Unit 1& 2- Micro Economics- Consumer Demand

Micro Eco

1. ECONOMICS-I Presented By: Dr. Shuchi Singhal Assistant Professor SoMC 1

2. Meaning, Definition and Scope of Economics- Concept, definition, methodology and Scope of Micro Economics Concept Economics deals with the allocation of scarce resources among alternative uses to satisfy human wants 2

3. Human wants refer to all the goods, services, and conditions of life that individuals desire. Economic resources are the inputs, the factors, or the means of producing the goods and services we want. They can be classified broadly into land, labor, capital and entrepreneurship. 3

4. Scarcity: The Pervasive Economic Problem Resources have alternative uses. For example- a particular piece of land could be used for a factory, housing, roads, or a park. Becauses resources are generally limited, the amount of goods and services that any society can produce is also limited. 4

5. Thus, the society must chose which commodities to produce and which to sacrifice. In short, society can only satisfy some of its wants. If human wants were limited or resources unlimited, there would be no scarcity and there would be no need to study economics. 5

6. Over time, the size and skills of the labor force rise, new resources are discovered and new uses are found for available land and natural resources, the nation’s stock of capital is increased, and technology improves. Through these advances, the nation’s ability to produce goods and services increases. But human wants always seem to move well ahead of society’s ability to satisfy them. This scarcity remains. Scarcity is the fundamental economic fact of every society. 6

7. Definition Economics is essentially the study of how people- individuals and society- allocate their limited resources to derive maximum gain from the use of their resources. However, the eminent economists of different generations- right from Adam Smith, the Father of Economics, down to modern economists- have defined economics differently. 7

8. For example, Adam Smith defined economics as ‘ an inquiry into the nature and causes of wealth of the nations’. According to Alfred Marshall, a great economist of the 20 th Century, ‘Economics is the study of mankind in the ordinary business of life’. One may find many other definitions of economics offered by the economists of later times. But, none of the definitions is considered as an appropriate definition of economics. The reason is that the subject matter and scope of economics have expanded so vastly since its origin that defining economics in a sentence has become a difficult task. 8

9. Economics is the most widely applied social science to resolve the economic, social and political problems of the country and the most popular subject of study among the social sciences. 9

10. Economics as a social science studies economic behavior of the people and economic problems of the society. Economic behavior means a conscious effort of the people to derive maximum gains from the use of their limited resources (land, labour , capital, time, etc.) and opportunities available to them. Economics is, fundamentally, the study of how people allocate their limited resources to their alternative uses to produce and consume goods and services to satisfy their endless wants and to maximize their gains. 10

11. Reasons for Economizing Behavior The reason for economizing or optimizing behavior of the people is a natural tendency due to certain basic economic facts of human life like: Human wants and desires are endless. Resources available to satisfy human wants are scarce and limited. People by nature want to maximize their gains or their economic welfare from their resources 11

12. Branches of Economics: The mainstream of modern economics is divided in two major branches- Microeconomics and Macroeconomics. The division of economics between microeconomics and macroeconomics, is crystallized after the Great Depression of 1930s. 12

13. Microeconomics analyses the economic behavior of the people at micro level, i.e., at the individual level of consumers, firms and resource owners. In effect, microeconomics analyses the following aspects of economic system: How individual consumers and producers make their choices; How their decision and choices affect the demand and supply conditions; How consumers and producers interact to settle the prices of goods and services in the market; How prices are determined in different market settings and; How total output is distributed among those who contribute to production i.e., between landlords, labor, capital supplier, and the entrepreneurs. 13

14. Macroeconomics, on the other hand, studies the working and performance of the economy as a whole. It analyses how the levels of the national economic aggregated including national income, aggregate consumption, aggregate savings and investment, total employment, the general price level, and country’s balance of payments are determined. 14

15. Microeconomics Microeconomics is fundamentally the study of how individual economic entities including individual consumers, producers (firms) and resource owners find solution to the problem of maximizing their gains from their limited resources and how their decisions affect market conditions, prices and production. Microeconomics studies how individuals make their choices. 15

16. How consumers make their choices as to ‘what to consume’ and ‘how much to consume’ to maximize their total utility from their limited income. Similarly, it analyses how individual firms decide ‘what to produce’, ‘how to produce’, ‘for whom to produce’ and what price to charge so that their profit is maximized from their limited resources. Microeconomics is the study of decision making behavior at the micro level, i.e., at the level of individual decision makers. 16

17. Methodology In microeconomic theory, we seek to predict and explain the economic behavior of individual consumers, resource owners, and business firms and the operation of individual markets. For this purpose, we use models. A model abstracts from the many details surrounding an event and identifies a few of the most important determinants of the event. 17

18. For example- the amount of a commodity that an individual demands over a given period of time depends on the price of the commodity, the individual’s income, and the price of related commodities ( i.e substitute and complementary commodities). It also depends on the individual’s age, gender, education, background, whether the individual is single or married, whether he or she owns a house or rents, the amount of money he or she has in the bank, the stocks the individual owns, the individual’s expectations of future income and prices, geographic location, climate, and many other considerations. 18

19. However, given the consumer’s tastes and preferences, demand theory identifies the price of the commodity, the individual’s income, and the price of related commodities as the most important determinants of the amount of a commodity demanded by an individual. Although it may be unrealistic to focus only on these three considerations, demand theory postulates that these are generally capable of predicting accurately and explaining consumer behavior and demand. 19

20. One could, of course, include additional considerations or variables to gain a fuller or more complete explanation of consumer demand, but that would defeat the main purpose of the theory or model, which is to simplify and generalize. A theory or model usually results from casual observation of the real world. For example, we may observe that consumers generally purchase less of a commodity when its price rises. Before such a theory of demand can be accepted, however, we must go back to the real world to test it. We must make sure that individuals 20

21. in different places and over different periods of time do indeed, as a group, purchase less of a commodity when its price rises. Only after many such successful tests and the absence of contradictory results can we accept the theory and make use of it in subsequent analysis to predict and explain consumer behaviour . If, on the other hand, test results contradict the model, then the model must be discarded and a new one formulated. 21

22. According to the Nobel Laureate economists Milton Friedman, a model is not tested by the realism or lack of realism of its assumption but rather by its ability to predict accurately and explain. The assumptions of the model are usually unrealistic in that they must necessarily represent a simplification and generalization of reality. However, if the model predicts accurately and explains the event, it is tentatively accepted. 22

23. For example- demand theory, as originally developed, was based on the assumption that utility is cardinally measurable. This assumption is clearly unrealistic. Nevertheless, we accept the theory of demand because it leads to the correct prediction that a consumer will purchase less of a commodity when its price rises (other things remaining equal). 23

24. While most assumptions represent simplifications of reality, and to that extent are unrealistic, most economists take a broader position. According to these economists, the appropriate methodology of economics is to test a theory not only by its ability to predict accurately, but also by whether the predictions follow logically from the assumptions and by the internal consistency of those assumptions. 24

25. For example- the theory of perfect competition postulates that the economy operates most efficiently when consumers and producers are too small individually to affect prices and output. But this theory cannot be tested for the economy as a whole. It can only be tested by tracing the loss of welfare of individual consumers when the atomistic assumptions of the theory do not hold. Thus, an adequate test of the theory required not only confirming that the predictions are accurate but also showing how the outcome follows logically or results directly from the assumptions. 25

26. Scope of Microeconomics The scope of microeconomics consists of the theoretical analysis of economic behavior of the individual decision makers and the analysis of market mechanism, i.e., how market system works and how prices are determined. For the purpose of analyzing the economic behavior of the people, they are classified on the basis of their economic activity as Consumers- the consumers of all final goods and services, Producers- the firms producing goods and services, Resource Owners- the owners of factors of production. 26

27. Analysis of Consumer Demand: Consumer demand is the basis of all economic activities. Microeconomics seeks to analyse how consumers, given their income, preferences and choices, make decision on What to consume How much to consume How to allocate consumption expenditure on different consumer goods, and How to react to change in prices of goods and services. The analysis of how consumers take decision on these issues leads to the formation of theory of consumer demand. The study of the theory of consumer demand is the first element of the scope of microeconomics. 27

28. 2. Theory of Production and Cost: Given the demand for goods and services, production activity is carried out by the firms . Given their resources and objective, firms make decision on What to produce, How to produce, and How much to produce. The choice-making decisions on these issues are taken by the firms on the basis of their business objective and availability of resources. 28

29. Given their objective and resources, firms employ factors of production to produce goods or services. Besides, production of goods and services involves cost of production. Since increasing production requires increasing the use of inputs, cost of production increases with increase in production. Both the theory of production and the theory of cost make the second important scope of microeconomics. 29

30. 3. Analysis of Market and Price Determination: Consumers create demand and firms create supply of products. The interaction between consumers as buyers and firms as suppliers create a market system. There are a large number of buyers of almost all goods and services. But the number of sellers varies from market to market depending on the nature of the market. The number of sellers creates different kinds of markets, called market structure. 30

31. The price of a product in these kinds of market is determined under different systems and at different levels. The analysis of price determination in different kinds of markets gives rise to the theory of price determination, known also as the theory of firm. The theory of price determination is another important subject matter within the scope of microeconomics. 31

32. 4. Analysis of Factor Market and Income Distribution: They analysis of factor market and income distribution deals with the mechanism of the factor market, determination of factor price, and distribution of national income. Like product price is determined in product market, factor price is determined in factor market. Factors of production are generally classified as labor, land, capital and entrepreneur. Labor price is expressed as wage rate, land price as rent, capital price as rate of interest, entrepreneur price as profit. 32

33. The analysis of factor market brings out the formulation of the theories of factor price determination- the theory of determination of wage rate, the theory of rent and the theory of interest rate determination. Given the supply of factors of production, once factor prices are determined, the total wage income, rent income, interest income, and profits get determined. This gives the distribution of the national income. 33

34. 5. Analysis of General Equilibrium and Economic Welfare: This aspect of microeconomics present the analysis of how an economy attains the general equilibrium. The concept of general equilibrium refers to the economic conditions under which all consumers, producers, and factor owners are in equilibrium. The general equilibrium implies that all goods and services are so distributed among the consumers that each consumer derives the same marginal utility from each product; production of 34

35. goods and services is so distributed among the firms that each firm has the same marginal cost in each product, and factors of production are so allocated that their productivity in each product is the same. The production and distribution of goods and services and factors of production under the conditions of the general equilibrium maximize the national production. Maximization of the national production maximizes the economic welfare of the society. 35

36. Concepts in microeconomics and forms of economic analysis Micro VS Macro The study of Economics is divided by the modern economist in two parts- Micro economics & Macro Economics. An economic system may be looked at as a whole or in terms of its innumerable decision making units (such as consuming units e.g., individual consumers and households), producing units (e.g., firms, farms business and mining concerns), individual factors of production 36

37. (e.g., labourers , land-owners, capitalists, entrepreneurs), and individual industries, (e.g., cotton textiles, iron and steel, toy-making). When we are analysing the problems of the economy as a whole, it is macro economic study. While an analysis of the behaviour of any particular decision- making unit, such as a firm and industry, a consumer, constitutes micro economics. Micro economics is also called Price Theory and Macro Economics is called Income Theory. 37

38. MICRO ECONOMICS The word ‘micro’ means a millionth part. When we speak of micro-economics or the micro approach, what we mean is that it is some small part of component of the whole economy that we are analysing . For example, we may be studying an individual consumer’s behavior or that of an individual firm or what happens in any particular industry. In micro economics, what we study is the price of a particular product or of a particular factor of production and not the general price level in the country. 38

39. Similarly, if it be demand that we are analysing , in micro-economics it is the demand of an individual or that of an industry that is studied and not the aggregate demand of the entire community. Thus, micro-economic theory studies the behavior of individual decision-making units such as consumers, resource owners and business firms. IMPORTANCE OF MICRO-ECONOMICS Micro Economics occupies a very important place in the study of economic theory. It has both theoretical and practical importance. 39

40. From the theoretical point of view, it explains the functioning of a free enterprise economy. It tells us how millions of consumers and producers in an economy take decisions about the allocation of productive resources among million of goods and services. It explains how through markets mechanism, goods and services produced in the community are distributed. It also explains the conditions of efficiency both in consumption and production and departure from the optimum. As for practical importance, micro economics helps in the formulation of economic policies calculated to promote efficiency in production and the welfare of the masses. 40

41. Thus, the role of micro-economics is both positive and normative. It not only tells us how the economy operated but also how it should be operated to promote general welfare. Limitations: Micro economics suffers from certain limitations: It cannot give an idea of the functioning of the economy as a whole. An individual industry may be flourishing, whereas the economy as a whole may be languishing. It assumes full employment which is a rare phenomenon, at any rate in the capitalist world. It is therefore an unrealistic assumption. 41

42. Macro –Economics or The Theory of Income and Employment In recent years, thanks to the late Lord Keynes, increasing attention has been given to the analysis of economic system as a whole. This is macro-economics. In macro-economics, we study, as it were, the forest, whereas in micro-economics we study the trees. Macro-economics is concerned with aggregates and averages of the entire economy, such as national income, aggregate output, total employment, total consumption, savings and investment, aggregate demand, aggregate supply, general level of prices, etc. 42

43. In other words, in macro-economics, we study how these aggregates and averages of the economy as a whole are determined and what causes fluctuations in them. Macro-economics deals also with how an economy grows. In other words, it analyses the chief determinants of economic development and the various stages and processes of economic growth. This part of economic theory has been largely developed in the recent decades. 43

