Basic Laws of Consuption and Demand Analysis

BASIC LAWS OF
CONSUPTION AND
DEMAND ANALYSIS
Introduction
The scope of Managerial Economics
broadly Further grouped as
 Consumption
 Production
 Exchange
 Distribution
Basic Laws of Consumption
• The law of Diminishing Marginal Utility
• The Law of Equi – Marginal Utility
• Consumer Surplus
• The Concept of Indifference Curves
• Consumer Equilibrium
The Law of Diminishing Marginal Utility
 The marginal utility derived on the
consumption of every additional unit goes on
diminishing, other things remaining the same.
 Marginal utility refers to the additional utility
derived from consumption of an additional unit.
 Total utility refers to the sum of total of the
utilities of all units of a commodity consumed a
t a particular time.
 The amount of total utility goes on increasing
but at a diminishing rate.
 Example
The Law of Equi – Marginal Utility
 Explains the prerequisite for the consumer to

be in equilibrium.
 It states that the consumer is in equilibrium
when the marginal utilities obtained from the
products bought are equal.
Marginal utility of product X = Marginal utility of product Y
Price of X Price of Y
Where X and Y refers to the products brought
Consumer Surplus
 It is defined as the difference between the price

that the consumer is prepared to pay and the
price that he is exactly paying.
 It is the value consumers get from a good
without paying for it.
 In many cases, the consumer is prepared to pay
a higher price for the product many reasons i.e.
--He wants the product badly
-He likes particular design
The Indifference Curves
An indifference curve is a curve which
reveals certain combinations of goods or
services which yields the same utility.
The consumer is indifferent to a particular
combination as every combination is
yielding him the same utility.
Assumptions underlying indifference curves:
(a) The consumer behaves rationally (to
maximise his satisfaction)
(b) The prices and incomes do not change during
the analysis.
(c) Tastes and preferences of the consumer do
not change during analysis.
Properties of Indifference Curve
 It slopes down from left to right
 It is convex to the origin
 It can not intersect with another indifference
curve
Consumer Equilibrium
 A consumer is said to be in equilibrium when

he maximises his utility, given the budget
constraint.
 When the budget line is tangential to any of
the indifference curves, then he is said to be in
equilibrium.
Demand Analysis
DEMAND
 Every want supported by the willingness and
ability to buy constitutes demand for a
particular product or service.
The conditions to be satisfied are
 Desire on the part of the buyer to buy
 Willingness to pay for it
 Ability to pay the specified price for it

Nature and types of demand
 Consumer goods Vs Producer goods
 Autonomous demand Vs Derived demand
 Durable Vs Perishable goods
 Firm Demand Vs Industry demand
 Short – run demand Vs long – run demand
 New demand Vs Replacement demand
 Total market and Segment market demand
Factors determining demand
 Price of the product (P)
 Income level of the consumer (I)
 Tastes and preferences of the consumer (T)
prices of related goods which may be substitutes /
complementary (PR)
 Expectations about the prices in future(EP)
 Expectations about the income in the furture (EI)
 Size of the population (SP)
 Distribution of consumers over different regions (DC)
 Advertising efforts (A)
any other facotr capable of affecting the demand. (O)
DEMAND FUNCTION
 A demand function is a function which
describes a relationship between one variable
and its determinants.
 The demand function for a good relates the
quantity of a good which consumer demand
during a given period to the factors which
influence the demand.
Mathematically ,
Qd = f(P,I,T,PR,EP,EI,SP,DC,A,O)
Impact of the determinants on the
demand
 Price of the product
 Income of the consumer
 Prices of substitutes or complementaries
 Tastes and preferences
Law of demand
 The law of demand states: “Other things
remaining the same, the amount of quantity
demanded rises with every fall in the price and
vice versa.”
Assumptions of the law of demand
 Except the price and demand of a particular
product other things remains same, ex income
level of the consumer, tastes, preferences etc.
Operation of the Law of demand
Exceptions to the law of demand
 Where there is a shortage of necessities feared
 Where the product is such that it confers

