Contents

Contents 1

1 Business Economics 1
1.1 Business Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Features of Business Economics . . . . . . . . . . . . . . . . . . . . . 2
1.2.1 Scope of Business Economics . . . . . . . . . . . . . . . . . . 2
1.2.2 Importance of Business Economics . . . . . . . . . . . . . . . 3
1.3 Rate of Transformation . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.4 Production Possibility Curve . . . . . . . . . . . . . . . . . . . . . . 5
1.4.1 The Shape of PPC . . . . . . . . . . . . . . . . . . . . . . . . 6
1.4.2 Shift of PPC . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.5 Basic Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.5.1 Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.5.2 Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.5.3 Identity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.5.4 Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.5.5 Slope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.5.6 Average and Marginal Concepts . . . . . . . . . . . . . . . . . 13
1.5.7 Derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

2 Demand Analysis 17
2.1 Demand Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.2 Law of Diminishing Marginal Utility . . . . . . . . . . . . . . . . . . 20
2.3 Importance of the Law of DMU . . . . . . . . . . . . . . . . . . . . . 22
2.4 The Law of Equi-marginal Utility . . . . . . . . . . . . . . . . . . . . 24

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 2.5 Practical Importance of the Law of EMU . . . . . . . . . . . . . . . 26
2.6 The Law of Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2.6.1 Separation of Income and Substitution Effect . . . . . . . . . 30
2.7 Exceptions to The Law of Demand . . . . . . . . . . . . . . . . . . . 32

3 Elasticity of Demand 35
3.1 Concepts of Elasticity . . . . . . . . . . . . . . . . . . . . . . . . . . 35
3.2 Price elasticity (ep ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
3.2.1 Degrees of Price Elasticity . . . . . . . . . . . . . . . . . . . . 37
3.3 Factors Influencing Price Elasticity . . . . . . . . . . . . . . . . . . . 38
3.4 Income Elasticity (eY ) . . . . . . . . . . . . . . . . . . . . . . . . . . 41
3.5 Cross Elasticity (ec ) . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
3.6 Promotional elasticity (ea ) . . . . . . . . . . . . . . . . . . . . . . . . 43
3.7 Measurement of Demand Elasticity . . . . . . . . . . . . . . . . . . . 43

4 Indifference Curve 51
4.1 Properties of Indifference Curve . . . . . . . . . . . . . . . . . . . . . 57
4.2 Consumers Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . 61

5 Consumer Surplus 65
5.1 Consumer Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
5.2 Evaluation of Consumer Surplus . . . . . . . . . . . . . . . . . . . . 68
5.3 Importance of Consumer Surplus . . . . . . . . . . . . . . . . . . . . 69
5.4 Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
5.5 The Law of Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
5.6 Elasticity of Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
5.7 Producers Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

6 Production Function 77
6.1 Production Function . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
6.1.1 Features of production function . . . . . . . . . . . . . . . . . 78
6.1.2 Types of Production Function . . . . . . . . . . . . . . . . . . 79
6.2 Some Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
6.3 The Law of Variable Proportion (LVP) . . . . . . . . . . . . . . . . . 83
6.4 Properties of Iso-quants . . . . . . . . . . . . . . . . . . . . . . . . . 86
6.5 Output Maximisation . . . . . . . . . . . . . . . . . . . . . . . . . . 91
6.6 Cost Minimisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

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6.7 Question Paper Pattern . . . . . . . . . . . . . . . . . . . . . . . . . 95

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Chapter 1

Business Economics

1.1 Business Economics

Businesses work in an uncertain environment, which makes them complicated. There-

fore, the primary function of business management is decision-making and forward
planning. Decision-making is the process of selecting one action out of the alternatives.
Whereas planning means establishing plans for the future. The question of choice
arises because resources are limited and can be employed for alternate uses.

In decision making economic theories are used, along with decision sciences like
mathematics, statistics, econometrics etc. Such integration of economic theory with
decision sciences is called business economics. Business Economics or Managerial
Economics is an application of economic theory and methodology to businesses.

According to McNair and Meriam, “Business economics consists of the use of economic
models of thought to analyse business situation”. According to Spencer and Siegelman,
business economics is an integration of economic theory with business practice to
facilitate decision-making and planning by management.

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1.2 Features of Business Economics
1. Business economics is microeconomics in character.

2. Business economics uses that part of economics known as ‘theory of the firm’
and ‘theory of profit’.

3. Business economics is pragmatic and it involves complications ignored in

economic theory through assumptions.

4. Business economics is normative rather than positive or prescriptive rather

than descriptive. In other words, it involves value judgement and tells us what
is good and what is bad.

5. Business economics also studies macroeconomics since it provides an under-

standing of the economic environment in which the business is to function.

1.2.1 Scope of Business Economics

1. Demand Analysis: Business firms produce for the sake of profit. They
transform unusable goods i.e resources or inputs into usable goods i.e final
product. Businesses produce as per market demand. Therefore, they need to
know or study the different factors shaping the demand for their products and
consumer behaviour. Thus, firms need to study demand analysis.

2. Demand Forecasting: Businesses have to decide the present and the future
output. Before the production schedule is prepared and resources are hired,
they need to know the demand for their product when it would be supplied in
the market or future demand. Knowing the future demand is known as demand
forecasting. Demand forecasting helps to decide the number of resources to be
hired, materials to be bought and plant size.

3. Cost Analysis: Cost is an important aspect of production as it directly

influences profit. To some extent, it can be controlled by businesses. As factors
are to be bought or hired from the market, factor remuneration is uncertain. The
firms need to be aware of costs, their measurement and behaviour. Therefore,
the firm must know about cost classification, cost-output ratios, cost behaviour,
economies and diseconomies of scale etc.

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 4. Production and Supply Analysis: Production analysis explains technical
aspects of production and is narrower than cost analysis. It is in physical
quantity rather than money. The firm needs to know about production function
or input-output ratios. Similarly, firms must know when, where, how and how
much to supply.

5. Pricing Methods and Policies: Pricing is a very crucial decision because if

it went wrong, can spoil every other planning of the business. The success of
a business in the short run largely depends on pricing policies and practices.
Once production is done it is only pricing which decides the fate of the business.

6. Income Distribution Income distribution means how the revenue is being

distributed among the factors in the form of factor remuneration. Businesses
should know when and why one factor can be paid more than other factors.
This is very crucial to control the cost of production.

7. Profit management: Profit is the most general objective of a business. It is

the chief indicator of success because it will decide the survival and expansion
of the business. As it is a residual of the revenue earned, it is the most volatile
among the factor remunerations.

8. Capital Management: Capital is the most flexible factor until it is not

invested and rigid once it is invested. Therefore, the firm has to be careful
while investing.

1.2.2 Importance of Business Economics

1. It culls from economic theory the concepts, principles and techniques of analysis
which are useful in the decision-making process.

2. Business economics incorporates useful ideas from other disciplines. It makes

managers more competent model builders.

3. Makes manager an integrating agent between various

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1.3 Rate of Transformation
The opportunity cost of given good (x) refers to the number of units of another
good (y) which is given up to produce an additional unit of good X. When we
shift resources from production of one to another good, in a way we transform one
good into another. The rate at which transformation happens is called a rate of
transformation or opportunity cost. Suppose with given resources, we can produce
one car or three bikes. Assume that the producer was producing one car and then
shift to bike production. Now we can say that by shifting resources, producer has
transformed one car into 3 bikes. Thus the opportunity cost or marginal rate of
transformation of car for a bike is three bikes is 3 and that of bike for a car is 1/3
car. It is because to produce one car he forgoes three bikes or for one bike, 1/3rd car.

no of units of y foregone
M RTxy = (1.1)
no of additional units of x produced

no of units of x foregone
M RTyx = (1.2)
no of additional units of y produced

Note that the M RTxy is inverse of M RTyx .

The meaning of M RT is very important in economics. When firm shifts from the
original line of production (y) to new (x), it has to shift factors. The shifting of factors
reveals factor productivity and some technicalities in shifting resources. We know that
factors, due to their quality, knowledge, skill differences are heterogeneous. While
shifting factors from one line of production to other, firm will think of productivity
of factor units in the original and the new line of production.

While shifting factors units firm first selects those factor units which are least
productive in the original line and will probably be more productive in the new line.
Because of this, the initial units of factor shifted to the new line of production will
cause smaller loss of output to the original line of production i.e M RT(new to original)
good will be smaller in the beginning. When the firm produces even more in the new
line of production, it will have to shift more and more productive factors to from the
original line of production. Therefore, loss of output in the original line of production
increase continuously i.e M RT(new to original) good will go on rising.

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 From this we can conclude that along with increase output of a given good
its opportunity cost or M RT in terms of other good rises.

1.4 Production Possibility Curve

Economics studies economic problems, arising out of unlimited wants and limited
resources with alternative uses. Had the resources at our disposal been unlimited,
there would have been no economic problem and no economics. But technically, every
economy is characterised by shortage1 . The shortage of resources is an effect of the
irreversibility phenomenon in nature or the second law of thermodynamics in physics2 .
That is why, we need to use resources in the best possible way. Economics guides to
use of resources in the best possible manner. Lionel Robbins defines economics as a
study of the allocation of scarce resources among competing ends or uses.

The edge of the comfort in availability of resources is that they have alternative
uses. The producer can shift his resources from one to other line of production or
he can transform his one good into other. This transformation happens in certain
manner because of technicalities of production process. The curve which explains this
transformation is called production possibility curve or transformation curve.

Assume that there is a producer, who has |100 to produce two goods x and y. With
his amount of |100, if he produces only y he can produce 5 units of x and if produces
only y he can produce 10 units of y. Or he can produce combinations of x and y.
As |100 are worth of 5x or 10y, we can say that 5x = 10y or x = 2y. It implies
that producer can produce other combinations like (x, 8y), (2x, 6y), (3x, 4y) and
(4x, 2y). Thes are few production possibilities. Between any two successive pairs of
possibilities, there are n number of possibilities. All these production possibilities are
shown by the curve P P . Therefore, it is known as production possibility curve.

Thus production possibility curve shows all possible combinations of output which
can be produced with the help of the given limited resources, provided they are fully
1 Shortage in the sense that though the particular type of resources is plenty, the resources with

which they are to be used are short in supply. This makes use of former types of resources practically
limited
2 It is also called as entropy law of thermodynamics.

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 PPC

(0,10)

8 (1,8)

good y
6 (2,6)

4 (3,4)

2 (4,2)

(5,0)
1 2 3 4 5 6
good x

Figure 1.1: Production Possibility Curve

utilised.

Due to scarcity of resources, an additional units of a good can be produced only

by forgoing production of some units of other good. It means there is an inverse
relationship between output of two goods as they are competing for the same stock
of resources. Thus, it is clear that such production possibility is a downward sloping
curve as shown in Figure 1.1.

It implies that to have more of one good, the firm has to give up a few units
of other goods.

1.4.1 The Shape of PPC

The shape and slope of production possibility curve implies the M RX and produc-
tivity of factor units. A downward sloping curve can be a straight line or a convex to
the origin or a concave to the origin curve as shown in Figure 1.2.

In Figure 1.2a, the P P C is a straight line with constant slope of -2. It means to
produce one more unit of x, the producer will have to give up 2 units of y, at all
levels of output. It implies that M RT is constant and all factor units are equally
productive and equally preferred while employing. But in reality, factor units are
heterogeneous and differently productive. Therefore, downward sloping P P C can

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 16 16
2 15 dy
14 14 M RSxy = = increasing
2 5 dy 2 dx
12 M RSxy = − = decreasing 12
2 11 dx 3
good y

10
2 4 9
8
2 7 4
6 3
dy 2 5
4 M RTxy = = Constant 4
dx 2 2 5
2 2
1 1
0
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
good x good x good x

(a) All factor units are equally pro- (b)

Less productive factor units are More productive factor units are (c)
ductive and equally preferred preferred to more productive preferred to less productive

Figure 1.2: The shape of Production Possibility Curve

not be a straight line.

In Figure 1.2b, the P P C is convex to the origin. It implies that M RS decreases

along with increase in output and factor units are heterogeneous. It also implies
that while employing less productive factor units are preferred to more productive
factor units, while removing from employment more productive units of factor are
removed before less productive factor units. It means lesser productive resources will
have greater chances of employment than more productive resources. Therefore, the
downward sloping P P C can not be convex to the origin.

In Figure 1.2c, the P P C is concave to the origin. It implies that resources are
heterogeneous. It also implies that while employing more productive factor units
are preferred to less productive factor units, while removing from employment
less productive factor units are removed before more productive factor units. It
means more productive resources will have greater chances of employment than less
productive resources. Therefore, the downward sloping P P C must be concave to the
origin.

In Figure 1.2c, if the firm used all its resources to produce good y, it can produce
15 units of y. If the firm wants to produce a few units of x, it will have to transfer
resources from production of y to production x. In a way, it will have to reduce
production of y to have good x. To have the first units of x, the firm will remove the
least productive unit of factor from production of y to the production of x. Because
of this for the first unit of x the firm looses only one unit of y. But to produce more
units of x, it will have to transfer more productive resources from production of y to
production of x. This leads to more loss in terms of y to have additional units of x.
The Figure shows that to have 2nd , 3rd , 4th and 5th unit of x, firm loses 2, 3, 4, and

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 y y

P2 P2
P P
P1

x x
P1 P P2 P1 P

(a) Resources Change (b) ProductivityChange

Figure 1.3: Shift of PPC

5 units of y respectively.

In other words, we can say that the marginal productivity of factors is inversely
related to the quantity used.

1.4.2 Shift of PPC

If at any time there is an increase in the availability of resources and/or increase in
efficiency in both the lines of production, PPC will move away from the origin on
both axes (from P P to P2 P2 ). Conversely, if there is a decrease in the availability of
resources and/or a decrease in inefficiency in both the lines of production, PPC will
move closer to the origin on both axes (from P P to P1 P1 ).

If there is efficiency improvement in the production of only one good, PPC will
move away from the origin along the axis on which that good has been measured,
while remaining unchanged along the other axis. If efficiency increased only in the
production of commodity x, PPC will shift from P P to P Px , while efficiency increases
in the production of commodity y will shift PPC from P P to P Py .

• Why does PPC slopes downward?: Because resources are limited.

• Why is a PPC non-linear to the origin?: Because resources are not a perfect
substitute for each other. Few are more productive than others in a line of
production and will be preferred in employment.

1.5 Basic Concepts

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1.5.1 Function
A function f from a set A (independent) to set B (dependent) i.e. (f : A → B) is a
relation which associates for each element of x in A, a unique (exactly one) element
y in B, then the element y is expressed as,

y = f (x) (1.3)

y is image of x under f . An f is also called a map or transformation. If such a

function exists, then A is called the domain of f and B is called the co-domainor
range of f . In case of consumption function, income is domain and consumption is
co-domain or range.

The function shows relationship between two or more variables. It also specifies
independent and dependent variable.

Remember that there can be same values of dependent variable for multiple
value of the independent variable but not vice versa

Function exist if there is relationship between variables. For example, price changes
demand and vice versa. Therefore,
D = f (P ) and P = f (D)

Weight is function of age, but not vice versa. Not necessary reverse function exist.
W = f (A) but not A=6 f (W )

Two variables are not always related in function. For example, Once weight and
others age are not related. i.e WA 6= f (AB )

Box 1.1. Activity

Similarly, take few pairs of different variables and check if the exist function or
not.

1. Hight of parents (h) and hight of child (c)

Yes, there exist relationship
Therefore, c = f (h)

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 2. Income of individual (Y) and hight of an individual (H)
No, there is no relationship
Therefore, H 6= f (Y ) and Y 6= f (H)

1.5.2 Equation

Function is a general relationship, to use it in a particular event we have to specify it

to the event. It is called specification of function. After specification we get a specific
relation between dependent and independent variable in the form of an equation.
Thus equation is a specification of function. It means in the given set of conditions,
relations are true as per equation. If conditions changed relations may change.

Now remember the law of demand, in which demand is dependent variable and price
is independent variable. It means change in demand is caused by change in price not
em vice versa. We can say that price is cause and demand is caused.

