2. consumer behavior and demand

CONSUMER BEHAVIOUR AND

DEMAND

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INTRODUCTORY MICROECONOMICS16

In Chapter 1 it was stated that, in a market-oriented economy, the central problems of“what”, “how” and “for whom” are solvedthrough forces of demand and supply forvarious goods and services. Who demands aparticular good and who supplies it? Thisdepends on the type of good or service inquestion.

Consider a final product such as alubhujia.1 As consumers, households are thedemanders of alu bhujia and companies likeBikanerwala and Leher are the suppliers.Another example is the service of a computerprogrammer. This service is demanded bycompanies or firms. Who are the suppliers ofthis service? The households, because somemembers of some households work ascomputer programmers.

In summary, in case of final goods andservices, households demand them and firmssupply them. In case of services that arerequired for production, households are the

1 Final goods and services include things that are consumedby households, e.g. a piece of bread, a haircut, a bicyclerepair job etc. As opposed to final goods and services,there are “intermediate” goods (or raw materials) thatare “consumed” (i.e. used up) by businesses. Theexamples are steel in a bicycle factory, wheat in a flourmill, and various automobile components in a Maruti carworkshop.

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CHAPTER 2

•2.1 Consumer's Equilibrium

2.2 Meaning andDeterminants of Demand

2.3 Market Demand Curve

2.4 Price Elasticity ofDemand

••

•

CONSUMER CHOICE AND THE DEMAND CURVE 17

suppliers and the firms are thedemanders.

This chapter deals with householdsas consumers and their demand forfinal goods and services. How should aconsumer decide how much of aproduct to buy? What factors do affectthis decision and how?

2.1 CONSUMER’S EQUILIBRIUM:THE BASIS OF THE LAW OFDEMAND

Let us ignore for the moment the word“equilibrium” or the phrase “Law ofDemand”, and focus on the question ofhow much of any particular good aconsumer should demand (or buy) ata given point of time. In order tounderstand this, we first have to learna few concepts.

2.1.1 Utility Concepts

We begin with the notion that aconsumer derives some satisfactionfrom consuming a product; otherwise,she would not demand it at all. This iscaptured by a term called total utility,defined as the total psychologicalsatisfaction a consumer obtains fromconsuming a given amount of aparticular good. Consider for exampleyour consumption of gol guppa - themouth-watering small round-shapedpuffed puris, served with tamarind(imli)– water and fillings.1

Imagine that you are hungry andhave come to your favourite gol guppavendor. Suppose that if you consumeonly one gol guppa you derive 20units of pleasure or utility measuredin some units. Let this (psychological)

unit be called “utils.” Thus, the totalutility from consuming one gol guppais 20 utils. Suppose that you like golguppa so much that eating just oneincreases your appetite for it. Let thesecond unit give an additional utilityof 22 utils. Then, the total utility fromconsuming two gol guppas is 20+22=42 utils. In the same manner we cancalculate total utility from consumingthree, four or five units and so on.

Besides total utility, there isanother important concept calledmarginal utility, defined as the utilityfrom the last unit consumed. Thusthe marginal utility from consumingone gol guppa is 20 and that fromconsuming two gol guppas is 22. Youcan now notice the relationship thattotal utility is the sum of marginalutilities.

Getting on with our story, yourintensity of desire for gol guppa mustfall, after consuming a certain amount,regardless of how much you like golguppa. Suppose that, in your case,such decline in the intensity of desirestarts with the third gol guppa youconsume. Accordingly, let the thirdunit give you utility equal to a numberless than 22, say, 18 utils. That is, themarginal utility and the total utilityobtained from consuming three golguppas are 18 and 42+18=60 utilsrespectively. The next (fourth) unitgives you still less utility, say,14 utils, and so on.

This pattern of marginal utility iscalled the law of diminishingmarginal utility. It states that, afterconsuming a certain amount of a good

1 Incase gol guppa is not known to the children, the teachers can use other popular eatable asexample to explain the concept.


or service, the marginal utility from itdiminishes as more and more isconsumed. If you think about it, thislaw is very natural and should holdfor any product one consumes. In factit is considered as a fundamentalpsychological law. You will see thecritical role of it a little later.

Let us resume our story once again.When you have already consumed quitea few gol guppas – say 8, and you arevery full in your stomach – supposethat the next (9th) unit gives zero utility.Imagine what will happen if you keepgulping more. Suppose that eating the10th unit makes you vomit! This isobviously not a pleasant experience andshould give you negative satisfaction.Accordingly, let the utility associated

with the 10th unit be -7 utils. That is,the marginal utility of ten gol guppas is-7 utils. (If you are crazy and still eatmore, each additional one can only giveyou more negative utility.)

Table 2.1 summarises yourexperience with gol guppa in terms ofmarginal utility and total utility up to10 units of consumption. Columns (2)and (3) present the marginal and totalutility schedules.

2.1.2 How many Gol Guppas willyou consume or buy?

From Table 2.1, it is clear that if youare a rational (not crazy) consumer,you will eat less than 10 gol guppas,since consuming 10 or more gives younegative marginal utility. If gol guppas

Table 2.1 Marginal and Total Utility

Units Consumed of Marginal Utility Total UtilityGol guppa (in utils) (in utils)

0 - 0

1 20 20

2 22 42

3 18 60

4 14 74

5 11 85

6 8 93

7 4 97

8 2 99

9 0 99

10 -7 92


were free, i.e., its price were zero, youwould have consumed 8 or 9 units atwhich your total utility is at itsmaximum. But as long as you paysomething for it, you may not wish toconsume so many. You would like toknow how much utility you could haveobtained if you had spent someamount on other items, e.g., ice cream,chocolate etc. In other words, exactlyhow many gol guppas you will eatwould depend not only on marginaland total utility from consuming golguppas, but also on the price of golguppas, and, how much a rupee isworth to you in terms of other goods.

We now define marginal utility ofone rupee as the extra utility when anadditional rupee is spent on otheravailable goods in general. Supposethat, for you, it is 4 utils and let theprice of gol guppa be Rs. 2 per piece.

