Analysis of Demand, Supply and Equilibrium

2.1 Introduction
2.2 Demand Theory
2.3 Law of Demand
2.4 Law of Supply
2.5 Market Equilibrium
2.6 Changes and Shift in Demand
2.7 Income vs. Substitution Effect
2.8 Relationships among Elasticities
2.9 Key Words
2.10 Some Useful Books

2.1 INTRODUCTION
This unit illustrates the key tools of the market demand curve and market supply
curve and the concept of an equilibrium price and quantity. Demand is a multivariate
relationship, that is, it is determined by many factors simultaneously. Some of the most
important determinants of the market demand for a particular product are its own price,
consumers’ income, prices of other goods, consumers’ tastes, income distribution,
population, consumers’ wealth, credit availability, government policy, etc.
There are two basic approaches for comparison of utilities, the cardinal approach
and the ordinal approach. The cardinal approach postulates that utility can be measured.
The ordinal approach postulates that utility is not measurable but is an ordinal magnitude.
Elasticity of demand is a concise way to describe substitutability of goods. The concept
of demand and supply curves and elasticity are important in many business decisions.
There are two types of changes in demand; i) change in demand for a product due
to change in price, ii) change in the quantity of a product demanded regardless of price.
When there is a change in amount purchased due to lower prices and surplus money
spending it is called the income effect. Income effects basically happen when real
incomes are on the rise. Substitution effect of demand is when the prices drop and
consumers buy more than usual at the expense of a different product.
The law of demand states that the quantity demanded is inversely proportional to
price. The law of supply states that the quantity supplied is directly proportional to price.
Market or equilibrium price is the place where what sellers are willing to sell for and
buyers are willing to buy for. This is the price the product will sell for. Price is negotiated
between the buyers and the sellers.

2.2 DEMAND THEORY

The demand theory starts with the examination of the behaviour of the consumer.
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. There are two basic approaches of consumer behaviour
for comparison of utilities, the cardinal approach and the ordinal approach. The cardinal
approach of the theory of demand assumes that utility can be measured cardinally i.e. it is

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possible to exactly know the number of units of utility (utils) that a commodity or service
contains for the consumer. The ordinal approach postulates that utility is not measurable
but is an ordinal magnitude. The consumer need not know in specific units the utility
of various commodities to make his choice. But he should be able to rank the various
combinations of goods according to the satisfaction that each combination gives him. He
must be able to determine his order of preference among the different combinations of
goods. The main ordinal theories are the indifference curve approach and the revealed
preference approach.

2.2.1 The Cardinal Utility Theory

Assumptions
a) Rationality : The consumer is rational. He aims at the maximisation of his utility and
makes constant choice.
b) Cardinal utility : The utility of each commodity is measurable in units (utils). The
most convenient measure is money that a consumer is ready to pay for another unit of
the commodity.
c) Constant marginal utility of money : This assumption is necessary if the money unit
is used as the measure of utility.
d) Diminishing marginal utility : The marginal utility of a commodity diminishes as
the consumer acquires larger quantities of it.
e) The total utility of a 'basket of goods' depends on the quantities of the individual
commodities. If there are n commodities in the bundle with quantities x1, x2, ....xn, the
total utility is
U = f (x1, x2, ....xn ).

Consumer equilibrium

In a simple model of a single commodity x, the consumer can either buy x or retain
his money income Y. Under these conditions the consumer is in equilibrium when the
marginal utility of x is equated to its market price (Px). i.e. MUx = Px.
If the marginal utility of x is greater than its price, the consumer can increase his welfare
by purchasing more units of x. Similarly if the marginal utility of x is less than its price
the consumer can increase his total satisfaction by having less quantity of x and saving
more of his income. Therefore, he maximises his utility when MUx = Px.

If there are more commodities, the equilibrium of the consumer is

MUx MUy MUn
Px = Py = .......= Pn .

The utility derived from spending an additional unit of money must be the same for all
commodities to attain equilibrium condition.

Derivation of the demand of the consumer

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A consumer demands a particular commodity because of the satisfaction or utility
received from consuming it. Up to a point, the more units of a commodity the consumer
consumes per unit of time, the greater the total utility received. Though total utility
increases, the extra or marginal utility received from consuming each additional unit
of the commodity usually decreases. At some level of consumption, the total utility
received by the individual from consuming the commodity will reach a maximum and the
marginal utility will be zero. This is saturation point. Beyond this, additional units of the
commodity cause total utility to fall and marginal utility to become negative because of
storage or disposal problems.