44. Utility of Macro-Analysis The importance that macro-analysis has come to acquire is not without reasons. The macro-approach is useful in several ways: It is helpful in understanding the functioning of a complicated economic system. It gives bird’s eye view of the economic world. For the formulation of useful economic policies for the nation, macro-analysis is of the utmost significance. Economic policies cannot be obviously based on the basis of the fortunes of a single firm or even a single industry or the price of an individual commodity. Macro analysis occupies an important place in economic theory in its pursuit of the solution of urgent economic problems. 44

45. These problems relate to aggregate output and national income. Limitations of Macro-Analysis Macro-analysis has limitations of its own: Individual is ignored altogether. It is individual welfare which is the main aim of Economics. Increasing national saving at the expense of individual welfare is not a wise policy. The macro-analysis overlooks individual differences. For instance, the general price level may be stable, but the prices of foodgrains may have gone spelling ruin to the poor. A steep rise in manufactured articles may conceal a calamitous fall in agricultural prices, while the average prices were steady. 45

46. Need for Integrating Macro and Micro-Economics It may be emphasized that neither of the two approaches outlined above can alone adequately help us in analysing the working of the economic system. It is very essential therefore to integrate the two approaches, if we wish to get correct solutions of our main economic problems. 46

47. Partial vs General Partial means analysis for a sector of the economy or for one or several partial groups of the economic units corresponding to a particular set of data. This entails a process of simplification, whereby, it excludes certain variable and relationship from the totality and studies only a few selected variables at a time. In other words, this method considers the changes in one or two variables keeping all others constant. 47

48. General: Fundamentally speaking, the price of any good or factor depends on the prices ruling in other markets. Commodities or factors must be either complementary or competitive, for there is nothing that stands unrelated (goods or factors). The complementarity arises out of the incompleteness of any single good or factor taken alone to satisfy a want. On the other hand, the goods or factors are competitive either because they are substitutable or else because with a given budget constraint, a large bundle of wants is to be satisfied. 48

49. Thus, the demand for, and the price of, a good depends upon the price of its substitutes or complements. In the same way, the demand for, and the price of, a factor are influenced by the prices of other factors that can be used with or for It. Not only that; the prices of goods and of factors in turn depend upon each other because the firms enter the product market as suppliers and enter the factor market as buyers. Households, on the other hand, are buyers in the product markets and suppliers in the factor markets. Study of interrelationship between various economic agents and markets is the subject matter of general equilibrium analysis. 49

50. Static vs. Dynamic Static: Imagine a photograph capturing a bustling market scene. This snapshot, frozen in time, is akin to static analysis in economics. It’s a method that compares different equilibrium states without the element of time, offering a simplified view of complex economic interactions. 50

51. Dynamic: Now, let’s turn the page to dynamic analysis, which is more like a movie than a photograph. It incorporates the dimension of time, allowing economists to chart the path of economic variables and observe how they evolve. Comparing Static and Dynamic Analysis in Practice Both static and dynamic analyses have their place in the economist’s toolkit. Static analysis, with its focus on equilibrium, is useful for understanding conditions at a given moment, while dynamic analysis provides a roadmap of economic processes over time. 51

52. Positive vs Normative Before we answer the question whether microeconomics is a positive or a normative science, let us understand what is a positive science and a normative science. According to Keynes, a positive science is a body of systematized knowledge concerning what is [and] a normative or regulatory science is a body of systematized knowledge relating to criteria of what ought to be and is concerned therefore with ideal as distinguished from actual." 52

53. Microeconomics as a Positive Science Microeconomics as a positive science seeks to analyze and explain economic phenomena as they stand. As a positive science, microeconomics seeks to answer such questions as 'what is', 'why it is' and 'what will be...". For example, look at some questions of positive nature. Why does a hungry person spend his or her first penny on food? When and why does he or she stop spending on food? Why do people buy more of a commodity when its price decreases? How does a firm decide what and how much to produce? How does the firm determine the price of its product? How does a labour decide what job to take up? Microeconomics as a positive science finds the answer to such questions. These are some questions of positive nature. 53

54. Microeconomics as a positive science explains the economic behaviour of individuals under given conditions and their response to change in economic conditions. Microeconomics as a Normative Science Microeconomics as a normative science seeks to answer the normative question 'what ought to be' on the basis of certain predetermined norms and social values. 'What people do' or 'what happens in the market' may not be desirable for the society. For example, production and sale of harmful goods like alcohol and cigarettes may be a very profitable business. But, a question arises here: 'Is production and sale of these goods desirable for the society?" This is a normative question a question in public interest. 54

55. Microeconomics as a social science examines such questions from the angle of social desirability of production and sale of such goods. Microeconomics as a normative science examines the social costs and benefits of production of goods like alcohol and cigarettes and answers the question whether production and sales of such goods are socially desirable. Consider another microeconomic problem. Given the growth of population and the supply of residential houses in India, house rents, if not controlled, will continue to increase and have, in fact, increased exorbitantly. Here a question arises: 'Should house rents be allowed to increase depending on the market demand and supply conditions or be controlled and regulated to protect the interest of tenants? This is a normative question-a question in public interest 55

56. To have a comparative view of positive and normative character of microeconomics, recall the issue of high food grain prices in India in 2001 and in 2010. On one hand, there was surplus food grain production in India, on the other hand, large-scale starvation and starvation deaths were reported from different parts of the country. This was a paradoxical situation. Yet, the Food Corporation of India (FCI), responsible for fixing the food grain price, did not take any steps to bring down the price of food grains 56

57. . This problem can be examined from both positive and normative angles. Examining 'how price of food grains is determined?' is a question for positive microeconomics and how should the prices of food grains be determined to prevent starvation?' is a question for normative microeconomics. It may, thus, be concluded that microeconomics is both a positive and normative science. However, it is important to note that microeconomics is, fundamentally, a positive science. It acquires its normative character from the application of microeconomic theories to examine the economic phenomena from their social desirability point of view; to show the need for a public policy action and; to evaluate the policy actions of the government. 57

58. Short Run vs. Long Run In the study of economics, the long run and the short run don't refer to a specific period of time, such as five years versus three months. Rather, they are conceptual time periods, the primary difference being the flexibility and options decision-makers have in a given scenario. “The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. The long run is a period of time in which the quantities of all inputs can be varied.” 58

59. Example of Short Run vs. Long Run Consider the example of a hockey stick manufacturer. A company in that industry will need the following to manufacture its sticks: Raw materials such as lumber Labor Machinery A factory Variable Inputs and Fixed Inputs Suppose the demand for hockey sticks has greatly increased, prompting the company to produce more sticks. It should be able to order more raw materials with little delay, so consider raw materials to be a variable input. Additional labor will be needed, but that could come from an extra shift and overtime, so this is also a variable input . 59

60. Equipment, on the other hand, might not be a variable input. It might be time-consuming to add equipment. Whether new equipment will be considered a variable input will depend on how long it would take to buy and install the equipment and to train workers to use it. Adding an extra factory, on the other hand, is certainly not something that could be done in a short period of time, so this would be the fixed input. The short run is the period in which a company can increase production by adding more raw materials and more labor but not another factory. Conversely, the long run is the period in which all inputs are variable, including factory space, meaning that there are no fixed factors or constraints preventing an increase in production output. 60

61. Concept of Margin In this section, we provide view of the crucial importance of the margin as the central unifying theme in all of microeconomics and examines clarifications on its use. The Crucial Importance of the Concept of the Margin Because of scarcity, all economic activities give rise to some benefits but also involve some costs. The aim of economic decisions is to maximize net benefits. Net benefits increase as long as the marginal or extra benefit from an action exceeds the marginal or extra cost resulting from the action. 61

62. The benefits are maximized when the marginal benefit is equal to the marginal cost. This concept applies to all economic decisions and market transactions. It applies to consumers in spending their income, to firms in organizing production, to workers in choosing how many hours to work, to students in deciding how much to study each subject and how many hours to work after classes, and to individuals in determining how much to save out of their income. It also applies in deciding how much pollution society should allow, in choosing the optimal amount of information to gather, in choosing the optimal amount of government regulation of the economy, and so on. Indeed, the concept of the margin and marginal analysis represent the key unifying concepts in all of microeconomics. 62

63. . It also applies in deciding how much pollution society should allow, in choosing the optimal amount of information to gather, in choosing the optimal amount of government regulation of the economy, and so on. Indeed, the concept of the margin and marginal analysis represent the key unifying concepts in all of microeconomics. 63

64. Specifically, the aim of consumers is to maximize the satisfaction or net benefit that they receive from spending their limited income. The net benefit or satisfaction of a consumer increases as long as the marginal or extra benefit that he or she receives from consuming one additional unit of a commodity exceeds the marginal or opportunity cost of forgoing or giving up the consumption of another commodity. A consumer maximizes satisfaction when the marginal benefit that he or she receives per dollar spent on every commodity is equal. 64

65. Similarly, it pays for a firm to expand output as long as the marginal or extra revenue that it receives from selling each additional unit of the commodity exceeds the marginal or extra cost of producing it. But as the firm produces and sells more units of the commodity, the marginal revenue may decline while its marginal cost rises. The firm maximizes total profits when the marginal revenue is equal to the marginal cost. 65

66. 1.3 Wants and Scarcity: The Pervasive Economic Problem Economics deals with the allocation of scarce resources among alternative uses to satisfy human wants. The essence of this definition rests on the meaning of human wants and resources, and on the scarcity of economic resources in relation to insatiable human wants. 66

67. Can Human Wants Ever Be Fully Satisfied? Human wants refer to all the goods, services, and conditions of life that individuals desire. These wants vary among different people, over different periods of time, and in different locations. However, human wants always seem to be greater than the goods and services available to satisfy them. Although we may be able to get all the hamburgers, beer, pencils, and magazines we desire, there are always more and better things that we are unable to obtain. In short, the sum total of all human wants can never be fully satisfied 67

68. Scarcity: The Pervasive Economic Problem Resources have alternative uses. For example, a particular piece of land could be used for a Factory, housing, roads, or a park. A laborer could provide cleaning services, be a porter, construct bridges, or provide other manual services. A student could be trained to become an accountant, a lawyer, or an economist. Because resources are generally limited, the amount of goods and services that any society can produce is also limited. 68

69. Thus, the society must choose which commodities to produce and which to sacrifice. In short, society can only satisfy some of its wants. If human wants were limited or resources unlimited, there would be no scarcity and there would be no need to study economics. 69

70. FUNCTIONS OF AN ECONOMIC SYSTEM Faced with the pervasiveness of scarcity, all societies, from the most primitive to the most advanced, must somehow determine (1) what to produce, (2) how to produce, (3) for whom to produce, (4) how to provide for the growth of the system, and (5) how to ration a given quantity of a commodity over time. 70

71. What to produce refers to which goods and services a society chooses to produce and in what quantities to produce them. No society can produce all the goods and services it wants, so it must choose which to produce and which to forgo. Over time, only those goods and services for which consumers are willing and able to pay a price sufficiently high to cover at least the costs of production will generally be produced. Automobile manufacturers will not produce cars costing $1 million if no one is there to purchase them. Consumers can generally induce firms to produce more of a commodity by paying a higher price for it. 71

72. On the other hand, a reduction in the price that consumers are willing to pay for a commodity will usually result in a decline in the output of the commodity. For example, an increase in the price of milk and a reduction in the price of eggs are signals to farmers to raise more cows and fewer chickens. How to produce refers to the way in which resources or inputs are organized to produce the goods and services that consumers want. Should textiles be produced with a great deal of labor and little capital or with little labor and a great deal of capital? 72

73. Since the prices of resources reflect their relative scarcity, firms will combine them in such a way as to minimize costs of production. By doing so, they will use resources in the most efficient and productive way to produce those commodities that society wants and values the most. When the price of a resource rises, firms will attempt to economize on the use of that resource and substitute cheaper resources so as to minimize their production costs. For example, a rise in the minimum wage leads firms to substitute machinery for some unskilled labor. 73

74. For whom to produce deals with the way that the output is distributed among the members of society. Those individuals who possess the most valued skills or own a greater amount of other resources will receive higher incomes and will be able to pay and coax firms to produce more of the commodities they want. Their greater monetary "votes" enable them to satisfy more of their wants. For example, society produces more goods and services for the average physician than for the average clerk because the former has a much greater income than the latter. 74

75. In all but the most primitive societies there is still another function that the economic system must perform: It must provide for the growth of the nation. Although governments can affect the rate of economic growth with tax incentives and with incentives for research, education, and training, the price system is also important. For example, interest payments provide the savers an incentive to postpone present consumption, thereby releasing resources to increase society's stock of capital goods. 75

76. Capital accumulation and technological improvements are stimulated by the expectations of profits. Similarly, the incentive of higher wages (the price of labor services) induces people to acquire more training and education, which increases their productivity. Through capital accumulation, technological improvements, and increases in the quantity and quality (productivity) of labor, a nation grows over time. 76

77. Finally, an economic system must allocate a given quantity of a commodity over time. Rationing over time is also accomplished by the price system. For example, the price of wheat is not so low immediately after harvest that all the wheat is consumed very quickly, thus leaving no wheat for the rest of the year. Instead, some people (speculators) will buy some wheat soon after harvest (when the price is low) and sell it later (before the next harvest) when the price is higher; the available wheat is thus rationed throughout the year. 77

