UNIT 2: DEMAND, ELASTICITY AND
SUPPLY
2.1 Ordinal Analysis of Demand –
Indifference Curve
Meaning of Ordinal Utility
The Ordinal Utility Approach states that:
Utility cannot be measured in numbers but can be ranked in order of preference.
This approach was given by Hicks and Allen and is based on Indifference Curve Analysis.
Indifference Curve (IC)
Meaning:
An Indifference Curve shows different combinations of two goods that give equal satisfaction
to the consumer.
👉 The consumer is indifferent between combinations on the same curve.
Example:
Combination of Tea and Coffee giving same satisfaction.
Combination Tea Coffee
A 1 5
B 2 3
C 3 2
D 4 1
All combinations give same satisfaction → Same Indifference Curve
Properties of Indifference Curve
1. Downward Sloping
To increase one good, the consumer must give up another good.
2. Convex to Origin
Due to diminishing marginal rate of substitution.
3. Indifference Curves Never Intersect
4. Higher IC Represents Higher Satisfaction
5. IC does not touch axes
Marginal Rate of Substitution (MRS)
Meaning:
MRS is the amount of one good the consumer is willing to sacrifice to get one more unit of
another good.
Formula:
MRS = ΔY / ΔX
Law of Diminishing MRS:
As consumer consumes more of X, he gives up less of Y.
2.2 Consumer Equilibrium using Indifference
Curve
Meaning of Consumer Equilibrium
Consumer equilibrium is the point where the consumer gets maximum satisfaction given
income and prices.
Budget Line
Meaning:
Budget line shows combinations of two goods that consumer can buy with given income.
Formula:
PX × X + PY × Y = Income
Where:
PX = Price of good X
PY = Price of good Y
Consumer Equilibrium Condition
Consumer is in equilibrium where:
Indifference Curve is tangent to Budget Line
Mathematical Condition:
MRS = PX / PY
This is very important for exams.
2.3 Price Effect, Income Effect and
Substitution Effect
When price of a good changes, quantity demanded changes. This change is called Price Effect.
Price Effect = Income Effect + Substitution Effect
1. Price Effect
Change in quantity demanded due to change in price of a good.
If price falls → Quantity demanded increases
2. Income Effect
Change in demand due to change in real income when price changes.
Price falls → Real income increases → Demand increases
For inferior goods → Demand decreases
3. Substitution Effect
When price of a good falls, consumers substitute cheaper good for expensive good.
So demand for cheaper good increases.
Summary Table
Effect Meaning
Price Effect Change in demand due to price change
Income Effect Change in demand due to real income change
Substitution Effect Change in demand due to relative price change
Formula:
Price Effect = Income Effect + Substitution Effect
2.4 Determinants of Demand
Demand depends on many factors:
Main Determinants of Demand:
1. Price of the Product
Price ↑ → Demand ↓
Price ↓ → Demand ↑
2. Income of Consumer
Income ↑ → Demand ↑ (Normal goods)
Income ↑ → Demand ↓ (Inferior goods)
3. Price of Related Goods
o Substitute goods (Tea & Coffee)
o Complementary goods (Car & Petrol)
4. Taste and Preferences
5. Population
6. Advertisement
7. Future Expectations
8. Season and Weather
9. Government Policy (Taxes/Subsidies)
10. Fashion and Trends
2.5 Price Elasticity of Demand and its
Relation to Revenue
Meaning of Price Elasticity of Demand
Price elasticity of demand measures responsiveness of demand due to change in price.
Formula:
Ed = % Change in Quantity Demanded / % Change in Price
Types of Elasticity of Demand
Type Elasticity
Perfectly Elastic Ed = ∞
Perfectly Inelastic Ed = 0
Elastic Demand Ed > 1
Inelastic Demand Ed < 1
Unitary Elastic Ed = 1
Relation Between Elasticity and Total Revenue
Elasticity Price Change Total Revenue
Elastic (Ed > 1) Price ↓ TR ↑
Elastic Price ↑ TR ↓
Inelastic (Ed < 1) Price ↓ TR ↓
Inelastic Price ↑ TR ↑
Unitary (Ed = 1) Price change TR constant
Important Rule:
Elastic → Price and TR move opposite
Inelastic → Price and TR move same direction
2.6 Law of Supply and Determinants of
Supply
Law of Supply
The Law of Supply states that:
Other things remaining constant, higher the price, higher the quantity supplied and lower the
price, lower the quantity supplied.
So:
Price ↑ → Supply ↑
Price ↓ → Supply ↓
Supply curve is upward sloping.
Determinants of Supply
Supply depends on:
1. Price of the product
2. Cost of production
3. Price of related goods
4. Technology
5. Government policy (tax/subsidy)
6. Number of sellers
7. Weather and natural conditions
8. Expectations of future price
9. Availability of factors of production
10. Transport and infrastructure