Box 1.2. Answer the following questions.

1. What is edible oil consumption of your family at market prices in the

last year?
Ans: 5 litre/month i.e 60 litre/year.

2. What quantity of oil will your family consume if it is offered free of cost?
Ans: 80 litre/year.

3. What will be effect of increase in price by |1 on your consumption.

Ans: Demand will decrease by 2 litre.

The we can write the demand function of your family as,

D = 80 − 2p (1.4)

Note that dependent variable is expressed as a function of independent variable. Also

check that relationship between them is inverse. It is inverse when price term carries
negative sign when compared with standard form of equation.

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 Box 1.3. Activity

Similarly, you can frame questions and answers to specify

• Supply Function: price (p) independent variable and supply (S) dependent
variable.

• Consumption Function: income (Y ) independent variable and consump-

tion (C) dependent variable.

• Loan demand function: the rate of interest (i) independent variable and
amount of loan (L) dependent variable.

1.5.3 Identity

Function shows relation in general, an equation shows a relation under specific

conditions, while identity shows relations which are all time true or universal relation.
Identities are shown by ≡ sign. Identity is an equation that is always true.

For example, income and expenditure are equal in the long-run. Export and import
are equal in the long run.

Box 1.4. Activity

Find few more identities in economics and out of economics.

1.5.4 Curve

A curve is a graphical presentation of equation. When values of a dependent variable

are plotted for different value of independent variable, it gives a curve. While plotting
a curve an independent variable is measured along the X-axis and dependent variable
along the Y-axis.

In case of an inverse relationship between the variables, the curve is downward sloping,
e.g. demand curve, while direct relationship is represented by upward sloping curve,

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i.e. supply curve. If dependent variable is constant for all values of independent
variable, curve will be parallel to the axis of independent variable. If dependent
variable can assume any value at given constant value of independent variable, curve
is perpendicular to the independent axis.

If changes in dependent variable are smaller than change in independent variable, the
curve will be flatter. If dependent variable changes faster than independent variable
the curve will be steeper.

Box 1.5. Activity

1. Classify the curves of functions in the Box 1.3 as downward and upward
sloping curves.

2. Calculate slope of all segment of curves in Figure 6.12a and 6.12b i.e of
AB, BC, CD etc.

3. Draw linear demand and curves.

4. Draw a demand curve with diminishing slope.

5. Draw a demand curve with increasing slope.

6. Draw a supply curve with diminishing slope.

7. Draw a supply curve with rising slope.

1.5.5 Slope

Slope is on of the most important attributes of curve. It shows rate of change in

dependent variable as against a unit change in dependent variable. It is ratio of
change in dependent variable to change in independent variable. It is equal to tan θ
where θ is an angle made by the curve or by its tangent at the given point with
X-axis.

Slope of a curve rising upward from left to right is positive and that of a curve
falling from left to right is positive. A flatter curve has smaller slope and steeper

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 A G

15 15
14 14
−dy dy
dy dy
12 slope =− dx 12 slope = dx
marginal utility

marginal utility
B F
dx dx

9 9
C E

5 5
D D

E C
F B
G A
0 0
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Demand Demand

(a) Negative Slope (b) Potisive Slope

Figure 1.4: Slope

curve means larger slope. Slope of a curve parallel to X-axis is zero and slope of a
curve parallel to Y-axis is ∞. Slope is a cardinal number without unit. It is visual
presentation. Change of scale of measurement along the axes causes change in slope
of the curve. Therefore, it must be used carefully.

Box 1.6. Activity

1. Calculate slope of all segment of curves in Figure 6.12a and 6.12b i.e of
AB, BC, CD etc.

2. Draw linear demand and curves.

3. Draw demand and curves with diminishing slope.

4. Draw demand and supply curve with increasing slope.

1.5.6 Average and Marginal Concepts

Average is ratio of total value of dependent variable to total value of dependent

variable. Or it is value of dependent variable per unit of independent variable. It is

13
slope of the line joining a given point of curve to the origin.
Total Cost TC
Average Cost (AC) = = (1.5)
Total Output Q

Marginal means change in dependent variable due to a unit unit change in independent
variable. It is ratio of change in dependent variable to change in independent variable.
It is the first order derivative of the function or a rate of change. It is change in
dependent variable due to a unit change in independent variable.
Change in Total Cost d(T C)
Marginal Cost (AC) = = (1.6)
Change in Total Output dQ

Example 1.1. Rohan secured 532 marks writing 7 exams each of 100 marks in his
10 grade examination. After two years he appeared for 12 grade examination secured
406 marks while writing exam of 600 marks. Calculate his average marks in both the
exams as well as change in his average marks.

Example 1.2. Rohan secured 600 marks writing 8 exams each of 100 marks in his
10 grade examination. After two years he appeared for 12 grade examination secured
1200 marks while writing 10 exams each of 150 marks. Calculate his average marks
in both the exams as well as change in his average marks and percentage marks.

1.5.7 Derivative
Derivative calculates rate of change. It is a marginal concept. For example, we know
that when a consumer consumes more of a good utility increases, the rate at which
it is increasing is calculate by derivative of the total utility function.

At simplest level we can summarise derivative as,

1. Derivative of a constant cumber is zero.

dy
2. If, y = axn the derivative of the function is = a · n · xn−1
dx

dy du dv
3. if y = u + v then = +
dx dx dx

dy du dv
4. if y = u − v then = −
dx dx dx

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Example 1.3. Differentiate the following functions with respect to (w.r.t.) the
independent variable.

1. y = 10 10. C = 4q 6

2. y = 10 + x 11. C = 300 + 0.4Y

3. z = k (k is constant) 12. Q = 4040 + 3p

13. Q = 3400 − 5p
4. y = 5 + x 2
14. L = 5000 − 0.09i
5. y = 7 − 4x 4
15. U = 4q1 q2
6. U = 4q 2
16. T R = 4Q − 0.2Q2
7. C = 4 + 3q + q 2
17. U = 4Q2
8. R = 200 + 5x
18. U = 3pq (p is constant)
9. C = 430 − 3x 2

Questions

1. Define business economics. Write its features, scope and importance. Or

Write a detailed note on Business Economics. (Long answer)

2. What is production possibility curve? Explain its shifts. (Long answer)

3. Short answers for 1) rate of transformation 2) function 3) Equation 4)

Identity 5) Curve 6) Slope 6) Average and marginal concepts 7) Derivative
examples

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Chapter 2

Demand Analysis

Demand for a good is a desire to buy backed by the ability to pay and willingness to
buy the good. The demand for a commodity at a given price is the quantity that
consumers buy at that price during a period. People demand good(s) or any unit of
a specific good, if it is useful or give(s) utility worth of the price to be paid.

Demand analysis searches the factors that influence the demand and their pattern
influence. It is a multivariate relationship. Goods can be classified as intermediate
goods and final goods. Final goods can ve reclassified as consumption goods and
investment goods. The traditional theory of demand deals only with final and
consumption goods. The traditional theory also assumed that firms sell their product
directly to the consumer who follows the axiom of utility maximisation. Consumer
behaviour is studied with two approaches - cardinal and ordinal.

2.1 Demand Function

Demand is a multivariate function, i.e. demand depends on multiple factors simulta-
neously. The demand function shows the relationship between quantity demanded
and the factors that influence demand. When this relationship is expressed in a
mathematical form, it is called the demand function. Demand the function can be

17
expressed as,
Qz = f (P, Y, P0 , T, N, W, L, G, Dt−1 , Yt−1 ) (2.1)

The most important demand determinants are,

1. Price (P ): The most important, quicker and urgent factor to influence the
demand for goods is the price of the same good. It is most important because
it is true for all commodities, in the short and long run. It is quicker because
no other factor impacts demand so directly and quickly as price does. It is the
most urgent because in the very short run (buyer and seller are on the counter)
it is the only factor to affect the demand. There is an inverse relationship
between price and demand, where the price is an independent variable (the law
of demand).

2. Consumers Income (Y ): The second most important factor to influence

demand is the income of consumers. Income forms the base for demand,
therefore, when it increases the demand grows stronger. There is a direct
relationship between consumers’ income and the quantity demanded.

3. Prices of other commodities (PO ): This is the strongest distortion in the

demand for a given commodity. Depending on the kind of effect, goods are
classified as substitutes for or complementary to the given goods. If an increased
price of other goods causes demand increases they are called substitutes for
each other and if increased price results in decreased demand they are called
complementary to each other.

4. Consumer’s Taste (T ): The consumer’s taste is also a cause of change in

demand which becomes stronger with an increase in the former. Change in
taste means a change in the degree of liking or dislike for the good.

5. Income Distribution (Gini coefficient): Equal distribution of income

causes higher demand and unequal distribution of the same income causes
lower demand. It is because with equal distribution of given income people can
imitate the consumption of each other. Under unequal distribution, the poor
cannot imitate the rich because they don’t have purchasing power and if the
richer imitate the poor their demand will decrease.

6. Total Population (N ): An increase in population needs an increased quantity

18
 of all goods, therefore, market demand for the goods increases.

7. Consumer’s Wealth (W ): People are likely to demand more with an increase

in their wealth and lesser with decrease in their wealth.

8. Credit Availability (L): An availability of credit increases the money supply

and market demand for goods. Therefore, the demand which otherwise would
have materialised in the future is preponed.

9. Government policy (G): The government may have a policy either to

encourage or discourage aggregate demand or demand for a specific commodity.
When there is unemployment in the economy government encourages demand
and when there is inflation, the government discourages demand.

10. Past Demand (Dt−1 ): In general the higher the past demand the more will
be the current demand.

11. Past Income (Yt−1 ): The past level of income also influence consumption.
The higher the past income, the more will be present demand.

The above function 2.1 shows that the quantity demanded of a commodity depends
on the price of the same commodity, the income of the consumer, prices of other
commodities, taste, climate, promotion or advertisement etc. In the above function,
variables may change simultaneously or independently. But the function does not
specify the resulting change in the demand due to the given change variables. If we
want to find such an effect, we will have to specify1 the demand function.

The traditional theory of demand is partial equilibrium analysis i.e it considers only
a few factors, a part of the market, only final goods and the final consumer, which is
not the reality in modern economies. It does not deal with the demand for investment
goods and intermediate goods. Also assumes that there is no lag between supply and
demand.

Utility

The utility is wants satisfying power of a good. The more is the quantity of good the
more will be utility. The change in total utility because of the last unit of consumption
1

19
is called marginal utility. Marginal Utility refers to an additional utility derived by
the consumer from an additional unit of the good. In consumption consumer attach
equal importance neither to different goods nor to different units of the same goods.
For him some goods are more urgent and important than other. Therefore, he will
buy some goods but not other. He will buy a good if it is useful and will not buy it
it is not useful for him.

Now question how much of a good consumer will buy. The answer is decided by the
law of diminishing marginal utility.

2.2 Law of Diminishing Marginal Utility

The law of diminishing marginal utility describes a familiar and fundamental tendency
of the human behaviour. It states that: “As a consumer consumes more and more
units of a good, utility from the successive units goes on diminishing”. Marshall
states, “The additional benefit which a person derives from an increase in his stock
of a thing, diminishes with every increase in the stock that he already has”. Similarly,
we can say that with every diminution of his stock, the marginal utility goes up. In
other words, ceteris paribus marginal utility of good varies inversely with the stock
of goods. When a consumer increases consumption, an additional satisfaction from
each successive unit diminish.

Table 2.1: Diminishing Marginal Utility

Units 0 1 2 3 4 5 6 7 8

TU 0 5 9 12 14 15 15 14 12

MU – 5 4 3 2 1 0 -1 -2

The Table 2.1 and Figure 2.1 show that with every increase in consumption, total
utility increases but diminishing rate, reaches at the maximum when M U = 0, and
then declines when M U < 0. This quantity at which total utility is maximum or
marginal utility is zero is called a satiation quantity or satiety point.

Why does marginal utility fall?

The law of diminishing marginal utility is based on three facts.

20
 15
14
12

marginal utility
9

−3
1 2 3 4 5 6 7 8
Demand

Figure 2.1: The Law of Diminishing Marginal Utility

• Firstly, total wants are unlimited but every single want can be fully satisfied.

• Secondly, Different goods are not perfect substitutes for each other. Had goods
been perfect substitutes for each other, they would have satisfied other wants
also and marginal utility would not have diminished.

• Thirdly, The marginal utility of money is assumed to be constant. It is because

none can be used to satisfy nearly for wants.

Derivation of the Demand Curve

The marginal utility is a change in total utility ∆T U due to change in consumption

∆q or slope of the total utility function ∆T U/∆q. The marginal utility decreases
with an increase in consumption of commodities. Therefore, total utility increases,
but at a diminishing rate, up to a certain quantity where it reaches the maximum,
say x, and then starts declining when the marginal utility becomes negative.

If marginal utility is measured in monetary units, where 1 util is equivalent to 1 unit

of currency, the demand curve is identical to the positive segment of the marginal
utility curve. At point A, marginal utility M U1 is equal to P1 . Hence at price P1 ,
consumer demand is x1 . Similarly, at demand x2 , marginal utility is M U2 which is
equal to P2 . Hence at price P1 , consumer demand is x2 .

21
Marginal Utility and Demand

The diminishing marginal utility provides a simple rationale for the law of demand.
It supports the idea that price must fall to make the consumer increase his demand.
Because of an increase in the stock of a good, the marginal utility will diminish and
the consumer will purchase more of the good only when additional units are available
at a lower price. Thus, the negative slope of the demand curve is due to diminishing
marginal utility.

2.3 Importance of the Law of DMU

The law of diminishing utility has a great practical importance in economics. The
law of demand, the theory of consumer surplus, and consumer equilibrium are based
on the law of diminishing marginal utility.

1. To buy or not: To buy the first unit of a good or not is decided by the
consumer based on its (marginal) utility. If he thinks that the utility from the
first unit (i.e. its marginal utility) is greater than or equal to the utility of
the amount of money to be paid as price, he will buy, otherwise not. If the
utility of the unit is lesser than utility of the amount to be paid, the consumer
prefers the amount to the unit. To summarise, will buy if M U1 ≥ P rice and
M U1 < P rice will not buy.

2. Basis of Demand Curve: The law of diminishing marginal utility and the
law of demand is closely related to each other. The law of demand is a special
case of the law of diminishing marginal utility. If one unit of utility util costs
one currency unit, the demand curve will be same as the M U curve. If it costs
more than one unit of currency, the demand curve will be below the M U curve
and if it costs lesser than one unit of currency, the demand curve will be above
the M U curve. In Figure ??, point A on demand curve D corresponds to price
|1 and unit demand. In Figure ?? price of 1 until is less than |1 and the
consumer will have more than 1 utils with 1 unit consumption. Therefore, the
marginal utility curve lies above the demand curve. In Figure ?? price of 1
until is |1 and consumer will have 1 utils with 1 unit consumption. Therefore,
the marginal utility curve same as the demand curve. In Figure ?? price of
1 until is more than |1 and the consumer will have less than 1 util with 1

22
 unit consumption. Therefore, the marginal utility curve lies below the demand
curve. This is only a theoretical explanation, as there is no well-defined unit
called util and no need to consider its price different than |1. Thus, by default,
1 util = |1 and the marginal utility curve are the same as the demand curve.

3. Water-Diamond Paradox: As you know price offered for a unit of a good

is equal to the marginal utility of that unit. If a diamond is being bought at a
higher price its marginal utility must be high and when water is cheaper its
marginal utility must be low. Marginal utility is higher at a lower quantity
and smaller at a larger quantity. It means a smaller quantity of diamond and a
large quantity of water is being sold and bought. The reason behind this lies
on the supply side i.e diamonds are short in supply and water is plenty.

u/p

CS on Water

CS on Diamond

δ D

w W

O
Q

Figure 2.2: Water-Diamond Paradox

In Figure 2.2 marginal utility of the first unit of water is much larger than
that of water. Diamonds being short in supply are bought at the upper point
(W) of the demand curve while water being plenty is bought at the lower point
(W) of the demand curve. This results in higher marginal utility and price
of demand and lowers marginal utility and price of water. This generates a
smaller consumer surplus on diamonds and a larger one on the water. Thus,
buyers are to pay for the nearly full value of the diamond while only small parts
of the value of water will be paid. Thus, we can say due to the non-availability
of consumer surplus diamonds are costlier and water is cheaper because there

23
 is plenty of consumers.

