Module - 3

Production Theory

Production function- production with one and two variable inputs, Stages of
production, Economies of scale, Estimation of Production function, Cost theory and
estimation, Economic value analysis, Short and Long run cost functions- their nature,
shape and inter relationship, Law of returns to scale, numerical problems and case
studies

Definition of Production:

According to James Bates and J.R. Parkinson “Production is the organized activity of
transforming resources into finished products in the form of goods and services; and the
objective of production is to satisfy the demand of such transformed resources”.

Production consists of various processes to add utility to natural resources for gaining greater
satisfaction from them by:

(i) Changing the form of natural resources. Most manufacturing processes consist of
use of physical inputs such as raw materials and transforming them into physical
products possessing utility, e.g., changing the form of a log of wood into a table or
changing the form of iron into a machine. This may be called conferring utility of
form.
(ii) Changing the place of the resources from a place where they are of little or no use
to another place where they are of greater use. This utility of place can be obtained
by:
(a) Extraction from earth e.g., removal of coal, minerals, gold and other metal
ores from mines and supplying them to markets.
(b) Transferring goods from where they give little or no satisfaction, to places
where their utility is more, e.g., tin in Malaya is of little use until it is brought to
the industrialised centres where necessary machinery and technology are available
to produce metal boxes for packing. Another example is: apples in Kashmir

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 orchards have a little utility to farmers. But when the apples are transported to
markets where human settlements are thick and crowded like the city centres, they
afford more satisfaction to greater number of people. These examples emphasise
the additional utility conferred on goods, by all forms of transportation systems,
by transport workers and by the agents who assist in the movement and marketing
of goods.

(iii) Making available materials at times when they are not normally available e.g.,
harvested food grains are stored for use till next harvest. Canning of seasonal fruits is
undertaken to make them available during off-season. This may be called conferring
of utility of time.

(iv) Making use of personal skills in the form of services, e.g., those of organisers,
merchants, transport workers etc.

PRODUCTION FUNCTION

The production function is a statement of the relationship between a firm’s scarce

resources (i.e. its inputs) and the output that results from the use of these resources.
More specifically, it states technological relationship between inputs and output. The
production function can be algebraically expressed in the form of an equation in which
the output is the dependent variable and inputs are the independent variables.

The equation can be expressed as:

Q=f(a,b,c,d……n)

Where ‘Q’ stands for the rate of output of given commodity and a, b, c, d…….n, are
the different factors (inputs) and services used per unit of time. Assumptions of
Production Function: There are three main assumptions underlying any production
function. First we assume that the relationship between inputs and outputs exists for a
specific period of time. In other words, Q is not a measure of accumulated output over
time.

Second, it is assumed that there is a given “state-of-the-art” in the production

technology. Any innovation would cause change in the relationship between the given

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inputs and their output. For example, use of robotics in manufacturing or a more
efficient software package for financial analysis would change the input-output
relationship.

Third assumption is that whatever input combinations are included in a particular

function, the output resulting from their utilization is at the maximum level.

The production function can be defined as: The relationship between the maximum
amount of output that can be produced and the input required to make that output. It is
defined for a given state of technology i.e., the maximum amount of output that can
be produced with given quantities of inputs under a given state of technical
knowledge. (Samuelson)

It can also be defined as the minimum quantities of various inputs that are required to
yield a given quantity of output.

The output takes the form of volume of goods or services and the inputs are the
different factors of production i.e., land, labour, capital and enterprise. To illustrate,
for a company which produces beverages, the inputs could be fixed assets such as
plant and machinery; raw materials such as carbonated water, sweeteners and
flavourings and labour such as assembly line workers, support-staff and supervisory
personnel.

For the purpose of analysis, the whole array of inputs in the production function can
be reduced to two; L and K. Restating the equation given above, we get:

Q = f (L, K).