Having the information on priceand marginal utility of a rupee, we candetermine how many gol guppas youwill consume. Consider first whetheryou will buy just one gol guppa. Fromconsuming only one, you obtain utilityequal to 20 utils (from Table 2.1). Sincethe marginal utility of a rupee is 4 utils,we can say that, from consumingone gol guppa, you get utility worthRs. 20/4 = Rs. 5. On the other hand,you pay – and thus sacrifice – Rs. 2 forit. Hence you will buy the first unit.Similarly, from the second unit, youget utility worth Rs. 22/4 = Rs. 5.50,while you pay only Rs. 2. Hence youwill buy the second gol guppa also.

We keep on making suchcomparisons for successive units. For

example, the 5th gol guppa is worthhaving it since it gives Rs. 11/4 =Rs. 2.75 worth of utility, which isgreater than the price.

What happens with the 6th golguppa is a bit different. It gives youutility worth Rs. 8/4 = Rs. 2, which isequal to the price. Will you buy it? Theanswer is that you will be “indifferent,”that is, whether or not you buy the 6th

unit does not make any difference.However, it is clear that you will not buy(consume) more than 6. Because, at anylevel of consumption beyond 6, themarginal utility in terms of rupees isless than the price (you can check thisdirectly). Hence we have found theanswer to our query: you will buy 5 or6 gol guppas.

The above comparisons betweenhow much of marginal utility in termsof money you get and the price you payimplies that, at either of these two levelsof consumption, the difference betweenthe total utility in terms of money andyour total expenditure on gol guppas(defined as price × quantity purchased)is maximised. Table 2.2 illustrates this.Its second column gives total utility interms of money, defined as total utilitydivided by the marginal utility of onerupee (equal to 4 utils in this example).Column (3) gives your total expenditureor spending on gol guppas. The lastcolumn gives the difference betweenthese two columns; this is like the netgain to a consumer. We see that thisdifference is maximised (equal toRs. 11.25) when your gol guppaconsumption is either 5 or 6.

Having gone through the example,we can now understand why this


Table 2.2 Difference between Total Utility in Terms of Money and TotalExpenditure

Amount Consumed Total Utility in Total Differenceof gol guppas terms of money (Rs.) Expenditure (Rs.) (Rs.)

0 0 0 0

1 5 2 3

2 10.50 4 6.50

3 15 6 9

4 18.50 8 10.50

5 21.25 10 11.25

6 23.25 12 11.25

7 24.25 14 10.25

8 24.75 16 8.75

9 24.75 18 6.75

10 23 20 3

section is titled “Consumer’sEquilibrium.” The word “equilibrium”,frequently used in economics, means aposition of rest. In this example, youwill rest, stop – or, as economists say,attain consumer’s equilibrium – at 5or 6 gol guppas. Because you do notwant to consume less or more thanthese quantities. In general, we canthen say that consumer’s equilibriumwith respect to the purchase of onegood is attained when the differencebetween total utility in terms of moneyand the total expenditure on it ismaximised.

2.1.3 The General Principle

From the example just worked out, wecan now derive the general principle of

consumer’s equilibrium with respect toany particular good. Recall that one ofour answers is 6 gol guppas. Ignoringthe other answer for the moment, notethat, at this level of consumption, themarginal utility in terms of money (Rs.2) is equal to price (Rs. 2). This is indeedthe principle and we can state this intwo alternative ways. That is, theconsumer’ s equilibrium is attainedwhen

Price Its

Rupeea of Utility Marginal

Producta of Utility Marginal)A(

= Or

Price Its

Producta of Utility Marginal)(B

Rupee.a of Utility Marginal =


In particular, the condition (A) saysthat the marginal utility of a product interms of money be equal to its price.Sometimes, this is loosely stated as“marginal utility is equal to price.”

Now go back to the example onceagain and see that the consumer’sequilibrium is also attained at 5 golguppas, where the principle is notsatisfied. This possibility exists becausegol guppas are not perfectly divisible:they cannot be measured continuouslylike points on a straight line. If, instead,a product is perfectly divisible and thuscan be measured continuously, forexample by weight on a weighing scale,there will be just one level ofconsumption at which the consumer’sequilibrium is achieved, with condition(A) [or (B)] met.

We do implicitly assume from nowon that a product is perfectly divisibleand thus treat (A) or (B) as the conditionof consumer’s equilibrium.2

2.2 MEANING AND DETERMINANTSOF DEMAND

Our analysis of consumer’s equilibriumimplies that the price of a product is animportant factor in determining howmuch of the product a consumer willbe willing to buy within a given timeperiod. It is because, as the productprice changes, the ratio of marginalutility to price changes so that theconsumer’s equilibrium will occur at adifferent level of consumption.

This forms the basis of definingdemand for a particular good by aconsumer: it is the quantity of thegood that she is willing to buy atdifferent prices within a given periodof time.

However, the price of a product isnot the only factor that influences howmuch a consumer should buy of thatproduct. For example, if there is a tastechange, it will change the marginalutilities from a product, and, theconsumer’s equilibrium condition willbe fulfilled at some other level ofconsumption even when there is nochange in price.

Moreover, while our precedinganalysis is confined to one good (e.g.gol guppa), in reality, a consumerbuys many goods. The consumer’sequilibrium analysis with respect tomany goods (which is outside ourscope) suggests two other factors,namely, prices of related goods andincome. This is quite natural. If aperson consumes, for example, teaand coffee, then a change in the priceof tea should affect her consumptionof coffee and vice versa. Also, if incomechanges, different amounts can bebought even when the prices of goodsand services she consumes remainunchanged.

The last three factors justmentioned are called thedeterminants of demand. They arenamely,

2 Nothing essential or important is gained by deviating from this assumption. The only modification isthat, when a good is not perfectly divisible, the condition (A) or (B) holds either exactly or approximately.


The law of demand in tabular formis called a demand schedule. If wegraph a demand schedule, we obtain ademand curve. It typically measuresown price along the y-axis and quantitydemanded on the x-axis. The demandcurve corresponding to the demandschedule in Table 2.3 is shown infig. 2.1. We see that the demand curveis downward sloping. It is because anincrease in the own price lowers the

(a) prices of related goods,(b) income and(c) tastes. 3

The next question is how the ownprice of a product as well as these threefactors affect the quantity demanded ofa particular good.

