse relationship between the
price of a product and quantity demanded. The demand for a product decreases with increase in
its price, while other factors are constant, and vice versa.

For example, consumers prefer to purchase a product in a large quantity when the price of the
product is less. The price-demand relationship marks a significant contribution in oligopolistic
market where the success of an organization depends on the result of price war between the
organization and its competitors.

P increases – D Falls

Price falls - demand increases

ii. Income:

Constitutes one of the important determinants of demand. The income of a consumer affects
his/her purchasing power, which, in turn, influences the demand for a product. Increase in the
income of a consumer would automatically increase the demand for products by him/her, while
other factors are at constant, and vice versa.

For example, if the salary of Mr. X increases, then he may increase the pocket money of his
children and buy luxury items for his family. This would increase the demand of different
products from a single family. The income-demand relationship can be analyzed by grouping
goods into four categories, namely, essential consumer goods, inferior goods, normal goods, and
luxury goods.

iii. Tastes and Preferences of Consumers:

Play a major role in influencing the individual and market demand of a product. The tastes and
preferences of consumers are affected due to various factors, such as life styles, customs,
common habits, and change in fashion, standard of living, religious values, age, and sex.

A change in any of these factors leads to change in the tastes and preferences of consumers.
Consequently, consumers reduce the consumption of old products and add new products for their
consumption. For example, if there is change in fashion, consumers would prefer new and
advanced products over old- fashioned products, provided differences in prices are proportionate
to their income.

iv. Price of Related Goods:

Refer to the fact that the demand for a specific product is influenced by the price of related goods
to a greater extent.

Related goods can be of two types, namely, substitutes and complementary goods, which
are explained as follows:

a. Substitutes:

Refer to goods that satisfy the same need of consumers but at a different price. For example, tea
and coffee, jowar and bajra, and groundnut oil and sunflower oil are substitute to each other. The
increase in the price of a good results in increase in the demand of its substitute with low price.
Therefore, consumers usually prefer to purchase a substitute, if the price of a particular good gets
increased.

Tea coffee

10/- 10/-

12/- 10/-

b. Complementary Goods:

Refer to goods that are consumed simultaneously or in combination. In other words,

complementary goods are consumed together. For example, pen and ink, car and petrol, and tea
and sugar are used together. Therefore, the demand for complementary goods changes
simultaneously. The complementary goods are inversely related to each other. For example,
increase in the prices of petrol would decrease the demand of cars.

v. future Expectations of Consumers about prices:

Imply that expectations of consumers about future changes in the price of a product affect the
demand for that product in the short run. For example, if consumers expect that the prices of
petrol would rise in the next week, then the demand of petrol would increase in the present.
On the other hand, consumers would delay the purchase of products whose prices are expected to
be decreased in future, especially in case of non-essential products. Apart from this, if consumers
anticipate an increase in their income, this would result in increase in demand for certain
products. Moreover, the scarcity of specific products in future would also lead to increase in their
demand in present.

vi. Effect of Advertisements:

Refers to one of the important factors of determining the demand for a product. Effective
advertisements are helpful in many ways, such as catching the attention of consumers, informing
them about the availability of a product, demonstrating the features of the product to potential
consumers, and persuading them to purchase the product. Consumers are highly sensitive about
advertisements as sometimes they get attached to advertisements endorsed by their favorite
celebrities. This results in the increase demand for a product.

vii. Distribution of Income in the Society:

Influences the demand for a product in the market to a large extent. If income is equally
distributed among people in the society, the demand for products would be higher than in case of
unequal distribution of income. However, the distribution of income in the society varies widely.

This leads to the high or low consumption of a product by different segments of the society. For
example, the high income segment of the society would prefer luxury goods, while the low
income segment would prefer necessary goods. In such a scenario, demand for luxury goods
would increase in the high income segment, whereas demand for necessity goods would increase
in the low income segment.

viii. Growth of Population:

Acts as a crucial factor that affect the market demand of a product. If the number of consumers
increases in the market, the consumption capacity of consumers would also increase. Therefore,
high growth of population would result in the increase in the demand for different products.

ix. Climatic Conditions:

Affect the demand of a product to a greater extent. For example, the demand of ice-creams and
cold drinks increases in summer, while tea and coffee are preferred in winter. Some products
have a stronger demand in hilly areas than in plains. Therefore, individuals demand different
products in different climatic conditions.

x. Fashion

Law of demand
There is an inverse relationship between quantity demanded and its price. The people know that
when price of a commodity goes up its demand comes down. When there is decrease in price the
demand for a commodity goes up. There is inverse relation between price and demand . The law
refers to the direction in which quantity demanded changes due to change in price.