4. Importance to a Consumer: A consumer, to get maximum satisfaction, has

to distribute his income among goods in such a way that the marginal utility of
his income in all the uses is equal. Here again, the concept of marginal utility
helps the consumer in deciding his budget for each good.

5. Taxes and Subsidies: It is assumed that the law of diminishing marginal

utility does not apply to money. This assumption is useful to simplify economic
analysis but is not practical. If it is true that income is acquired for the
procurement of goods and wealth itself is good, and every unit of a good is
equivalent to a certain amount of money. Then along with diminishing marginal
utility, the marginal utility of money must fall. When a particular amount is
collected from rich people and transferred to the poor as a subsidy comparative
rich will lose smaller utility and the poor will gain larger utility. Therefore,
taxes on the rich and subsidy the poor is advisable.

2.4 The Law of Equi-marginal Utility

It is simply an extension of the law of diminishing marginal utility to more than one
good. Every prudent person has to make the best possible use of his resources to
maximise his satisfaction. For this purpose, he will compare the marginal utilities
of different goods and will substitute high marginal utility goods for low marginal
utility goods. While doing so the consumer will maximise his utility.

The law of equi-marginal utility states that, when prices of goods are equal, total
utility from consumption would be the maximum when marginal utilities of all goods
are equal. If the marginal utility of all goods in consumption is not equal, the
consumer gains by substituting higher marginal utility goods for lower marginal
utility goods.

But in reality, prices are not equal, therefore, we will have to modify the law to
compare the marginal utility of money in different goods. In cardinal utility analysis,
this law is stated by Lipsey, “The household, maximising the utility, will so allocate
the expenditure between commodities that the utility of the last penny (unit of
money) spent on each item is equal”. The law of equi-marginal utility states that

24
“A rational person, to get maximum satisfaction, allocates his expenditure between
different goods in such a way that utility of the last rupee spent on each good is
equal”.

To get maximum satisfaction out of the given fund (money), the consumer carefully
weighs the satisfaction obtainable from each rupee that he spends. If he found that a
rupee spent on commodity A gives greater utility than a rupee spent on commodity
B, he will spend more on A and lesser on B. In other words, he substitutes a good of
higher utility/rupee for a good of lower utility/rupee. As a result of this substitution
and operation of the law of DMU, MU of A will fall and that of B will rise. This
will be continued until the marginal utility/rupee of two commodities is equal. That
is why this law is also called the law of substitution or equi-marginal utility. This
law has been illustrated with the help of the 2.2.

Suppose a consumer has |38 income (Table 2.2), price of good A, B and C is |3, |2
and |1. He will go on spending as per marginal utility. By the time has spent |38,
he would have 7, 6 and 5 units of commodity A, B and C respectively. He will also
find that total utility is 217 utils and MU/|is 3 units in all 3 goods.

Table 2.2: Law of Equi-Marginal Utility

Q 1 2 3 4 5 6 7 8 9

M UA \U nit 27 24 21 18 15 12 9 6 3

M UA \| 9 8 7 6 5 4 3 2 1

M UB \U nit 16 14 12 10 8 6 4 2 0

M UB \| 8 7 6 5 4 3 2 1 0

M UC \U nit 7 6 5 4 3 2 1 0 -1

M UC \| 7 6 5 4 3 2 1 0 -1

If the consumer decreased consumption of any good to increase that of others, his
satisfaction will decrease. Suppose he decided to consume one unit less of good A,
he will lose 9 utils and |3 will be released.

1. If he uses |3 to increase consumption of each good B and C by 1 unit. He loses

9 utils and gains 4+2=6 utils.

25
 2. If he spent |3 only on good C, He loses 9 utils and gains 2+1+0 = 3 utils from
consumption of 5th, 6th and 7th units of good C.

3. If |3 is used for good B only, he will have 1.5 units more and a utility of 5 utils
from good B. Here also he loses a net 4 utils. Thus, by making a reshuffling in
consumption he loses.
mu

O
6 5 7 Q
mub mua
muc

Figure 2.3: Law of Equi-Marginal Utility

Thus, by making any type of reshuffle in the consumption combination, the consumer
does not gain but certainly loses. Therefore, it is advisable to consume in such a way
that MU/| in each line of consumption is equal, because it maximises satisfaction.
Mathematically it can be expressed as,
M U1 M U2 M U3 M Un
= = = ··· = (2.2)
P1 P2 P3 Pn

2.5 Practical Importance of the Law of EMU

The law of equi-marginal utility has wide applications in almost every sphere of
economic affairs. In Samuelson’s words, "It is not merely a law of economics, it is a
law of logic itself". It is called the law of substitution because it tells us why and how
to substitute one good for another. It is also called the law of maximum satisfaction
because it explains the principle of satisfaction maximisation. It is called the law
of equi-marginal utility because it discusses what happens if the marginal utility of
goods is equal. The law is also known as the law of indifference because marginal
utilities of goods in consumption are indifferent to its fulfilment. It is also called a
proportionate rule because the ratio of marginal utility to the price is equal for all
goods.

26
1. Consumption: In the field of consumption, the law tells how a consumer
should spend his income or resources to secure maximum utility. The law not
only does explain the number of units of various goods to be consumed but
also helps the consumer in allocating his income among the multiple goods.
Further, a decision regarding the proportion of income to be spent and to be
saved is guided by the law.
M U1 M U2 M U3 M Un
= = = ... = = M UM (2.3)
P1 P2 P3 Pn
It means that a consumer should spend in such a way that the marginal utility
of money in each good as well as in saving is equal.

2. Allocation of Resources or Factor Income Maximisation: To suit pro-

duction, the law can be modified as the law of equi-marginal productivity.
Remuneration to the factors is decided by factor productivity. Factor owners
would like to shift factors from one use to another in search of higher remunera-
tion. According to this law, total remuneration to the factor owner will be the
maximum when the marginal productivity of factors in each line of production
is equal.
M P A = M PB = M P C = . . . = M P n (2.4)
Where M PA , M PB , M PC , M PN are marginal products

In a case of inequality in marginal factor productivity among different uses, the

factor owner will shift factors from lower productivity uses to higher productivity
uses. The process of shifting will continue until factor remunerations among
the uses are equal.

3. Factor Combinations: Firms would like to substitute more productive factors

for less productive factors. The output would be maximum when the marginal
productivity of each factor is equal. It means high productivity factors will be
used in a larger quantity than low productivity factors. If the prices of factors
are different it will be decided based on the ratio of marginal productivity to
the factor remuneration.
M PL M Pn M PC M Pπ
= = = (2.5)
r w i π

4. Barter Exchange: The law of equi-marginal utility is also applicable in barter

27
 exchange. Under barter exchange, low utility goods are exchanged for high
utility goods. The exchange will continue, until the marginal utility of a good
received, is equal to that of the good given up. This condition is true for both
parties in the exchange. When consumer exchanges commodities for money,
the process of exchange is no way different. The consumer will buy more till
the MU/|of the good becomes equal to the marginal utility of rupee for him.

M UA = M UB = M UC = . . . = M Un (2.6)

5. Distribution and Price Determination: We know that production is a

result of joint efforts of different factors of production (i.e., land, labour, capital
and entrepreneur). The remuneration of factors (rent, wages, interest and
profits) in the production process is determined by the principle of marginal
productivity. The producer will employ each factor in such a way that remu-
neration is equal to the marginal productivity of the factor.

M PL = r, M PN = w, M PC = i, M PE = π (2.7)

6. Public Finance: The modern states are welfare states, which undertake
various expenditures for social welfare. The Government can realise its objective
to achieve a maximum social advantage through applications of the law of
substitution in taxes, subsidies and debt.

• The welfare state has to spend on the various heads so that the marginal
benefit (utility) is equal in all the heads, thus benefit from the expenditure
is maximum. i.e.
M SB1 = M SB2 = b

• The tax should be collected in such a way that marginal sacrifice (disutility)
of rupee in all taxes and to all taxpayers is equal. i.e.

M SS1 = M SS2 = t

• To gain maximum social advantage marginal benefit from the public

expenditure should be equal to marginal social sacrifice from the tax
payment.
b=t

28
2.6 The Law of Demand
The law of demand states relationship between demand and price. The demand for
anything, at a given price, is the quantity bought per unit of time. It simply means
how much a person is willing to buy of a commodity at the given price. “By demand,
we mean various quantities of a given commodity or service which consumers would
buy in one market in a given period at various prices, or various incomes or various
prices of related goods.” (Bobber)

The law of demand expresses the relationship between the price of a good and
quantity demanded, ceteris paribus. The law states that demand varies inversely
with price, not necessarily proportionately. If the price falls, demand will increase
and vice-versa.
1
q∝ (2.8)
p
Remember that the law of demand is a two-variable function in which price is an
independent variable and demand is a dependent variable.

q = f (p) (2.9)

Suppose that we have to specify the demand function as a linear function y = c + mx.
Remember that

• Beyond a certain higher price consumer will buy nothing i.e there is Y-intercept.

• Even at zero price consumers will buy the limited quantity, that is there is an
X-intercept.

• there is an inverse relationship between price and quantity demanded I.e it

slopes negative

Assuming that price is the independent variable and demand is the dependent variable,
the demand function can be written as

q = a − bp (2.10)

This is a linear demand function. a is X-intercept and shows the quantity consumer
will buy at zero price. −b is the slope of the demand curve and shows required
price variation to change demand by one unit. Its negative sign indicates an inverse
relationship between demand and price.

29
 Price

A
P1

B
P2

D
O
Q1 Q2 Demand

Figure 2.4: The Law of Demand

Why demand curve slopes downward?

Remember that the law of demand is price effect I.e the effect of price on demand.
It involves other two effects, substitution and income effect.

With price changes, the goods will be relatively cheaper or costlier than other goods.
Therefore, cheaper goods will be substituted for relatively costlier goods. This is the
substitution effect.

A change in the price of a good changes purchasing power of consumer. That is he

becomes better-off than before with fall in price and worse-off than before with rise
price. Being richer or poorer than before, consumer will consume more with a fall in
price or less with a price rise. In case of inferior good opposite is true. It means the
substitution effect always increases demand on fall price, but the income effect may
increase or decrease in demand.

Price Effect = Substitution Effect + Income Effect (2.11)

Thus, demand curve slopes downward because of the substitution effect of price
change.

2.6.1 Separation of Income and Substitution Effect

Think of a consumer, having a budget of |100, who consumes 5 units of each tea and
coffee when the price of both is |10. If the price of tea falls to |5 and that of coffee

30
remains the same, the consumer becomes better-off than before or his real income
increases.

To keep consumers neither better off nor worse off than before, we will keep with
him |75 i.e. price of 5 units of each tea and coffee. Such a change in income (|25) is
called compensated variation.

In the new price and income situation, the consumer can buy 5 units of each tea
and coffee. But now he may prefer to substitute cheaper tea for relatively costlier
coffee. Thus, consumption of tea will increase and that of coffee will decrease. This
change in consumption is called the substitution effect because the change intends to
substitute one good for another.

1. Say, a consumer reduces the consumption of coffee by one unit and increases
that of tea by two units, then the substitution effect in the terms of tea would
be +2 units and in the terms of coffee -1 unit.

2. If he reduced consumption of coffee by two units and increased consumption

of tea by 4 units, then the substitution effect in the terms of tea would be +4
units and in the terms of coffee -2 units and so on.

Now we will allow the consumer to be better off than before due to falling in the
price of tea, by returning him compensated variation of |25. Being richer than before,
he may increase his consumption of tea or/and coffee. This change in consumption
is an income effect because it is caused by a change in real income.

Table 2.3: Substitution and Income Effect

Coffee Tea Substitution or Income Effect

Original Rs. 100 5 5 ——

Rs. 75 4 7 -1C/2T Substitution Effect

Final Rs 100 6 8 2C/1T Income Effect

1. Say, with Rs. 25 consumer increased consumption of only tea by 5 units, then
income effect in terms of tea is +5 units and in terms of coffee 0 units.

2. If he bought only coffee, the income effect would be 0 units of tea and 2.5 units
of coffee.

31
 3. If he bought 1 tea and 2 coffee with |25, then the income effect in terms of tea
would be +1 and in terms of coffee +2 and so on.

Thus, the substitution effect and income effect are always there in the price effect or
the law of demand.

Normal, Inferior and Giffen Goods

p p Y Y
d2 d3

d1 d4
O O O O
Q Q Q Q

(a) normal (b) Giffen (c) normal (d) inferior

Figure 2.5: Normal, Inferior and Giffen Goods

On the decrease in the price of demand

• increases - it is a normal goods

• decreases but not enough to overcome the substitution effect - it is inferior

good.

• decreases and enough to overcome the substitution effect - it is Giffen good.

Thus we can say that it is the substitution effect because which demand curve slopes
downward.

2.7 Exceptions to The Law of Demand

1. Giffen Goods: All normal goods obey the law of demand. Sir Robert of
Ireland observed that poor people used to spend more of their income on
inferior goods like potatoes when they are costlier and had lesser income on
meat, where the potato was a staple food. When the price of potatoes increased,
after purchasing potatoes people had not enough money to buy meat, so they
bought potatoes, instead of meat. Thus, a rise in the price of potatoes compels

32
 Original New 1 New 2 New 3

W@25/kg-25 kg W@30/kg-25 kg W@30/kg-30 kg W@20/kg-20 kg

R@50-5 kg R@50-5 kg R@50-0 kg R@50-10 kg

625 + 250 750 + 250 900 +0= 900 400 + 500

875 1000 900 900

Uneasy Easy Easy

the poor to buy more of them. This is against the law of demand. This is
known as the Giffen paradox.

Suppose a family needs 1 kg of food either wheat or rice every day. Wheat
is their staple food. In a month the family consumes wheat for 25 days and
rice for 5 days. Thus, the family requires 25 kg of wheat and 5 kg of rice per
month. Suppose wheat costs |20 and rice |50. Thus, the monthly budget of
the family would be |500 + |250 = Rs. 750.

If the price of staple wheat rises to |25/kg, the new budget will |625 + rupees
250 = |875, which is unbearable for the family. To reduce the budget, they
may stop consuming costlier rice completely and only wheat for all 30 days.
This will bring their budget to |750.

2. Conspicuous Consumption: This exception to the law of demand is asso-

ciated with the doctrine, propounded by Thorsten Veblen and is applicable
for goods like diamonds, which can be purchased by only the rich and wealthy
section of society. The prices of these goods are so high that they are beyond
the reach of common. The higher the price of the diamond the higher its
prestige value of it. When the price of these goods falls, the prestige value of
these goods comes down. So the quantity demanded of these goods falls with
the fall in their price. So the law of demand does not hold.

3. Conspicuous Necessities: Certain things become necessities of the modern

lifestyle, so we have to purchase them despite their high prices. The demand
for T.V. sets, automobiles and refrigerators etc. has not gone down despite
increased prices. These things have become a symbol of status. So they are
purchased despite their rising price. These can be termed as “U” sector goods.

33
4. Ignorance: A consumer’s ignorance may induce him to purchase more of the
commodity at a higher price. This is especially so when the consumer phobia
is the higher the price the better the quality.

5. Emergencies: Emergencies like war, famine etc. negate the operation of the
law of demand. During such times, households behave abnormally. Households
accentuate scarcities and induce further price rises by purchasing more at a
higher price. During the depression, on the other hand, a fall in price doesn’t
induce sufficiently the consumer to demand more.

6. Future Changes in Prices: Households act as speculators. When the prices

rise households may purchase large quantities out of the apprehension that
prices may still go up. When prices are expected to fall further, they wait to
buy goods at a still lower price in the future. So the quantity is demanded and
the price falls.