78. Opportunity Cost : Life is full of choices but resources are scarce. With the given time, should one study business economics or visit a friend? With the given money, should one buy car or travel abroad? In each of these cases, one is required to give up something in order to have another thing. In other words, to get something it is costing us the opportunity to do something else. The cost associated with the alternative which is foregone is called ‘ opportunity cost ’. Opportunity cost is concerned with the cost of the next best alternative opportunity which was foregone in order to pursue a certain action. It is the cost of the missed opportunity and involves a comparison between the policy that was chosen and the policy that was rejected. Since resources are limited, every time you make a choice about how to use them, you are also choosing to forego other options. Economists use the term  opportunity cost  to indicate what must be given up to obtain something that’s desired. A fundamental principle of economics is that every choice has an opportunity cost. If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else. In short, opportunity cost is all around us. 78

79. The opportunity cost of using capital is the interest that it can earn in the next best use with equal risk. Suppose, budgetary allocation of a certain remote region which is devoid of electricity as well as paved roads is Rs . 500 crores. The people have voted for a thermal power station. The opportunity cost of the money spent on the power station is number of good roads. If a machine can produce 2 units of product ‘X’ or 10 units of product ‘Y’, then the opportunity cost of 1 unit of product ‘X’ is equal to 5 units of product ‘Y’. 1.5.1 Opportunity Cost and Individual Decisions In some cases, recognizing the opportunity cost can alter personal behavior. Imagine, for example, that you spend $8 on lunch every day at work. You may know perfectly well that bringing a lunch from home would cost only $3 a day, so the opportunity cost of buying lunch at the restaurant is $5 each day (that is, the $8 that buying lunch costs minus the $3 your lunch from home would cost). Five dollars each day does not seem to be that much. However, if you project what that adds up to in a year—250 workdays a year × $5 per day equals $1,250—it’s the cost, perhaps, of a decent vacation. If the opportunity cost were described as “a nice vacation” instead of “$5 a day,” you might make different choices. 79

80. If no information about quantities is available, then the opportunity cost can be calculated in terms of the ratio of their respective prices, i.e. P x /P y All decisions involving choice have opportunity cost calculations. For optimal allocation of resources, a manager should consider the opportunity cost of using resources, human or non-human. By choosing one course of action, he sacrifices the other alternative courses. It is possible to evaluate the chosen course of action in terms of the other (next best) alternative which is sacrificed. In a given situation, if there are no sacrifices, then there is no opportunity cost. Thus, the opportunity cost of resource having no alternative use is zero. The concept of opportunity cost finds application in ‘Production Possibility Curve’. 1.5.2 Production Possibility Curve : Production possibility curve (PPC) or production possibility frontier represents graphically all the possible alternative combinations of maximum amount of two goods, which can be produced with the available productive resources of an economy. As the total productive resources of the economy are limited and have alternative uses, the economy has to choose between different goods. 80

81. Increase in production of one good will imply reduction in the production of other goods as less of productive resources are left for the latter. PPC is based upon the following assumptions : Goods for production may be many but to make the analysis simple, we assume the production of only two goods. The economy has a fixed quantity of resources and addition to them is not possible. The resources can however be shifted from the production of one good to the other. These resources are also assumed to be perfectly mobile and are suitable for the production of both the goods. All resources are fully employed, i.e., economy is working at full employment. There is no wastage or underemployment. The level of technology is constant. It is assumed not to undergo change. Effect of prices is not taken into account. Different units of productive resources are imperfect substitutes of each other. Some units are more efficient in the production of one commodity, while others are more efficient in the production of another. 81

82. Now, let us assume that the economy produces only two goods, say guns and butter. The alternative production possibilities are represented by different combinations of quantities of guns and butter that can be produced with the help of the given resources of the economy. On the extreme, if all the resources are used for the production of butter (a civilian good), maximum amount of butter can be produced depending upon the quantities and qualities of the resources and the technological efficiency. Suppose, with the help of given resource and the state of technology, the economy can produce 5 million tonnes of butter. On the other extreme, all the resources of the economy can be used for the production of guns alone. Suppose that the economy can produce 15 thousand guns in that case. Thus, we have two combinations of butter and guns that can be produced (in isolation) by utilising all the available resources. In one combination, we have 5 million tonnes of butter with no guns and in the other, we have 15 thousand guns and no butter. 82

83. In between the two combinations, there are many other possible combinations of butter and guns that can be produced. Table 1 shows some of these possible combinations. In table 1 above, ‘A’, ‘B’, ‘C’, ‘D’, ‘E’ and ‘F’ represent the various possible combinations of guns and butter that can be produced by fully utilising all the available resources of the economy. ‘A’ and ‘F’ are the extreme possibilities. 83 Alternative Possibilities Butter (million tonnes) Guns (thousands) A 15 B 1 14 C 2 12 D 3 9 E 4 5 F 5 Table 1: Alternative Production Possibilities

84. Point ‘A’ represents the production of 15 thousand guns with no butter and point ‘F’ represents 5 million tones of butter with no guns. ‘B’, ‘C’, ‘D’ and ‘E’ represent other possible combinations of butter and guns that can be produced. From table1, it is clear that if the economy produces more and more quantity of one good, it can produce less and less of the other. ‘B’, ‘C’, ‘D’ and ‘E’ are the cases when the economy produces less and less of butter and more and more of guns, thus, transforming butter into guns. As resources are fully employed, it is not possible to increase the production of one good without cutting down the production of the other good . The alternative production possibilities can be represented graphically as shown in figure 2. In figure 2, production of butter is taken on X-axis and the production of guns is taken on the Y-axis. The points ‘A’, ‘B’, ‘C’, ‘D’, ‘E’ and ‘F’ in figure 2 represent graphically the various combinations of butter and guns as given in table 1 . The curve obtained by joining the points A, B,C,D,E and F (Cont…) 84

85. is called the production possibility curve (PPC). 85 Figure 2: Production Possibility Curve

86. The PPC is also called the ‘transformation curve’, because in moving from one alternative to another, say from B to C, we are transforming guns into butter by shifting resources from the production of guns to the production of butter. PPC also called ‘production-possibility frontier (PPF)’ shows the maximum quantity of goods that can be efficiently produced by an economy, given its technological knowledge and the quantity of available inputs. 86

87. Conclusion Opportunity cost is concerned with the cost of the next best alternative opportunity which was foregone in order to pursue a certain action. The concept of opportunity cost finds application in ‘Production Possibility Curve’. Production possibility curve (PPC) or production possibility frontier represents graphically all the possible alternative combinations of maximum amount of two goods, which can be produced with the available productive resources of an economy. 87

88. Unit 2 88

89. 2. 1 CARDINAL UTILITY APPROACH: DIMINISHING MARGINAL UTILITY Cardinal Utility Approach Introduction: The theory of demand starts with the examination of the behaviour of the consumer. In explaining consumer behaviour, economics relies on the fundamental premise that people choose those goods and services that they value most highly. To describe the way consumers choose among different consumption possibilities, economists developed the notion of ‘utility’. ‘Utility’ denotes satisfaction. More precisely, if basket A has higher utility than basket B for Smith, this indicates that Smith prefers A over B. The consumer is assumed to be rational. Given his income and the market prices of the various commodities, he plans the spending of his income so as to attain the highest possible satisfaction or utility. This is the axiom of utility maximisation. It is assumed that the consumer has full knowledge of all the information relevant to his decision, that is he has complete knowledge of all the available commodities , their prices and his income. 89

90. The consumer must be able to compare the utility (satisfaction) of the various ‘baskets of goods’ which he can buy with his income. There are two basic approaches to the problem of comparison of utilities- the Cardinalist approach and the Ordinalist approach . Cardinalist Approach: The cardinalist school postulated that utility can be measured. Utility can be measured in monetary units, by the amount of money the consumer is willing to sacrifice for another unit of a commodity. The measurement of utility may also be in subjective units, called utils . 90

91. Assumptions of Cardinal Utility Theory: Rationality : The consumer is rational. He aims at the maximisation of his utility subject to the constraint imposed by his given income. Cardinal Utility : The utility of each commodity is measurable. The most convenient measure is money that the consumer is prepared to pay for another unit of the commodity. Constant Marginal Utility of Money : this assumption is necessary if money is used as the measure of utility. The essential feature of a standard unit of measurement is that it be constant. If the marginal utility of money changes as income increases (or decreases), the measuring-rod for utility becomes like an elastic ruler, inappropriate for measurement. Diminishing Marginal Utility : The marginal Utility of a commodity diminishes as the consumer acquires larger quantities of it. 91

92. Marginal Utility and the Law of Diminishing Marginal Utility: Suppose that consuming the first unit of ice cream gives you a certain level of satisfaction or utility. Now imagine consuming a second unit. Your total utility goes up because the second unit of the good gives you some additional utility. What about adding a third and fourth unit of the same good? Eventually, if you eat enough ice cream, instead of adding to your satisfaction or utility, it makes you sick ! This leads us to the fundamental economic concept of ‘ Marginal Utility ’. When you eat an additional unit of ice cream, you will get some additional satisfaction or utility. The increment to your utility is called ‘ Marginal Utility ’ The term ‘Marginal’ means ‘additional’ or ‘extra’. Marginal utility denotes the additional utility you get from the consumption of an additional unit of a commodity. 92

93. One of the fundamental ideas behind demand theory is the ‘ law of diminishing marginal utility ’. This law states that the amount of extra or marginal utility declines as a person consumes more and more of a good. Utility tends to increase as you consume more of a good. However, as you consume more and more, your total utility will grow at a slower and slower rate. This is the same as saying that the marginal utility (extra utility added by the last unit consumed of a good) diminishes as more of a good is consumed. ‘ The law of diminishing marginal utility states that, as the amount of a good consumed increases, the marginal utility of that good tends to decline .’ 93

94. Total Utility (TU): TU is the sum of all the utilities derived from the total number of units consumed. It is the sum of marginal utilities associated with the consumption of successive units. TU n = MU 1 + MU 2 + MU 3 +……+ Mu n Where TU is the total utility of ‘n’ units. MU 1 , MU 2 , MU 3 ,…. MU n represent marginal utilities of 1 st , 2 nd , 3 rd ,……. n th unit of the commodity. Marginal Utility (MU): MU n = TU n – Tu n- 1 Where MU n is the Marginal Utility of the n th unit of the commodity, TU n is the total utility of the n th unit of the commodity and TU n- 1 is the total utility of the last unit of the commodity i.e. n- 1 th unit. Average Utility (AU): It is obtained by dividing total utility by the number of units of the commodity. AU = TU/Q 94

95. Table 1 shows in column (2) that total utility (TU) enjoyed increases as consumption (Q) grows, but it increases at a decreasing rate. Column (3) measures marginal utility as the extra utility gained when 1 extra unit of the good is consumed. Thus, when the individual consumes 2 units, the marginal utility is 18-10 = 8 units of utility. 95

96. The column (3) shows that the marginal utility declines with higher consumption. This illustrates the law of diminishing marginal utility. Relationship between TU and MU: MU goes on diminishing as the consumer consumes more and more units of a commodity. And TU increases but, at a diminishing rate. When MU is Zero, TU is the maximum and it is the point of maximum satisfaction. i.e., point of satiety.  When MU becomes negative, total utility starts decreasing. This is the area of dissatisfaction. 96

97. 97 Figure 1: Relationship between TU and MU

98. Equilibrium of the Consumer A consumer can either buy commodity X or retain his income. When a consumer pays some price for the commodity X, he compares the utility he derives from the additional unit of the commodity X with the price he is paying for that unit of the commodity X. Thus, consumer is in equilibrium when the Marginal Utility of X is equated to the its Market Price ( P x ). Thus, MU x = P x If MU x > P x , the consumer can increase his welfare by purchasing more units of X. Similarly, if the MU x < P x , the consumer can increase his total satisfaction by cutting down the quantity of X and keeping more of his income unspent. 98

99. Conclusion The cardinalist school postulated that utility can be measured. Utility can be measured in monetary units, by the amount of money the consumer is willing to sacrifice for another unit of a commodity. The law of diminishing marginal utility states that, as the amount of a good consumed increases, the marginal utility of that good tends to decline. Thus, consumer is in equilibrium when the Marginal Utility of X is equated to the its Market Price ( P x ). 99

100. 2.2 CARDINAL UTILITY APPROACH: LAW OF EQUI- MARGINAL UTILITY Cardinal Utility Approach: Law of Equi -Marginal Utility 100

101. Law of Equi -Marginal Utility We assume that each consumer maximizes utility, which means that the consumer chooses the most preferred bundle of goods from what is available. We also assume that the consumers have a certain income and face given market prices for goods. Let’s take two goods, A and B. The price of good A and B are P A and P B respectively. 101

102. The consumer is in equilibrium when the marginal utility of a good (MU) is equal to its price (P). Thus, we have, MU = P Therefore, MU A = P A ---(1) and MU B = P B --------(2) Dividing (1) by (2): MU A /P A = MU B /P B 102

103. If good A costs twice as much as good B, then buy good A only when its marginal utility is at least twice as great as good B’s marginal utility. This leads to the ‘ equimarginal principle ’ that I should arrange my consumption so that the last rupee spent on each good is bringing me the same marginal utility. 103

104. In case of more two commodities, the condition for the equilibrium of the consumer is the equality of the ratios of the marginal utilities of the individual commodities to their prices: MU A = MU B = MU per rupee of income P A P B Equimarginal principle : The fundamental condition of maximum satisfaction or utility is the equimarginal principle. It states that a consumer will achieve maximum satisfaction or utility when the marginal utility of the last rupee spent on a good is exactly the same as the marginal utility of the last rupee spent on any other good. 104

105. Why must this condition hold? If any good gave more marginal utility per rupee, I would increase my utility by taking money away from other goods and spending more on that good- until the law of diminishing marginal utility drove its marginal utility per rupee to equality with that of other goods. The common marginal utility per rupee of all commodities in consumer equilibrium is called the ‘marginal utility of income’. It measures the additional utility that would be gained if the consumer could enjoy an extra rupee’s worth of consumption. 105