The Table 1 gives a hypothetical example of a consumer consuming various alternative

qualities of commodity x per unit of time. The total utility rises up to quantity 5 and
becomes constant at quantity 6 and then decreases (Fig.1) . Marginal utility is decreasing
continuously, becomes zero at quantity 6 and then negative beyond that. The falling MUx
curve illustrates the principle of diminishing marginal utility in Fig.2.

Table 1.
Qx TUx MUx
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2

TUx MUx
35 15
30
10
25 TUx
20 5
15
10 0
Qx
5 1 2 3 4 5 6 7
0 -5
Qx MUx
0 1 2 3 4 5 6 7
Fig. 2
Fig.1

Critique of the cardinal approach

The cardinal approach has some basic weaknesses. The assumption of cardinal utility
is extremely doubtful. The satisfaction derived from various commodities can not be
measured objectively. The use of subjective units (utils) for the measurement of utility
does not provide any satisfactory solution. The assumption of constant utility of money
is also unrealistic. As income increases, the marginal utility of money changes. Finally,
the axiom of diminishing marginal utility has been established from introspection, it is a
psychological law which must be taken for granted.

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2.2.2 Indifference Curve Theory

Assumptions

a) Rationality : It is assumed that the consumer behaves rationally. He aims at the

Maximization of his utility given his income and market prices.

b) Ordinal utility : Ordinal utility implies that the consumer is in a position to rank the
alternative combination of goods available to him by a simple comparison of the
satisfaction obtainable from the combination without quantitative measurement of
utilities.

c) Diminishing marginal rate of substitution : Preferences are ranked in terms of

indifference curves, which are assumed to be convex to the origin. This implies that
the slope of the indifference curve increases. The slope of the indifference curve
shows the diminishing marginal rate of substitution of the commodities. This means
that as the amount of the commodity with the consumer goes on increasing he is
prepared to exchange lesser and lesser amount of the other commodity for equal units
of the commodity whose amount is increasing.

d) 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. Similarly,
it is assumed that consumer's choices are characterised by transitivity: if bundle A is
preferred to B, B is preferred to C, then bundle A, is preferred to C.

e) The total utility of the consumer depends on the quantities of the commodities
consumed
U = f ( q1 , q2 , . . .qx , . . . qn )

Indifference Curve

An indifference curve shows the various combinations of commodity X and commodity

Y which yield equal utility or satisfaction to the consumer. A higher indifference curve
shows greater amount of satisfaction than a lower one. Indifference curves exhibit three
basic characteristics : they are negatively sloped, they are convex to the origin and they
cannot intersect (Fig. 3 ).

5 III
dy
dx II
I
0
X
Marginal Rate of Substitution

The marginal rate of substitution of X and Y (MRSxy) refers to the amount of Y that a
consumer is willing to give up in order to gain one additional unit of X (and still remain
on the same indifference curve). As the individual moves down an indifference curve, the
MRSxy diminishes.
dy
MRSxy = - dx = slope of indifference curve

The marginal rate of substitution (the slope of the indifference curve) is equal to the ratio
of the marginal utilities of the commodities involved in the utility function :

MUx MUy
MRSxy = MUy or MRSyx = MUx

Budget Line

The budget line AB in Fig.4 shows all the different combinations of the two commodities
that a consumer can purchase, given his or her money income and the prices of the two
commodities.
Y = pxqx + pyqy

Consumer Equilibrium

A consumer is in equilibrium when, given his or her income and price constraints, the
consumer maximises the total utility or satisfaction from his or her expenditures. In other
words, a consumer is in equilibrium when, given his or her budget line the person reaches
the highest possible indifference curve (Fig. 4).
Qy
MUx Px A
MRSxy = MUy = Py

III
II
I
0 Qx
B
Fig. 4

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2.2.3 The Revealed Preference Theory

The revealed preference theory is considered as a major breakthrough in the theory of

demand, because it has made possible the establishment of the ‘law of demand’ directly
without the use of indifference curves and all their restrictive assumptions.
The theory of revealed preference rests on the following assumptions:

a) Rationality : The consumer is assumed to behave rationally, in that he prefers

bundles of goods that include more quantities of commodities.

b) Consistency :The consumers behave consistently; that is, if the consumer is

observed to prefer bundle A to bundle B, then this consumer will never prefer B to A.

c) Transitivity : If A is preferred to B and B to C, then A is preferred to C.

d) The revealed preferred axiom :The consumer, by choosing a collection of goods

in any one budget situation, reveals his preference for that particular collection.
The chosen bundle is revealed to be preferred among all other alternative bundles
available under the budget constraint.