Statement of Law:
Alfred Marshal says, “other things being equal, the amount demanded increase with a fall in
price, diminishes with a rise in price.”

Assumptions of the law

1. There is no change in income of consumers.

2. There is no change in quality of product.
3. There is no substitute of the commodity.
4. The prices of related commodities remain the same.
5. There is no change in taste and preference of consumers.
6. The size of population remains the same.
7. The climate and weather conditions are same.

Explanation of the law

The relationship between price of a commodity and its demand depends upon many factors. The
most important factor is nature of commodity. The demand schedule shows response of quantity
demanded to change in price of that commodity. This is the table that shows prices per unit of
commodity and amount demanded per period of time.

Demand schedule
Price in Rupees Demand in Kg.

5 100

4 200

3 300

2 400

The table shows the demand of all the consumers in a market. When the price decreases there is
increase in demand for goods and vice versa. When price is Rs 5 demand is 100 kilograms.
When the price is Rs 4 demand is 200 kilograms. Thus the table shows the total amount
demanded by all consumers various price levels.

Diagram
There is same price in the market. All consumers purchase commodity according to their needs.
The market demand curve is the total amount demanded by all consumers at different prices. The
market demand curve slopes from left down to the right because of inverse relationship between
price and qty demended.

ELASTICITY OF DEMAND
Types of elasticity of demand:
Price elasticity of demand

Definition  

All other things being same,

1. Charles G. Lipsey  says, that elasticity of demand is the rate of the percentage change in
demand to the percentage change in price.
2. K. E. Boulding says that elasticity of demand measures the responsiveness of demand to
change in price.
3. A. K. Chairncross says that the elasticity of demand for a commodity is the rate at which
quantity bought changes as the price changes.

Formula is: Pe= % Change Qty Demanded/% Change in Price

Income elasticity of demand

The percentage change in quantity demanded due to percentage change in income is called
income elasticity of demand. Income elasticity of demand measures the responsiveness of
demand for a good to change in income of consumer. When income of people increases they like
to buy more of the goods. The concept of income elasticity gives an idea about essential and non
essential-goods. Luxury goods have high-income elasticity. People buy such goods and large part
of income is spent. Necessities of life have low-income elasticity. Part of income spent on soap,
matches fall as the income of people increase.

Definition

D.S. Waston says that income elasticity of demand means the ratio of the percentage change in
the quantity demand to the percentage change in income.

Income elasticity of demand can be measured through mathematics. Proportionate change in

demand is divided by proportionate change in income. It can be written as:

Ey = Proportionate change in demand / proportionate change in income

= Δq/q ÷ Δy/y
= y/q × Δq/Δy

Ey means income elasticity of demand. ΔQ is the change in demand. Q is original demand. Y is

original income and Δy change in income. Suppose the income of a person is $2000 and he
purchases 20 liter of milk. If his income increases to $2500 he purchases 30 liter of milk.
Therefore income elasticity of demand is is 2000 divided by 500 multiplied by 10 divided by 20
and result is 2. It means demand for milk is income elastic.

Cross elasticity of demand

There is cross elasticity of demand when demand for a commodity changes due to a change in
the price of another related commodity. In fact cross elasticity of demand measures the change in
demand of a commodity (say coffee) when the prices of another related commodity (say tea)
changes by small amount. There is positive cross-elasticity of demand when two goods are
substitutes of each other increase in the price of one increases the demand for other. There is
negative cross-elasticity of demand for complementary goods because increase in the price of
goods decreases the demand for its complementary goods.

Definition

According to Ferguson 'cross elasticity of demand is proportional change in the quantity of x

demanded resulting from a given relative change in the price of relative good y'.