106. 106

107. 107

108. 108

109. Conclusion The fundamental condition of maximum satisfaction or utility is the equimarginal principle. It states that a consumer will achieve maximum satisfaction or utility when the marginal utility of the last rupee spent on a good is exactly the same as the marginal utility of the last rupee spent on any other good. 109

110. 2.3 Assumptions of Indifference Curve Properties of Indifference Curve Perfect Substitutes and Perfect Complements 110

111. 2.3 ORDINAL UTILITY APPROACH: INDIFFERENCE CURVES 111

112. Suggested Readings Author : Robert S. Pindyck & Daniel L Rubinfeld Title of the Book : Microeconomics Chapter’s Name : Consumer Behavior Author : Paul A. Samuelson & William D. Nordhaus Title of the Book : Economics Chapter’s Name: Demand and Consumer Behaviour https://economictimes.indiatimes.com/definition/indifference-curve 112

113. 2.3 ORDINAL UTILITY APPROACH: INDIFFERENCE CURVES Ordinal Utility Approach The assumption of cardinal utility is extremely doubtful as the satisfaction derived from various commodities cannot be measured objectively. The ordinalist school postulated that utility is not measurable. The consumer need not know in specific units the utility of various commodities to make his choice. It suffices for him to be able to rank the various ‘baskets of goods’ according to the satisfaction that each bundle gives him. 113

114. Indifference curves approach is one of the main ordinal theories. 114

115. Indifference Curves : An indifference curve is the locus of points- particular combinations or bundles of goods- which yield the same utility (level of satisfaction) to the consumer, so that he is indifferent as to the particular combination he consumes. An indifference map shows all the indifference curves which rank the preferences of the consumer. Combinations of goods situated on an indifference curve yield the same utility. 115

116. Combinations of goods lying on a higher indifference curve yield higher level of satisfaction and are preferred. Combinations of goods on a lower indifference yield a lower utility. 116 Figure 1: A Consumer’s Indifference Curve

117. Assumptions : Rationality : The consumer is assumed to be rational- he aims at the maximisation of his utility, given his income and market prices . It is assumed that he has full knowledge of all the relevant information. 2. Utility is ordinal : It is taken as axiomatically true that the consumer can rank his preferences according to the satisfaction of each basket. He need not know precisely the amount of satisfaction . It suffices that he expresses his preference for the various bundles of commodities. 117

118. It is not necessary to assume that utility is cardinally measurable. Only ordinal measurement is required. 3. Diminishing marginal rate of substitution : Preferences are ranked in terms of indifference curves, which are assumed to be convex to the origin. The convexity of indifference curves implies a diminishing marginal rate of substitution. 118

119. 4. Consistency and transitivity of choice : It is assumed that the consumer is consistent in his choice, that is, if in one period he chooses bundle A over B, he will not choose B over A in another period if both bundles are available to him. The consistency assumption may be symbolically written as follows: If A > B, then B> A Similarly, it is assumed that consumer’s choices are characterised by transitivity: if bundle A is preferred to B, and B is preferred to C, then bundle A is preferred to C. 119

120. Symbolically we may write the transitivity assumption as follows: If A > B, and B > C, then A > C Non Satiety : This assumption implies that the consumer has not reached the point of saturation in the consumption of any good. Thus, he always prefers to have more of both the commodities. He always tries to move to a higher indifference curve to get higher and higher satisfaction. 120

121. Properties of the Indifference Curves: Negative Slope : An indifference curve has a negative slope, which denotes that if the quantity of one commodity (y) decreases, the quantity of the other (x) must increase if the consumer is to stay on the same level of satisfaction. Higher Indifference Curves are Preferred : The further away from the origin an indifference curve lies, the higher the level of utility it denotes: bundles of goods on a higher indifference curve are preferred by the rational consumer. 121

122. Indifference curves do not intersect : Indifference curves do not intersect. If they did, the point of intersection would imply two different levels of satisfaction, which is impossible. It is illustrated in figure 3. 122

123. Figure 3: Indifference Curves Do Not Cross Bundle A and C lie on the same indifference curve IC 1 . Thus, the consumer is indifferent between the two bundles A and C. Bundle A and B lie on the same indifference curve IC 2 . (Cont…) 123

124. Thus, the consumer is indifferent between these two bundles A and B. Thus, in terms of utility,: A = B & A= C Therefore, B = C However, since bundle B contains more units of commodity Y as compared to bundle C (and same units of commodity X), the consumer will prefer B over C and thereby B can not be equal to C in terms of utility. 124

125. Convex to the origin : This property is based on the principle of diminishing marginal rate of substitution (MRS). It implies that the slope of an indifference curve decreases (in absolute terms) as we move along the curve from the left downwards to the right. 125

126. Perfect Substitutes and Perfect Complements Two goods are perfect substitutes if the consumer is willing to substitute one good for the other at a constant rate. The simplest case of perfect substitutes occurs when the consumer is willing to substitute the goods on a one-to-one basis. 126

127. Example- Red pencils and blue pencils. Figure 5 shows Bob’s preferences for Red Pencils (Good X) and Blue Pencils (Good Y). These two goods are perfect substitutes for Bob because he is entirely indifferent between having a red pencil or the blue one. In this case, the MRS of red pencils for blue pencils is 1. 127

128. Bob is always willing to trade 1 blue pencil for 1 red pencil. In general, we say that two goods are perfect substitutes when the marginal rate of substitution of one for the other is a constant. Indifference curves describing the trade-off between the consumption of the goods are straight lines. 128

129. The slope of the indifference curves need not be 1 in the case of perfect substitutes. For ex- the consumer believes that one 16-megabyte memory chip is equivalent to two 8-megabyte chips because both combinations have the same memory capacity. In that case, the slope of the indifference curve will be 2. 129

130. 130 Figure 5: Indifference Curve in Case of Perfect Substitutes Figure 6: Indifference Curve in Case of Perfect Complements Left Shoe Right Shoe Red Pencils Blue Pencils

131. Figure 6 illustrates Jane’s preferences for left shoes and right shoes. For Jane, the two goods are perfect complements because a left shoe will not increase her satisfaction unless she can obtain the matching right shoe. In this case, the MRS of right shoes for left shoes is zero whenever there are more right shoes than left shoes; Jane will not give up any left shoes to get additional right shoes. 131

132. Correspondingly, the MRS is infinite whenever there are more left shoes than right because Jane will give up all but one of her excess left shoes in order to obtain an additional right shoe. Two goods are perfect complements when the indifference curves for both are shaped as right angles. 132

133. Conclusion An indifference curve is the locus of points- particular combinations or bundles of goods- which yield the same utility (level of satisfaction) to the consumer, so that he is indifferent as to the particular combination he consumes. Two goods are perfect substitutes if the consumer is willing to substitute one good for the other at a constant rate. The simplest case of perfect substitutes occurs when the consumer is willing to substitute the goods on a one-to-one basis. Two goods are perfect complements when the indifference curves for both are shaped as right angles. 133

134. 2.4 Marginal Rate of Substitution Why does MRS diminish? 134

135. 2.4 MARGINAL RATE OF SUBSTITUTION 135

136. Suggested Readings Author : Robert S. Pindyck & Daniel L Rubinfeld Title of the Book : Microeconomics Chapter’s Name : Consumer Behavior Author : Paul A. Samuelson & William D. Nordhaus Title of the Book : Economics Chapter’s Name: Demand and Consumer Behaviour Author : Christopher R. Thomas & S. Charles Maurice Title of the Book : Managerial Economics-Foundations of Business Analysis and Strategy Chapter’s Name: Theory of Consumer Behaviour https://www.princeton.edu/~dixitak/Teaching/InternationalTrade/Precepts/ECO352_Precept_Wks1-2.pdf 136

137. 2.4 MARGINAL RATE OF SUBSTITUTION Marginal Rate of Substitution (MRS) An important concept in indifference curve analysis is the ‘Marginal Rate of Substitution’. MRS is the rate at which one commodity can be substituted for another, the level of satisfaction remaining the same. It measures the number of units of Y that must be given up per unit of X added so as to maintain a constant level of utility. 137

138. Figure 1 : 138

139. The negative of the slope of the indifference curve at any point is called MRS of the two commodities, X and Y. Thus, slope of indifference curve = - dy / dx or –∆ y/ ∆x = MRSx,y In going from bundle A to bundle B in figure 1 , you would swap 3 of your 6 clothing units for 1 extra food unit. The consumer is indifferent between combinations A ( 1 X, 6Y) and B(2X, 3Y). The rate at which the consumer is willing to substitute is: MRS x,y = - ∆Y = -(3-6) = -(-3) = 3 ∆X 2 -1 1 139

140. But from B to C, you would sacrifice only 1 unit of your remaining clothing to obtain a 3 rd food unit- a 1 for 1 swap. The consumer is indifferent between combinations B (2X, 3Y) and C (3X, 2Y). The rate at which the consumer is willing to substitute is: ` MRS x,y = - ∆Y = -(2-3) = -(- 1) = 1 ∆X 3-2 1 140

141. For a fourth unit of food, you would sacrifice only ½ unit of clothing. The consumer is indifferent between combinations C (3X, 2Y) and D (4X, 1 .5Y). The rate at which the consumer is willing to substitute is: MRS x,y = ∆Y = -( 1 .5-2) = -(- 0.5) = 0.5 ∆X (4-3) 1 141

142. Thus, the value of MRS has declined from 3 to 1 to 0.5. The scarcer a good, the greater its relative substitution value; its marginal utility rises relative to the marginal utility of the good that has become plentiful. An indifference curve is convex as shown in figure 1. The marginal rate of substitution (the slope of the indifference curve) is equal to the ratio of the marginal utilities of the commodities involved : MRS x,y = MU x MU y 142

143. Why does the MRS diminish? Diminishing subjective marginal utility : The MRS decreases along the IC because, in most cases, no two goods are perfect substitutes for one another. In case any two goods are perfect substitutes, the indifference curve will be a straight line with a negative slope and constant MRS. Since most goods are not perfect substitutes, the subjective value attached to the additional quantity of a commodity decreases fast in relation to the other commodity whose total quantity is decreasing. 143

144. Therefore, when the quantity of one commodity (X) increases and that of the other (Y) decreases, the subjective MU of Y increases and that of X decreases. Therefore, the consumer becomes increasingly unwilling to sacrifice more units of Y for one unit of X. 144

145. Decreasing ability to sacrifice a good : When combination of two goods at a point on indifference curve is such that it includes a large quantity of one commodity (Y) and a small quantity of the other commodity (X), then the consumer’s capacity to sacrifice Y is greater than to sacrifice X. Consumer’s willingness and capacity to sacrifice a commodity is greater when its stock is greater and it is lower when the stock of a commodity is smaller. 145

146. Conclusion MRS is the rate at which one commodity can be substituted for another, the level of satisfaction remaining the same. It measures the number of units of Y that must be given up per unit of X added so as to maintain a constant level of utility. 146

147. 2.5 Budget Line and Consumer Equilibrium Change in Price and Shift in Budget Line Change in Income and Shift in Budget Line Price Effect Income Effect Substitution Effect 147

148. 2.5 BUDGET LINE AND CONSUMER EQUILIBRIUM 148

149. Suggested Readings Author : Robert S. Pindyck & Daniel L Rubinfeld Title of the Book : Microeconomics Chapter’s Name : Individual and Market Demand Author : Christopher R. Thomas & S. Charles Maurice Title of the Book : Economics Chapter’s Name: Theory of Consumer Behaviour Author : Paul A. Samuelson & William D. Nordhaus Title of the Book : Economics Chapter’s Name: Demand and Consumer Behaviour https://www.yourarticlelibrary.com/economics/consumers-equilibrium-assumptions-and-conditions-economics/10785 149

150. 2.5 BUDGET LINE AND CONSUMER EQUILIBRIUM Budget Line and Consumer Equilibrium The consumer has a given income which sets limits to his maximising behaviour. Income acts as a constraint in the attempt for maximising utility. The income constraint, in the case of two commodities, may be written Y = P x q x + P y q y ------( 1 ) Where P x = the price of good X q x = quantity of good X P y = the price of good Y q y = the quantity of good Y 150

151. The income constraint is represented graphically by the budget line , whose equation is derived from eq. ( 1 ), by solving for q y : q y = 1 Y – P x q x -----(2) P y P y Assigning successive values to q x (given the income, Y and the commodity prices, P x , P y ), we may find the corresponding values of q y . 151

152. Thus, if q x = 0 (that is, if the consumer spends all his income on y), the consumer can buy Y/ P y units of y. Similarly, if q y = o (that is, if the consumer spends all his income on x) the consumer can buy Y/ P x units of x. In figure 1 these results are shown by points A and B. If we join these points with a line we obtain the budget line. 152

153. Figure 1 : Budget Line 153 Y/ P y Y/ P x A B O X Y Good X Good Y

154. The slope of the budget line is the ratio of the prices of the two commodities : Slope of Budget Line = Px Py Geometrically, the slope of the budget line is : OA = Y/ P y = P x OB Y/ P x = P y 154

155. Syllabus 155

156. Consumer Equilibrium The consumer is in equilibrium when he maximises his utility, given his income and the market prices . Two conditions must be fulfilled for the consumer to be in equilibrium : The first condition is that the marginal rate of substitution be equal to the ratio of prices of the two commodities. MRS x,y = Mu x = Px MU y Py This is a necessary but not sufficient condition for equilibrium . 156