Where Q = Output L= Labour K= Capital

Short-Run Vs Long-Run Production Function

The production function of a firm can be studied in the context of short period or long
period. It is to be noted that in economic analysis, the distinction between short-run
and long-run is not related to any particular measurement of time (e.g. days, months,
or years). In fact, it refers to the extent to which a firm can vary the amounts of the
inputs in the production process. A period will be considered short-run period if the
amount of at least one of the inputs used remains unchanged during that period. Thus,

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short-run production function shows the maximum amount of a good or service that
can be produced by a set of inputs, assuming that the amount of at least one of the
inputs used remains fixed (or unchanged). Generally, it has been observed that during
the short period or in the short run, a firm cannot install a new capital equipment to
increase production. It implies that capital is a fixed factor in the short run. Thus, in
the short-run, the production function is studied by holding the quantities of capital
fixed, while varying the amount of other factors (labour, raw material etc.) This is
done when the law of variable proportion is studied.

The production function can also be studied in the long run. The long run is a period
of time (or planning horizon) in which all factors of production are variable. It is a
time period when the firm will be able to install new machines and capital equipments
apart from increasing the variable factors of production. A long-run production
function shows the maximum quantity of a good or service that can be produced by a
set of inputs, assuming that the firm is free to vary the amount of all the inputs being
used. The behaviour of production when all factors are varied is the subject matter of
the law of returns to scale.

Cobb-Douglas Production Function

A famous statistical production function is Cobb-Douglas production function. Paul

H. Douglas and C.W. Cobb of the U.S.A. studied the production function of the
American manufacturing industries. In its original form, this production function
applies not to an individual firm but to the whole of manufacturing in the United
States. In this case, output is manufacturing production and inputs used are labour and
capital.

Cobb-Douglas production function is stated as:

Q = KLa C (1-a)

where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital. ‘K’ and
‘a’ are positive constants.

The conclusion drawn from this famous statistical study is that labour contributed
about 3/4th and capital about 1/4th of the increase in the manufacturing production.

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Although, the Cobb-Douglas production function suffers from many shortcomings, it
is extensively used in Economics as an approximation.

The Law of Variable Proportions or The Law of Diminishing Returns

In the short run, the input output relations are studied with one variable input (labour)
with all other inputs held constant. The laws of production under these conditions are
known under various names as the law of variable proportions (as the behaviour of
output is studied by changing the proportion in which inputs are combined) the law of
returns to a variable input (as any change in output is taken as resulting from the
additional variable input) or the law of diminishing returns (as returns eventually
diminish).

The law states that as we increase the quantity of one input which is combined with
other fixed inputs, the marginal physical productivity of the variable input must
eventually decline. In other words, an increase in some inputs relative to other fixed
inputs will, in a given state of technology, cause output to increase; but after a point,
the extra output resulting from the same addition of extra input will become less and
less.

Before discussing this law, if would be appropriate to understand the meaning of total
product, average product and marginal product.

Total Product (TP): Total product is the total output resulting from the efforts of all
the factors of production combined together at any time. If the inputs of all but one
factor are held constant, the total product will vary with the quantity used of the
variable factor. Column (1) of Table 1 presents the quantity of variable factor (labour)
used along with the factors whose quantity is held constant and column (2) represent
the total product at various levels of use of the variable input.

Table 1: Product Schedule

Quantity of Total Product Average Product Marginal Product

Labour
(1) (2) (3) (4)

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 1 100 100.0 100
2 210 105.0 110
3 330 110.0 120
4 440 110.0 110
5 520 104.0 80
6 600 100.0 80
7 670 95.7 70
8 720 90.0 50
9 750 83.3 30
10 750 75.0 0
11 740 67.3 -10

We find that when one unit of labour is employed along with other factors of
production, the total product is 100 units. When two units of labour are employed, the
total product rises to 210 units. The total product goes on rising as more and more
units of labour are employed. With 9 or 10 units of labour, the total product rises to
maximum level of 750 units. When 11 units of labour are employed, total product
falls to 740 units due to negative returns from the 11th unit of labour.

Average Product (AP): Average product is the total product per unit of the variable
factor. AP= Total Product [Link] units of Variable Factor It is shown as a schedule in
column (3) of Table 1. When one unit of labour is employed, average product is 100,
when two units of labour are employed, average product rises to 105. This goes on, as
shown in Table 1.

Marginal Product (MP): Marginal product is the change in total product per unit
change in the quantity of variable factor. In other words, it is the addition made to the
total production by an additional unit of input. Symbolically,

MP n = TP n – TP n-1

The computed value of the marginal product appears in the last column of Table 1.
For example, the MP corresponding to 4 units is given as 110 units. This reflects the

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 fact that an increase in labour from 3 to 4 units, has increased output from 330 to 440
units.