2.2.1 Own Price: The Law ofDemand

To isolate its effect, hold the otherfactors constant and ask how thequantity demanded of a productchanges as its own price changes. Theanswer is summarised as what is calledthe Law of Demand. It states that otherthings remaining unchanged, as theown price of a commodity increases,the quantity demanded of it by aconsumer falls. “Other things” refer tothe prices of related goods, income andtastes.

Suppose that, for a particular family,within a month, Table 2.3 lists itsquantities demanded of apples atdifferent prices, which are consistent withits consumer’s equilibrium. The leftcolumn lists various prices, while theright column lists the correspondingquantities demanded. It is assumed thatthe prices of related goods, family incomeand tastes are kept fixed at somepre-determined levels.

3 Apart from (a), (b) and (c), there may be other determinants of demand for a good, e.g., future priceexpectation. Consider an essential product, say, edible oil or sugar. Suppose there is a weatherprediction that your village or town will be hit by a severe cyclone in the next three days. You wouldthen anticipate that supply interruptions would occur and prices of these commodities would sky-rocket. If you are a rational consumer, you would buy more of these commodities now (and store them)even if prices, income or tastes do not change.Moreover, taste changes can occur not only because of natural changes in a person’s liking, but also dueto advertising of products.

Table 2.3 A Demand Schedule

Own Price Quantity Demanded(in Rs.) of Apples

12 24

13 17

14 12

15 9

16 7

17 6

quantity demanded. Each point of thedemand curve shows the quantitydemanded that is consistent withconsumer’s equilibrium.

Why is the Demand Curve DownwardSloping?

Isn’t it obvious that the demand curveis downward sloping? That is, as


the own price increases, the quantitydemanded of a product falls.Interestingly, it is not. There is a reasonbehind it, namely, the law ofdiminishing marginal utility. Indeed,the demand curve is essentially themarginal utility curve.4

Consider Table 2.4, which lists themarginal utility from consumingT-shirts. Mark that, for simplicity,diminishing marginal utility sets in withthe very first unit of consumption.Assume further, again for simplicity ofexposition, that the marginal utility ofa rupee is equal to 1 util. Then, ourconsumer’s equilibrium condition (A)can be stated as “Marginal Utility =Price.”

To begin with, suppose that theprice of a T -shirt is Rs. 45. Theconsumer’s equilibrium conditionholds at 7 T-shirts consumed. This can

Fig. 2.1 Demand Curve Correspondingto Table 2.3

4 An intuitive way to see this is that, as a consumer buys more of a good, her marginal utility decreasesand therefore she is willing to pay less per unit. This can be turned around to say that if the price of aproduct falls, a consumer buys more of it.

Table 2.4 Marginal UtilitySchedule and the Demand

Schedule

Quantity of Marginal Utility of T-shirts T-shirts

1 75

2 70

3 65

4 60

5 55

6 50

7 45

be restated as follows. The quantitydemanded of T-shirts is 7 when theprice is Rs. 45. Thus the pair (45, 7)will be on the demand curve. Similarly,suppose that the price of T-shirtsincreases to Rs. 65. The consumer’sequilibrium condition now holds at 3T-shirts consumed, that is, at priceRs. 65, the quantity demanded is 3.Hence the pair (65, 3) will be on thedemand curve too. Likewise, we candetermine that all other points on themarginal utility schedule are points onthe demand schedule. This means thatthe marginal utility curve itself is thedemand curve, and, the demand curveis downward sloping because of the lawof diminishing marginal utility.


2.2.2 Determinants of Demand

Now turn to the remaining factors thataffect the quantity demanded of aparticular product, or, what we havecalled the determinants of demand.

Change in Price of a Related Good

Suppose that Mrs. Das, who lives nextdoor to you, has a weakness for sweets.Burfi and gulab jamun are herfavourites. Suppose that burfis becomemore expensive: from Rs. 5 a piece toRs. 8 a piece. How will this affect Mrs.Das’s demand for gulab jamun? It willincrease. Why, because burfi and gulabjamun are substitutes of each other inconsumption. Consider anotherexample: that of tea and coffee. Thesame should happen to the demand fortea if the price of coffee rises or viceversa, because tea and coffee are alsosubstitutes. We say that good A is asubstitute of good B if an increase inthe price of good B increases thedemand for good A.

On the other hand, consider tea andsugar. Sugar is complementary to tea

in consumption. Thus, if the price of teagoes up, the quantity demanded of teashould fall, which will reduce thedemand for sugar. Another example ofa pair of complementary products ispetrol and cars. If the price of petrol rises,the quantity demanded of cars shouldfall. In other words, good A is said to becomplementary to good B if an increasein the price of good B decreases thedemand for good A.

These examples illustrate crossprice effects: how the demand for oneparticular product is affected by achange in the price of another.Numerical examples of cross priceeffects are given in Tables 2.5 and 2.6.

In Table 2.5, note that as the priceof coffee rises from Rs. 200 to Rs. 250,the quantity demanded of tea increasesfor any given price of tea. For example,given price of coffee = Rs. 200, at teaprice equal to Rs. 170, the quantitydemanded of tea is 11, whereas, givencoffee price = Rs. 250, at the same teaprice (Rs. 170), the quantity demandedof tea is 18. The demand schedules of

Table 2.5 Effect of an Increase in the Price of Coffee on Demand for Tea

Price of Tea Quantity Demanded of Tea Quantity Demanded of Tea(per kg) when Price of Coffee when Price of Coffee

Rs. (per kg) = Rs. 200 (per kg) = Rs. 250

150 20 28

170 11 18

190 5 10

210 2 7

230 1 4


Table 2.6 Effect of an Increase in the Price of Tea on Demand for Sugar

Price of Sugar Quantity Demanded of Quantity Demanded of Sugar(per kg) Sugar when Price of Tea when Price of Tea

Rs. (per kg) = Rs. 170 (per kg)= Rs. 200

5 20 12

8 14 7

11 9 4

14 6 2

17 5 1

tea given in column (2) and (3) ofTable 2.5 are graphed in Figure 2.2.We see that demand curve for teawhen the price of coffee is Rs. 250 liesto the right of that when the price ofcoffee is Rs. 200. Hence, an increase(a decrease) in the price of a substitutegood shifts the demand curve for aproduct to the right (left).