7. Change in Fashion: A change in fashion and tastes affects the market. When
a broad-toe shoe replaces a narrow-toe shoe in fashion, a fall in the price of the
latter is not enough to clear the stock. Broad toe, on the other hand, will have
more customers even though its price rises. The law of demand becomes invalid.

Long Answer to

1. Demand function

2. Law of Diminishing Marginal Utility

3. Importance of the law of DMU

4. Law of equilibrium-marginal Utility

5. Practical Importance of the Law of EMU

6. The Law of Demand

7. Exceptions to The Law of Demand

34
Chapter 3

Elasticity of Demand

3.1 Concepts of Elasticity

The law of demand states that demand varies inversely with price, but it does not tell
us how much will be a change in demand for a given change in the price of the good.
To know this we will have to estimate the demand function. The demand function
is used to find demand at different prices. The elasticity of demand expresses the
relationship between demand and other factors. The elasticity of demand studies the
nature of change in demand due to different stimuli. These stimuli may be the price
of the same good or any other good, the income of the consumer, or other stimuli
capable of influencing the demand.

Demand for a good is a function of different factors like price, income, price of other
commodities, taste, fashion, climate, place etc. Change in any one or all of them
leads to change in demand. This phenomenon of demand to give response to change
in stimuli is known as elasticity of demand. The elasticity of demand can be defined
as a degree of responsiveness of demand to change in stimuli or the factors affecting
demand. It can be calculated as the ratio of proportionate (∆q/q) or the percentage
change in demand to proportionate (∆v/v) or percentage change in stimulus variable.

35
Demand Elasticiity (ep ),

Proportionate change in Demand

ep =
Proportionate change in Stimulus Variable
dq/q
=
dv/v
dq v
= × (3.1)
dv q
Depending on the factors affecting demand, elasticity can be called price elasticity,
income elasticity, cross elasticity, promotional elasticity etc.

3.2 Price elasticity (ep )

When a stimulus to change in demand is price, elasticity is called price elasticity of
demand. It is a responsiveness of the demand to changes in price. It can be given
as the ratio of percentage or proportionate change in demand to the percentage or
proportionate change in price.

Price Elasticiity (ep ),

Proportionate change in Demand

ep =
Proportionate change in Price
∆q/q
=
∆p/p
∆q p
= × (3.2)
∆p q
If change in price is infinitesimally small ∆q = dq and ∆p = dp

dq p
ep = × (3.3)
dp q
1 p
= ×
dp/dq q
But dp/dq is the slope of the demand curve.

1 p
ep = × (3.4)
slope q

36
Value of Price Elasticity

Price elasticity can be positive, zero or negative. It is positive for Giffen’s goods,
negative for normal goods and zero for neutral goods or goods towards which the
customer is neutral. It is low for life necessities and high for luxurious.

3.2.1 Degrees of Price Elasticity

Depending on value price elasticity is classified into the following degrees.

1. Perfectly Elastic: When elasticity is infinite, it is said to be perfectly elastic

demand. It means even infinitesimally small change in price causes an infinitely
large change in demand. In this case, the demand curve is parallel to the X-axis
or the slope of the demand curve is zero. The figure 3.1a shows that at price p
any quantity like q1 or q2 is sellable in the market.

cost cost

D
p2 A
A B
p D
p1 B

O q1 q2 O q
good good

(a) Perfectly Elastic Demand (b) Perfectly Inelastic Demand

Figure 3.1: Price Elasticity

2. Perfectly Inelastic: When elasticity is zero demand is perfectly inelastic.

It means any price change would cause no change in demand. In this case,
the demand curve is parallel to the Y-axis or the slope of the demand curve
is infinity. The figure 3.1b shows that irrespective of price p1 or p2 quantity
demanded remains constant at q units.

3. Relatively Elastic: When elasticity 1 < e < ∞, demand is said to be

relatively inelastic. It means a small percentage change in price will bring a
relatively bigger and opposite direction percentage change in demand. In this
case, the demand curve is flatter and downward-sloping. The Figure 3.2a shows
that for a change of price from p1 to p2 , demand changes q1 q2 which is larger

37
 per cent change than that in the price. Such goods are likely to be luxurious.

cost cost

A
p1

A
p1 B
p2 B
D p2

O q1 q2 O q1 q2
Output Output

(a) Relatively Elastic (b) Relatively Inelastic

Figure 3.2: Elasticity of Demand

4. Relatively Inelastic: When elasticity 1 > e > 0, demand is said to be

relatively inelastic. It means even a larger change in price would cause relatively
a smaller change in demand. In this case, the demand curve is steeper and
downward-sloping. The Figure 3.2b shows that for relatively larger change of
price from p1 to p2 , change in demand is smaller like q1 q2 . Such commodities
are generally essential.

5. Unitary Elastic: When price elasticity is one, demand is called unitary

elastic. It means any percentage change in price will bring the same but
opposite percentage change in demand. In this case, the demand curve is a
rectangular hyperbola. It means that area lying under any point of the demand
curve will be the same. Or irrespective of the price charged and quantity sold,
total consumer expenditure on that goodwill is constant.

3.3 Factors Influencing Price Elasticity

1. Nature of the need that commodity satisfy: In general, luxury or comfort
goods are price elastic, while necessary goods are inelastic in demand. It is
because there is an element of compulsion in the case of essential goods while
consumption of luxurious goods can be changed, preponed or postponed easily.

38
 price

D
O
good

Figure 3.3: Unitary Elastic Demand

2. Availability of Substitutes: When a close substitute for a good exists,

demand will be elastic; while the demand for goods having no substitutes
will be inelastic. Thus, elasticity increases with an increase in the number of
substitutes and vice versa e.g demand for petroleum products are inelastic in
the absence of substitutes.

3. Number of Uses of goods: A single-use good has less elastic demand

compared to multiple uses goods. It is because if multiple-use goods are
cheaper they will be put for more uses and demand will go up while at a higher
price they will be used for urgent uses only and demand will decrease.

4. Level of Consumer’s Income: Generally, the higher is income, the more

elastic the demand of the consumer. Suppose that depending on uses we
classified goods as basic, normal goods, and luxurious. Now we can say that
poor people consume more basic goods while rich people consume more luxurious
goods. Thus, the consumption of poor people is lesser elastic as compared to
that of the higher-income groups.

5. Proportion of Consumer’s Income Spent: Goods that occupy a smaller

proportion of the family budget tend to have a relatively inelastic demand.
While those that occupy a larger pie of the budget show elastic demand. It is
because goods which occupy a small proportion of income are likely to have
restricted use i. e. demand is not changeable. While goods which occupy a

39
 larger proportion of income are likely to have extended use and demand can be
decreased or increased.

This can be also because with a fall in price more money can be saved by
purchasing a larger quantity. Conversely, goods occupying a smaller proportion
of income are consumed in a smaller quantity and with a fall or rise in the
price, there would be no significant change in the budget.

6. Price Level: In the geometric method elasticity is measured as the ratio of

the lower segment of the demand curve to the upper segment of the demand
curve. From this method, we can infer that demand is more price elastic at a
higher price than demand at a lower price.

7. Level of Price Change: The demand for luxurious goods is lesser elastic at
the smaller change in price and more elastic at a larger price change. While
the demand for essential goods is likely to be equally elastic for smaller and
bigger price changes. This is because a smaller price change fails to convert
savings to expenditure as a larger change does.

8. Durability of Goods: In the case of durable goods, demand is inelastic in

the short run and elastic in the long run, while the demand for perishable goods
is elastic in the short run and inelastic in the long run.

9. Influence of Habits and Customs: There are certain articles which have
demand on account of conventions, customs and habits, they show inelastic
demand.

10. Time: In the short run demand tends to be inelastic and in the long run it
turns more elastic.

11. Recurrence of Demand: If demand for a good is recurring, its price elasticity
is higher than goods which are used rarely or once.

12. Urgency of Consumption: In the case of those goods which are urgently and
immediately required, demand will be inelastic. While demand for a commodity
where consumption is postponable, demand is elastic.

40
3.4 Income Elasticity (eY )
When a stimulus to change demand is a consumer’s income, elasticity is called income
elasticity of demand. It is a degree of responsiveness of demand to changes in income
of the consumer. It can be calculated as a ratio of percentage or proportionate change
in demand to the percentage or proportionate change in income i.e. Income Elasticity
(eY ),

Proportionate change in Demand

(eY ) =
Proportionate change in Income
∆q/q
=
∆Y /Y
∆q Y
= × (3.5)
∆Y q

Income elasticity can be positive, zero or negative. It is positive for normal goods,
negative for inferior goods and zero for unrelated goods. Income elasticity is lower
for life essential goods and higher for luxurious goods.

Determinants of Income elasticity

1. The nature of good: Depending on the proportion of the income spent that is
spent on the given commodity we can guess the nature of the good. i.e. Engel’s
Law

2. Level of income: Some goods are luxurious at a lower level of income while
they become a necessity at a higher level of income.

3. Time: Consumption pattern changes over time and therefore, income elasticity
changes.

Importance Income Elasticity

Based on forecasting the aggregate economic activities firm can forecast demand for its
product. If income elasticity is greater than one they will gain or lose proportionately
more than increase or decrease in national income respectively. Therefore, such firms
will closely observe the level of aggregate economic activities. Conversely, if income
elasticity is smaller than one they will gain or lose proportionately lesser than an

41
increase or decrease in national income. Such firms will not be more interested in
knowing the level of aggregate economic activities. It also reveals that the income of
farmers does not grow as that of other sectors.

3.5 Cross Elasticity (ec )

When a stimulus to change in demand for a given good is the price of another good,
elasticity is called cross elasticity of demand. It is a degree of responsiveness of
demand for a good x to the price of other good py . It can be given as,

Proportionate change in Demand of good X

(ec ) =
Proportionate change in price of good Y
∆x/x
=
∆py /py
∆x py
= × (3.6)
∆py x

Cross elasticity can be +ve, zero and −ve. It is +ve for substitutes, zero for unrelated
goods and −ve for complementary goods. A high +ve cross elasticity means goods
are better substitutes for each other and a high −ve elasticity of demand means
goods are the better complement of each other and zero cross elasticity means goods
are unrelated i.e. neither substitutes nor complements of each other.

Importance of Cross Elasticity

The concept of cross elasticity is very important to multi-product firms to evaluate

the effect of change in the price of other products on the demand for given products.

An industry is defined as a group of firms producing homogeneous products i.e.

products with high positive cross elasticity. The cross elasticity of demand is used to
define an industry.

It is also used to decide cases relating to anti-trust laws and monopolistic practices.
Cross elasticity of goods of firms merging will help to find out; whether mergers and
amalgamations will lead to monopoly or not.

42
3.6 Promotional elasticity (ea )
It is the responsiveness of demand to promotional activities like advertisement,
salesmanship etc. It can be given as,

Proportionate change in Demand

ea =
Proportionate change in Promotional Expenditure
dq/q
=
dA/A
dq A
= × (3.7)
dA q
Generally, promotional activity is positive.

3.7 Measurement of Demand Elasticity

When we know the demand function we can calculate the elasticity of demand with
reference to any stimulus, by differentiating the given function with respect to the
stimulus of interest. The calculus method is the best of all and is the expected
method of study. For example, the price elasticity of demand will be calculated as,

dq p
Price Elasticity (ep ) = × (3.8)
dp q
But due to a lack of knowledge of the exact demand function, we have to be satisfied
with statistical or geometrical methods only. These methods are not as precise as
the calculus method. Each of these methods has its own merits and demerits as well.

1. Ratio Method: This method calculates the elasticity of demand at a point

on the demand curve. For example, by this method price elasticity is calculated
as,

Proportionate change in Demand

(ep ) =
Proportionate change in Price
dq/q
=
dp/p
dq p
= × (3.9)
dp q

43
 This method can be used to measure all types of demand elasticity. This
formula shows that in the case of the straight-line demand curve, where the
slope is constant, the elasticity of demand is not constant, but diminishes with
an increase in the quantity demanded.

Being discrete, this method invites calculation for each price change separately.
Therefore, it is laborious.

2. Expenditure Outlay Method: In this method, one can know whether the
elasticity is equal to or less than or greater than 1. From this method, we come
to know, whether the commodity has relatively elastic or relatively inelastic
or unitary elastic demand. Or we can know if the commodity is a luxurious
commodity or an essential commodity or not distinguishable. This method can
be used to calculate price elasticity as follows.

If due to a price decrease, total sales proceeds increase demand is elastic if

it decreases demand is inelastic and if it remains constant demand is unitary
elastic.

Table 3.1: Total Outlay Method

Price 2 3 4 5 6 7 8 8 10

D 90 80 70 60 50 45 40 25 20

R 180 240 280 300 300 315 320 325 200

e >1 >1 >1 =1 >1 >1 >1 <1<1 –

This method is a counter method or yes-no type. It can be used to solve the
problem of urgent liquidity, but can not be a long-term policy variable.

3. Point or Geometric Method: If the demand curve is known we can calculate

the elasticity of demand at any point on the demand curve by the following
formula.
Length of Lower of Demand Curve
Price Elasticity (ep ) = (3.10)
Length of Upper of Demand Curve

If the given demand curve is a straight line, we can measure elasticity at any
point on it, simply by using the length of the lower segment and that of the

44
 price price

A A

B B

D
D
O O
C Q C Q

upper segments of the demand curve made by the point. But when the demand
curve is not a straight line but a curve, we will have to draw a tangential to
the demand curve at the point at which we want to calculate the elasticity
of demand. Then the length of lower and upper segments of tangential will
be measured and with the help of the above formula, we can calculate the
elasticity of demand.

This method is useful for stimuli which have an inverse relationship with the
quantity demanded. This method simply implies that if the demand curve is a
straight line, the elasticity of demand is not constant but goes on decreasing
with an increase in quantity. This method can be used only if the demand
curve is given.

4. Arc or Mid-Point Method: When we calculate the price elasticity of demand

by percentage or proportionate method, we face the problem of whether to
use the initial or final set of price and quantity as a base in the calculation.
This problem is more important when a price change is larger. To avoid this
difficulty we can use the average of initial and final price and quantity in the
calculation of elasticity of demand.

dq (p1 + p2 )/2
Price Elasticity (eP ) = ×
dp (q1 + q2 )/2
dq (p1 + p2 )
= × (3.11)
dp (q1 + q2 )

This method solves the problem of the reverse change paradox of elasticity
measurement i.e. if stimulus and demand changed from initial to final and back

45
 to the initial price-quantity set, the demand elasticity would be the same. But
it is highly aggregative. If the range of change is smaller will give good results;
but for a larger change, results can be misleading.

Example 3.1. Suppose that price of commodity increased from |5/- to |7/- and
therefore, demand decreases from125 units to100 units. Then calculate the elasticity.

Sol. Given q = 125 , p = 5, dq = -25, dp = 2

dq p
Price Elasticity (ep ) = ×
dp q
− 25 5
= × = −0.5
2 125

Example 3.2. Suppose a 5 per cent increase in price decreases by 24 per cent,
calculate the elasticity of demand.

Sol.
percentage change in demand
Price Elasticity(eP ) =
ercentage change in price
− 24
= = −4.8
5
The price elasticity of demand is -4.5 i.e relatively elastic. The good is normal.

Example 3.3. Due to rising in price from |5 to |6, demand for a good decreases
from 150 to 120 units.
(a) calculate the price elasticity of demand for forward and reverse the change.
(b) find the difference between elasticities measured with the ratio method and
mid-point method.
(c) guess out the nature of the good.

dp p
(a) Price Elasticity (ep ) = ×
dq q
p1 = 5, p2 = 6, q1 = 150, q2 = 120
=⇒ dq = -30 and dp = 1
− 30 5
× = −1
1 150

46
 dq (p1 + p2 )
(b) Price Elasticity (eP ) = ×
dp (q1 + q2 )
− 30 (5 + 6)
= ×
1 (150 + 120)
− 30 11
= × = −1.22
1 270
The difference between the elasticities measured with the ratio method and mid-point
method is 0.22.
(c) The good is normal because price elasticity is negative.