Relationship between Average Product and Marginal Product: Both average product
and marginal product are derived from the total product. Average product is obtained
by dividing total product by the number of units of the variable factor and marginal
product is the change in total product resulting from a unit increase in the quantity of
variable factor. The relationship between average product and marginal product can
be summed up as follows:

(i) when average product rises as a result of an increase in the quantity of

variable input, marginal product is more than the average product.
(ii) when average product is maximum, marginal product is equal to average
product. In other words, the marginal product curve cuts the average product
curve at its maximum.
(iii) when average product falls, marginal product is less than the average
product.
Table 1 and Figure 1 confirm the above relationship

The Law of Variable Proportions or the Law of Diminishing Returns

examines the production function with one factor variable, keeping quantities
of other factors fixed. In other words, it refers to input-output relationship,
when the output is increased by varying the quantity of one input. This law
operates in the short run ‘when all factors of production cannot be increased
or decreased simultaneously (for example, we cannot build a plant or
dismantle a plant in the short run).

The law operates under certain assumptions which are as follows:

1. The state of technology is assumed to be given and unchanged. If there is any

improvement in technology, then marginal product and average product may rise instead of
falling.

2. There must be some inputs whose quantity is kept fixed. This law does not apply to cases
when all factors are proportionately varied. When all the factors are proportionately varied,
laws of returns to scale are applicable.

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3. The law does not apply to those cases where the factors must be used in fixed proportions
to yield output. When the various factors are required to be used in fixed proportions, an
increase in one factor would not lead to any increase in output i.e., marginal product of the
variable factor will then be zero and not diminishing. 4. We consider only physical inputs and
outputs and not economic profitability in monetary terms then be zero and not diminishing. 4.
We consider only physical inputs and outputs and not economic profitability in monetary
terms

The behaviour of output when the varying quantity of one factor is combined with a fixed
quantity of the others can be divided into three distinct stages or laws. In order to understand
these three stages or laws, we may graphically illustrate the production function with one
variable factor. This is done in Figure 1.

In this figure, the quantity of variable factor is depicted on the X axis and the Total Product
(TP), Average Product (AP) and Marginal Product (MP) are shown on the Y-axis. As the
figure shows, the TP curve goes on increasing upto to a point and after that it starts declining.
AP and MP curves first rise and then decline; MP curve starts declining earlier than the AP
curve.

The behaviour of these Total, Average and Marginal Products of the variable factor
consequent on the increase in its amount is generally divided into three stages (laws) which
are explained below.

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Stage 1: The Stage of Increasing Returns: In this stage, the total product increases at an
increasing rate upto a point (in figure upto point F), marginal product also rises and is
maximum at the point corresponding to the point of inflexion and average product goes on
rising. From point F onwards during the stage one, the total product goes on rising but at a
diminishing rate. Marginal product falls but is positive. The stage 1 ends where the AP curve
reaches its highest point.

Thus, in the first stage, the AP curve rises throughout whereas the marginal product curve
first rises and then starts falling after reaching its maximum. It is to be noted that the marginal
product although starts declining, remains greater than the average product throughout the
stage so that average product continues to rise.

Explanation of law of increasing returns: The law of increasing returns operates because in
the beginning, the quantity of fixed factors is abundant relative to the quantity of the variable
factor. As more units of the variable factor are added to the constant quantity of the fixed
factors, the fixed factors are more intensively and effectively utilised i.e., the efficiency of the
fixed factors increases as additional units of the variable factors are added to them. This
causes the production to increase at a rapid rate. For example, if a machine can be efficiently
operated when four persons are working on it and if in the beginning we are operating it only
with three persons, production is bound to increase if the fourth person is also put to work on
the machine since the machine will be effectively utilised to its optimum. This happens
because, in the beginning some amount of fixed factor remained unutilised and, therefore,
when the variable factor is increased, fuller utilisation of the fixed factor becomes possible
and it results in increasing returns. A question arises as to why the fixed factor is not initially
taken in a quantity which suits the available quantity of the variable factor. The answer is
that, generally, those factors which are indivisible are taken as fixed. Indivisibility of a factor
means that due to technological requirements, a minimum amount of that factor must be
employed whatever be the level of output. Thus, as more units of the variable factor are
employed to work with an indivisible fixed factor, output greatly increases due to fuller
utilisation of the latter. The second reason why we get increasing returns at the initial stage is
that as more units of the variable factor are employed, the efficiency of the variable factor
increases. This is because introduction of division of labour and specialisation becomes
possible with sufficient quantity of the variable factor and these results in higher productivity.