Similarly, in Table 2.6, notice that,as the tea price increases from Rs. 170to Rs. 200, the quantity demanded ofsugar decreases for any given price ofsugar. Figure 2.3 graphs Table 2.6.The demand curve for sugar when teaprice is Rs. 200 lies to the left of thatwhen the sugar price is Rs. 170. Thus,an increase (a decrease) in the priceof a complementary good shiftsthe demand curve for a product to theleft (right).

A Change in Income

Suppose that you only buy peanutsand ice cream from your pocket money.Ice cream is your favourite but it iscostly. You like peanuts much less, but

they are cheap. Suppose that yourpocket money increases. Will you buymore of ice cream, more of peanuts orboth? We bet that you will buy moreice cream. Whether you will buy morepeanuts is not clear. Very likely, you willbuy less of peanuts, not because yourtaste changes but because you canafford more ice cream, which is yourfavourite.

Hence, generally, we can say that,as income increases, a consumer may

Fig. 2.2 Change in demand due to increasein the price of a substitute good


buy more or less of a product. If shebuys more (e.g. ice cream), then we saythat the product in question is a normal

those, for which demand falls asincome rises.

Table 2.7 presents numericalexamples of both normal and inferiorgoods. Observe that, at any given price,as income increases, quantitydemanded of the normal good increases(by comparing columns (2)-(3)) and thatof the inferior good decreases (bycomparing columns (5)-(6)). These aregraphed in figs. 2.4 and 2.5. Theoriginal demand curve for the normalgood, when income is Rs. 300, isindicated by the line NN0 in fig. 2.4.This represents the column pair (1)-(2).The new demand curve, when incomeof Rs. 400, is marked by NN1 thatrepresents the column pair (1)-(3).Hence an increase in income shifts thedemand curve to the right if the goodis normal. For the inferior good,the demand curves are indicatedby FF0 (original) and FF1 (new) in

Fig. 2.3 Change in demand due toincrease in the price of acomplementary good

good. If she buys less (e.g. peanuts),then we say that it is an inferior good.Put differently, normal goods arethose, for which demand increases asincome increases. Inferior goods are

Table 2.7 Normal and Inferior Goods

A Normal Good An Inferior GoodOwn Price (Quantity (Quantity Own Price Quantity Quantity

Demanded: Demanded: Demanded: Demanded:Income = Income = Income = Income =Rs. 300 Rs. 400 Rs. 300 Rs. 400

1 15 19 3 20 15

2 12 16 4 17 12

3 9 13 5 14 9

4 7 11 6 11 6

5 5 9 7 8 3

6 3 7 8 5 0


fig. 2.5. Thus an increase in incomeshifts the demand curve to the left ifthe good is inferior.

In the real world, there are muchfewer examples of inferior goods thannormal goods. Yet there are importantexamples. In India, cereals as a singlecategory of goods (that includes rice,wheat, bajra, jowar etc.) constitute aninferior good. Within this category, theinferior-good characteristic applies tobajra, jowar, maize and related cereals.

A Change in Tastes

Finally, consider a taste change.Suppose you are impressed by anadvertisement in TV, in which yourfavourite actor drinks Coca Cola, and,as a result, your liking for Coca Colaincreases. This will shift your demandcurve for Coca Cola to the right. This isan example of a “favourable” change intastes. An unfavourable change in tastewill imply the opposite. We can then say

Fig. 2.4 Change in demand due toincrease in income (Normal Good)

Fig. 2.5 Change in demand due toincrease in income (Inferior Good)

that a favourable (an unfavourable)change in tastes shifts the demandcurve to the right (left).

A taste change may result from achange in a person’s liking, or, from someother source. If, for instance, for healthreasons, you have to consume more of aproduct although you don’t like it, thisis also considered a taste change.

2.2.3 Change in QuantityDemanded Versus Change/Shift in Demand

We have seen that the quantitydemanded of a product depends onown price and “other” factors likeprices of related goods, income andtastes. The law of demand refers to theeffect of a change in the own price. Agraphical representation of this is thedemand curve, which is downwardsloping. A change in the own pricecauses a movement along a givendemand curve: higher (lower) the price,less (more) is the quantity demanded.


Such a movement is called a changein the quantity demanded.

In contrast, when a change in anyother factor causes a (left or rightward)shift of a demand curve, we call this achange in demand.

The distinction between the twoconcepts is illustrated in fig. 2.6.Fig. 2.6(a) illustrates a change in thequantity demanded. There is a pricechange from P0 to P1. As a result, thereis a movement along the same demandcurve from A to B. The quantitydemanded changes from Q0 to Q1. Incontrast, fig. 2.6(b) shows a change indemand, meaning a shift of a demandcurve from DD0 to DD1 due to a changein the prices of related goods, incomeor tastes.

2.3 MARKET DEMAND CURVE

We have studied consumer’sequilibrium and the determinants ofdemand for a good from the perspectiveof a single individual. How do we getthe demand curve of a product by allindividuals together in an economy,e.g., the economy of a region or acountry? The economy-wide demandcurve for a particular product is calledthe market demand curve. It isobtained by summing up the demandcurves across consumers orhouseholds.

Consider the market for, say, gulabjamun. Suppose that there are threeconsumers in the market: Amar, Akbarand Anthony. If at the price equal toRs. 3 a piece, Amar demands 5, Akbar6 and Anthony 8 per week, then thetotal quantity demanded is 19. Hence

Fig. 2.6 Change in Quantity DemandedVersus Change in Demand

(3, 19) is a point on the market demandcurve. Repeat the same exercise forother possible prices and obtain thecorresponding points. Plot the points,join them and you get the marketdemand curve.