Example 3.4. A consumer changes his demand for a good from 80 units to 125
units in response to an 8 per cent change in price. Calculate the price of electricity.

Example 3.5. A seller of eggs planning to reduce the price of eggs from |6/unit
to |5/unit. His current sales are 200 dozen per day. The price elasticity of eggs is
estimated to be -0.7. Calculate his new total revenue.

Example 3.6. A demand function of a good is given as q = 2000 − 5p. Calculate

elasticity at price |10.

Sol ;

dq p
Price elasticity of demand(Pe ) = ×
dp q
whrere, p = 10
q = 200 − 5p
= 200 − 5 × 10
= 200 − 50 = 150
dq d(200 − 5p)
=
dp dp
= −5

By putting these values in the above equation,

10
(Pe ) = −5 ×
150
= 1/3

47
Example 3.7. Slope of the demand curve at price |210 and quantity 630 is -0.8.
Find price elasticity of demand.

Example 3.8. The equation of a straight line tangent to the demand curve, at price
|30 and quantity 40, is q = 120 - 2p, where p is price and q is quantity. Calculate
price elasticity.

Example 3.9. When the consumer’s income increased from |450 tp |600, he in-
creased his expenditure on a good from |60 60 rupees 75. Calculate the elasticity of
demand.

Example 3.10. Demand function of a good is q= 5000 + 2Y, where q is quantity

and Y is income. g Find out income elasticity if per capita income is |75000.

Example 3.11. The demand function of good is given as q = 2000 + 12Y - 2.1p,
where q is demand, Y is income in thousands and p is price. Calculate price and
income elasticities when p= 80 and y= |12 thousand. Also the fine effect of rising
prices on total revenue and rising income on sales.

Example 3.12. If two goods have a cross price elasticity of 1.5. (a) Decide if goods
are substitutes or complements. (b) If the price of one good rise by 10 per cent, what
would happen to the demand for other goods?

Example 3.13. A firm to increase revenue and profit increases price and advertising
expenditure by 5 per cent each. If the price elasticity of demand is -1.5 promotional
elasticity is 8 per cent. Would you predict an increase or decrease in total revenue?

Auestions
1. Elasticity and its types (price, income, cross and promotional)

2. Price elasticity its types (relatively elastic, relatively inelastic etc.)

3. Factors influencing price elasticity

4. Method of measurement of elasticity (ratio, outlay, geometric, mid point

method)

5. Short answers for:

48
(a) price elasticity, income, cross, promotional elasticity

(b) Problems or sums on all types of elasticity.

(c) Determinants and importance of income elasticity.

(d) Importance of cross elasticity

49
50
Chapter 4

Indifference Curve

Scale of Preference

Prof Hicks introduced the concept of “scale of preferences” of consumer as the

base of indifference curve technique. He discarded the Marshalian assumption of
cardinal measurement and suggested an ordinal measurement of utility. Ordinal
measurement1 means comparison or ranking. According to Hicks, the level of
satisfaction is comparable but not quantifiable. He mentioned that it is possible to
experience preferences by experiments; but satisfaction cannot be quantified. He
viewed utility as a level of satisfaction rather than an amount of satisfaction. The
level of satisfaction is a function of increasing stock of goods. The larger is the stock
of goods, the higher is the satisfaction and vice versa (more is better). A rational
consumer can arrange combinations of goods in the order of preferences. This is
known as scale of preferences.

Suppose a consumer consumes two commodities x and y as in the table 4.1. It means
that the first combination is preferred to the second which in turn is preferred to the
third combination. Consider the following array.

The scale of preference is a subjective drawn in the mind of consumer consciously or

unconsciously. It is drawn independent of prices of goods and consumer’s income. It

51
 Table 4.1: Preference Scale

Combinations
Sr. Satisfaction Scale of Preferences
A B

1 10 10 Highest I

2 07 07 Middle II

3 03 03 Least III

represents ordinal comparison of satisfaction. There are three axioms about consumer
preferences.

Indifference Schedule

When a consumer lays down his scale of preferences for different combinations of
two goods, he may come across some combinations which yield the same level of
satisfaction and prefers them equally. In such case, he is said to be indifferent between
combinations and combinations are known as indifference schedule.

Table 4.2: Indifference Schedule

Combinations

A B C D E F

Apple 1 2 3 4 5 6

Banana 20 15 11 8 6 5

Suppose that consumer consumes only two commodities i.e. apples and bananas as
shown in the Table 4.2. If the consumer consumes different combinations of apples
and bananas but derive the same level of satisfaction, the consumer is indifferent
between the combinations.

An indifference schedule shows different combinations of goods which yield the

same level of satisfaction. Thus, indifference schedule represents a part of scale of
preferences.

52
Indifference Curve

(x1 , y1 ) ∼ (x2 , y2 ) i.e consumer is indifferent between two combinations or with one
combination consumer would be as satisfied as with the other combination.

An indifference curve is a graphical presentation of indifference schedule. It is a locus

of points representing various combinations of goods which give an equal level of
satisfaction to the consumer. Suppose that consumer consumes only two commodities
i.e. apples and bananas. Apples are measured on X-axis and bananas on Y -axis.
Points A, B, C, D, E and F in the Figure 4.1 are taken from indifference schedule.
If we join all these points together, we get a curve known as indifference curve.

20
Bananas

10

6.66
5
3.3 IC

1 2 3 4 5 6
apples

Figure 4.1: Indifference Curve

Thus, an indifference curve can be obtained by plotting graphically all such combina-
tions which yield same level of satisfaction.

Indifference Map

An indifference map is a set of indifference curves. Indifference schedule shows

different combinations of two goods which yield same level of satisfaction. There can
be such several indifference schedules each representing different level of satisfaction.
Therefore, we can draw several indifference curves, each representing specific level of
satisfaction. A group of such indifference curves is called an indifference map.

Suppose a consumer consumes only two commodities i.e. x and y. His purchase of
two goods at different level of income will be different and is given in the Table 4.3.
There are three sets of combinations. All combinations in the same set give equal

53
 Table 4.3: Indifference Map

Combinations (xi , yj ) (xi , yj ) (xi , yj )

1 (1, 20) (1,25) (1,30)

2 (2,15) (2,20) (2, 25)

3 (3, 11) (3,16) (3, 11)

4 (4, 8) (4, 13) (4 ,18)

5 (5, 6) (5, 11) (5 ,16)

satisfaction. Therefore, we can draw three indifference curves as in the Figure 4.2.

25

20

15
Bananas

10

IC4
5 IC3
IC2
IC1
0
0 1 2 3 4 5 6
apples

Figure 4.2: Indifference Map

Marginal Rate of Substitution

The concept of marginal rate of substitution is the rate at which a consumer is ready
to exchange or substitute one good for the other. It is price of one good in terms of
other good. It shows how many unit of other good consumer is ready to give up to
have one unit of the given good.

54
 no. of units of y consumer ready to give up
M RSxy = (4.1)
no of units x consumer receives
change in consumption of y
M RSxy = (4.2)
change in consumption of x
change in consumption of x
M RSyx = (4.3)
change in consumption of y

Table 4.4: Marginal Rate of Substitution

Com. X Y Y:X MRSxy MRSyx

A 1 20 — — —

B 2 15 - 5:1 -5 - 1/6

C 3 11 - 4:1 -4 - 1/4

D 4 8 - 3:1 -3 - 1/3

E 5 6 - 2:1 -2 - 1/2

F 6 5 - 1:1 -1 - 1/1

G 7 4.2 -0.8:1 - 0.8 - 10/8

(1,20)

(2,15)

(3,11)

(4,8)
(5,6)
(6,5)
IS

O
L

Figure 4.3: Iso-quant is convex

55
In the Table 4.4, consumer while moving from point A to B is ready to give up 5 units
of good y for an additional unit of good x. Therefore, marginal rate of substitution
of X for Y (M RSxy ) is 5. While M RSyx is 1/5. Thus, M RSxy and M RSyx are
inverse of each other.

The Table 4.4 and Fig.4.1 shows that as consumer moves from point A → B → C →
D → E, he is ready to surrender decreasing quantity of y for every succeeding unit
of x. While moving in the reverse direction from E → D → C → B → A he is ready
to surrender decreasing quantity of x for for every succeeding unit of y. The slope
of indifference curve measures M RSxy and inverse of slope measures M RSyx . This
explains the diminishing M RS or the convexity of the indifference curve.

If we have two good x and y where good y is a composite good representing consump-
tion of all other goods, which can be measured in terms of residual money income
after spending for good x. Then M RSxy represents the amount of money income
the consumer is ready pay for an additional unit of good x or marginal willingness
to pay. We can say that M RS is equivalent to the marginal utility of the respective
unit. As marginal utility decides price offered by the consumer so does the M RS.
We must remember that there can be difference between what price consumer offers
and what price he actually does pay. What price consumer offers depends on the
value he assigns to the unit and what he actually does pay is an average value to the
society.

Behaviour of M RS

The M RS decides the shape of indifference curve. For example, if M RS is constant

at all levels of consumption of a good indifference curve will be a straight line. If
it is decreasing indifference curve will be convex to origin and if it is increasing
indifference curve will be concave to origin. It is −1 for perfect substitutes, ∞ for
neutrals, +1 for perfect complements.

Budget /Price Line

The budget line shows the maximum quantity of good(s) that can be purchased by
the consumer with the help of given amount of money income, at given constant
prices. It is also known as budget line because it indicate budget of the consumer. It
is also known as price line because it shows relative prices of goods. Remember that

56
it is a straight line, if prices are constant. For variable prices it becomes non-linear.

Table 4.5: Price Line of |100

Goods Combinations

A B C D E F

xp = |20 0 1 2 3 4 5
A
yp = |10 10 8 6 4 2 0

For example assume that a consumer has income of |100, price of good x is |20 and
that of good y is |10. Therefore, consumer can purchase 5 units of x at maximum
and nothing of y or 10 units of y and nothing of x. Between these two extreme
possibilities, consumer can purchase different combinations as shown in the Table 4.5
and Figure 4.4.

10

8 B
Good y

6 C

4 D

2 E

F
1 2 3 4 5
Good x

Figure 4.4: Price Line

4.1 Properties of Indifference Curve

An indifference curve is a locus of consumption combinations with shows same level
of satisfaction. If we graphed such combinations we will have an indifference curve.
If number of such combinations is large the indifference curve will be continuous.
Now question is what is nature of an indifference curve.

57
1. Indifference curve slopes downward from left to right: Assume that
indifference curve is a straight line. If so, it may be either parallel to X-axis or
parallel to Y-axis or upward sloping or downward sloping.
y y y
IC
IC
A B y2 B y2 B
ȳ IC
y1 A y1 A
O x1 x2 x O x O x1 x2 x
x̄

Figure 4.5: Slope of Isoquant

If indifference curve is parallel to X-axis, it means that consumption of good y

is constant and that of good x changes but there is no changein satisfaction. If
indifference curve is parallel to Y-axis, it means that consumption of good x is
constant and that of good y changes but there is no changein satisfaction. If
indifference curve is upward sloping, it means that consumption of both goods
x and y increases or decreases together but there is no changein satisfaction.
All these possibilities are rejected in the common logic, therefore, they cannot
be indifference curve.
good y

IC2
O
good x

Figure 4.6: Indifference curve slopes downward

The logic says that to maintain satisfaction constant, rise in satisfaction due to
increased consumption of a good must be reversed by decrease in consumption
of another good i.e. with increased consumption of one good that of other good
must decreased to keep satisfaction constant. It makes indifference curve to
slopes downward.

58
2. Indifference curve is convex to origin:We have established that indifference
cure slopes downward, but question is if it is a straight line or a convex or concave
to the origin. Such nature is decided by the ratio of change in consumption
of one good to change in consumption of other good, while satisfaction being
constant i.e. marginal rate of substitution (M RS).

If M RS remains constant, for any change in consumption combinations, the

indifference curve will be a straight line. If M RS increases with increase in
consumption of a good the indifference curve will be concave to the origin and
if M RS decreases with increase in consumption of a good the indifference curve
will be convex to the origin.

y y y

IC IC IC
O x O x O x

(a) Constant MU (b) Rising MU (c) Diminishing MU

Figure 4.7: Iso-quant is convex

As discussed above, marginal rate of substitution is a similar concept as marginal

utility in cardinal utility analysis. It indicates relative price of good in the
terms of other good. With increase in consumption of a good its marginal
utility decreases, therefore, M RS must decrease with increase in consumption
of the good. It implies that indifference curve must be convex to the origin.

3. The farther is indifference curve from the origin the higher is level
of satisfaction: In the Figure 4.8, IC1 and IC2 are two indifference curves
showing distinct level of satisfaction. At point A on IC1 consumer consumes x1
units if good x and y1 units of good y. While at point B on IC2 , he consumes
same x1 units of x and y2 units of y. Thus, satisfaction at point B must be
greater than satisfaction at point A. This is because at point B consumer is
consuming same number of units of x as at point B, but more units of good y.
In this way we can say that satisfaction on IC2 is greater than satisfaction on

59
 IC1 .

good y

B(x1 , y2 )

A(x1 , y1 ) IC2

IC1
O
good x

Figure 4.8: indifference Curve and level of satisfaction

4. Indifference curves depicting distinct level of satisfaction never in-

tersect to each other: Consider two distinct indifference curves IC1 and
IC2 shown in Figure 4.9.

good y

(x1 , y1 )

(x, y)
y (x2 , y2 )
IC2
IC1

O x good x

Figure 4.9: Indifference Map

Assume that there are three consumption combinations (x1 , y1 ) on indifference

curve IC1 , (x2 , y2 ) on indifference curve IC2 and (x, y) at the intersection of
two indifference curves. By definition (x1 , y1 ) ∼ (x, y) and (x, y) ∼ (x2 , y2 ),
it implies that (x1 , y1 ) ∼ (x2 , y2 ). This contradicts with the fact that two
indifference curve depicts distinct level of satisfaction or axiom of transitivity
is violated. This contradiction establishes that indifference curves depicting
distinct level of satisfaction cannot intersect each other.

60
4.2 Consumers Equilibrium
Every consumer, at given level of his income, tries to maximise satisfaction, for which
he changes his consumption composition. Once he arrived at maximum satisfaction,
he will spot changing it. This state of the consumer where no change is intended by
him is called consumer’s equilibrium. Consumer’s equilibrium can be explained with
the help of indifference curve and price line.

good y

P
a

IC4
d IC3
IC2
e
IC1
O
L good x

Figure 4.10: indifferenceMap

If we superimpose indifference map and price line, we will get Figure 4.10. In
the figure IC1 , IC2 , IC3 and IC4 are indifference curves. P L is price line. Each
indifference curve shows different and specific level of satisfaction. Price line shows
all possible combinations of commodities which can be bought by the consumer with
the help of the given limited income and at given prices.

If consumer is consuming at point a, he will spend his total income and will earn
satisfaction shown by indifference curve IC1 . When he shifts his consumption from
a to b he will get on IC2 level of satisfaction which is higher than IC1 . If he further
shifts his consumption at point c, he will have even more satisfaction shown by IC3
indifference curve.

Therefore, it consumer will change his consumption to point c. He will not move
beyond point c, i.e. on d and e, because by doing so he will merely find himself on a
lower indifference curves with smaller satisfaction. Therefore, consumer will be in
equilibrium at point c. If c is satisfaction maximising point, it must be different from

61
other points.

If we compare points a, b, c, d and e we will find that at point c price line and
indifference curve are tangential to each other and at other points they intersect to
each other. Consumer cannot attain any point on IC4 because his income is not
enough to reach there.