According to the theory of revealed preference, a consumer’s preferences can be

inferred from a sufficient number of observed choices or purchases in the marketplace,
without any need to inquire directly into the individual’s preferences. For example, if a
consumer is observed to purchase basket A rather than basket B, and A is not cheaper
than B, then for this consumer A must be superior to B.

Suppose that the consumer is observed to be at point A on budget line NN

in Fig.5. Then, A is preferred to any point on or inside NN. On the other hand, points
above and/or to the right of A are superior to A since they involve more of X and/or Y.
Thus the consumer’s indifference curve must be above NN, except at point A where it is
tangent to NN, and to the left and below shaded area LAM. Such an indifference curve
must be negatively sloped and convex to the origin. To locate more closely the
indifference curve, we can chip away the lower zone of ignorance by showing that the
consumer can be induced to purchase basket b on NN if Px/Py falls sufficiently, say to PP.
Then, every point on PP is inferior to B, which is inferior to A. We have, thus eliminated
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area NBP from the lower zone of ignorance. On the other hand, budget line SS through
point A shows the same real income as at point A, but since Px/Py is higher than at point
A, the consumer will purchase less of X and more of Y, as at point G. Then all baskets in
the shaded area above and to the right of G are preferred to G, which is preferred to A.
Thus, we have eliminated some of the upper zone of ignorance. These processes can be
repeated any number of times so that the location of the indifference curve can be
pinpointed more precisely. Thus, the theory of revealed preference can be used to derive
a demand curve easily and without indifference curve.

2.3 LAW OF DEMAND

The law of demand expresses the functional relationship between price and
quantity demanded. According to the law of demand, other things remaining constant,
if price of a commodity falls, the quantity demanded of it will rise and if the price of
the commodity rises, its quantity demanded will decline. Thus, according to the law of
demand there is inverse relationship between price and quantity demanded, other thing
remaining the same. These other things which are assumed to be constant are the tastes
and preferences of the consumer, the income of the consumer, and prices of the other
goods. If these other factors which determine demand also undergo a change, then the
inverse price-demand relationship may not hold good. Thus, the constancy of these other
things is an important assumption of the law of demand.
In the demand schedule of Table 3, we see that the lower the price of the commodity,
greater the quantity demanded by the individual. This inverse relationship between price
and quantity is reflected in the negative slope of the demand curve of Fig. 6.

Table 3.
Price Quantity
2.4 (Rs.) Demanded LAW OF SUPPLY
8 7 10 Law of
7
6 Supply 6 20 states the
5 5 30 relationship
4
3 between 4 40 price of a
2 3 50 commodity
1
0 and its 2 60 supply.
0 10 20 30 40 50 60 70 1 70 According
Quantity
Fig. 6
to the law of supply, other things remaining
constant, the supply of a commodity extends with
a rise in its price and contracts with a fall in its price. The minimum price for a given
amount of a commodity which is necessary to induce a seller to offer that amount for
sale is known as supply price. The other factor which affects supply price is cost of
production. In order to get a producer’s supply schedule and supply curve of a
commodity, certain factors which influence costs of production must be held constant.
These are technology, the prices of the inputs, and for agricultural commodities, climate
and weather conditions.
In the supply schedule of Table 4, we see that the lower the price of the
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commodity, the smaller the quantity offered by the supplier. The reverse is, of course,
also true. The direct relationship between price and quantity is reflected in the positive
slope of the supply curve in Fig. 7.

Table 4.

Price Quantity
8 (Rs.) Supplied
7 1 10
6
5
2 20
Price (Rs.)