A numerical example is given inTable 2.8. Individual demandschedules are given by column pairs(1)-(2), (1)-(3) and (1)-(4). The column

(a) Change in Quantity Demanded

(b) Change in Demand


pair (1)-(5) gives the market demandschedule. Note that for each row (price),the entry in column (5) is the sum ofcorresponding entries in columns (2),(3) and (4).

These individual demand schedulesand the market demand schedule aregraphed in fig. 2.7. Amar’s, Akbar’s andAnthony’s demand curves arerespectively marked by their names.The right most line is the marketdemand curve. This is obtained byhorizontally summing the individualdemand curves.

What are the determinants of themarket demand curve? They are thedeterminants of the individual demandcurve described earlier plus how manyconsumers buy the product, that is,(a) prices of related goods;(b) income levels across individuals, or

what we can call, the distributionof income;

(c) consumers’ tastes

(d) the number of consumers who buythe product, or what we can call, themarket size.5

2.4 PRICE ELASTICITY OFDEMAND

We have seen how various factors likeown price and income affect the demandfor a commodity. The direction ofchange was our focus - whether thequantity demanded increases ordecreases as price, income or otherfactors change. The concept of elasticitycaptures the magnitude of change orthe degree of responsiveness. Forexample, the price elasticity of demandquantifies the effect of a change in ownprice on the quantity demanded.

Table 2.8 Individual and Market Demand Schedules for Gulab Jamun

Price of Gulab Amar’s Akbar’s Anthony’s MarketJamun in Rs. Demand Demand Demand Demand

1 7 15 13 35

2 6 10 10 26

3 5 6 8 19

4 4 3 7 14

5 3 1 6 10

6 2 0 5 7

5 Many multinational firms today look at the Indian or the Chinese market as very lucrative, because oftheir market sizes, which refer to the huge number of consumers in these countries.


2.4.1 Definition and Formulas

Formally, Elasticity of demand isdefined as

price own the in change %demanded quantity the in change %

demand of elasticity Price )(

−=

= DeC

Since the changes in price andquantity along a demand curve occurin opposite directions, the ratio of %change in quantity demanded and thatin the own price is negative in sign.Hence attaching a negative sign in frontof the ratio makes the sign of eD positive.Some other textbooks define the priceelasticity the same way as above, exceptfor the “minus” sign. But there is noreason to get confused. Strictly speaking,our definition gives the absolute valueof the elasticity, which is, often, referredto as “elasticity”.

Along a given demand curve, let theoriginal price be P0 and the originalquantity be Q0. Suppose that the priceincreases to P1 and the quantitydemanded falls to Q1. Then the %changes in price and quantitydemanded are respectively equal to[(P1–P0)/P0]×100 and [(Q1–Q0)/Q0]×100.Thus (C) can be written as

./)(/)(

)(001

001

PPPQQQ

eD D −−

−=

If we further denote a change in

quantity as Q∆ and a change in price

as P∆ , we can also write

./

Q/Q)(

0

0

PPeE D ∆

∆−=

Consider the following numericalexample. Suppose that in your hometown, rasgoolas were being available atRs. 5.00 per piece and the residents of

Fig. 2.7 Individual and Market Demand Curves


the town were buying 1200 rasgoolasper day. Now they become moreexpensive for some reason, at Rs. 5.50per piece. Fewer people are eatingrasgoolas and many who eat, are eatingless. Suppose that the people in thetown are now buying 960 rasgoolas perday. What is the price elasticity ofdemand?

We have to do some arithmetic. The% change in the price is equal to[(5.50 –5.00)/5.00]×100=10. The %change in quantity is equal to [(960–1200)/1200]×100=–20. Hence, e

D, the

price elasticity, is equal to 20/10 = 2.

Properties

1. A very desirable property of theelasticity formula in measuring thedegree of responsiveness is that itis independent of the choice ofunits. It is because any percentagechange of a variable is independentof units.

2. If two demand curves intersect, attheir point of intersection, theelasticity associated with theflatter demand curve is higher. Thisis exhibited in fig. 2.8. The demandcurves DD and DD� intersect at thepoint C. At this point, P0 is the priceof the product. The claim is that, atprice P0, the elasticity is greateralong the flatter demand curve DD�.Why? Because the original quantitydemanded is the same, equal to D0,along both demand curves, and, ifthere is an increase in price, say toP1, the quantity demanded fallsmore along the flatter demand curve(by amount D2D0 as compared to

D1D0 along DD). This implies that,while the % change in price is thesame along both demand curves,the % change in quantity demandedis greater along DD�. Therefore,price elasticity associated with DD�

is higher.3. Higher the value of the price

elasticity, greater is the degree ofresponsiveness of quantitydemanded to price. In particular, ifeD>1, then the % change in quantitydemanded must exceed the %change in price. We then say thatthe product demand is elastic (e.g.jewellery). If eD<1, the % change inquantity demanded is less than thatof the price, and, we say that theproduct demand is inelastic.Typically, the demand for luxurygoods is elastic and that fornecessary goods (e.g. basic fooditems) is inelastic. Finally, if eD=1, itis said that the demand is unitarilyelastic. In this special case, thedemand curve takes a particular

Fig. 2.8 Elasticity Comparison


shape, called rectangular hyperbolain geometry. It is a curve, whichextends towards the x-axis and y-axisin a uniform manner withouttouching them. Fig. 2.9 exhibits this.

4. There are two other special cases. Ifthe product is absolutely essential,like demand for a rare medicine orsome very bad case of addiction toundesirable products like opium,the demand curve is vertical. In thiscase, the price elasticity is zero, i.e.,the product demand is totally orperfectly inelastic. This is evident,because, along a vertical demandcurve, the quantity demanded istotally insensitive to any change inprice. This case is exhibited infig. 2.10(a). The last special case isthe one, where demand curve ishorizontal and thus the demand isperfectly elastic, i.e., the price

2.4.2 Factors Affecting theMagnitude of Price Elasticity

In general, the magnitude of priceelasticity depends on the followingfactors.