Therefore, we can say that consumer will earn maximum possible satisfaction at the
point where price line and indifference curve are tangential to each other. This is
first order or essential condition of consumer’s equilibrium. In calculus this condition
can be stated as
dy px
Slope of IC = M RSxy = = = slope of P L (4.4)
dx py
Where, dy is change in y, dx is change in x, px and py are prices of commodity
x and y respectively. But this condition is not sufficient for equilibrium, because
satisfaction may or may not be maximum2 .

good y

P
a

d
IC2
IC1

O
L good x

Figure 4.11: indifferenceMap

In Figure 4.10 IC1 is tangential to price line at point b, where it is concave to the
origin. If consumer is consuming at point b, he will get satisfaction shown by IC1
2 The first order or essential condition shows reversal in the direction of variation and do not

explain if there is maximisation or minimisation. When indifference curve is concave to origin,

tangency with price line shows minimum satisfaction rather than maximum. It means when
indifference curve is concave to the origin at the point of tangency, satisfaction is not maximum.
Satisfaction would be maximum when indifference curve is convex to origin.

62
and will spend his total income shown by price line P P . At the same amount of
expenditure at point c consumer can get higher level of satisfaction shown by IC2 .
Therefore, instead of consuming at point b consumer will like to consume at point c.

At both the points indifference curve and price line are tangential to each other. But
the difference between these two points is that at point b indifference curve is concave
to the origin and at point c it is convex to the origin. Therefore, we can infer that at
tangency indifference curve must be convex to the origin.

This is second order or sufficient condition for consumer’s equilibrium. In calculus,

this condition can be stated as

d(M RS) d2 y
= <0 (4.5)
dx dx2
Thus, first order condition for consumer’s equilibrium is that indifference curve and
price line should be tangential to each other and second order condition is that at
the tangency, indifference curve must be convex to origin.

63
64
Chapter 5

Consumer Surplus

5.1 Consumer Surplus

The demand curve slopes downward from left to right showing that the marginal
utility of every succeeding unit of consumption goes on diminishing (the law of DMU).
Therefore, the consumer is ready to pay a higher price for the initial units, while
decreasing the price for the successive units. But in reality, he pays, for all units,
equal to marginal utility to an average consumer1 in the society. Thus, an average
buyer, except for the last unit, pays less than what he would have paid otherwise.
That is why there is a difference between the total utility received by the consumer
and the utility of money paid by him. This difference is called consumer surplus.

Consumer surplus can be expressed as,

CS = {Total utility received} − {Utility paid}

= {What consumer is willing to pay} − {What he actually does pay}
= p1 + p2 + p3 + . . . + pn − {p · q}
Xn
= pi − p · q (5.1)
i=1

1 An average utility means utility to an average consumer who is not an odd one....

65
A consumer’s surplus can be defined as, “excess of utility received by the consumer
over and above the price paid by him for the given consumption”. It is the difference
between the total utility received by a consumer and the utility paid by him.

The concept of consumer surplus can be explained with the help of Table 5.1 and
Figure 5.1. Suppose that the marginal utility of the first unit of a commodity is
worth |20, therefore, the consumer is ready to pay |20 for that unit. The marginal
utility of the second unit is worth |15 and the consumer is ready to pay |15 and so
on. With an increase in consumption, a marginal utility for the successive units will
fall and the consumer offers decreasing price.

Table 5.1: Consumers Surplus

Price Consumer Surplus

Units Marginal Utility
Offered Paid

1 20 20 5 15

2 15 15 5 10

3 11 11 5 6

4 8 8 5 3

5 6 6 5 1

6 5 5 5 0

Total 65 65 30 35

Similarly, he is ready to pay |15, 11, 08, 06, and 05 for 2nd , 3rd , 4th , 5th and 6th
units of commodity respectively. But in market price is decided equal marginal utility
to an average consumer which is only |5. Therefore, the consumer receives excess
utility from all the units except the last unit. In total, the consumer receives a utility
of 65, therefore, he would have paid |65, but actually, he does pay only |30. The
excess of utility equivalent to |35 is the consumer’s surplus. A surplus because the
consumer receives it free of cost or over and above the total amount paid by him.

Consumer Surplus and Price Changes

Due to the change in the price of a good consumer surplus changes in the opposite
direction. That is a fall in the price of goods causes a rise in consumer surplus and
vice versa. This change in consumer surplus arises firstly, due to consumption of

66
 Utility 20

15

11
8
P=5

1 2 3 4 5 6
Demand

Figure 5.1: Consumer Surplus

previous units at a new price and secondly due to the change in consumption of a
good.

A
P1
B
P2
C

O
Q1 Q2 Q

Figure 5.2: Change in Price and Consumer surplus

In the Figure 5.2 when P1 is price, Q1 is demand and DP1 A is consumer surplus.
When price changes to P2 , demand changes to Q2 and consumer surplus to DP2 C.
The change consumer surplus is P1 P2 BA. Of this P1 P2 CA is due to the consumption
of the previous quantity at a new price and ABC is due to the change in the quantity
consumed. The figure reveals that a rise in price decreases demand and a fall in price

67
increases consumer surplus.

5.2 Evaluation of Consumer Surplus

1. Unrealistic Assumptions: The assumptions of cardinal measurement of
utility, the constant marginal utility of money is an unrealistic assumption.
Assumptions that different units of the goods give different amounts of satisfac-
tion to the consumer. When a consumer takes more of a commodity, it is not
merely the utility of the marginal units that declines but also of the previous
units he has. As all units are identical and would have the same utility. If the
price of the marginal unit is equal to marginal utility, it will be equal to the
utility of the previous units and the consumer will have no consumer surplus.

2. Hypothetical and Illusory Concept: A consumer has several wants to

spend his money income. The maximum that a consumer can pay is limited by
his income. When an account is taken of the total purchase that a consumer
makes the price he is willing to pay and what he does pay are the same.
consumer spends a smaller amount and turns to the next good to buy out of
the remaining amount. Hence, there is no question of the consumer getting
any consumer surplus for his total purchase.

3. Ignores Interdependence of Goods: It ignores the interdependence of

goods. Utility from a commodity increases because of complements or decreases
because of substitutes being used.

4. Meaningless: The concept of consumer surplus is hypothetical, imaginary

and meaningless. Prof. Nicholson asks," of what avail is it to say that utility
of income of £100 is worth of £1000".

5. Critics also pointed out that when a consumer takes more units of a good, it is
not only the utility of the marginal unit that declines but also of the previous
units consumed.

68
5.3 Importance of Consumer Surplus
Consumer surplus arises because of diminishing marginal utility. Consumer surplus
is an excess of utility over and above the price paid by the consumer. It is a utility
available to the consumer without payment or free of cost. The concept of consumer
surplus does not have practical importance, but it has great theoretical importance.

1. Water Diamond Paradox: Why is water greatly useful and so cheaper and
diamond with low utility is so costlier? To find an answer for it we have to
differentiate between total use value and marginal value. The price of a good
in the market is decided by marginal valuation, not by total value. Total use
value is the equal amount he pays plus consumer surplus. As water is available
in plenty its marginal valuation is very low, while that of a diamond is very
high because supply is limited. It means the diamond is costlier because the
customer pays for the maximum utility derived i.e. there is no consumer surplus.
On the another hand, in the case of water consumer, pays only a fraction of the
utility i.e. there is a very large consumer surplus. Therefore, water is priced
very low and diamond high.

PD D

PW W

O
QD QW Q

Figure 5.3: Water-Diamond Paradox

In the figure 5.3 dotted pattern shows consumer surplus on water, While the
grey area shows consumer surplus on the diamond. The price of diamonds is
higher than that of water.

69
2. Taxation: In the figure refcstaxsubsidy D is demand curve and P is initial
price. P 0 is the price after tax or subsidy.
In Figure 5.4a after specific tax t price increases to P 0 = (P + t), consumer
surplus will decrease byP 0 BAP of which the tax collection will be equal to
dotted area P 0 BCP . This is the transfer of utility from the consumer to the
government. The grey shaded area ABC is dead weight loss or loss in welfare
over tax revenue. This deadweight loss can not be compensated by tax revenue.

In Figure 5.4b, if the government grants specific subsidy s, the price will come
down to P 0 = (P − s), consumer surplus will increase by P ABP 0 , ABC would
be bonus welfare above loss to the public exchequer. ABC is a bonus consumer
surplus from additional units being bought due to a fall in price.

P/U P/U

B A
P0 S’ P S
A B
P S P0 S’
C C D
D
O
O
Q Q
(a) Tax (b) Subsidy

Figure 5.4: Subsidy

Consumer surplus guides the government in taxation whether to impose a tax

or grant subsidy on a commodity and if yes to what extent. It advises not
imposing a tax on commodities without consumer surplus, as its demand will
shrink to zero. It is because the price will exceed the marginal utility for the
consumer. But the commodities with consumer surplus can be taxed.

3. Selection between Substitutes: If two goods are substitutes of each other,

other things being equal, a consumer should prefer commodities with larger
consumer surplus to commodities with smaller consumer surplus.

4. International Trade: In international trade, the country should avoid the

70
 import of goods with a smaller consumer surplus and conversely should prefer
to import goods with a larger consumer surplus. Similarly, if the possible
country should export goods with a smaller consumer surplus and export fewer
goods with a high consumer surplus. In such a case, consumer surplus should
be measured as peruse in their own country for economical purposes and in a
foreign country for political purposes.

5. Cost Benefit Analysis: Consumer surplus is very useful in cost-benefit

analysis. The price paid is the same as the cost and the utility received is the
same as the benefit. Therefore, consumer surplus is the net benefit. It means
the higher the consumer surplus, the higher the net benefit and vice-versa.

P/U

B
P0 S’

A
P S
C
D

O
Q

Figure 5.5: Consumer Surplus and Cost Benefits

6. Subsidies: If any product is essential and there is no or smaller consumer

surplus, the government can subsidies such product, so that the consumer’s
surplus would be available, to increase public welfare.

7. Social Welfare: If the government spend on commodities with consumer

surplus public welfare will be larger than otherwise.

8. Useful to Monopolists: Monopolists have a chance of a price increase when

there is a consumer surplus on their product.

71
 9. Welfare economics: It is also useful in welfare economics because consumer
surplus is the same as welfare. Consumer surplus and hence welfare will be
higher when good is in plenty.

5.4 Supply
Supply means the quantity offered for sale at a given price. We may define a supply
curve as a schedule of the quantity of a good that would be offered for sale at different
prices at a given moment or during a period. Supply is different from stock.

Stock and Supply

Stock is the total volume of the commodity which can be brought into the market for
sale in a short period at any price and supply means the quantity which is offered
for sale in the market at a given price. In the case of perishable commodities, supply
and stock are very close. The number of units of a good that the firm offers for sale
in the market depends on several factors like; the price of a commodity (P ), prices of
inputs (F ), state of technology (T ), price of related goods, (Po ), future expectations
(E)
Supply function, Q = f (P, F, T, P0 , E) (5.2)

5.5 The Law of Supply

Other things running the same, as the price of a good rises its supply expands and
as its price falls supply contracts. The quantity offered for the sale varies directly
with the price. The law of supply can be explained with the help of the following
table and diagram.

In Figure 5.6 quantity supplied is measured along X-axis and the price along Y-axis.
The supply curve slopes upward from left to right showing a direct relationship
between price and quantity supplied. The higher is price, the higher is supply and
vice versa. It should be noted that if the price falls too much, supply may dry up
altogether. The price below which sellers refuse to sell is called the em reserve price.
Similarly, even if the price rises too much, the seller may not be in a position to
supply more because of production limits.

72
 Price

P2

P1

O
S1 S2 Q

Figure 5.6: The Law of Supply

The supply curve not only slopes upward but also at an increasing rate. This is because
when a firm produces more cost of production increases more than proportionately
because of diseconomies of scale. In other words, the average cost goes up.

Increase and Expansion of Supply

When supply changes because of a price change it is either expansion or contraction

of supply. It is a movement along the supply curve. While change is supply, because
of factors other than the price of the same good, is an increase or a decrease in
supply. An increase in supply is shown by the southeast shift of the supply curve and
a decrease in supply by the northwest shift of the supply curve. It is called increase
because at the same price a larger quantity will be supplied by sellers and decrease.
After all, at the same price, a smaller quantity will be supplied.

5.6 Elasticity of Supply

The responsiveness of supply to changes in price is measured as the price elasticity

of supply. It is a ratio of the percentage or proportionate change in supply to the

73
percentage or proportionate change in price. Elasticiity of Supply
proportionate change in supply
(eS ) =
proportionate change in price
∆S/S
=
∆P/P
∆S P
= × (5.3)
∆P S
The elasticity of supply is positive. It means price an increase always stimulates
supply and decreased prices reduce supply.

5.7 Producers Surplus

The supply curve shows the quantity of output that which supplier is ready to sell in
the market at various prices. It slopes upward from left to right. It means that the
producer offers a lower quantity at lower prices and a higher quantity at a higher
price. We can also say that a producer is ready to sell initial units of his output at a
lower price and subsequent units only at an increasing price. While doing so he will
not make any losses. It is because the supply curve is nothing but a marginal cost
curve and the price at which he is ready to sell includes the total cost of each factor’s
remuneration along with his normal profit. When he takes his output in the market,
he need not sell all these units at offered lower prices but at market price, which is
decided by market demand and supply rather than individual demand and supply.
Thus, these initial units, which he is ready to sell at lower prices, fetch more than
the expected price. This excess price received is known as the producer’s surplus.

A producer’s surplus (P S) refers to an amount which the producer gets over and
above the minimum price that he would insist on, rather than taking the product
back from the market.

(P S) = (Total Price Received) - (Price he prepared to accept) (5.4)

= (P · Q) − (M C1 + M C2 + M C3 + . . . + M Cn )
n
!
X
= (P · Q) − M Ci ) (5.5)
i=1

The concept of producer’s surplus can be explained with the help of following table
and diagram.

74
 Table 5.2: Consumers Surplus

Units Price Paid Cost Price sought Producer surplus

1 20 5 5 15

2 20 6 6 14

3 20 8 8 12

4 20 11 11 9

5 20 15 15 5

6 20 20 20 0

Total 120 65 65 55

P=5

20
Utility

15

11
8

1 2 3 4 5 6
Demand

Figure 5.7: Producer’s Surplus

The concept of producer surplus can be explained with the help of Table 5.2 and
Figure 5.7. Suppose that the marginal cost of the first unit of the good is |5, therefore,
the producer will be ready to offer that unit for |5. The marginal cost of the next
unit is |6 and the producer will be ready to offer for |6 and so on. With an increase
in supply, the marginal cost of the successive units will increase and producers seek
increasing prices.

Similarly, he will be ready to offer 2nd , 3rd , 4th , 5th and 6th units at |8, 11, 15, 20,
and 26 respectively. But in market price is decided equal marginal cost which is |26.
Therefore, the producer receives excess money for all units except the last. In total,
the producer has paid the cost of |65, therefore he would have supplied 6 units for
|65, but actually, he does receive |120. The excess revenue of |55 is the producer’s

75
surplus. A surplus because the producer receives it free of cost or over and above the
total cost.

76
Chapter 6

Production Function

Production: Production involves a transformation of inputs into outputs along

with an addition of use value. Production covers not only physical transformation
or physical output but also services rendered, as there is also value addition. The
inputs could be land, labour, capital, entrepreneurship etc. and the output could be
tangible goods or intangible services.
A technical problem: In the real life, manufacturers want to know quantity of
each input will be required to produce a given output, so that they can assess their
requirements of inputs and estimate the cost.

6.1 Production Function

The production function expresses time specific relationship between flows of inputs
and resulting output flows. More precisely, a production function explains com-
binations of quantities different inputs to yield a given quantity of output or the
maximum output that can be produced from the given quantities of inputs.
The production function is a technical relation that describes the proportions of
inputs to each other to produce any particular quantity of output. Since production
function is related with the physical aspects of production, it is more a concern of
technicians than of economists. Only a technician can tell how a specific quantity of
output can be produced by different combinations of various productive resources.

77
Production function can be expressed as,

Q = f (N, L, C, E, T . . . , ν, γ) (6.1)

where,

N - natural resources L - labour

C – Capital, E - Entrepreneurship,
T - Technology. ν - returns to scale
γ - efficiency parameter

Production function depends on quantities of resources used, state of technology,

possible process, size of firms, nature of the organisation and how factors are combined.
A commodity may be produced by various methods of production.