4 3 30
3 4 40
2 5 50
1
6 60
0
0 10 20 30 40 50 60 70
7 70
Quantity
2.5
Fig. 7 MARKET EQUILIBRIUM

Equilibrium refers to the market condition which, once achieved, tends to persist. This
occurs when the quantity of a commodity demanded in the market per unit of time
equals the quantity of the commodity supplied to the market over the same time period.
Geometrically, equilibrium occurs at the intersection of the commodity’s market demand
curve and market supply curve. The price and quantity at which equilibrium exists are
known, respectively, as the equilibrium price and the equilibrium quantity (Fig. 8).

Table 5.

Price8 Quantity Quantity

(Rs.)7 Demanded Supplied
6
1 5 70 E 10
Price (Rs.)

2 4 60 20
E
3 3 50 30
4 2 40 40
5 1 30 50
0
6 0
20 60
10 20 30 40 50 60 70
7 10 Quantity 70
Fig. 8

2.6 CHANGES AND SHIFT IN DEMAND

The change in demand or variation in demand may be caused by change in price
or change in other factors (income, tastes and preferences change in prices of related
commodities etc.). A movement along a given demand curve for a commodity as a result
of a change in price is called change in the quantity demanded, whereas, a shift in the
entire demand curve of a commodity resulting from a change in the individual’s income,
tastes and preference, or prices of other commodities is called shift in demand.
The difference between the two concepts can be shown with the help of diagrams.
In the following diagram, Fig 9. the demand curve D shows the amount demanded X1
for price P1. When price decreases to P2 the quantity demanded increases to X2. This
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movement along the demand curve is called change in quantity demanded due to change
in price.
A shift in the entire demand curve is shown in the diagram, Fig 10. Price
remaining fixed at P, the entire demand curve shifts to the right from its old position D to
the new position D’. In this diagram the increase in demand is measured as X1X2.

P1 P

P2
D D`
D
0
0 X1 X
X1 X
2
2 Fig. 10
Fig. 9

2.7 INCOME VS. SUBSTITUTION EFFECT

When the price of a commodity changes, consumer’s demand for it also changes.
The increase in demand in response to a fall in price is called Price Effect. The Price
Effect may be split into two separate effects, a substitution effect and an income
effect. The substitution effect is the increase in the quantity bought as the price of the
commodity falls, after adjusting income so as to keep the purchasing power of the
consumer the same as before. This adjustment in income is called compensating variation
and is shown graphically by a parallel shift of the new budget line until it becomes
tangent to the initial indifference curve (Fig.11). The purpose of the compensating
variation is to allow the consumer to remain on the same level of satisfaction as
before the price change. The compensated-budget line A`B` is tangent to the original
indifference curve (I) at a point (e1) to the right of the original tangency (e). The
movement from e to e1 shows the substitution effect of the price change: the consumer
buys more of x now that it is cheaper, substituting y for x. However, the compensating
variation is a device which enables the isolation of the substitution effect, but does not
show the new equilibrium of the consumer. This is defined by point e2 on the higher
indifference curve II. The consumer has in fact a higher purchasing power, and he spend
some of his increased real income on x, thus moving from x1 to x2 . This is the income
effect of the price change.
Qy

A`
e2
e
e1

II
I
0 Qx
X X1 X2 B B` C
’
Fig. 11
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Hicks vs. Slutsky Analysis

Price effect is the combined result of the income effect and the substitution effect. To
find out the substitution effect we need to keep the real income of the consumer constant.
Now, there are two concepts of real income available to us. The first is that of Hicks and
the second is developed by Slutsky.
According to Hicks if an imaginary budget line is drawn which is tangential to the
indifference curve I on which the consumer was in equilibrium before the price fall of the
commodity taking care that it is also parallel to the redrawn budget line (AC) after the
price fall, then the imaginary budget line A`B` represents the same level of real income
as the old budget line (AB). Therefore, Hicks’ Substitution Effect is the movement of
the consumer along the same indifference curve (I) from one combination (e) to another
combination (e1). In Fig. therefore, as the consumer moves from equilibrium point e to
e2, he purchases xx2 more of the commodity. Out of this, xx1 is the substitution effect,
and x1x2 is the income effect.

In Slutsky’s view, if we draw an imaginary budget line (A``B``) that is parallel

to the redrawn budget line (AC) after the fall of price of commodity X, and which also
passes through the old equilibrium point e on the old budget line (AB), it represents the
same old level of real income. This is because the A``B`` budget line gives the consumer
a choice to buy the old equilibrium combination e if he likes. But moving down the same
budget line A``B`` he can choose a combination e1` which lies on a higher indifference
curve I1 . The substitution effect in Slutsky’s view is equivalent to rotating the budget line
about a point which leads to the movement of the consumer into a higher indifference
curve than before (Fig.12). The Slutsky’s substitution effect is shown in the diagram as
xx1`.