157. The second condition is that the indifference curves be convex to the origin at the point of equlibrium . This condition is fulfilled by the axiom of diminishing MRS x,y , which states that slope of the indifference curve decreases (in absolute terms) as we move along the curve from the left downwards to the right. 157

158. Graphical Presentation of the Equilibrium of the Consumer: Given the indifference map of the consumer and his budget line , the equilibrium is defined by the point of tangency of the budget line with the highest possible indifference curve. The consumer is in equilibrium at point ‘e’ in figure 2. At the point of tangency, the slope of the budget line ( P x / P y ) and of the indifference curve ( MRS x,y = MU x / MU y ) are equal: MU x = P x MU y = P y 158

159. The first condition is denoted graphically by the point of tangency of the budget line and IC. The second condition is implied by the convex shape (Cont..) 159 Figure 2: Consumer’s Equilibrium

160. of the indifference curves. The consumer maximises his utility by buying x* and y* if the two commodities. 160

161. Change in Price and Shift in Budget Line: Suppose the budget line in the beginning is BL, given certain prices of the goods X and Y and a certain income. Suppose the price of X falls, the price of Y and income remaining unchanged (Figure 1 ). Now, with a lower price of X the consumer will be able to purchase more quantity of X than before with his given income. Let at the lower price of X, the given income purchases OL’ of X which is greater than OL. 161

162. Since the price of Y remains same, there can be no change in the quantity purchased of good Y with the same given income and as a result there will be no shift in the point B. Thus, with the fall in the price of good X, the consumer’s money income and the price of Y remaining constant, the price line will take the new position BL’ 162

163. 163 Figure 1: Changes in Budget Line as a Result of Changes in Price of Good X Figure 2: Changes in Budget Line as a Result of Changes in Price of Good Y

164. Now, what will happen to the budget line (initial budget line BL) if the price of good X rises, the price of good Y and income remaining unaltered (Figure 1 ) With higher price of good X, the consumer can purchase smaller quantity of X, say OL’’ than before. Thus, with the rise in price of X, the budget line will shift to BL’’ 164

165. Figure 2 shows the changes in the budget line when price of good Y falls or rise, with the price of good X and income remaining the same. The initial budget line is LB. With the fall in the price of good Y, other things remaining unchanged, the consumer could buy more of Y with the given money income and therefore budget line will shift to LB’. Similarly, with the rise in price of Y, other things being constant, the budget line will shift to LB’’. 165

166. Changes in Income and Shifts in Budget Line What happens to the budget line if income changes, while the price of goods remain the same ? The effect of changes in income on the budget line is shown in figure 3. Let BL be the initial budget line, given certain prices of goods and income. If the consumer’s income increases while the prices of both goods X and Y remain unaltered, the budget line shifts upward to B’L’ and is parallel to the original budget line BL. On the other hand, if income of the consumer decreases, the prices of both goods X and Y remaining unchanged, the budget line shifts downward to B’L’ but remains parallel to the original budget line BL. 166

167. 167 Figure 3: Shifts in Budget Line as a Result of Changes in Income

168. Price Effect: Price effect is defined as the total change in the quantity consumed of a commodity due to change in its price. To examine price effect, let us assume there is a change in the price of good X, holding constant the price of good Y and income of the consumer as shown in figure 4. Suppose that the consumer is initially in equilibrium at point E 1 . Now suppose the price of X falls so that the budget line shifts from LR to LS. 168

169. As a result, the consumer reaches a higher indifference curve IC 2 and his new equilibrium point is E 2 . Here, his consumption of X increased by UR. This is the price effect on the consumption of good X. By joining the various points of equilibrium resulting from fall in price of good X, we get a curve called Price Consumption Curve (PCC). PCC is a locus of points of equilibrium on indifference curves, resulting from the change in the price of the commodity. 169

170. Price effect of change in price of a good includes both income effect and substitution effect. Figure 4: Price Consumption Curve 170

171. Income Effect We have studied consumer’s equilibrium under the assumption that consumer’s income and market prices of goods, X and Y, remain constant. Let us now examine the response of consumer to the change in his income, assuming the prices of all goods to remain constant. This response is shown by the income effect. Income effect means the change in consumer’s purchases of the goods as a result of a change in his income. 171

172. With given prices and a given money income as shown by the budget line P 1 L 1 , the consumer is initially at equilibrium at point Q 1 on indifference curve IC 1 and is having OM 1 of X and ON 1 of Y. Now suppose that income of the consumer increases. With his increased income, he would be able to purchase larger quantities of both goods. As a result, budget line will shift upward and will be parallel to the original budget line P 1 L 1 . Let us suppose the new budget line is P 2 L 2 . 172

173. With the new budget line P 2 L 2 , the consumer will now be in equilibrium at point Q 2 on indifference curve IC 2 and is now buying OM g of X and ON 2 of Y. Thus, as a result of increase in his income the consumer buys more quantity of both the goods. If his income increase further, the budget line will shift again and point of equilibrium will change. When we join the various points showing consumer’s equilibrium at various levels of income, we get Income Consumption Curve . 173

174. 174 Figure 5: Income Consumption Curve: Income Effect

175. Income effect (I.E) for a good can either be positive or negative . I.E is positive when with the increase in income of the consumer, his consumption of the good also increases. This is the case of a normal commodity. I.E is said to be negative when with the increase in his income, the consumer reduces his consumption of the good. Such goods for which income effect is negative are called inferior goods. 175

176. 176 Figure 6: Income Consumption Curve in Case of Good X being Inferior Good

177. Figure 7: Income Consumption Curve in case of Good Y being Inferior Good 177

178. Substitution Effect (S.E) The last section explained the effect of changes in income on the consumption of a good. Another factor responsible for the changes in consumption of a good is the S.E S.E is shown in figure 8. 178

179. With a given money income and prices of two goods, the initial budget line is PL and consumer is in equilibrium at point Q on the indifference curve IC and is purchasing OM of good X and ON of good Y. Suppose that price of good X falls so that the budget line shifts to PL ’. With the fall in price of X, consumer’s real income or purchasing power would increase. 179

180. Figure 8: Substitution Effect 180

181. In order to find the substitution effect, this gain in real income should be wiped out by reducing the money income of the consumer by such an amount that forces him to remain on the same indifference curve IC on which he was before the change in price of good X (i.e. to bring the consumer back on the original indifference curve or keep his level of satisfaction unchanged). When some money is taken away from the consumer to cancel out the gain in real income, then the budget line which shifted to PL’ will now shift downward but will be parallel to PL’. The budget line AB parallel to PL’ has been drawn at such a distance from PL’ that it touches the indifference curve IC. 181

182. Thus, reduction of consumer’s income by the amount PA (in terms of Y) or L’B (in terms of X) has been made so as to keep him on the same indifference curve (i.e. keep his satisfaction unchanged). PA or L ’B is called the compensating variation in income. The budget line AB represents the new relative prices of goods X and Y since it is parallel to the budget line PL’ which we obtained when the price of good X had fallen. 182

183. Since X is now relatively cheaper and Y is now relatively dearer than before, he will buy more of X and less of Y. Thus, with budget line, consumer will be in equilibrium at point T and is now buying OM’ of X and ON’ of Y. Thus, in order to buy more, he moves on the same indifference curve IC from point Q to point T. The increase in the quantity purchased of good X by MM’ and decrease in the quantity purchased of good Y by NN’ is due to the change only in the relative prices of goods X and Y, since the effect due to the gain in real income has been wiped out by making a simultaneous reduction in consumer’s income. S.E is always negative. 183

184. PRICE EFFECT (SUBSTITUTION EFFECT + INCOME EFFECT) : NORMAL GOODS In order to understand the way in which price-demand relationship is established in indifference curve analysis, let’s consider figure 4. Given the price of two goods and the income of the consumer, the consumer will be in equilibrium at E on indifference curve IC 1 (Initial budget line is AB). Let us suppose that the price of good X falls, price of Y and his money income remaining unchanged so that the budget line now shifts to AD. 184

185. The consumer will now be in equilibrium at a point on the new budget line AD. The new equilibrium point on AD will lie to the right of E, meaning thereby that the quantity demanded of the good X will increase as its price falls. The direction and magnitude of the change in the quantity demanded as a result of the fall in price of a good depend upon the direction and strength of income effect on the one hand and substitution effect on the other. 185

186. For normal goods, the income effect (IE) is positive . The substitution effect (SE) is always negative and it will raise the quantity demanded of the good if its price falls and vice versa. Thus, in case of a normal good, both the IE and the SE work in the same direction and would cause an increase in the quantity purchased of good X when its price falls. The consumer who is initially in equilibrium at E on IC I moves to point F on IC II when the price of good X falls and the budget line shifts from AB to AD. The movement from E to F represents the price effect. 186

187. 187 Figure 4: Price Effect Split up into Substitution and Income Effects for Normal Good

188. This price effect is the net result of two distinct forces, namely, SE and IE. PE can be decomposed into SE and IE in the following way: When the price of a good falls and the consumer moves to a new equilibrium position on a higher indifference curve, the income of the consumer is adjusted so as to offset the change in satisfaction resulting from the change in price of a good and bring the consumer back to his original indifference curve. For instance, in this case of a fall in the price of good X and the budget line shifts to AD , the real income of the consumer rises, i.e., he can buy more with his given money income. 188

189. With the new budget line AD, he is in equilibrium at point F on a higher indifference curve IC II . Now if his money income is reduced by the compensating variation in income so that he is forced to come back to the indifference curve IC I as before, he would buy more of X since X has now become relatively cheaper than before. Thus, with the reduction in his income now, the budget line shifts to LZ which has been drawn parallel to AD so that it just touches the indifference curve IC I where he was before the fall in price of X. Since the budget line LZ has got the same slope as AD, it represents the changed relative prices with X being relatively cheaper than before. 189

190. The consumer moves along IC I and substitutes X for Y. With the price line AB, he is in equilibrium at G on IC 1 and is buying 5 units more of X. This movement from E to G on the same indifference curve represents the substitution effect since this occurs due to the change in relative prices alone, real income remaining constant. Now, if the amount of money income which was taken away from him is now given back to him, he would move from G on IC I to F on a higher indifference curve IC II. 190

191. The movement from G to F is the result of the income effect. Price effect = 9 SE = 5 IE = 4 Price effect = SE + IE 9 = 5 + 4 191

192. PRICE EFFECT (SUBSTITUTION EFFECT + INCOME EFFECT) : INFERIOR GOODS In case of inferior goods, the income effect will work in opposite direction to the substitution effect. IE is negative for inferior goods and SE is always negative for any good. When price of an inferior good falls, its negative IE will tend to reduce the quantity demanded, while the SE will tend to increase the quantity demanded . 192

193. But the IE even when negative is generally too weak to outweigh the SE. Thus, the net result of the fall in price will be an increase in the quantity demanded . In figure 5, the fall in price of good X makes the consumer to shift from equilibrium Q to a new equilibrium R. As a result, the quantity purchased rises from OM to OT. 193

194. But the IE is negative and is equal to HT. The SE is equal to MH and is greater than the negative IE. Thus, the net effect of the fall in price of good X is the rise in quantity demanded by MT. 194

195. 195 Figure 5: Price Effect Split up into Substitution and Income Effects for Inferior Good

196. PRICE EFFECT (SUBSTITUTION EFFECT + INCOME EFFECT) GIFFEN GOODS There may be some inferior goods for which the negative IE is strong or large enough to outweigh the SE. In this case, quantity purchased of the good will fall as its price falls and quantity purchased of the good will rise at its price rises. Such an inferior good in which case the consumer reduces its consumption when its price falls and increases its consumption when its price rises is called a Giffen good. In figure 6, the consumer is initially in equilibrium at Q on indifference curve IC 1 . 196

197. With the fall in price of the good, the consumer shifts to point R on IC2. Thus, with the fall in price of good X, the consumer reduces his consumption of the good from OM to ON. This is the net effect of the negative IE which is equal to HN which induces the consumer to buy less of good X and the SE which is equal MH which induces the consumer to buy more of good X. Since the negative income effect HN is greater than the substitution effect HM, the net effect is the fall in quantity demanded of good X by MN with the fall in its price. 197

198. 198 Figure 6: Price Effect Split up into Substitution and Income Effects for Giffen Good

199. Thus, the quantity demanded of a Giffen good varies directly with price. Therefore, if a demand curve showing price-demand relationship is drawn, it will slope upward. 199

200. Conclusion The consumer has a given income which sets limits to his maximising behaviour. Income acts as a constraint in the attempt for maximising utility. The income constraint is represented graphically by the budget line The consumer is in equilibrium when he maximises his utility, given his income and the market prices. 200

201. 2.6 Determinants of Demand 201

202. 2.6 THEORY OF DEMAND 202

203. Suggested Readings Author : Paul A. Samuelson & William D. Nordhaus Title of the Book : Economics Chapter’s Name: Basic Elements of Supply and Demand Author : Christopher R. Thomas & S. Charles Maurice Title of the Book : Managerial Economics-Foundations of Business Analysis and Strategy Chapter’s Name: Demand, Supply and Market Equilibrium https://corporatefinanceinstitute.com/resources/knowledge/economics/demand-theory/ 203

204. 2.6 THEORY OF DEMAND Theory of Demand People demand goods because they satisfy the wants of the people. The demand for a commodity is the amount of it that a consumer will purchase or will be ready to take off from the market at various given prices in a period of time. Thus, demand in economics implies both the desire to purchase and the ability to pay for a good. Mere desire for a commodity does not constitute demand for it, if it is not backed by the ability to pay. 204