Availability of Close Substitutes: Ifclose substitutes of a product arereadily available, its price elasticity ofdemand is likely to be high, becauseeven a very small increase in price willmake consumers switch to other

Fig. 2.9 Unitarily Elastic Demand

Fig. 2.10 Elasticitiy = 0, ∞

(a) Perfectly Inelastic Demand

(b) Perfectly Elastic Demand

elasticity is equal to infinity.Fig. 2.10(b) shows this. Aneconomic example of this demandcurve will be given in Chapter 4.


products in a big way. Otherwise, in theabsence of close substitutes, theelasticity is likely to be small. Forexample, if it is a staple food item of aparticular region, say, rice in Orissa orWest Bengal, by definition, there are no(very) close substitutes available. It isindispensable. Hence the demand forrice is likely to be inelastic. Moregenerally, the demand for essentialproducts is likely to be inelastic. On theother hand, “luxury” items like eatingin a restaurant, buying a big-sizecolour TV etc. are relatively dispensable.Hence the demand for these items islikely to be relatively elastic.

Proportion of Total ExpenditureSpent on the Product: If the amountspent on a product constitutes a verysmall fraction of the total expenditureon all goods and services you consume,then the price elasticity is likely to besmall. The demand for salt is anexample. On the other hand, if it is ahigh-price item and takes a majorportion of your total expenditure, yourdemand for it is more sensitive to a pricechange; that is, the elasticity of demandis likely to be high.

Habits: Some products which are notessential for some individuals areessential for others. A form ofconsumption such as eating out in five-star restaurants is a luxury for manypeople; therefore, their demand for it isvery elastic. But, for someone who isvery rich, it may be an essentialdemand, because he is alreadyhabituated. Hence his demand for five-

star restaurant food is inelastic.Similarly, for an opium addict, thedemand for opium is very inelastic,whereas for other casual opium takers,the demand is likely to be elastic.

Time Period: All other things remainingthe same, the longer the time period,more elastic is the demand for anyproduct. The consumption of petrol isa prime example. In the 1970s, whenOPEC (Organisation of PetroleumExporting Countries) dramaticallyincreased the price of oil for the first timein history, the whole world wasshocked. Countries could notimmediately find and adopt any otherforms of energy for their needs. In otherwords, substitutes of oil could not beavailable and the demand for oil wasvery inelastic. But over years alternativetypes of energy were developed, and,substitutes became more readilyavailable. The demand for oil is moreelastic today than it was 30 years ago.

Clip 2-1 reports price elasticities forvarious products that have beenestimated by various authors.

2.4.3 Measurement of Elasticity

Finding price elasticity of demandusing its definition as such is called thepercentage method of measuringelasticity. In particular, when the pricechange is very small, a graphicalformula or a geometric method canalso be used to measure elasticity.

Suppose that it is a straight-linedemand curve, as shown in fig. 2.11,having intercepts A and B respectivelyon the price axis and quantity axis


Clip 2-1Price Elasticity Estimates

Price elasticities have been estimated for various products and services and inthe context of different countries. Five examples are reported below, four of whichare for India and one for America.As you see, the price elasticities for food items and clothing are less than one, asthese are essential items. Note that item No. 4 is an example of a service: longdistance phone calls from PCOs. The elasticity for this item is also less than one.It indicates that long-distance telephone calls are not a “luxury” demand anymore;they have become a necessity in a country like India.The item no. 5 shows that the demand for residential land in America is elastic,equal to 1.64.

Product/Service Price Elasticity Estimate Source

1. Cereals & cereal 0.544 Meenakshi and Raysubstitutes (1999)(India)

2. Other foods 0.804 Meenakshi and Ray(India) (1999)

3. Clothing 0.560 Meenakshi and Ray(India) (1999)

4. Long distance 0.580 Das and Srinivasanphone calls (1999)from PublicCall Offices(India)

5. Residential 1.640 Gyourko and VoithLand in (2001)Philadelphia(U.S.A.)

Das, P. and P.V. Srinivasan, “Demand for Telephone Usage in India,”Information Economics and Policy, 11, 1999, pages 177-194. Meenakshi, J. V.and Ranjan Ray, “Regional Differences in India’s Food Expenditure Pattern: AComplete Demand Systems Approach,” Journal of International Development,11, 1999, pages 47-74. Gyourko, J. and R. Voith, “The Price Elasticity of Demandfor Residential Land: Estimation and Some Implications for Urban Reform,”mimeo, Wharton School of Management, 2001.


respectively. Suppose that initially theprice is P0, and the quantity consumedis Q0, that is, the consumer is at point Con the demand curve. Then, for smallprice changes, the price elasticity turnsout to be equal to BC/AC. Thisgraphical formula is called pointelasticity. In other words, pointelasticity, at a certain point along astraight-line demand curve, is equal tothe lower segment divided by the uppersegment of the demand curve at thatpoint.

A proof of it is given in Appendix 2.The point elasticity formula impliesthat, as price increases, the ratio of thelower segment to the upper segmentincreases (as we are looking at pointshigher up on the demand curve) andtherefore the product becomes moreelastic.6,7,8

2.4.2 Total Expenditure and PriceElasticity

The concept of price elasticity does notjust quantify the relationship betweenprice and quantity demanded, it alsoindicates the direction in which the totalexpenditure on a product changes, asthere is a change in price.

Return to the rasgoola exampleand ask the following simple question.Because of the increase in the price of

Fig. 2.11 Point Elasticity along a StraightLine Demand Curve

rasgoolas, does consumer spending ortotal expenditure on rasgoolas increaseor decrease? By definition, the totalexpenditure on a particular good =price × quantity. If we denote totalexpenditure by TE, price by P andquantity by Q, then TE = PQ. Let us nowcalculate TE. Originally, P and Q wererespectively Rs. 5.00 and 1,200; henceTE was equal to Rs. 6,000. At the newprice Rs. 5.50 and quantity = 960, TE= Rs. 5,280. Thus the total expenditurehas fallen. Note also that the elasticityis equal to 2. That is, in the example,the demand for rasgoola is elastic, and,as there is a price increase, the totalexpenditure falls.