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Stage 2: Stage of Diminishing Returns: In stage 2, the total product continues to increase at a
diminishing rate until it reaches its maximum at point H, where the second stage ends. In this
stage, both marginal product and average product of the variable factor are diminishing but
are positive. At the end of this stage i.e., at point M (corresponding to the highest point H of
the total product curve), the marginal product of the variable factor is zero. Stage 2, is known
as the stage of diminishing returns because both the average and marginal products of the
variable factors continuously fall during this stage. This stage is very important because the
firm will seek to produce within its range.

Explanation of law of diminishing returns: The question arises as to why we get diminishing
returns after a certain amount of the variable factor has been added to the fixed quantity of
that factor. As explained above, increasing returns occur primarily because of more efficient
use of fixed factors as more units of the variable factor are combined to work with it. Once
the point is reached at which the amount of variable factor is sufficient to ensure efficient
utilisation of the fixed factor, any further increases in the variable factor will cause marginal
and average product to decline because the fixed factor then becomes inadequate relative to
the quantity of the variable factor. Continuing the above example, when four men were put to
work on one machine, the optimum combination was achieved. Now, if the fifth person is put
on the machine, his contribution will be nil. In other words, the marginal productivity will
start diminishing.

The phenomenon of diminishing returns, like that of increasing returns, rests upon the
indivisibility of the fixed factor. Just as the average product of the variable factor increases in
the first stage when better utilisation of the fixed indivisible factor is being made, so the
average product of the variable factor diminishes in the second stage when the fixed
indivisible factor is being worked too hard. Another reason offered for the operation of the
law of diminishing returns is the imperfect substitutability of one factor for another. Had the
perfect substitute of the scarce fixed factor been available, then the paucity of the scarce fixed
factor during the second stage would have been made up by increasing the supply of its
perfect substitute with the result that output could be expanded without diminishing returns.

Stage 3: Stage of Negative Returns: In Stage 3, total product declines, MP is negative,

average product is diminishing. This stage is called the stage of negative returns since the
marginal product of the variable factor is negative during this stage.

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Explanation the law of negative returns: As the amount of the variable factor continues to
be increased to a constant quantity of the other, a stage is reached when the total product
declines and marginal product becomes negative. This is due to the fact that the quantity of
the variable factor becomes too excessive relative to the fixed factor so that they get in each
other’s ways with the result that the total output falls instead of rising. In such a situation, a
reduction in the units of the variable factor will increase the total output.

Stage of Operation: An important question is in which stage a rational producer will seek to
produce. A rational producer will never produce in stage 3 where marginal product of the
variable factor is negative. This being so, a producer can always increase his output by
reducing the amount of variable factor. Even if the variable factor is free of cost, a rational
producer stops before the beginning of the third stage.

A rational producer will also not produce in stage 1 as he will not be making the best use of
the fixed factors and he will not be utilising fully the opportunities of increasing production
by increasing the quantity of the variable factor whose average product continues to rise
throughout stage 1. Even if the fixed factor is free of cost in this stage, a rational entrepreneur
will continue adding more variable factors.

It is thus clear that a rational producer will never produce in stage 1 and stage 3. These stages
are called stages of ‘economic absurdity’ or ‘economic non-sense’.

A rational producer will always produce in stage 2 where both the marginal product and
average product of the variable factors are diminishing. At which particular point in this
stage, the producer will decide to produce depends upon the prices of factors. The optimum
level of employment of the variable factor (here labour) will be determined by applying the
principle of marginalism in such a way that the marginal revenue product of labour is equal to
the marginal wages. (The principle of marginalism is explained in detail in the chapter
discussing equilibrium in different types of markets.)