205. Determinants of Demand: The following factors influence the quantity demanded of a commodity: Price of the commodity : Consumers are willing and able to buy more of a good the lower the price of the good and vice versa. Price and quantity are negatively (inversely) related because when the price of a good rises, consumers tend to shift from that good to other goods that are now relatively cheaper. Conversely, when the price of a good falls, consumers tend to purchase more of that good and less of other goods that are now relatively more expensive. Price and quantity demanded are inversely related when all other factors are held constant. 205

206. Income of the Consumer: An increase in income can cause the amount of a commodity purchased by consumers either to increase or decrease. If an increase in income causes consumers to demand more of a commodity, when all other things remain constant, such a commodity is called a ‘normal good’. Similarly, if a decrease in income causes consumers to demand less of a good, all other things remaining constant, such a good is also a normal good. 206

207. There are some goods for which increase in income would reduce consumer demand, other variables held constant. This type of commodity is referred to as an ‘inferior good’. In the case of inferior goods, rising income causes consumers to demand less of the good, and falling income causes consumers to demand more of the good. Some Egs of inferior goods- used cars, jowar , bajra , bus service. 207

208. 3. Price of Related Commodities : Commodities may be related in consumption in either of the two ways: as substitutes or as complements. Goods are substitutes if one good can be used in the place of other. Eg - Tea and Coffee. If the two goods are substitutes, an increase in the price of one good will increase the demand for the other good and vice-versa, holding other things constant. 208

209. If an increase in the price of a related good causes consumers to demand more of a good, then the two goods are substitutes and vice versa. Goods are said to be complements if they are used in conjunction with each other. Eg - DVD player and DVD, car and petrol, shoe and polish, etc. If the demand for one good increases when the price of a related good decreases, the two goods are complements. Similarly, two goods are complements if an increase in the price of one of the goods causes consumers to demand less of the other good, all other things constant. 209

210. Tastes and Preferences of the Consumer : An important factor which determines demand for a good is the tastes and preferences of the consumers for it. A good for which consumers’ tastes and preferences are greater, its demand would be large. If an increase in the price of a related good causes consumers to demand more of a good, then the two goods are substitutes and vice versa. Goods are said to be complements if they are used in conjunction with each other. Eg - DVD player and DVD, car and petrol, shoe and polish, etc. 210

211. If the demand for one good increases when the price of a related good decreases, the two goods are complements. Similarly, two goods are complements if an increase in the price of one of the goods causes consumers to demand less of the other good, all other things constant. 211

212. 5. Consumers’ Expectations With Regard to Future Prices : Expectations of consumers also influence consumers’ decisions to purchase goods and services. Consumers’ expectations about the future price of a commodity can change their current purchasing decisions. If the consumers expect the price to be higher in a future period, demand will probably rise in the current period. On the other hand, expectations of a price decline in the future will cause some purchases to be postponed- thus demand in the current period will fall. 212

213. Number of Consumers in the Market : An increase in the number of consumers in the market will increase the demand for a good, and a decrease in the number of consumers will decrease the demand for a good, all other factors held constant. Demand Function : Q d = f (P, Y, P R , T, P E , N) 213

214. Conclusion Determinants of Demand: Price of the commodity Income of the consumer Price of related goods Tastes and preferences of the consumer Consumer’s expectations with regard to future prices Number of consumers in the market 214

215. 2.7 Law of demand Why does the demand curve slope downward? Market demand Exceptions to the law of demand 215

216. 2.7 LAW OF DEMAND 216

217. Suggested Readings Author : Paul A. Samuelson & William D. Nordhaus Title of the Book : Economics Chapter’s Name: Basic Elements of Supply and Demand Author : Christopher R. Thomas & S. Charles Maurice Title of the Book : Managerial Economics-Foundations of Business Analysis and Strategy Chapter’s Name: Demand, Supply and Market Equilibrium https://m.economictimes.com/definition/law-of-demand?from=desktop 217

218. 2.7 LAW OF DEMAND Law of Demand According to the law of demand, other things being equal, if price of a commodity falls, the quantity demanded of it will rise and vice versa. This relationship between price and quantity bought can be shown through the demand schedule and the demand curve. A demand schedule shows a list of several prices and the quantity demanded per period of time at each of the prices, holding other things constant. 218

219. Five prices and their corresponding quantities demanded are shown in Table 1. Table 1 : Demand Schedule 219

220. The graphical representation of the demand schedule is the ‘demand curve’. The demand curve in Figure 1 graphs the quantity demanded on the horizontal axis and the price on the vertical axis. The quantity and price are inversely related, i.e. , Q goes up when P goes down. The curve slopes downward, going from northwest to southeast. 220

221. Figure 1 : Demand Curve 221

222. Why Does the Demand Curve Slope Downward ? Quantity demanded tends to fall as price rises for two most important reasons: First is the substitution effect , which occurs because a good becomes relatively more expensive when its price rises. When the price of good A rises, the consumer will generally substitute goods B, C, D, …. for it. For example, as the price of beef rises, the consumer may eat more chicken. 222

223. 2. A higher price generally also reduces quantity demanded through the income effect . This comes into play because when the price goes up, the consumer finds himself somewhat poorer than he was before. Increase in the price of the commodity in effect reduces the real income of the consumer, so the consumer naturally curbs his consumption of the commodity. 223

224. Another explanation for the inverse relationship between price and quantity demanded is the law of diminishing marginal utility . This law suggests that as more of a product is consumed the marginal (additional) benefit to the consumer falls, hence consumers are prepared to pay less. These points are the reasons behind the downward sloping demand curve of an individual consumer. In addition, the market demand curve is downward sloping due to one more reason: Less consumers are able to afford a good at a relatively high price. When the price falls, more consumers start purchasing the good because some of them who could not afford the commodity before can now afford it. 224

225. Market Demand: The market demand is the sum total of all individual demands. The market demand curve is found by adding together the quantities demanded by all individuals at each price . The market demand curve will slope downward to the right since the individual demand curves, whose summation gives us the market demand curve, normally slope downward to the right. 225

226. Exceptions to the Law of Demand: Some exceptions to the law of demand include: Goods having Prestige Value: Veblen Effect- One exception to the law of demand is associated with the name of the economist Thorstein Veblen who propounded the doctrine of conspicuous consumption. According to Veblen, some consumers measure the utility of a commodity entirely by its price i.e., for them, the greater the price of a commodity, the greater its utility. 226

227. For example, diamonds are considered as prestige good in the society and for the upper strata of the society, the higher the price of diamonds, the higher the prestige value of them and therefore the greater utility or desirability of demand. In this case, the consumer will buy less of the diamonds at a lower price because with the fall in price its prestige value will go down. On the other hand, when price of diamonds goes up, their prestige value will go up and therefore their utility and desirability. As a result, at a higher price, the quantity demanded of diamonds by a consumer will rise. This is called the Veblen Effect. 227

228. Giffen Goods : Another exception to the law of demand was pointed out by Sir Robert Giffen who observed that when the price of bread increased, the low-paid British workers in the early 19 th century purchased more bread and not less of it and this was contrary to the law of demand. The reason given for this is that these British workers consumed a diet of mainly bread and when the price of bread went up they were compelled to spend more on a given quantity of bread. 228

229. Therefore, they could not afford to purchase as much meat as before. Thus, they substituted even bread for meat in order to maintain their intake of food. After the name of Robert Giffen , such goods in whose case there is a direct price-demand relationship are called Giffen goods. With the rise in the price of a commodity, its quantity demanded increases and vice versa. Thus the demand curve will slope upward to the right and not downward. 229

230. All Giffen goods are inferior, all inferior goods are not necessarily Giffen . [ Giffen good is a special type of inferior good whose demand increases as the price of the good increases]. For example, if the price of an essential food staple, such as rice, rises it may mean that consumers have less money to buy more expensive foods, so they will actually be forced to buy more rice. 230

231. Conclusion According to the law of demand, other things being equal, if price of a commodity falls, the quantity demanded of it will rise and vice versa. A demand schedule shows a list of several prices and the quantity demand per period of time at each of the prices, holding other things constant. The graphical representation of the demand schedule is the ‘demand curve’. 231

232. 2.8 Movement Along the Demand Curve Shift in the Demand Curve 232

233. 2.8 MOVEMENT ALONG VS. SHIFT IN DEMAND CURVE 233

234. Suggested Readings Author : Christopher R. Thomas & S. Charles Maurice Title of the Book : Managerial Economics-Foundations of Business Analysis and Strategy Chapter’s Name: Demand, Supply and Market Equilibrium Author : Paul A. Samuelson & William D. Nordhaus Title of the Book : Economics Chapter’s Name: Demand and Consumer Behavior https://courses.lumenlearning.com/wmopen-microeconomics/chapter/changes-in-supply-and-demand/ 234

235. 2.8 MOVEMENT ALONG VS. SHIFT IN DEMAND CURVE Movement along vs. Shift in Demand Curve When as a result of change in price of the commodity, the quantity demanded rises or falls, extension or contraction in demand is said to have taken place and we move along a given demand curve. When the quantity demanded of a good rises due to the fall in price, it is called extension of demand and when the quantity demanded falls due to the rise in price, it is called contraction in demand. 235

236. Movement along the demand curve (i.e. change in quantity demanded) can be caused only by a change in price of the commodity, other determinants of demand remaining constant. Figure 1 shows the movement along a given demand curve, DD. When the price of the good is OP, then the quantity demanded of the good is OM. Now, if the price of the good falls to OP ’ , the quantity demanded of the good rises to ON. Thus, there is an extension in demand by the amount MN. On the other hand, if price of the food rises from OP to OP’’ the quantity demanded of the good falls to OL . Thus, there is contraction in demand by ML. 236

237. Figure 1 : Movement along the Demand Curve 237

238. Shift in Demand Curve : Increase in Demand: When demand changes due to factors other than price of the commodity (i.e., income of consumer, price of related goods, tastes and preferences of consumers, etc) there is a shift in the whole demand curve . In figure 2, DD is the demand curve. With the increase in income of the consumer, the demand curve shifts to the right to D’D’ which implies that at each price such as P 1 , P 2 , P 3 , the consumers demand more of the commodity than before. Everywhere along D’D’, the quantity demanded is greater than along DD for equal prices. This change in demand is called an increase in demand . 238

239. Decrease in Demand : A decrease in demand occurs when a change in one or more of the determinants of demand other than the price of the commodity causes the quantity demanded to decrease at every price and the demand curve shifts to the left. 239

240. Figure 2: Shift in Demand Curve 240

241. Let’s start with the demand curve DD. Now, suppose the income of the consumer declines. This will cause a decrease in the demand by the consumers. As a result of a decline in income, the demand curve shifts to the left to D”D” and at each price the quantity demanded is less than before. 241

242. Conclusion When as a result of change in price of the commodity, the quantity demanded rises or falls, extension or contraction in demand is said to have taken place and we move along a given demand curve. When the quantity demanded of a good rises due to the fall in price, it is called extension of demand and when the quantity demanded falls due to the rise in price, it is called contraction in demand. Movement along the demand curve (i.e. change in quantity demanded) can be caused only by a change in price of the commodity, other determinants of demand remaining constant. 242

243. 2.9 Price Elasticity of Demand Methods of calculating Elasticity of Demand 243

244. 2.9 CONCEPT OF MEASUREMENT OF ELASTICITY OF DEMAND 244

245. Suggested Readings Author : A. Koutsoyiannis Title of the Book : Modern Micro Economics Chapter’s Name : Theory of Demand Author : Paul A. Samuelson & William D. Nordhaus Title of the Book : Economics Chapter’s Name: Supply and Demand: Elasticity and Applications Author : Christopher R. Thomas & S. Charles Maurice Title of the Book : Managerial Economics-Foundations of Business Analysis and Strategy Chapter’s Name: Elasticity and Demand https://courses.lumenlearning.com/boundless-economics/chapter/price-elasticity-of-demand/ 245

246. 2.9 CONCEPT OF MEASUREMENT OF ELASTICITY OF DEMAND Most managers agree that the toughest decision they face is the decision to raise or lower the price of their firms’ products. When managers lower price to attract more buyers, revenues may either rise or fall, depending upon how responsive consumers are to a price reduction. The law of demand explains only the direction of change of the demand and price of a commodity. 246

247. It fails to explain the quantitative relationship between the two changes, i.e., how much quantity demanded will change as a result of a change in the price of the commodity. The intensity with which demand reacts to price changes is not captured by the demand curve. This is explained through the concept of elasticity of demand. The demand for a good like salt is not affected very much by a change in its price. On other hand, demand for luxuries like colour T.V . D.V.D players, etc , is considerably affected by a change in their respective prices. 247

248. Different goods respond differently to a change in their prices . For some goods, a small change in the price of a commodity may lead to a considerable change in the quantity demanded, but, sometimes even a considerable change in price may not lead to any change in quantity demanded. 248

249. Price Elasticity of Demand: The price elasticity is measure of the responsiveness of demand to changes in the commodity’s own price. It is equal to the percentage change in the quantity demanded of a commodity, divided by the percentage change in its price. It is always a negative number because P and Q are inversely related. 249

250. Methods of Calculating Elasticity of Demand There are various methods of calculating elasticity of demand for a good: Percentage Method Total Outlay Method Point Method Arc Method 250

251. Percentage Method : According to this method, elasticity of demand is the ratio of the percentage (or proportionate) change in quantity demanded of a commodity to a percentage (or proportionate) change in its price. Elasticity of Demand (e p ) = percentage (or proportionate) change in quantity demanded percentage (or proportionate) change in price = change in quantity demanded * 100 original quantity change in price * 100 original price 251

252. = ∆q ÷ ∆p q p = ∆q * p ∆p q Where ∆q is change in quantity ∆p is change in price p is original price q is original quantity 252