distinction
 Giffen’s paradox
 In case of ignorance of price changes

Change in Demand
 The increase or decrease in demand due to
change in the factors other than price is called
change in demand.
Increase in demand
Decrease in demand
Extension and Contraction in
demand
 An extension is the downward movement
along a demand curve, which indicates that a
higher quantity is demanded for a given fall in
the price of the good.
 A contraction is the upward movement along a
demand curve, which indicates that a lower
quantity is demanded for a given increase in
the price of the good.
Significance
 Primary law in the consumption theory of
economics
 Indicates the consumer behaviour for a given
change in the variables in the study.
 Provides the basis for decisions related to
costs, output, investment appraisals and so on.
 Basis for other economic laws
Elasticity of demand
 Elasticity : the rate of responsiveness in the
demand of a commodity for a given change in
price or any other determinants of demand.
Measurement of Elasticity
 Perfectly elastic demand
 Perfectly inelastic demand
 Relatively elastic demand
 Relatively inelastic demand
 Unity elasticity
Perfectly elastic demand
 When the quantity can be sold at a given price,
and when there is no need to reduce price, the
demand is said to be perfectly elastic.
 Small increase in price will lead to the fall in
demand
Perfectly inelastic demand
 When a significant degree of change in price
leads to little or no change in the quantity
demanded, then the elasticity is said to be
perfectly inelastic.
Relatively elastic demand
 The demand is said to be relativley elastic
when the change in demand is more than the
change in the price.
Relatively inelastic demand
 The demand is said to be relatively inelastic
when the change in the demand is less than the
change in the price.
Unity elasticity
 When the change in the demand is equal to the
change in the price then the elasticity in
demand is said to be unity.
Types of elasticity
 Price elasticity of demand
 Income elasticity of demand
 Cross elasticity of demand
 Advertising elasticity of demand
Price elasticity of demand
 Elasticity of demand in general refers to the
price elasticity of demand
 It refers to the quantity demanded of a
commodity in response to a given change in
price.
 Price elasticity is always negative, indicates
that the customer tends to buy more with every
fall in the price.
 Price elasticity of demand = Proportionate change in the quantity demanded for product X
Proportionate change in the price of X
Income elasticity of demand
 It refers to the quantity demanded of a
commodity in response to a given change in
income of the consumer.
 It is always positive, indicates that the
consumer tends to buy more and more with
every increase in income.
Income elasticity of demand = Proportional change in quantity demanded for product X
Proportional change in income
Cross elasticity of demand
 I t refers to the quantity demanded of a
commodity in response to a change in the price
of a related good, which may be substitute or
compliment.
Cross elasticity of demand = Proportionate change in quantity demanded for product X
Proportionate change in price of product Y
 Cross elasticity is always positive for

substitutes and negative for complements
Advertising elasticity of demand
 It refers to increase in the sales revenue
because of change in the advertising
expenditure.
Advertising elasticity = Proportionate change in quantity demanded for product X
Proportionate change in advertisement costs
 The advertising elasticity is said to be high

when even small percentage change in the
advertising expenditure results in a large
percentage of change in the level of quantity
demanded or sales
Factors governing elasticity of
demand
 Nature of product
 Time frame
 Degree of postponement
 Number of alternative uses
 Tastes and preferences of the consumer
 Availability of close substitutes
 In case of complementaries or joint goods
 Level of prices
 Availability of subsidies
 Expectation of prices
 Durability of the product
 Government policy
Significance of elasticity of demand
 Prices of factors of production
 Price fixation
 Government policies
 Forecasting demand
 Planning the levels of output and price
Point elasticity and Arc elasticity

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BASIC LAWS OF

 Explains the prerequisite for the consumer to

 It is defined as the difference between the price

 A consumer is said to be in equilibrium when

 Willingness to pay for it

 Ability to pay the specified price for it

 Where the product is such that it confers

 In case of ignorance of price changes

 Cross elasticity is always positive for

 The advertising elasticity is said to be high

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