Returns to Scale

A change in scale means that all factors of production are increased or decreased in the same
proportion. Change in scale is different from changes in factor proportions. Changes in output
as a result of the variation in factor proportions, as seen before, form the subject matter of the
law of variable proportions. On the other hand, the study of changes in output as a

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consequence of changes in scale forms the subject matter of returns to scale which is
discussed below. It should be kept in mind that the returns to scale faced by a firm are solely
technologically determined and are not influenced by economic decisions taken by the firm
or by market conditions.

Returns to scale may be constant, increasing or decreasing. If we increase all factors i.e.,
scale in a given proportion and output increases in the same proportion, returns to scale are
said to be constant. Thus, if doubling or trebling of all factors causes a doubling or trebling of
output, then returns to scale are constant. But, if the increase in all factors leads to more than
proportionate increase in output, returns to scale are said to be increasing. Thus, if all factors
are doubled and output increases more than double, then the returns to scale are said to be
increasing. On the other hand, if the increase in all factors leads to less than proportionate
increase in output, returns to scale are decreasing. It is needless to say that this law operates
in the long run when all the factors can be changed in the same proportion simultaneously.

It should be remembered that increasing returns to scale is not the same as increasing
marginal returns. Increasing returns to scale applies to ‘long run’ in which all inputs can be
changed. Increasing marginal returns refers to the short run in which at least one input is
fixed. The existence of fixed inputs in the short run gives rise to increasing and later to
diminishing marginal returns.

Constant Returns to Scale: As stated above, constant returns to scale means that with the
increase in the scale in some proportion, output increases in the same proportion. Constant
returns to scale, otherwise called as “Linear Homogeneous Production Function”, may be
expressed as follows:

kQx = f( kK, kL)

= k (K, L)

If all the inputs are increased by a certain amount (say k) output increases in the same
proportion (k). It has been found that an individual firm passes through a long phase of
constant returns to scale in its lifetime.

Increasing Returns to Scale: As stated earlier, increasing returns to scale means that output
increases in a greater proportion than the increase in inputs. When a firm expands, increasing
returns to scale are obtained in the beginning. For example, a wooden box of 3 ft. cube

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contains 9 times greater wood than the wooden box of 1 foot-cube. But the capacity of the 3
foot- cube box is 27 times greater than that of the one foot cube. Many such examples are
found in the real world. Another reason for increasing returns to scale is the indivisibility of
factors. Some factors are available in large and lumpy units and can, therefore, be utilised
with utmost efficiency at a large output. If all the factors are perfectly divisible, increasing
returns may not occur. Returns to scale may also increase because of greater possibilities of
specialisation of land and machinery.

Decreasing Returns to Scale: When output increases in a smaller proportion relative to an

increase in all inputs, decreasing returns to scale are said to prevail. When a firm goes on
expanding by increasing all inputs, decreasing returns to scale set in. Decreasing returns to
scale eventually occur because of increasing difficulties of management, coordination and
control. When the firm has expanded to a very large size, it is difficult to manage it with the
same efficiency as earlier.

The Cobb-Douglas production function, explained earlier is used to explain “returns to scale”
in production. Originally, Cobb and Douglas assumed that returns to scale are constant. The
function was constructed in such a way that the exponents summed to a+1-a=1. However,
later they relaxed the requirement and rewrote the equation as follows:

Q = K La C b

Where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital, ‘K’ and ‘a’ and
‘b’ are positive constants.

If a + b > 1 Increasing returns to scale result i.e. increase in output is more than the
proportionate increase in the use of factors (labour and capital).

a + b = 1 Constant returns to scale result i.e. the output increases in the same proportion in
which factors are increased.

a + b < 1 decreasing returns to scale result i.e. the output increases less than the
proportionate increase in the labour and capital.

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COST CONCEPTS

Accounting Costs and Economic costs:

An entrepreneur has to pay price for the factors of production which he employs for
production. He thus pays wages to workers employed, prices for the raw materials, fuel and
power used, rent for the building he hires and interest on the money borrowed for doing
business. All these are included in his cost of production and are termed as accounting costs.
Accounting costs relate to those costs which involve cash payments by the entrepreneur of
the firm. Thus, accounting costs are explicit costs and includes all the payments and charges
made by the entrepreneur to the suppliers of various productive factors. Accounting costs are
expenses already incurred by the firm. Accountants record these in the financial statements of
the firm.