253. Price elasticity of demand is negative . The reason is that price and quantity demanded of a commodity move in opposite directions. Demand can be: Perfectly inelastic (e p = 0) iv. Elastic ( e p >1) Inelastic (e p <1) v. Perfectly Elastic (e p = ∞) Unit Elastic (e p = 1 ) 253

254. Perfectly inelastic- quantity demanded of a commodity does not change at all due to the change in its price. Example- life saving drugs. Inelastic - Percentage change in demand of a commodity is less than percentage change in price. Example- food, medicines, etc. Unit elastic- Percentage change in demand of a commodity is equal to percentage change in its price. 254

255. Elastic - Percentage change in demand of a commodity exceeds the percentage change in its price Perfectly elastic- A small reduction in price would cause the buyers to increase the quantity demanded from zero to all they could obtain. On the other hand, a small rise in price of the product will cause the buyers to switch completely away from the product so that its quantity demanded falls to zero. 255

256. 256 Figure 2: Perfectly Inelastic Demand Figure 1: Perfectly Elastic Demand Figure 3: Unitary Elastic Demand

257. Figure 4: Elastic Demand Figure 5: Inelastic Demand 257

258. Total Outlay Method : In this method, elasticity of demand is studied in relation to change in total outlay (expenditure) as a result of change in price and the consequent change in demand for a product. By knowing the expenditure incurred on a commodity before and after the change in the price, the elasticity of demand of the product can be measured. However, this method fails to give the precise value of the elasticity of demand. Hence, the outlay method is restrictive and only a rough measure of elasticity. 258

259. By this method, we can only know whether the elasticity is equal to one (unit elastic), greater than one (elastic demand) or less than one (inelastic demand). Elasticity is one : if the rise or fall in price of the commodity leaves the total expenditure unaffected, then elasticity is said to be one. In this case, change in price (rise or fall) is neutralised by the change in demand (fall or rise) such that net effect on consumer outlay is zero. (Cont..) 259

260. (ii) Elasticity is More than One: If the fall in price leads to increase in total outlay, while rise in price reduces total outlay, elasticity is more than one. In this case, change in demand is proportionately more than the change in price. (iii) Elasticity is Less than One: . if the fall in price reduces total outlay, while rise in price increases this total outlay, elasticity is less than one. In this case, change in demand is proportionately less than the change in price 260

261. 261 Table 1: Total Outlay Method

262. Point Method It is used to measure elasticity at a point on the demand curve. Elasticity of demand on a straight line demand curve is different at different points. This method is appropriate for very small movements in the price. 262

263. Figure 5: Point Elasticity 263

264. In figure 5, Point A is at the middle of the demand curve DD 1 . Elasticity at a point on the demand curve = Lower segment Upper segment Thus, elasticity at point A = AD 1 / DA. Since AD 1 = DA, therefore elasticity at point A is 1 . Similarly, elasticity at point B, which is equal to BD 1 /DB is greater than one. For any point that lies above the middle point A, the elasticity will be greater than 1 . AD is the zone of the demand curve where the elasticity is greater than 1 . 264

265. For any point that lies above the middle point A, the elasticity will be greater than 1 . AD is the zone of the demand curve where the elasticity is greater than 1 . As we move further towards D, the elasticity of demand increases. This is because as we move towards point D, lower segment will become larger and larger, while the upper segment will be decreasing. At point D, elasticity is equal to infinity (DD 1 /0 = ∞) If we move downward from the middle point A of the demand curve DD 1 , the elasticity of demand decreases. 265

266. The reason is that as we move downward, the lower segment of the demand curve decreases and the upper segment of the demand curve increases. At every point between A and D 1 , the lower segment of the curve is smaller than the upper segment. Thus, elasticity of demand which is defined as the lower segment divided by the upper segment of the demand curve, is less than one at all points between A and D 1 . At point D 1 , elasticity of demand is equal to zero, because at this point D 1 , there is no lower segment of demand curve. 266

267. To conclude, at the mid point of the straight line demand curve, elasticity of demand is equal to unity. At points higher than the middle point, elasticity of demand is greater than unity. At points lower than the middle point, elasticity is less than unity. At the highest point of the demand curve, where it meets the vertical axis, elasticity is equal to infinity. At the lowest point where the demand curve meets the horizontal axis, elasticity of demand is equal to zero. 267

268. 4. Arc Method : In the calculation of point elasticity of demand, we are concerned with elasticity over a very small range of the curve. But generally, change in price is not too small, so that we have to measure the elasticity over a substantial range of a demand curve . For this purpose, another method is used called the Arc method. 268

269. This method measures the elasticity of demand over a range, or arc of a demand curve like the range R R 1 in figure 6. Elasticity (e) = New quantity- Original quantity (Original quantity + New quantity)/2 New price – Original price (Original price + New price)/2 q 2 – q 1 ÷ p 2 -p 1 = q 1 + q 2 p 1 + p 2 2 2 269

270. = ∆q * (p 1 +p 2 ) (q 1 + q 2 ) ∆p = ∆q * p 1 +p 2 ∆p q 1 + q 2 270

271. 271 Figure 6: Arc Method

272. Conclusion The intensity with which demand reacts to price changes is not captured by the demand curve. This is explained through the concept of elasticity of demand. There are various methods of calculating elasticity of demand for a good: Percentage Method Total Outlay Method Point Method Arc Method 272

273. 2.10 Factors Affecting Elasticity of Demand 273

274. 2. 1 0 FACTORS AFFECTING ELASTICITY OF DEMAND 274

275. Suggested Readings Author : Christopher R. Thomas & S. Charles Maurice Title of the Book : Managerial Economics-Foundations of Business Analysis and Strategy Chapter’s Name: Elasticity and Demand Author : A. Koutsoyiannis Title of the Book : Modern Micro Economics Chapter’s Name : Theory of Demand Author : Paul A. Samuelson & William D. Nordhaus Title of the Book : Economics Chapter’s Name: Supply and Demand: Elasticity and Applications https://www.tutor2u.net/economics/reference/factors-affecting-price-elasticity-of-demand 275

276. 2.10 Factors Affecting Elasticity of Demand There are a number of factors which affect the elasticity of demand of a commodity: Nature of Commodity : The first and foremost determinant of the elasticity of demand is the nature of the commodity. Necessities (like food grains) and prestige goods have an inelastic demand, while luxuries and comforts have relatively elastic demand . Necessities (essentials of life) are demanded, whatever be their price. 276

277. . In the case of luxuries and comforts, the change in price makes the consumer change the quantity demanded relatively more and so it is more elastic. For the poor people, the demand is less elastic as they mostly purchase necessities of life. For middle and upper class people, the demand is relatively elastic as they purchase a number of commodities. 277

278. Number of Substitutes : Commodities with few and poor substitutes like wheat and salt have low price elasticity of demand. If the commodity has many close substitutes, the demand for such a commodity will be highly elastic. The reason is that even a small rise in its price will induce buyers to go in for its substitutes, whose prices have remained the same. On the other hand, a fall in its price will induce people to buy this commodity than its substitutes. Thus, availability of close substitutes makes people sensitive to the change in the price of the commodity. 278

279. Demand for a good tends to be perfectly inelastic if no substitutes are available. Number of Uses of a Commodity : The greater the number of uses to which a commodity can be put, the greater will be its price elasticity of demand . Thus, electricity, which can be used in heating, cooking, lighting and industrial purposes will have high price elasticity of demand. When its price increases, it will be put to only most important use (i.e., lighting). 279

280. On the other hand, when its price falls it will be put to less important uses like cooking, heating, etc and consequently its quantity demanded will rise significantly. Demand for a commodity, which has a number of uses may be elastic in some uses and inelastic in some other uses. 280

281. For instance, if the price of coal rise, the railways will continue to use it for the generation of steam power and consumers may give it up and shift to alternative domestic fuels (e.g., gas or kerosene oil). Thus, demand for coal is inelastic in one use (for railways) and elastic in the other use (for consumers for domestic use) 281

282. Position of Commodity in Consumer’s Budget : The proportion of consumer’s income spent on a particular commodity also influences the elasticity of demand for it. The greater the proportion of income spent on a commodity, the greater will generally be its elasticity of demand and vice-versa. 282

283. The demand for common salt, soap, matches, ink, etc. tends to be highly inelastic, because the consumers spend a small proportion of their income on each of them. When the price of such a commodity changes, they will continue to purchase almost the same quantity of that commodity. The demand for cloth, however, tends to be elastic on which a considerable part of their expenditure is spent. 283

284. Postponement of Demand : Demand for a commodity tends to be elastic, if the demand for it can be postponed. For example , when the price of cement rises, people may postpone their plans for house building for this reason. Thus, demand for cement is elastic. 284

285. Period of Time: If the price of a product rises, consumers will search for cheaper substitutes. The longer the period they have, the more likely they are to find substitute. Demand will, therefore, be more price elastic in the long run and less elastic in the short run. 285

286. 7. Consumer’s Behaviour : Consumer’s habits, tastes, preferences, etc. also affect the elasticity of demand. If a consumer is habituated or addicted to use of tobacco, alcohol or drugs, its demand will be inelastic. Further, if a certain type of garment is his vogue and its customers stick to it, a sharp increase in its price will not reduce its demand much. 286

287. Conclusion There are a number of factors which affect the elasticity of demand of a commodity: Nature of Commodity Number of Substitutes Number of Uses of a Commodity Position of Commodity in Consumer’s Budget Postponement of Demand Period of Time Consumer’s Behaviour 287

288. 2.11 Income Elasticity of Demand 288

289. 2. 11 INCOME ELASTICITY OF DEMAND 289

290. Suggested Readings Author : Christopher R. Thomas & S. Charles Maurice Title of the Book : Managerial Economics-Foundations of Business Analysis and Strategy Chapter’s Name: Elasticity and Demand Author : A. Koutsoyiannis Title of the Book : Modern Micro Economics Chapter’s Name : Theory of Demand https://www.tutor2u.net/economics/reference/income-elasticity-of-demand 290

291. 2. 11 INCOME ELASTICITY OF DEMAND Income Elasticity of Demand: It is defined as the percentage (proportionate) change in the quantity demanded resulting from a proportionate change in income. e y = percentage change in the quantity demanded of commodity percentage change in income of the consumer e y = ∆q q ∆y y = ∆q * y ∆y q 291

292. where q stands for the quantity demanded y stand for the income of the consumer ∆q stands for the change in the quantity demanded ∆y stands for the change in income of the consumer 292

293. For most of the goods, income elasticity of demand will be positive, as with the increase in the level of income, people tend to demand more of the goods. Such goods are called normal goods. For some of the goods, income elasticity is negative (less than zero). After an increase in income, if the quantity demanded by the people falls, these goods are called inferior goods. Necessity - A commodity is a necessity if its income elasticity is small (less than unity, usually). Luxury- A commodity is considered to be a luxury if the income elasticity is greater than unity. 293

294. Greater than 1 ( e y >1) : When % change in quantity demanded is greater than the % change in income. Eq - Luxury goods. Equal to 1 ( e y = 1): When % change in quantity demanded is equal to the % change in income. Less than 1 but greater than 0 (0 < ey < 1): When % change in quantity demanded is less than the % change in income. Eq - Necessities . 294

295. Equal to 0 ( e y = 0): When there is no change in quantity demanded with the change in income. Less than zero ( e y < 0): After an increase in income, if the quantity demanded by the people falls. Eg - Inferior goods. Greater than zero: with the increase in the level of income, people tend to demand more of the goods. Eg - Normal goods 295

296. Conclusion It is defined as the percentage (proportionate) change in the quantity demanded resulting from a proportionate change in income. 296

297. 2.12 Cross Elasticity of Demand 297

298. 2. 12 CROSS ELASTICITY OF DEMAND 298

299. Suggested Readings Author : Christopher R. Thomas & S. Charles Maurice Title of the Book : Managerial Economics-Foundations of Business Analysis and Strategy Chapter’s Name: Elasticity and Demand Author : A. Koutsoyiannis Title of the Book : Modern Micro Economics Chapter’s Name : Theory of Demand https://economictimes.indiatimes.com/definition/cross-elasticity-of-demand 299

300. 2.12 Cross Elasticity of Demand It is defined as the proportionate change in the quantity demanded of commodity x resulting from a proportionate change in the price of commodity y e xy = percentage change in the quantity demanded of commodity x percentage change in the price of commodity y e xy = ∆ q x = ∆ q x * p y q x ∆ p y q x ∆ p y p y 300

301. The sign of the cross-elasticity is negative if x and y are complementary goods and positive if x and y and substitute goods. In the extreme case, when the two goods are perfect complements, the cross elasticity of demand between them is -∞ Similarly, for perfect substitutes, cross elasticity of demand is plus infinity. If the two goods have no relation between them, then the cross elasticity is zero. 301

302. Value of Elasticity Relationship Between X and Y + ∞ Perfect Substitutes >0 Substitutes = 0 Unrelated < 0 Complements - ∞ Perfect Complements 302

303. Conclusion It is defined as the proportionate change in the quantity demanded of commodity x resulting from a proportionate change in the price of commodity y 303

304. 2.13 Advertising Elasticity of Demand 304

305. 2. 1 3 ADVERTISING ELASTICITY OF DEMAND 305

306. Suggested Readings Author : Christopher R. Thomas & S. Charles Maurice Title of the Book : Managerial Economics-Foundations of Business Analysis and Strategy Chapter’s Name: Elasticity and Demand Author : A. Koutsoyiannis Title of the Book : Modern Micro Economics Chapter’s Name : Theory of Demand https://smallbusiness.chron.com/advertising-affect-price-elasticity-65925.html 306