6.1.1 Features of production function

1. Production function represents purely technical relationship between physical

quantities of inputs and outputs. It is not related with factor remuneration or
product price.

2. It is a flow concept. It means every change in inputs will be reflected in the

quantity of output.

3. Output is the result of joint use of factors of production.

4. Productivity of a single factor can be measured only then all other things are
constant.

5. The number of factors and their combination depend on the state of technolog-
ical knowledge.

6. In specifying production function, we have to take into account the variability

of the factors of production and also whether they are divisible or non-divisible.

7. Functional relationship between input and output depends on the time.

78
6.1.2 Types of Production Function

Production function can be classified based on different factors like time, nature of
equation, combination of factors etc.

1. Short-term and long-term production function: A long run is a period

during which all factors of production are changeable or no factor is fixed.
Therefore, long run production function can be written as,

Q = f (N, L, C, E, T . . . , ν, γ) (6.2)

A short run is a period during which at least one factor of production is

not changeable or all the factors cannot be changed. Therefore, short run
production function can be written as,

Q = f (N, L, C̄, E, T̄ . . . , ν̄, γ̄) (6.3)

where capital, technology, returns to scale and efficiency is considered to be

constant.

2. Fixed and variable proportion production function: Production func-

tion can be classified as a fixed proportion or variable proportion production
function, based on factor combination. In the fixed proportion production,
the factors can be combined in certain fixed ratio. More or less of any one
factor does not work. For example, vehicle and driver need to be in 1:1 ratio.In
variable proportion production factors can be combined in different ratio. For
example, by increasing number of tyres a vehicle can be used to carry more
load.

When only one factor is variable production function is expressed by the law of
variable proportion. When two factors are variable production function is expressed
an iso-quant. When all the factors of production are variable by same proportion,
production function is expressed by returns to scale.

79
 Variable Production Returns to
Proportion Equilibrium Scale

Instruments Product Iso-quant Iso-quants

Curves - TP, and Iso-cost and Iso-
AP, MP costs

Factor single factor multiple fac- all factors

Variabil- is variable tors are vari- are variable
ity able in same
proportion

Time Short-run Short-run Long-run

6.2 Some Definitions

1. Total Product Curve: The production function can be shown geometrically
with the help of the total product curve. A total product curve shows the
level of output at the different quantities of factors measured on the horizontal
axis. Change in output due to the factor measured on the X-axis is shown by
movement along the curve and change in output due to other factors is shown
by a shift in the total product curve.

q2 = f (L)K2

q1 = f (L)K1

O
L

Figure 6.1: Total Product Curve

In the Figure 6.1, if quantity of labour, measured along the horizontal axis,
changes output change is shown by move along the curve. If the are changes
in any other factors change in output will be shown by shifts of total product
curve. In the Figure 6.1, q1 is total product curve when capital is K1 and q2 is
total product curve when capital is K2 .

80
2. Marginal Product: Marginal product is a change in output due to a unit
change in the factor of production. It is the first order derivative of the total
product function.

dQ
Marginal Product of Labour M PL = (6.4)
dL
dQ
Marginal Product of Capital M PK = (6.5)
dK

3. Income /Budget /Iso-cost: Assume a situation in which producer has a

limited amount of money and real resources are to be purchased/hired in the
factor market. What quantity of resources he can buy/hire depends on his
money and factor prices. With limited amount of money, if producer buys/hires
more of one factor he will have less of other factors.

Considering only two factors labour (L) and capital(C), we plot all such
possible combinations which can be bought/hired by the producer with his
limited resources. On joining these points we will have a downward sloping
curve called iso-cost. It shows all possible combinations of factors which can be
bought/hired by the producer with a given limited money resources, provided
he spends full of his money. The curve will be a straight, if prices are constant.
For variable prices it becomes non-linear. It is also known as budget line
because it shows the budget of the producer. It is also known as factor price
line because it shows prices of factors.

Assume that producer has |100, wage rate is |20 and interest rate is |10. We
will have the Table 6.1.

Table 6.1: Iso-cost of |100

Factors Combinations

A B C D E F

wage rate (w) = |20 0 1 2 3 4 5

interest rate (i)= |10 10 8 6 4 2 0

For example, assume that a producer has amount of |100, wage rate w is
|20 and rate of interest i is |10. Therefore, consumer can hire 5 units of L

81
 10 A(0,10)
B(0,8)
8

Capital (C)
C(0,6)
6
D(0,4)
4
E(0,2)
2
F(5,0)
0
1 2 3 4 5
Labour (L)

Figure 6.2: Iso-Cost Line

at maximum and nothing of C or 10 units of C and nothing of L. Between

these two extreme possibilities, producer can hire/purchase their different
combinations as shown in the Table 6.1 and Figure 6.2.

It is also called an iso-cost line because it shows the relative prices of factors.
If the price of any factor(s) changed, while that of the other is constant, one
will become relatively costlier and the other cheaper. In this case, the price
line will shift accordingly.

(a) If the factor along Y-axis becomes costlier, the iso-cost line will become
flattered.

(b) If the factor along Y-axis becomes cheaper, the iso-cost line will become
steeper.

(c) If the factor along X-axis becomes costlier, the iso-cost line will become
steeper.

(d) If the factor along the X-axis becomes cheaper, the iso-cost line will become
flattered.

(e) If both factors’ prices changed in the same proportion, no of them will be
costlier or cheaper. The new price line will be parallel to the origin.

4. Marginal rate of technical substitution: This concept in ordinal measure-

82
 ment is counterpart of marginal rate of substitution in indifference curve and
marginal utility or marginal productivity in cardinal measurement. M RT S of
a given factor is number of units of another factor required to substitute one
unit of the given factor, while production remaining the same. For example
M RT SXY is number of units of Y required to substitute one unit of factor X,
while production is unchanged.
change in no units of capital
M RT SLK = (6.6)
change in no units of labour
change in no units of labour
M RT SLK = (6.7)
change in no units of capital
The M RT S of factor measured on horizontal axis is always equal to the slope
of iso-quant and negative when both factors are positively productive; but also
can be positive when at least one factor is negatively productive. It would be
parallel to an axis when factor measured on the other axis is no more productive.
M RT S of a given factor decreases along with increase in its quantity. It means
that with increase in a factor, say labour, and decrease in other factor, say
capital, increased factor labour will find difficult to work. Therefore, with every
given constant increase in labour we can decrease only smaller and smaller
quantity of capital.

6.3 The Law of Variable Proportion (LVP)

The law of variable proportion explains the relationship between output and a variable
factor other factors being constant. It is also known as the law of returns. The
law of variable proportion states that as the quantity of a variable factor increases,
other things remain constant, the output will increase more than proportionately (at
an increasing rate) in beginning, and then it may increase in the proportion (at a
constant rate) and ultimately less than proportionately (at the diminishing rate).

The law of variable proportion can be split into four stages depending on the rate at
which the total product is increasing.

Stage I: Increasing Average Returns

Total products increase at an increasing rate. An M P and AP also increase and

M P > AP . In the Figure 6.3, in this stage the slope of T P curve increases. M P

83
 Table 6.2: Variable Proportions

Stage TP is in- AP MP
creases @

I increasing increasing increasing & > AP

rate

II constant rate constant constant (= AP)

III diminishing decreasing decreasing and <

rate AP

Stage TP is de- −ve decreasing and −ve

IV creases

Table 6.3: The Law of Variable Proportion

VF 1 2 3 4 5 6 7 8 9 10 11 12

TP 30 80 150 240 330 420 490 540 570 580 570 540

AP 30 40 50 60 66 70.0 70.0 67.5 63.3 58.0 51.8 45.0

MP 30 50 70 90 90 90 70 50 30 10 -10 -30

curve lies above the AP curve.

The phase of increasing returns arises because of the indivisibility of fixed factors.
When fixed factors are proportionately abundant relative to the variable factor, the
fixed factor(s) remains under-utilised. When more of the variable factors are used
with the same quantity of the fixed factor(s), the latter is used more effectively. This
causes more than a proportionate increase in production. The increase in the product
also may be because of improved coordination between variable factors. This stage
comes to an end when M P of the variable factor is the highest and equal to M P .

Stage II-Constant Average Returns

Total products increase at a constant rate. M P and AP remains constant and

M P = AP . In the Figure 6.3, the slope of T P curve remains constant. M P and

84
 TP

TP
PT↑ PT↑ PT↑ PT↓

L1 L2 L3 L
Stage I Stage II Stage III Stage IV
TP MP↑ MP MP↓ MP↓
AP↑ AP AP↓ MP↓ & − ve

AP
L1 L2 L3 L
MP

Figure 6.3: The Law of Variable Proportion

AP curves run together. This stage results because of the proper combination of
fixed and variable factors. There is an optimal exploitation variable factor and slight
underutilisation of fixed factors. The total product increases at a constant rate
because the increase in variable factor causes a decrease in its marginal productivity
but it will be just compensated by more efficient use of slightly under-utilised fixed
factors. This stage lasts when fixed factors are used at optimum.

Stage III-Diminishing Average Returns

The total product increases at a diminishing rate. M P and AP decline. M P < AP .

The slope of the T P curve diminishes.

Production reaches stage III when the fixed factor is combined with a proportionately
more variable factor. Therefore, there will be over-utilisation of fixed factors and
underutilisation of variable factors. This causes a decrease in the marginal product
of the variable product or an increase in the total product at a diminishing rate.
This stage comes to an end when T P is maximum or M P = 0.

85
Stage IV- Diminishing Total Returns

All three products fall of which MP is negative. This starts when the variable
factor becomes excess relative to the fixed factor(s). Additional units of variable
factor, instead of adding to the T P hinder production. This stage is the result of
overcrowding of variable factors.

Where does the producer produce?

In technical sense production with the proper combination of a fixed and variable
factor is advisable, if considering productivity and cost variable and fixed factors
are equally priced. This implies production at the endpoint of stage II. However,
business firms decide on their production at profit maximising combination. Because
of factor prices the firm may produce some different combinations of variable and
fixed factors. The firm will increase the variable factor (say labour) up to the point
where the marginal product of the labour equals the given wage rate in the labour
market.

6.4 Properties of Iso-quants

Iso-quant means equal quantity. Iso-quant is producer’s indifference curve which
shows an equal level of output with different combinations of factors. It is a locus
of points that shows all possible combination of factors (say labour and capital) of
production which give same quantity of output. If we join these points of locus we
will have a curve or a line. First we will assume that iso-quant is a straight line and
will try to find its slope.

1. Iso-quant slopes downward from left to right: If iso-quant is a straight

line. There are three possibilities- it is parallel to one of the axes or it slopes
upward or slopes downward. Each of these possibilities has its implications.

An iso-quant parallel to any of axes implies that, with a given constant quantity
a factor, any change in the variable factor does not change output. It means
variable factor has zero productivity. Or an increase in quantity of a factor in
production, does not release any quantity of other factors. The upward sloping
iso-quant means to produce the same given quantity, with increase in quantity
of one factor we will have to increase factors also. It simply means productivity

86
 K K

Q̄

K2 B
A B
K̄ Q̄

K1 A

O O
L1 L2 L L1 L2 L

Figure 6.4: Slope of Isoquant

of one factor is negative. Therefore, an iso-quant cannot be upward sloping or

parallel to any of the coordinate axes.

(L − δL, K + δK) (L + δL, K + δK)

K1
(L, K)

(L − δL, K − δK) (L + δL, K − δL)

Q̄
O
L1 L

Figure 6.5: Iso-quant slopes downward

The third possibility implies that, other things being equal, if producer decreases
one of the factors of production he will have to increase other factor to maintain
the same output. Similarly, if he increases any of the factors, it will allow
him to decrease other factor while maintaining the same level of output. This
condition will be fulfilled only by the an iso-quant sloping negatively.

2. Iso-quant is convex to origin: When it has been established that iso-quant

slopes negatively, there arise 3 possibilities- iso-quant is a straight line or it is
concave to the origin or it is convex to the origin. This property of iso-quant
explains changes in productivity of factors when they substitute each other.

87
A straight line iso-quant means factor combinations does not affect factor
productivity and all units of factor are homogeneous. That is why an iso-quant
cannot be a straight line.

A concave to origin iso-quant implies that with an increase in the quantity of

a factor, other things being equal, its productivity increases. In other words
when we substitute labour for capital, the productivity of labour increases and
that of capital decreases. It means every next factor unit is a better. But
the reality is that factors are not perfect substitutes and iso-quant cannot be
concave to the origin.

(1,20)

(2,15)

(3,11)

(4,8)
(5,6)
(6,5)
Q̄

O
L

Figure 6.6: Iso-quant is convex

The convexity of an iso-quant shows that with an increase in the quantity

of a factor its marginal productivity decreases. The decreasing marginal
productivity is a result of the under-utilisation of the increased factor. If one
factor is substituted for other, an increased factor will be combined with less of
decreased factor. This will reduce the marginal productivity of the increased
factor and that of decreased factor will increase. It is also true that while
recruiting more productive units of factor are preferred to less productive units
and while removing factor units lesser productive units will be removed. It
means that, while producing, with every successive increase in labour (capital),

88
 it will release decreasing quantity of capital (labour) from production. Therefore,
iso-quant is always convex to the origin.

Thus we can say that convexity of iso-quant is result of two thins, one factor
co-ordination and non-homogeny of factors.

3. The larger is the distance of an iso-quant from the origin the higher
is output shown by it: In the Figure 6.7 Q̄1 and Q̄2 are two iso-quants
showing two different levels of output.

B(4,6)

A(4,4) Q̄2

Q̄1
O
L

Figure 6.7: Iso-quant and level of Output

At a point, A on Q̄1 the producer uses 4 units of labour L and 4 units of

capital C. While at point B he uses 4 units of labour L and 6 units of capital
C. Therefore, production at point B must be greater than that at point A,
because at point B producer uses the same number of units of labour as at
point B, but more of capital. In this way, we can say production on Q̄2 must
be greater than production on Q̄1

4. Iso-quants cannot intersect to each other: If two iso-quant intersect each

other, they violate the law of transitivity. Let us see what happens when two
iso-quant intersects with each other. In Figure 6.8, we can say the quantity
produced at points A and B is the same, as they are on the same iso-quant.
Similarly, we can say the quantity produced at points B and C also is the
same. Thus, as per the law of transitivity, (if A = B and B = C, then A = C)
quantity produced at points A and C must be the same. But as A and C lie on
different indifference curves. The output at these points cannot be same. This
inconsistency is the result of their intersection, therefore, they cannot intersect

89
 with each other.
C

B
y
A
Q̄2
Q̄1
O x L

Figure 6.8: Isoquants cannot Intersect

5. Iso-quants are oval shaped: If one factor of production is continuously

increased, it is marginal productivity decreases to become zero and then
negative. Negatively sloping iso-quant shows positive marginal productivity
of factors, labour and capital. When it becomes parallel to any of the axes, it
means the productivity of the factor on that axis is zero. If further, it becomes
upward sloping, it is because of the negative productivity of the factor. To
compensate for the loss out of negative productivity of the factor, the producer
will have to increase another factor too to produce the same quantity.

Q̄

D
B

O L

Figure 6.9: Iso-quant: Oval shaped

When iso-quant becomes parallel to X-axis, it means productivity of labour is

zero. If further it becomes positively sloping, it shows labour productivity is

90
 negative. To compensate negative productivity of labour, producer will have
to use an increased quantity of capital too. On the other hand, when iso-quant
becomes parallel to Y-axis, it means productivity of capital is zero. If further
it becomes positively sloping, it shows capital productivity is negative. To
compensate negative productivity of increased capital producer will have to
use an increased quantity of labour too. Therefore, iso-quant is oval shaped.

6.5 Output Maximisation

A producer’s equilibrium is a state of production that producer does not want to
change. Such a state would be at maximum output. In the short run, other things
being constant, the producer tries to maximise output or minimise cost. It is because
in the short run output maximisation or cost minimisation is in line with profit
maximisation.