6 This is not a general property of price elasticity. It may not hold when the demand curve is not a straightline.

7 At point B the elasticity is zero and at point A it is infinity.8 If it is not a straight-line demand curve, then the point elasticity measure at a point on it is based on

the tangent to the curve at that point. You will find a treatment of this in a higher-level micro economicstextbook.


It turns out that such oppositemovements in the directions of priceand total expenditure changes hold, notjust in this example, but always, whenthe product demand is elastic. Similarly,if the product demand is inelastic, thetotal expenditure always increases asprice increases. Moreover, as a specialcase, if the product demand is unitarilyelastic, then the total expenditure doesnot change with any price change. Youcan relate the last case to fig. 2.9, whichdepicts the unitarily-elastic case. Thatis, the total expenditures at all pointson that demand curve are the same.

There is thus a general relationshipbetween the direction of price changeand the direction of change in totalexpenditure, depending on themagnitude of price elasticity. If theproduct demand is elastic, unitarilyelastic or inelastic, an increase in priceleads respectively to a decrease, nochange or an increase in the totalexpenditure on the product. Table 2.9presents this result in a tabular form.

This result can be provenalgebraically, but it is beyond our

scope. However, it is quite intuitive. Ifthe demand for a product is elastic, itmeans that a small price change invitesa relatively large adjustment in thequantity. Hence the total expendituremust change in the same direction inwhich the quantity changes. Now yousee that, as price increases, quantityfalls and the fall in quantity is associatedwith a fall in the total expenditure. Justthe opposite holds when the productdemand is inelastic. In this case a largeprice change leads only to a relativelysmall adjustment in quantity. Hence thetotal expenditure must change in thesame direction as the price change, i.e.,a price increase leads to an increase intotal expenditure.

So far we have discussed how wecan determine the direction of changein total expenditure, given the directionof change in the price and givenwhether the product is elastic orinelastic. Alternatively, if we know thedirection of change in price and thedirection of change in total expenditure,we can infer whether the productdemand is elastic or inelastic. For

Table 2.9 Price Change and Its Effect on Total Expenditure

Price Change Elasticity Total Expenditure

↑ 1>De ↓

↓ 1>De ↑

↑ 1<De ↑

↓ 1<De ↓

↑ ↓ 1=De No Change


instance, if because of a price increase,the total expenditure increases, thenthe product demand must be inelastic.You can readily verify that from Table2.9.

This link, via price elasticity, betweenchanges in price and total expenditure hasimportant practical implications. Returnonce again to the rasgoola example.Suppose that there is only one (giant)halwai shop in town, who sells rasgoolas.If you are the halwai shop owner and are

thinking about increasing the price ofrasgoola, wouldn’t you want to know if aprice increase would increase or decreaseyour total sales in rupees? From a seller’sperspective, the total value of sales isusually called total revenue and note thattotal revenue is equal to the totalexpenditure by the consumers.9 Hencethe relationships between elasticity, pricechange and total expenditure areimportant from the viewpoint of decisionmaking by a producer or a firm.

9 We will see the use of the term “total revenue” in Chapters 4, 6 and 7.

SUMMARY

� Total utility is equal to the sum of marginal utilities.

� A rational consumer will never consume that much of a product suchthat the marginal utility from it is negative.

� At the consumer’s equilibrium, the difference between total utility interms of money and the total expenditure on a good is maximised.

� Consumer’s equilibrium is attained when the condition that themarginal utility in terms of money is equal to the price is met.

� The law of demand defines demand curve, which is downward sloping.

� The demand curve is downward sloping because of the law ofdiminishing marginal utility.

� The demand curve is essentially same as the downward sloping portionof the marginal utility curve.

� A shift of the demand curve is caused by a change in the prices of relatedgoods, a change in income or a change in tastes.

� An increase in the price of a substitute good causes an increase indemand or a rightward shift of the demand curve, while an increase inthe price of a complementary good causes a decrease in demand or aleftward shift of the demand curve.

� As income increases, the demand for a product increases or decreases,i.e., the demand curve shifts to the right or left, depending on whetherthe good is normal or inferior.


� A favourable taste change increases the demand for a good, i.e.,shifts the demand curve to the right; an unfavourable change doesthe opposite.

� Market demand curve is obtained by horizontally summing upthe individual demand curves.

� The determinants of market demand curve are prices of relatedgoods, distribution of income, tastes and the market size.

� The price elasticity of demand is independent of the choice of units.

� When two demand curves intersect, the elasticity associated withthe flatter demand curve is greater.

� Greater the availability of close substitutes of a product, the higheris the price elasticity of demand for a product.

� Typically, the demand for luxury products is elastic and that fornecessary goods is inelastic.

� Greater is the share of the total budget spent on a particular good,the more elastic is the demand for it.

� Longer the time horizon, the more elastic is the demand for aproduct.

� If the demand curve is vertical (horizontal), the price elasticity iszero (infinity). In case of elasticity equal to one, the demand curveis a rectangular hyperbola.

� Given that the demand is a straight line, the point elasticity isequal to the lower segment divided by upper segment of thedemand curve at that point.

� If demand is elastic (inelastic), an increase in the price of theproduct leads to a decrease (an increase) in the total expenditureon the product.

� In case of a unitarily elastic demand, a change in price leaves thetotal expenditure on the product unchanged.

EXERCISES

Section I2.1 Define total utility.

2.2 Define marginal utility.


2.3 How is total utility derived from marginal utilities?

2.4 State the law of diminishing marginal utility.

2.5 Give the meaning of demand.

2.6 Name two determinants of the demand.

2.7 List the factors that cause changes in demand.

2.8 What is the law of demand?

2.9 What is a demand schedule?

2.10 Give an example of a pair of commodities that are substitutes ofeach other.

2.11 Give an example of a pair of commodities such that one of themis complementary in consumption to the other.

2.12 If the price of good X rises and it leads to an increase in demandfor good Y, how are the two goods related?

2.13 If the price of good X rises and this leads to a decrease in demandfor good Y, how are the two goods related?

2.14 Define price elasticity of demand.

Section II2.15 A person’s total utility schedule is given below. Derive her

marginal utility schedule.