307. 2.13 Advertising Elasticity of Demand The expansion of demand through advertisement can be measured by advertising or promotional elasticity of demand ( e A ), which shows responsiveness of demand to changes in advertising or other promotional expenses. e A = Proportionate change in demand Proportionate change in advertisement expenditure = ∆Q ÷ ∆A = ∆Q * A Q A ∆A Q 307

308. Where Q and A represent demand and advertisement expenditure respectively. The advertising elasticity of demand should be positive , as advertisement expenditure is supposed to boost up the market. The higher is the value of this elasticity, the greater would be the incentive for the firm to go for advertisement of its product. 308

309. Conclusion The expansion of demand through advertisement can be measured by advertising or promotional elasticity of demand ( e A ), which shows responsiveness of demand to changes in advertising or other promotional expenses 309

310. 2.14 Need and Objectives of Demand Forecasting Methods of Demand Forecasting 310

311. 2. 1 4 DEMAND FORECASTING: NEED, OBJECTIVE AND METHODS IN BRIEF 311

312. Suggested Readings Author : Christopher R. Thomas & S. Charles Maurice Title of the Book : Managerial Economics-Foundations of Business Analysis and Strategy Chapter’s Name: Demand Estimation and Forecasting Author : Robert S. Pindyck & Daniel L Rubinfeld Title of the Book : Microeconomics Chapter’s Name : Individual and Market Demand https://www.tradegecko.com/ebooks/demand-forecasting 312

313. 2.14 Demand Forecasting: Need, Objectives and Methods in Brief Information about demand is essential for making pricing and production decisions. General Motors, Ford, Nissan and other large automobile manufacturers all use empirical estimates of demand in making decisions about how many units of each model to produce and what prices to charge for different car models. Managers at the national headquarters of Domino’s Pizza need to estimate how pizza demand in the U.S. is affected by a downturn in the economy. A knowledge of future demand conditions can also be extremely useful to managers of both price-taking and price-setting firms when they are planning production schedules, inventory control, advertising campaigns, output in future periods, and investment, among other things. 313

314. Many medium and large-size firms rely on their own forecasting departments to provide forecasts of industry or firm-level demand. Good strategic planning rests on the foundation of good forecasting. It is an essential tool in developing new products, scheduling production, determining necessary inventory levels and creating a distribution system. 314

315. Forecasting is an attempt to foresee the future by examining the past. Business firms can estimate and minimize the future risk and uncertainty through forecasting. Without forecasting, forward planning will be directionless and meaningless. Forecasts are not to be confused with guesses. Guesses are estimates of future events, but they are not necessarily unbiased or objectively calculated. Mostly, they are based on neither systematic nor objective measurement of facts. They are opinions. In contrast, good forecasts are built by applying sound scientific procedures as to minimize the error of estimation. 315

316. Need and Objectives: Need and Objectives of Short-Term Forecasting: It is useful in the following ways: Appropriate Production Scheduling : the firm can avoid the problem of over-production and the problem of short supply by estimating seasonal variation in demand. 316

317. Suitable Purchase Policy : Demand forecasting helps the firm in reducing costs of purchasing raw materials and controlling inventory by determining its future resource requirement. Appropriate Price Policy : Appropriate price policy can be determined depending upon the anticipation of market demand conditions. It can also avoid an increase in price, when the market conditions are expected to be weak and a reduction in price, when the market is going strong. 317

318. Setting Realistic Sales Targets for Salesmen : If targets are set too high, they will discourage salesmen, who fail to achieve them. If targets are set at unrealistically low level, the targets will be achieved easily and hence incentives given by management will prove to be meaningless. Forecasting Financial Requirements : Cash requirements depend on demand level and production operations. Moreover, it takes time to arrange for funds on reasonable terms. Demand forecasts will, therefore, enable arrangement of sufficient funds on reasonable terms well in advance for production, advertisement, etc. 318

319. Need and Objectives of Long-Term Forecasting: It provides information for major strategic decisions. Introduction of new products, invariably, involves a long-term forecast. In this case, researcher has to consider long-term changes in population, tastes and preferences of the buyers, technology, product life cycle, etc. Following are the important uses of long-term forecasting: Business Planning : Starting of new unit or expansion of an existing unit of production requires an analysis of the long-term demand potential of the products in question. A multi-product firm must ascertain not only the total sales situation, but also the demand and (Cont..) 319

320. and its distribution over various products. If a company has better knowledge than its rivals of the growth trends of the aggregate demand , its competitive position would be much better. Financial Planning : Planning for raising funds requires considerable advance notice. Long-term demand forecasts are quite essential to assess long-term financial requirements for purchasing machines, raw materials, R&D programmes, etc. Planning Man-Power Requirements : Training and personnel development are long-term propositions, taking considerable time to complete. They can be started well in advance only on the basis of estimates of manpower requirements according to long-term demand forecasts. 320

321. Methods of Demand Forecasting: The commonly used methods of demand forecasting can be divided into: Survey methods Statistical methods Selection of a particular method has to be appropriate to the situation, i.e., time horizon, objective, nature of product, data availability, cost, etc. It is always prudent to use more than one method for cross-checking and for improving the credibility of forecast. 321

322. Figure 1 : Forecasting Methods 322

323. Survey Methods : Under this approach, surveys are conducted about the intentions of consumers (individuals, firms or industries), opinion of experts, etc. Under census survey, all consumers/ experts/ markets are surveyed. New products’ demand forecasting makes use of survey approach, as data availability problem is overcome through surveys of consumers. The important survey methods are: Survey of Buyers’ Intentions : The most direct method of estimating demand in the short run is to ask customers what they are planning to buy for the forthcoming time period. By using this method, a firm can ask consumers, what and how much they are planning to buy at various prices of the product. 323

324. However, a number of biases may creep into the surveys. The customers may tend to exaggerate their requirements. The customers may know what their total requirements are, but they may misjudge or may be uncertain about the quantity they intend to purchase from a particular firm. This method is not very useful in the case of household customers for several reasons, viz., irregularity in customers’ buying intentions, their inability to foresee their choice when faced with multiple alternatives and the possibility that the buyers’ plans may not be real . Moreover, households customers are numerous making this method rather impracticable and costly. 324

325. Delphi Method : It consists of an attempt to arrive at a consensus in an uncertain area by questioning a group of experts repeatedly until the responses appear to converge along a single line or the issues causing disagreement are clearly defined. The participants are supplied the responses to previous questions from others in the group by a coordinator or leader of some sort. 325

326. The leader provides each expert with the responses of the others including their reasons. Each expert is given the opportunity to react to the information or considerations advanced by others but interchange is anonymous so as to avoid or reduce the issues involved with publically expressed opinions. This method was originally developed at Rand Corporation of the U.S.A in the late 1940s by Olaf Helmer, Dalkey and Gordon. It has been successfully used in the area of technological forecasting, i.e., predicting technical changes. It has proved more popular in forecasting non-economic rather than economic variables. 326

327. The Delphi method has some exclusive advantages : First, it facilitates the maintenance of anonymity of the respondent’s identity throughout. It renders it possible to pose the problem to the experts at one time and have their response. Thus, it saves time and other resources. 327

328. However this method presumes the following two conditions: First, the panellists must be rich in their expertise, possess wide knowledge and experience of the subject and have an aptitude and earnest disposition towards the participants. Secondly, this method presupposes that it conductors are objective in their job, possess ample abilities to conceptualise the problems for discussion, generate considerable thinking, stimulate dialogue among panellists and make inferential analysis of the multitudinal views of the participants. 328

329. 3. Expert Opinion Method : An expert opinion method to demand forecasting is to ask experts in the field to provide their own estimates of likely sales. Experts may include executives directly involved in the market, such as dealers, distributors and suppliers or others whose major interest is in the forecast itself such as industry analysts, specialists, marketing consultants, etc. Each expert is asked independently to provide a confidential estimate and the results could be averaged . 329

330. The advantage of this approach is: There is no danger that the group of experts develops a group-think mentality where their independent judgement is impaired by their desire to be seen as loyal and conforming members of the group. Another advantage is that the forecasting is done quickly and easily without the need of elaborate statistics. 330

331. Collective Opinion Method : Under this method, salesmen are required to estimate expected sales in their respective territories and sections. The rationale for this method is that salesmen, being the closest to the customers, are likely to have the most intimate feel of the market, i.e., customer reaction to the products of the firm and their sales trends. The estimates of individual salesmen are consolidated to find out the total estimated sales. 331

332. They are then reviewed to eliminate the bias of optimism on the part of some salesmen and pessimism on the part of others. These revised estimates are further examined in the light of factors like proposed changes in selling prices, product designs and advertisement programmes, expected changes in competition, changes in purchasing power, income distribution, employment, population, etc. The final sales forecast would emerge after these factors have been taken into account. 332

333. The advantages of this method are : This method is simple and does not involve the use of statistical techniques. The forecasts are based on first-hand knowledge of salesmen and others directly connected with sales. The disadvantages are : It is almost completely subjective as personal opinions can possibly influence the forecast. 333

334. The usefulness of this method is restricted to short-term forecasting. These forecasts may not be useful for long-term production planning. Salesmen may be unaware of the broader economic changes likely to have an impact on the future demand. Their jobs usually require full-time attention to the present so that they do not get time to think about the future. In many cases, they may lack the necessary breadth of vision for looking into the future, say, five years ahead or more. 334

335. Controlled Experiments : U nder this method, an effort is made to vary separately certain determinants of demand which can be manipulated, e.g., price, advertising, etc., and conduct the experiments assuming that the other factors remain constant. Thus, the effect of factors like price, advertisement, packaging, etc., on sales can be assessed by either varying them over different markets or by varying them over different time periods in the same market. 335

336. This method is relatively new and less tried. This is due to several reasons: First, such experiments are expensive as well as time-consuming. Secondly, there is a great difficulty in planning the study as it is not always easy to determine what conditions should be taken as constant and what factors should be regarded as variable so as to segregate and measure their influence on demand. 336

337. Statistical Methods : these methods make use of historical data (time series or cross section) as a basis for determining quantitative relationship to arrive at the future demand patterns and trends. The data may be analysed through econometric models. They are based on scientific way of estimation, which are logical and unbiased. These methods cannot be used to forecast the demand for new products and the products having short existence due to data problem. These methods are: Naive Models: Naïve forecasting models are based exclusively on historical observation of sales (or other variables such as earnings, cash flows, etc.) 337

338. There are three Naïve models : A simple example of a naïve model type would be to use the actual sales of the current period as the forecast for the next period. Y t+ 1 = Y t Where Y t+ 1 is the forecasted value and Y t is the actual value of current period 338

339. If we consider trends, then Y t+ 1 = Y t + ( Y t – Y t- 1 ) This model adds the latest observed absolute period-to-period changes to the most recent observed level of the variable. Y t- 1 is the value of the previous period. If we want to incorporate the rate of change rather than the absolute amount, then Y t+ 1 = Y t Y t Y t- 1 339

340. 2. Smoothing Techniques: There are two typical forms: Moving averages and Exponential smoothing. With the moving average, a manager simply employs the most recent observations, drops the oldest observation, in the earlier calculation and calculates an average, which is used an the forecast for the next period. (Cont..) 340

341. The moving average is simple to use and easy to understand. However, it has two shortcomings: One has to retain a great deal of data and carry it along with him from one forecast period to another forecast period. All data in the sample are weighted equally. If more recent data are more valid than older data, why not give them greater weight? 341

342. Exponential smoothing method gets around these disadvantages . It is a popular technique for short-run forecasting. It uses a weighted average of past data as the basis for a forecast. The procedure gives heaviest weight to more recent information and smaller weights to observations in the more distant past. The reason for this is that the future is more dependent on the recent past than on the distant past. F t = F t- 1 + a (A t- 1 – F t- 1 ) Where F t is the new forecast, F t- 1 is the last period’s forecast, a= smoothing constant (0<a<1) and A t- 1 is the previous period’s actual demand 342

343. Analysis of Time Series and Trend Projections : A firm which has been in existence for sometime will have accumulated considerable data on sales pertaining to different time periods. Such data over a period of time is called time series. A trend line can be fitted through a series by means of statistical techniques such as the method of least squares. The analyst chooses a plausible algebraic relation (linear, quadratic, logarithmic, etc) between sales and the independent variable. 343

344. The basic assumption of the trend method is that the past rate of change of the variable under study will continue in the future. This technique yields acceptable results so long as the time series shows a persistent tendency to move in the same direction. Whenever a turning point occurs, however, the trend projection breaks down. 344

345. Regression Method: It involves the following steps : See whether a relationship exists between the demand for a product and certain economic indicators. Establish the relationship through the method of least squares and derive the regression equation. Assuming the relationship to be linear, the equation will be of the form Y = a + bX 345

346. Once regression equation is derived, the value of ‘Y’, i.e., demand, can be estimated for any given value of ‘X’. Judgemental Approach: Management may have to use its own judgement when : Analysis of time series and trend projections is not feasible because of wide fluctuations in sales, etc; and Use of regression method is not possible because of lack of historical data or because of management’s inability to predict or even identify causal factors. 346

347. When statistical methods are used, it might be desirable to supplement them by use of judgement for the following reason: Even the most sophisticated statistical methods may not incorporate all the potential factors affecting demand as, for example, a major technological breakthrough in product or process design. 347

348. Conclusion Forecasting is an attempt to foresee the future by examining the past. Business firms can estimate and minimize the future risk and uncertainty through forecasting. Without forecasting, forward planning will be directionless and meaningless. The commonly used methods of demand forecasting can be divided into: Survey methods Statistical methods 348

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