However, it generally happens that an entrepreneur invests a certain amount of capital in his
business. If the capital invested by the entrepreneur in his business had been invested
elsewhere, it would have earned a certain amount of interest or dividend. Moreover, an
entrepreneur may devote his time to his own work of production and contributes his
entrepreneurial and managerial ability to do business. Had he not set up his own business, he
would have sold his services to others for some positive amount of money. Accounting costs
do not include these costs. These costs form part of economic cost.

Thus, economic costs include:

1) the normal return on money capital invested by the entrepreneur himself in his own
business;

2) the wages or salary not paid to the entrepreneur, but could have been earned if the services
had been sold somewhere else.

Likewise, the monetary rewards for all factors owned by the entrepreneur himself and
employed by him in his own business are also considered a part of economic costs. Economic
costs take into account these accounting costs; in addition, they also take into account the
amount of money the entrepreneur could have earned if he had invested his money and sold
his own services and other factors in the next best alternative uses. Accounting costs are also
called explicit costs whereas the cost of factors owned by the entrepreneur himself and
employed in his own business is called implicit costs. Thus, economic costs include both

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accounting costs and implicit costs. Therefore, economic costs are useful for businessmen
while making decisions.

The concept of economic cost is important because an entrepreneur must cover his economic
cost if he wants to earn normal profits. Normal profit is part of implicit costs. If the total
revenue received by an entrepreneur just covers both implicit and explicit costs, then he has
zero economic profits. Super normal profits or positive economic profits (abnormal profits)
are over and above these normal profits. In other words, an entrepreneur is said to be earning
positive economic profits (abnormal profits) only when his revenues are greater than the sum
of his explicit costs and implicit costs.

Outlay costs and Opportunity costs:

Outlay costs involve actual expenditure of funds on, say, wages, materials, rent, interest, etc.
Opportunity cost, on the other hand, is concerned with the cost of the next best alternative
opportunity which was foregone in order to pursue a certain action. It is the cost of the missed
opportunity and involves a comparison between the policy that was chosen and the policy
that was rejected. For example, the opportunity cost of using capital is the interest that it can
earn in the next best use with equal risk.

A distinction between outlay costs and opportunity costs can be drawn on the basis of the
nature of the sacrifice. Outlay costs involve financial expenditure at some point of time and
hence are recorded in the books of account. Opportunity cost is the amount or subjective
value that is foregone in choosing one activity over the next best alternative. It relates to
sacrificed alternatives; it is, in general not recorded in the books of account.

The opportunity cost concept is generally very useful for business managers and therefore it
has to be considered whenever resources are scarce and a decision involving choice of one
option over other(s) is involved. e.g., in a cloth mill which spins its own yarn, the opportunity
cost of yarn to the weaving department is the price at which the yarn could be sold. This has
to be considered while measuring profitability of the weaving operations.

In long-term cost calculations also opportunity cost is a useful concept e.g., while calculating
the cost of higher education, it is not the tuition fee and cost of books alone that are relevant.
One should also take into account the earnings foregone, other foregone uses of money which
is paid as tuition fees and the value of missed activities etc. as the cost of attending classes.

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Direct or Traceable costs and Indirect or Non-Traceable costs:

Direct costs are those which have direct relationship with a component of operation like
manufacturing a product, organizing a process or an activity etc. Since such costs are directly
related to a product, process or machine, they may vary according to the changes occurring in
these. Direct costs are costs that are readily identified and are traceable to a particular
product, operation or plant. Even overhead costs can be direct as to a department;
manufacturing costs can be direct to a product line, sales territory, customer class etc. We
must know the purpose of cost calculation before considering whether a cost is direct or
indirect.

Incremental costs and Sunk costs:

Theoretically, incremental costs are related to the concept of marginal cost. Incremental cost
refers to the additional cost incurred by a firm as result of a business decision. For example,
incremental costs will have to be incurred by a firm when it makes a decision to change its
product line, replace worn out machinery, buy a new production facility or acquire a new set
of clients. Sunk costs refer to those costs which are already incurred once and for all and
cannot be recovered. They are based on past commitments and cannot be revised or reversed
if the firm wishes to do so. Examples of sunk costs are expenses incurred on advertising, R&
D, specialised equipments and fixed facilities such as railway lines. Sunk costs act as an
important barrier to entry of firms into business.