Formula:

The formula for measurement of cross elasticity of demand is as follows:

Ecr = Proportionate change in demand for x / Proportionate change in the prices of y

For example when price of tea increases from $10 to $15 per kilogram and as a result demand for
coffee increases from 20 tones to 30 tones per month price of coffee remaining constant. If we
put values in the formula the result is: Δq ÷ Δp × p ÷ q

In the example; Δq = 30 - 20 =10; q = 20; Δp = 15 - 10 = 5; p = 10

Putting the values in the question the result is; Ecr = 10 ÷ 5 ×10 ÷ 20 = 1

The same formula is used to measure cross-elasticity of demand for a commodity in response to
change in the price of its complementary goods. The example of complementary goods is petrol
to car. When the price of car increases there is decrease in the demand for petrol.

Degrees of Elasticity of Demand

1. Perfectly Elastic Demand (EP = ∞)

The demand is said to be perfectly elastic if the quantity demanded increases infinitely (or by
unlimited quantity) with a small fall in price or quantity demanded falls to zero with a small rise
in price. Thus, it is also known as infinite elasticity. It does not have practical importance as it is
rarely found in real life.
In the given figure, price and quantity demanded are measured along the Y-axis and X-axis
respectively. The demand curve DD is a horizontal straight line parallel to the X-axis. It shows
that negligible change in price causes infinite fall or rise in quantity demanded.

2. Perfectly Inelastic Demand (EP = 0)

The demand is said to be perfectly inelastic if the demand remains constant whatever may be the
price (i.e. price may rise or fall). Thus it is also called zero elasticity. It also does not have
practical importance as it is rarely found in real life.

In the given figure, price and quantity demanded are measured along the Y-axis and X-axis
respectively. The demand curve DD is a vertical straight line parallel to the Y-axis. It shows that
the demand remains constant whatever may be the change in price.  For example: even after the
increase in price from OP to OP2 and fall in price from OP to OP1, the quantity demanded
remains at OM.

3. Relatively Elastic Demand (EP> 1)

The demand is said to be relatively elastic if the percentage change in demand is greater than the
percentage change in price i.e. if there is a greater change in demand there is a small change in
price. It is also called highly elastic demand or simply elastic demand. For example:

If the price falls by 5% and the demand rises by more than 5% (say 10%), then it is a case of
elastic demand. The demand for luxurious goods such as car, television, furniture, etc. is
considered to be elastic.
In the given figure, price and quantity demanded are measured along the Y-axis and X-axis
respectively. The demand curve DD is more flat, which shows that the demand is elastic. The
small fall in price from OP to OP1 has led to greater increase in demand from OM to OM1.
Likewise, demand decrease more with small increase in price.

4. Relatively Inelastic Demand (Ep< 1 )

The demand is said to be relatively inelastic if the percentage change in quantity demanded is
less than the percentage change in price i.e. if there is a small change in demand with a greater
change in price. It is also called less elastic or simply inelastic demand. For example: when the
price falls by 10% and the demand rises by less than 10% (say 5%), then it is the case of inelastic
demand. The demand for goods of daily consumption such as rice, salt, kerosene, etc. is said to
be inelastic.

In the given figure, price and quantity demanded are measured along the Y-axis and X-axis
respectively. The demand curve DD is steeper, which shows that the demand is less elastic.The
greater fall in price from OP to OP1 has led to small increase in demand from OM to OM1.
Likewise, greater increase in price leads to small fall in demand.

5. Unitary Elastic Demand ( Ep = 1)

The demand is said to be unitary elastic if the percentage change in quantity demanded is equal
to the percentage change in price. It is also called unitary elasticity. In such type of demand, 1%
change in price leads to exactly 1% change in quantity demanded. This type of demand is an
imaginary one as it is rarely applicable in our practical life.
In the given figure, price and quantity demanded are measured along Y-axis and X-axis
respectively. The demand curve DD is a rectangular hyperbola, which shows that the demand is
unitary elastic. The fall in price from OP to OP1 has caused equal proportionate increase in
demand from OM to OM1. Likewise, when price increases, the demand decreases in the same
proportion. 

Measurement of elasticity of demand

Three popular methods for measuring price elasticity of demand are discussed below:

1. Percentage method

The percentage method measures price elasticity of demand by dividing the percentage change in
amount demand by percentage change in price of commodity. The elasticity of demand is unity,
greater than unity and less than unity. Demand is unity if change in demand is proportionate to
the change in price. Demand is greater than unity when change in demand is more than
proportionate change in price. The demand is less than unity if change is less than proportionate
change in price. The coefficient of price elasticity of demand is always negative because change
in price brings a change in demand in opposite direction. Negative signs are usually disregarded.