Amount Consumed Total Utility

0 0

1 10

2 25

3 38

4 48

5 55

2.16 A person’s marginal utility schedule is given below. Derive hertotal utility schedule. (Assume that the total utility of consumingzero is zero.)


Amount Consumed Marginal Utility

1 7

2 10

3 8

4 6

5 3

6 0

2.17 What is consumer’s equilibrium.

2.18 State the condition of consumer’s equilibrium.

2.19 Starting from an initial situation of consumer’s equilibrium, supposethat the marginal utility of a rupee increases. Will it increase ordecrease the quantity demanded of the product?

2.20 Ice creams sell for Rs. 30. Lakhmi, who loves ice cream, has alreadyeaten 3. Her marginal utility from eating 3 ice creams is 90. Supposefurther that, for her, the marginal utility of one rupee is 3. Shouldshe eat more ice cream or should she stop?

2.21 Explain the determinants of demand.

2.22 What is meant by cross price effects? Give two numerical examplesto illustrate this.

2.23 What is meant by one good being a substitute of another?

2.24 What is meant by one good being complementary to another?

2.25 Differentiate between substitute and complementary goods.

2.26 How will an increase in the price of coffee affect the demand for tea?

2.27 How will an increase in the price of tea affect the demand for sugar?

2.28 Suppose that good A is a substitute of good B. How will an increasein the price of good B affect the demand curve for good A?

2.29 Suppose that good A complementary to good B in consumption.How will an increase in the price of good B affect the demand curvefor good A?

2.30 Give two examples of normal goods and two examples of inferiorgoods.

2.31 How does an increase in income affect the demand curve for a normalgood?


2.32 How does an increase in income affect the demand curve for aninferior good?

2.33 Define (a) complementary goods, (b) substitute goods, (c) inferiorgood and (d) normal good.

2.34 Distinguish between a change in quantity demanded and achange in demand.

2.35 How is the market demand curve derived from the individualdemand curves?

2.36 There are four consumers of a fruit called Smile. They are Isha,Ifraah, Ila and Ibema. Their demand curves for Smile are givenbelow. Derive the market demand curve.

Price Quantity Quantity Quantity Quantity (Rs.) Demanded by Demanded by Demanded by Demanded by

Isha Ifraah Ila Ibema

1 16 7 15 8

2 11 6 12 6

3 7 5 9 4

4 4 4 6 2

5 2 3 3 0

6 1 2 0 0

2.37 Explain the determinants of the market demand curve.

2.38 Distinguish between individual and market demand curves.

2.39 Originally, a product was selling for Rs. 10 and the quantitydemanded was 1000 units. The product price changes toRs. 14 and as a result the quantity demanded changes to 500units. Calculate the price elasticity.

2.40 Which of the following commodities have inelastic demand? Salt,a particular brand of lipstick, medicine, mobile phone and schooluniform.

2.41 Draw diagrams showing elasticity equal to (a) zero, (b) one and(c) infinity.


2.42 Draw a straight line demand curve. Choose any three points onit and compare the point elasticities at these three points.

2.43 Consider the above straight line demand curve. Compare thepoint elasticities between the points A, B and C.

2.44 The price elasticity is 2. The % change in price is equal to 5.Find the % change in quantity.

2.45 The price elasticity is 0.5. The % change in quantity is 4. Whatis the % change in price?

2.46 As the price of peanut packets increases by 5%, the number ofpeanut packets demanded falls by 8%. What is the elasticity ofdemand for peanut packets?

2.47 As the price of a product decreases by 7%, the total expenditureon it has gone up by 3.5%. What can we say about the elasticityof demand for this product?

2.48 The price of cauliflower goes up by 8% and the total expenditureby a family on cauliflower goes up by 8%. What can we sayabout the elasticity of demand for cauliflower by this family?

2.49 Show the effect of an increase in price on total expendituredepending on the values of price elasticity.

2.50 A dentist was charging Rs. 300 for a standard cleaning job andper month it used to generate total revenue equal to Rs. 30,000.She has since last month increased the price of dental cleaningto Rs. 350. As a result, fewer customers are now coming fordental cleaning, but the total revenue is now Rs. 33,250. Fromthis, what can we conclude about the elasticity of demand forsuch a dental service?


2.51 “If a product price increases, a family’s spending on the producthas to increase.” Defend or refute.

2.52 Determine how the following changes (or shifts) will affect marketdemand curve for a product.(a) A new steel plant comes up in Jharkhand. Many people who

were previously unemployed in the area are now employed.How will this affect the demand curve for colour TVs andBlack and White TVs in the region?

(b) In order to encourage tourism to Goa, the Government ofIndia suggests Indian Airlines to reduce air fare to Goa fromthe four major cities, Chennai, Kolkata, Mumbai and NewDelhi. If the Indian Airlines reduces the air fare to Goa, howwill this affect the market demand curve for air travel to Goa?

(c) There are train and bus services between New Delhi andJaipur. Suppose that the train fare between the two citiescomes down. How will this affect the demand curve for bustravel between the two cities?

Section III2.53 Discuss how the market demand curve is derived from the

individual demand curves and the determinants of marketdemand.

2.54 Explain why consumer’s equilibrium is attained when themarginal utility of a product in terms of money is equal to itsprice.

2.55 Suppose there are three consumers in a particular market:Leander, Andre and Tim. Their demand schedules are given inthe following table.

Price Quantity Demanded Quantity Demanded Quantity Demandedby Leander by Andre by Tim

1 60 55 24

2 50 40 13

3 40 25 5

4 30 10 0

5 20 0 0


(a) Derive the market demand schedule and plot the market demandcurve.

(b) Suppose Andre drops out of the market. Derive the new marketdemand curve.

(c) Suppose Andre stays in the market and another person, Marat, joinsthe market, whose quantity demanded at any given price is half ofthat of Leander. Derive the new market demand curve.

2.56 Why does the demand curve slope downwards?

2.57 Explain the factors affecting the magnitude of price elasticity of demand.

2. consumer behavior and demand

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