Historical costs and Replacement costs:

Historical cost refers to the cost incurred in the past on the acquisition of a productive asset
such as machinery, building etc. Replacement cost is the money expenditure that has to be
incurred for replacing an old asset. Instability in prices make these two costs differ. Other
things remaining the same, an increase in price will make replacement costs higher than
historical cost.

Private costs and Social costs:

Private costs are costs actually incurred or provided for by firms and are either explicit or
implicit. They normally figure in business decisions as they form part of total cost and are
internalised by the firm. Social cost, on the other hand, refers to the total cost borne by the
society on account of a business activity and includes private cost and external cost. It

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 16

includes the cost of resources for which the firm is not required to pay price such as
atmosphere, rivers, roadways etc. and the cost in terms of dis-utility created such as air, water
and environment pollution.

Fixed and Variable costs:

Fixed or constant costs are not a function of output; they do not vary with output upto a
certain level of activity. These costs require a fixed expenditure of funds irrespective of the
level of output, e.g., rent, property taxes, interest on loans and depreciation when taken as a
function of time and not of output. However, these costs vary with the size of the plant and
are a function of capacity. Therefore, fixed costs do not vary with the volume of output
within a capacity level.

Fixed costs cannot be avoided. These costs are fixed so long as operations are going on. They
can be avoided only when the operations are completely closed down. These are, by their
very nature, inescapable or uncontrollable costs. But, there are some costs which will
continue even after the operations are suspended, as for example, for storing of old machines
which cannot be sold in the market. These are called shut down costs. Some of the fixed costs
such as costs of advertising, etc. are programmed fixed costs or discretionary expenses,
because they depend upon the discretion of management whether to spend on these services
or not.

Variable costs are costs that are a function of output in the production period. For example,
wages of casual labourers and cost of raw materials and cost of all other inputs that vary with
output are variable costs. Variable costs vary directly and sometimes proportionately with
output. Over certain ranges of production, they may vary less or more than proportionately
depending on the utilization of fixed facilities and resources during the production process.

COST FUNCTION

Cost function refers to the mathematical relation between cost of a product and the various
determinants of costs. In a cost function, the dependent variable is unit cost or total cost and
the independent variables are the price of a factor, the size of the output or any other relevant
phenomenon which has a bearing on cost, such as technology, level of capacity utilization,
efficiency and time period under consideration. Cost function is a function which is obtained
from production function and the market supply of inputs. It expresses the relationship

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 17

between costs and output. Cost functions are derived from actual cost data of the firms and
are presented through cost curves. The shape of the cost curves depends upon the cost
function. Cost functions are of two kinds: They are short-run cost functions and long-run cost
functions.

SHORT RUN TOTAL COSTS

Total, fixed and variable costs:

There are some factors which can be easily adjusted with changes in the level of output. A
firm can readily employ more workers if it has to increase output. Similarly, it can purchase
more raw materials if it has to expand production. Such factors which can be easily varied
with a change in the level of output are called variable factors. On the other hand, there are
some factors such as building, capital equipment, or top management team which cannot be
so easily varied. It requires comparatively longer time to make changes in them. It takes time
to install new machinery. Similarly, it takes time to build a new factory. Such factors which
cannot be readily varied and require a longer period to adjust are called fixed factors.

Corresponding to the distinction between variable and fixed factors, we distinguish between
short run and long run periods of time. Short run is a period of time in which output can be
increased or decreased by changing only the amount of variable factors such as, labour, raw
materials, etc. In the short run, quantities of fixed factors cannot be varied in accordance with
changes in output. If the firm wants to increase output in the short run, it can do so only by
increasing the variable factors, i.e., by using more labour and/or by buying more raw
materials. Thus, short run is a period of time in which only variable factors can be varied,
while the quantities of fixed factors remain unaltered. On the other hand, long run is a period
of time in which the quantities of all factors may be varied. In other words, all factors become
variable in the long run.

Thus, we find that fixed costs are those costs which are independent of output, i.e., they do
not change with changes in output. These costs are a “fixed amount” which are incurred by a
firm in the short run, whether the output is small or large. Even if the firm closes down for
some time in the short run but remains in business, these costs have to be borne by it. Fixed
costs include such charges as contractual rent, insurance fee, maintenance cost, property
taxes, interest on capital employed, managers’ salary, watchman’s wages etc. The fixed cost
curve is presented in figure 5.