Qy
A
A``
A`
e
e2
e1`
e1
II
I1
I
0 X x1 X1` X2 B B` B`` C Qx

Hick’s
Substitution Effects
Slutsky’s
Fig. 12

Thus, in the above two analysis, the Slutsky’s approach gives us a greater
substitution effect than Hicks. The budget line A``B`` lies vertically higher than the
budget line A`B`. The point of equilibrium e1` of Slutsky’s is on a higher indifference
curve I1 while the point of equilibrium e1 of Hicks is on the old indifference curve I.
Correspondingly the substitution effect xx1` of Slutsky is greater than xx1 of Hicks. The
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Slutsky’s method of eliminating the income effect is preferable to the Hicksian method
because it is more objective in its approach. Though Slutsky shows constant real income
by a different indifference curve than the original, the Slutskian measure is conceptually
less satisfying.

2.8 RELATIONSHIPS AMONG ELASTICITIES

When price of a commodity falls (rises), its demand goes up (down) on account of
two factors which we call the income effect and substitution effect. The two effects when
added, is called price effect. Therefore, when the price of a commodity falls, it means an
increase in real income of the consumer. He will like to purchase more of the commodity
that has become cheaper on account of the income and the substitution effects. The
increase in amount demanded of the commodity as a result of a fall in its price will
depend upon : (a) the proportion of increased (real) income that will be spent to an
increased purchase of this commodity. This will depend on the nature of the commodity
and the income effect it is able to induce on the consumer. If we call the proportion of
increased income spent on this commodity as k and the income elasticity of demand E i,
the influence on demand as a result of a fall in price will be k x Ei ; (b) the proportion of
increased (real) income that will be spent to an increased purchase of other commodities.
It will depend on the strength of the substitutability between this commodity and other
commodities. The balance of increased income that will remain with the consumer is 1-
k. If Es is the elasticity of substitution, then the second influence on the demand for the
commodity whose price has fallen is (1-k) Es.
The first influence is the income effect and the second is the substitution effect.
Since price effect is the net result of those two effects, we can set up the relation

Price elasticity of demand, Ed = income effect + substitution effect

i.e. Ed = kx x Ei + (1-kx) x Es

Where,
Ei is the income elasticity of demand, and
Es is the substitution elasticity of demand
kx is the proportion of income spent on the commodity x, and
(1- kx) is the proportion of income spent on other goods.

The practical importance of the interrelationship formula is that if we know the two
elasticities of demand we can find out the third.

2.9 KEY WORDS

Utility : The property of a commodity that satisfies a want or need of a
consumer.

Total Utility : The overall satisfaction that an individual receives from

consuming a specified quantity of a commodity per unit of time.

Marginal Utility : The change in the total utility per unit change in the quantity of a
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 commodity consumed per unit of time.

Income Effect : The increase in the quantity purchased of a commodity with a

given money income when the commodity’s price falls.

Substitution Effect : When prices drops consumers buy more than the usual at the
expense of a different product.

Indifference Curve : Shows the various combinations of two commodities which

yield
equal utility or satisfaction to the consumer.

Hicksian Substitution Effect : The change in the quantity demanded of a commodity

resulting from a change in its price, while holding real income
constant by keeping the consumer on the same indifference curve
before and after the price change.

Slutsky Substitution Effect : The change in the quantity demanded of a commodity

resulting from a change in its price, while keeping real income
constant in the sense that the consumer could, if he or she wanted,
purchase the same bundle of goods after the price change as the
consumer did before the price change.

2.10 SOME USEFUL BOOKS

Koutsoyiannis, A., 1979, Modern Microeconomics, ELBS/, Macmillan Publishers Ltd.,

Hong Kong.

Salvatore, Dominick., 1983, Microeconomic Theory, McGraw-Hill, Singapore.

Gould, J. P and E. P. Lazear,1998, Microeconomic Theory, Richard D. Irwin, Inc.,

Illinois.

Chopra, P. N., 1996, Advance Economic Theory, Kalyani Publishers. Ludhiana.

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