The following formula is used for the measurement of price elasticity of demand:

Ep = Δq/Δp × p/q

Elasticity less than unity:

A consumer buys 5 kg of commodity at $10. If the price falls to $6 the consumer buys 6
kilograms. Elasticity in this case is less than 1.

Ep = Δq/Δp × p/q = 1/4 × 10/5 = 1/2 < 1 (less elastic)

Elasticity is unity:
A consumer buys 5 kg of commodity at $10. If the price rises to $12 the consumers buys 4
kilograms. Elasticity in this case is1.

Ep = Δq/Δp × p/q = 1/2 × 10/5 = 1 (unity)

Elasticity is more than unity:
A consumer buys 5 kg of commodity at $10. if the price rises to $11 the consumers buys 4
kilograms. Elasticity in this case is more than 1. Thus

Ep = Δ q /Δ p × p/q = 1/1 × 10/5 = 2 > 1 (elastic)

2. Total expenditure method

Marshal evolved total expenditure (outlay) of consumer or total revenue of seller as measure of
elasticity. Total expenditure of a producer is compared before and after change in price. Total
outlay is equal to price multiplied by quantity demanded. This method of the measurement of
price elasticity of demand tells us whether demand for a commodity is elastic or greater than
unity When fall in its price leads to increase in total expenditure in it and a rise the price causes
decrease in total expenditure. Demand is equal to unity when total expenditure remains the same
whether there is increase in price or decrease in price of goods. Demand is said to be inelastic or
less than unity when total expenditure decrease with decrease in price and increase with
increase in price.

Schedule for expenditure unit elastic demand

Price Quantity demanded outlay

12 2 24

6 4 24

3 8 24

The total expenditure remains unchanged at Rs. 24 in unitary elastic demand. There is fall in
price from Rs.12 to Rs.6 and Rs.3, the total expenditure remains unchanged at Rs.24. When there
is rise in price from Rs.3 to Rs.6 and Rs.12, the total expenditure remains unchanged at Rs.24.
The elasticity of price is = 1 or unitary elastic demand whether there is increase in price or
decrease in price.

Schedule of expenditure elastic demand

Price Quantity demanded Outlay

12 2 24

6 6 36

3 16 48

The total expenditure rises from Rs.24 to Rs.36 and Rs.48 respectively with the fall in price from
Rs.12 to Rs.6 and Rs.3. The total expenditure falls from Rs.48 to Rs.36 and Rs.24 respectively
with the rise in price from Rs.3 to Rs.6 and Rs.12. The elasticity of price is > 1 in this case.

Schedule of expenditure inelastic demand

 Price Quantity demanded Outlay

12 2 24

6 3 18

3 4 12

The total expenditure falls from Rs.24 to Rs.18 and Rs.12 respectively with fall in price from
Rs.12 to Rs.6 and Rs.3. The total expenditure rises from Rs.12 to Rs.18 and Rs.24 respectively
with the rise in price from Rs.3 to Rs.6 and Rs.12. The elasticity price is < 1. There is inelastic
demand in such case.

This method is simple as it classifies the elasticity into three categories. Its drawback is that it
fails to measure elasticity in exact figures.

3. Point elasticity method

The point elasticity of demand is proportionate change in quantity demand in response to very
small proportionate change in price. The point elasticity concept is useful when change in price
and the consequent change in quantity demanded is very small. Marshal suggested this method.
It is also called geometrical method because graph is drawn to show the demand curve. This
method is explained with the help of (1) straight line demand curve and (2) convex demand
curve.

(1). Straight line demand curve:

The diagram shows a straight line demand curve. We join both sides of the straight line demand
curve with the two axes at points D and C. Elasticity at any points is equal to the ratio of the
distance from the point P to the X axis and the distance to the Y axis. In the diagram the point N
is half way between D and C. The elasticity of demand is = Ep = NC / ND. The elasticity is equal
to 1 at this point. Similarly at point M elasticity is greater than 1. The elasticity at point P is less
than 1. 

(2). Convex demand curve:

There is convex demand curve DD. Suppose we want to check price elasticity at point A. we can
draw a tangent RS at the point A. the elasticity is found as AS / AR. Similarly for finding out
elasticity at point B we draw a tangent at this point to the demand curve. The elasticity at this
point is given by the ratio of the distance along the tangent to the X-axis divided by the distance
of the Y-axis.