π = R−C
= p·q−C (6.8)

If p and C are constant, we maximise profit π by maximising output and if p and Q

are constant by minimising cost C.

π =p·Q−C (6.9)

The main objective of the firm is profit maximisation i.e. maximisation of the
difference between total revenue (R) and total cost (C).

In the Figure 6.10, each of the iso-quants IS100 , IS200 , IS300 and IS400 shows a
specific level of output that can be produced with different combinations of factors.
KL is an iso-cost line which shows all possible combinations of factors which can
be purchased or hired, at given prices of factors, with given limited resources. The
producer can produce at any point on or below the iso-cost line. If producer produces
on the iso-cost line he will use his total resources and if he produces below the iso-cost
line he will produce with less than full resources. He cannot reach above the iso-cost
line.

If the producer prefers to produce with his full resources (M ) he can do it at any
point on KL. Suppose the producer produces at point c by using more capital and

91
 K

K
c

IS400
f IS300
IS200
h
IS100
O
L L

Figure 6.10: Producer’s Equilibrium: Output Maximisation

less labour, he will have an output of 100 units. If he increased labour and decreased
capital to shift production at point d he reaches to 200 units with the same cost
of production shown by the iso-cost line. With his further move to point e with
even more labour and less capital, he will produce an output of 300 units. Again
if he increased labour and decreased capital to shift to point f or h he will merely
find that quantity produced has decreased to 200 or 100 respectively. Therefore, the
producer would like to produce at point e, where his output is maximum at a given
constant cost. In other words, all points of KL other than e lie below iso-quant than
IS300 .

In Figure 6.10, point e on KL differs from other points, in a sense that at point e,
iso-cost line and iso-quant are tangent to each other, while at any other point of KL
they intersect each other. Therefore, we can infer that producer is at equilibrium
when iso-quant and iso-cost lines are tangent to each other. It also means that
iso-quant and iso-cost lines have the same slope.

Slope of isoq-uant = slope of iso-cost line

M RT SLC = K/L

where, M RT SLC - marginal rate of technical substitution of labour for capital,

K - maximum of capital which producer can purchase
L - maximum of labour which producer can purchase

92
From iso-cost line KL we have K = M/i and L = M/w
M
K i
M RT SLC = = M
= w/i
L w

1 i
M RT SCL = =
M RT SLC w
Therefore, the firm will be at equilibrium where M RT SLC = w/i or M RT SKL = i/w.

6.6 Cost Minimisation

As we have defined a producer’s equilibrium is a state of production that the firm
does not want to change. At a given set of variables or production conditions, the
firm tries to minimise its cost, because in the short run output maximisation or cost
minimisation is in line with profit maximisation.

In Figure 6.11, IS is an iso-quant of 300 units of output that can be produced with
the help of different combinations of factors. KL1 , KL2 , KL3 and KL4 are iso-cost
lines at different levels of budget.

K4
a
K3

K2 b
K1

d e IS300
O
L1 L2 L3 L4 L

Figure 6.11: Producer’s Equilibrium: Cost Minimisation

Suppose the firm produces an output of 300 at point a, at a cost of |400. If it shifted
production to point b it can produce the same quantity at the decreased cost of |300.

Further, the shift of production to point c reduces the cost to |200. If the firm

93
made the further experiment of producing at d or e, it will merely find that cost of
production is increased to |300 or |400 respectively.

Therefore, the producer would like to produce at point c because it is the least cost
production.

In the Figure 6.11, point c of iso-quant IS300 is different from other points like a, b,
d and e because at point c iso-quant IS300 is tangent to iso-cost line K2 L2 , while
at other points like a, b, d and e it intersects to iso-cost lines. Therefore, we can
infer that the producer’s equilibrium is decided at the point where the iso-quant and
iso-cost lines are tangent to each other.

Slope of isoq-uant = slope of iso-cost line

M RT SLC = K2 /L2

where, M RT SLC - marginal rate of technical substitution of labour for capital,

K2 - maximum of capital which producer can purchase
L2 - maximum of labour which producer can purchase

From iso-cost line K2 L2 we have K2 = M/i and L2 = M/w

M
K2 i
M RT SLC = = M
= w/i
L2 w

1 i
M RT SCL = =
M RT SLC w
Therefore, the firm will be at equilibrium where M RT SLC = w/i or M RT SKL = i/w.

94
6.7 Question Paper Pattern
1. All three questions are compulsory.

2. Answer any two subquestions in each question.

3. Draw neat and labelled diagram wherever necessary.

4. You can start from any question.

5. Stat new question on NEW PAGE.

Module Subquestions Topics

I Q. a. Theory Business Economics,

1.

b Theory PPC,

c Theory Demand Analysis

d Numericals 5 x 2 marks

II Q. a. Theory Elasticity of Demand

2.

b Theory Indifference Curve,

c Theory

d Numericals 5 x 2 marks

II Q. a. Theory Consumer Surplus

3.

b Theory Producer Surplus

c Theory Production Function,

d Numericals 2 x 5 marks

95
Exercise
Identify if the following equation represents demand function or supply function.

1. Q = 23 - 4p .............

2. L = 34 + 0.2p .............

3. Q = 25 + 3p .............

4. D = 43 + 2p .............

5. y = 98 - 34p .............

6. x = - 39 + 9p .............

A G

15 15
14 14
−dy dy
dy dy
12 slope =− dx 12 slope = dx
marginal utility

marginal utility

B F
dx dx

9 9
C E

5 5
D D

E C
F B
G A
0 0
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Demand Demand

(a) Decreasing Negative Slope (b) Increasing Potisive Slope

Figure 6.12: Slope

At simplest level we can summarise derivative as,

1. Derivative of a constant cumber is zero.

dy
2. If, y = axn the derivative of the function is = a · n · xn−1
dx

dy du dv
3. if y = u + v then = +
dx dx dx

96
 dy du dv
4. if y = u − v then = −
dx dx dx
Example 6.1. Differentiate the following functions with respect to (w.r.t.) the
independent variable.

1. y = 10 9. C = 4q 6

2. y = 10 + x 10. C = 300 + 0.4Y

3. y = 5 + x2 11. Q = 4040 + 3p

4. y = 7 − 4x4 12. Q = 3400 − 5p

5. U = 4q 2 13. L = 5000 − 0.09i

6. C = 4 + 3q + q 2 14. U = 4q1 q2

7. R = 200 + 5x 15. T R = 4Q − 0.2Q2

8. C = 430 − 3x2

p p p

O p O p O p

(a) slope is zero and curve (b) slope is ∞ and curve is (c) slope is negative and lin-
is linear linear ear

At simplest level we can summarise derivative as,

1. Derivative of a constant cumber is zero.

dy
2. If, y = axn the derivative of the function is = a · n · xn−1
dx

97
 p p
p

O p O p O p
(a) slope is positive and lin- (b) rising at diminishing
(c) rising at increasing rate
ear rate

p p
p

O p O p O p
(a) demand that does not (b) price that does not
(c) falling at increasing rate
change with price change with demand

p p
p

O p O p O p
(a) demand that does not (b) price that does not
(c) rising at increasing rate
change with price change with demand

dy du dv
3. if y = u + v then = +
dx dx dx

98
 dy du dv
4. if y = u − v then = −
dx dx dx
Example 6.2. Differentiate the following functions with respect to (w.r.t.) the
independent variable.

1. y = 10 5. U = 4q 2

2. y = 10 + x 6. C = 4 + 3q + q 2

3. y = 5 + x2 7. R = 200 + 5x

4. y = 7 − 4x4 8. C = 430 − 3x2

99
 9. C = 4q 6 13. L = 5000 − 0.09i

10. C = 300 + 0.4Y 14. U = 4q1 q2

11. Q = 4040 + 3p 15. T R = 4Q − 0.2Q2

12. Q = 3400 − 5p

Example 6.3. Suppose that price of commodity increased from |5/- to |7/- and
therefore, demand decreases from125 units to100 units. Then calculate the elasticity.

Sol. Given q = 125 , p = 5, dq = -25, dp = 2

dq p
Price Elasticity (ep ) = ×
dp q
− 25 5
= × = −0.5
2 125

Example 6.4. Suppose a 5 per cent increase in price decreases by 24 per cent,

100
calculate the elasticity of demand.

Sol.
percentage change in demand
Price Elasticity(eP ) =
ercentage change in price
− 24
= = −4.8
5
The price elasticity of demand is -4.5 i.e relatively elastic. The good is normal.

Example 6.5. Due to rising in price from |5 to |6, demand for a good decreases
from 150 to 120 units.
(a) calculate the price elasticity of demand for forward and reverse the change.
(b) find the difference between elasticities measured with the ratio method and
mid-point method.
(c) guess out the nature of the good.

dp p
(a) Price Elasticity (ep ) = ×
dq q
p1 = 5, p2 = 6, q1 = 150, q2 = 120 =⇒ dq = -30 and dp = 1
− 30 5
= × = −1
1 150
For reverse change,

dp p
Price Elasticity (ep ) = ×
dq q
p1 = 6, p2 = 5, q1 = 120, q2 = 150 =⇒ dq = 30 and dp = -1
30 6
= × = −1.5
−1 120

dq (p1 + p2 )
(b) Price Elasticity (eP ) = ×
dp (q1 + q2 )
− 30 (5 + 6)
= ×
1 (150 + 120)
− 30 11
= × = −1.22
1 270

101
The difference between the elasticities measured with the ratio method and mid-point
method is 0.22.
(c) The good is normal because price elasticity is negative.

Example 6.6. A consumer changes his demand for a good from 80 units to 120
units in response to an 8 per cent decrease in price. Calculate the price elasticity.

percentage change in demand

Price elasticity (ep ) =
percentage change in price

Given, percentage change in price = - 8

120 − 80 40
percentage change in demand = = × 100 = 50
80 80
50
ep = = −6.25
−8

Example 6.7. A seller of eggs planning to reduce the price of eggs from |6/unit
to |5/unit. His current sales are 240 dozen per day. The price elasticity of eggs is
estimated to be -0.6. Calculate his new total revenue.

Sol. Given P1 = 6, P2 = 5 , ∆P = −1, ep = −0.6 and q1 = 240.

∆q p1
Price elasticity of demand(Pe ) = ×
∆p q1
q2 − 240 6
−0.6 = ×
5−6 240
− 1 × 240
−0.6 × = q2 − 240
6
− 240
−0.6 × = q2 − 240
6
240
= q2 − 200
60
q2 = 204

His new revenue = p2 × q2 = 5 × 204 = 1020

Example 6.8. A demand function of a good is given as q = 2000 − 5p. Calculate

elasticity at price |10.

102
Sol ;

dq p
Price elasticity of demand(Pe ) = ×
dp q
whrere, p = 10
q = 200 − 5p
= 200 − 5 × 10
= 200 − 50 = 150
dq d(200 − 5p)
=
dp dp
= −5

By putting these values in the above equation,

10
(Pe ) = −5 ×
150
= −1/3

Example 6.9. Slope of the demand curve at price |210 and quantity 630 is - 0.8.
Find price elasticity of demand.

Sol. Given, price = 210, quantity = 630, elasticity = -0.8

1 p
ep = ×
slope d
1 210
= ×
−0.8 630
1 3
= × = −0.42
−0.8 9

Example 6.10. The equation of a straight line tangent to the demand curve, at price
|30 and quantity 60, is q = 120 - 2p, where p is price and q is quantity. Calculate
price elasticity.

Sol. Reservation price, 0 = 120 − 2p =⇒ 2p = 120 =⇒ p = 60

Reservation quantity (RQ), q = 120 − 2(0) =⇒ q = 120

103
 A

O B

lower segment of demand curve

Price elasticity of demand(Pe ) = −
upper segment of demand curve
CB
= −
AB
qB
= −
Oq
RQ − q
= −
q
120 − 60
= − = −1
60
Price elasticity is a unit (-1).

Example 6.11. When the consumer’s income increased from |450 to |600, he
increased his consumption on a good from 60 inits to 75 units. Calculate the
elasticity of demand.

Sol. Given, Y1 = 450, Y2 = 600, ∆Y = 150, D1 = 60, D2 = 75 and ∆D = 15.

∆D Y
ep = ×
∆Y D

15 450
= × = 0.75
150 60

Example 6.12. Demand function of a good is q = 5000 + 2Y , where q is quantity

and Y is income. Find out income elasticity if per capita income is |75000.

104
Sol. By comparing demand function q = 5000 + 2Y with y = c + mx, the slope of
the demand function is 2.
∆D Y
ep = ×
∆Y D

1 Y
= ×
∆Y /∆D D
1 Y
= ×
slope D
1 75000
= ×
2 155000
= 75/310 = 0.2419354838709677 = 0.24

Example 6.13. The demand function of a good is given as q = 20 + 0.2Y − 0.5p,

where q is demand, Y is income in thousands and p is price. Calculate price and
income elasticities when p = 40 and y= |1200. Also the find effect of rising prices on
total revenue and rising income on sales.

Sol. Given, p = 40, y = 1200 =⇒ q = 20 + 0.2(1200) − 0.5(40) = 240

Slope of the function when price is variable function is -0.5 and when income is
variable is 0.02,

1 P
ep = ×
slope D
1 40
ep = × = −1/3
−0.5 240

1 Y
ep = ×
slope D
1 1200
ep = × = 25
0.2 240

Example 6.14. If two goods have a cross price elasticity of 1.5. (a) Decide if goods

105
are substitutes or complements. (b) If the price of one good rise by 10 per cent, what
would happen to the demand for other goods?

Example 6.15. A firm to increase revenue and profit increases price and advertising
expenditure by 5 per cent each. If the price elasticity of demand is -1.5 promotional
elasticity is 8 per cent. Would you predict an increase or decrease in total revenue?

∆P ∆A
Sol. Given = 0.05, = 0.05, ep = −1.5, eA = 0.08
P A

Proportionate change in demand

Price elasticity of demand(Pe ) =
Proportionate change in price
Proportionate change in demand
−1.5 =
0.05
Proportionate change in demand = −1.5 × 0.05 = 0.075

Percentage change in demand would be 7.5.

As price has been increased by 5 percent and demand decreases by 7.5 percent
1.05 x 0.925 = 97.125 Total revenue will decrease to 97.125 percent because of increase
in price.

Proportionate change in demand

Promotional elasticity of demand(PA ) =
Proportionate change in add expenditure
Proportionate change in demand
0.08 =
0.05
Proportionate change in demand = 0.8 × 0.05 = 0.040

Percentage change in demand would be 4.

As add expenditure is increased by 5 percent and demand increases by 4 percent
1.05 x 1.04 = 109.2 Total revenue will decrease to 109.2 percent because of increase
in price.

106.06

Example 6.16. If demand function is Q = 480 - 30p, calculate consumer surplus at

40.

Sol. Given Q = 480 - 30p, Q= 40

Reservation price, Q = 0 =⇒ 0 = 480 - 30p =⇒ 30p = 480 =⇒ p = 16.

106
Market price at 40 units. 40 = 480 - 30p =⇒ 30p = 480 - 40 =⇒ 30p = 440. =⇒
p = 14.67
Thus, Q = 40 p= 14.67 and PR = 16

16

14.67

D
40

1
Consumer Surplus = × base × hight
2
1
= × 40 × 1.33
2
= 26.6

Consumer surplus is 26.6 units.

Example 6.17. If supply function is Q= - 40+4p, calculate consumer surplus at 40.

Sol. Given Q = - 40 + 4p, Q= 40

Reservation price, Q = 0 =⇒ 0 = - 40 + 4p =⇒ 4p = 40 =⇒ p = 10.
Market price at 40 units. 40 = - 40 +4p =⇒ 4p = 40 + 40 =⇒ 4p = 80. =⇒ p
= 20
Thus, Q = 40 p= 20 and PR = 10

1
Consumer Surplus = × base × hight
2
1
= × 40 × 30
2
= 600

Producer surplus is 600 units.

107
 S

40

10
20

108