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 18

Variable costs, on the other hand are those costs which change with changes in output. These
costs include payments such as wages of casual labour employed, prices of raw material, fuel
and power used, transportation cost etc. If a firm shuts down for a short period, it may not use
the variable factors of production and therefore, will not therefore incur any variable cost.
Figure 6 presents completely variable cost curve drawn under the assumption that variable
costs change linearly with changes in output.

There are some costs which are neither perfectly variable, nor absolutely fixed in relation to
the changes in the size of output. They are known as semi-variable costs. It is well reflected
in the Fig. 7. Example: Electricity charges include both a fixed charge and a charge based on
consumption.

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 19

There are some costs which may increase in a stair-step fashion, i.e., they remain fixed over
certain range of output; but suddenly jump to a new higher level when output goes beyond a
given limit. E.g. Costs incurred towards the salary of foremen will have a sudden jump if
another foreman is appointed when the output crosses a particular limit.

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The total cost of a business is defined as the actual cost that must be incurred for producing a
given quantity of output. The short run total cost is composed of two major elements namely,
total fixed cost and total variable cost. Symbolically TC = TFC + TVC. We may represent
total cost, total variable cost and fixed cost diagrammatically.

In the diagram above, the total fixed cost curve (TFC) is a horizontal straight line parallel to
X-axis as TFC remains fixed for the whole range of output. This curve starts from a point on
the Y-axis meaning thereby that fixed costs will be incurred even if the output is zero. On the
other hand, the total variable cost curve rises upward indicating that as output increases, total
variable cost increases. The total variable cost curve starts from the origin because variable
costs are zero when the output is zero. It should be noted that the total variable cost initially
increases at a decreasing rate and then at an increasing rate with increases in output. This
pattern of change in the TVC occurs due to the operation of the law of increasing and
diminishing returns to the variable inputs. Due to the operation of diminishing returns, as
output increases, larger quantities of variable inputs are required to produce the same quantity
of output. Consequently, variable cost curve is steeper at higher levels of output. The total
cost curve has been obtained by adding vertically the total fixed cost curve and the total
variable cost curve. The slopes of TC and TVC are the same at every level of output and at
each point the two curves have vertical distance equal to total fixed cost. Its position reflects
the amount of fixed costs and its slope reflects variable costs.

Short run average costs

Average fixed cost (AFC) : AFC is obtained by dividing the total fixed cost by the number
of units of output produced. i.e. AFC= TFC/Q where Q is the number of units produced.
Thus, average fixed cost is the fixed cost per unit of output. For example, if a firm is
producing with a total fixed cost of ` 2,000/-. When output is 100 units, the average fixed cost
will be ` 20. And now, if the output increases to 200 units, average fixed cost will be ` 10.
Since total fixed cost is a constant amount, average fixed cost will steadily fall as output
increases. Therefore, if we draw an average fixed cost curve, it will slope downwards
throughout its length but will not touch the X-axis as AFC cannot be zero. (Fig. 10)

Average variable cost (AVC) : Average variable cost is found out by dividing the total variable cost by
the number of units of output produced, i.e. AVC= TVC /Q where Q is the number of units produced.
Thus, average variable cost is the variable cost per unit of output. Average variable cost normally

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 21

falls as output increases from zero to normal capacity output due to occurrence of increasing returns
to variable factors. But beyond the normal capacity output, average variable cost will rise steeply
because of the operation of diminishing returns (the concepts of increasing returns and diminishing
returns have already been discussed earlier). If we draw an average variable cost curve, it will first
fall, then reach a minimum and then rise. (Fig. 10)

Average total cost (ATC): Average total cost is the sum of average variable cost and
average fixed cost. i.e., ATC = AFC + AVC. It is the total cost divided by the number of
units produced, i.e. ATC = TC/[Link] behaviour of average total cost curve depends upon the
behaviour of the average variable cost curve and the average fixed cost curve. In the
beginning, both AVC and AFC curves fall, therefore, the ATC curve will also fall sharply.
When AVC curve begins to rise, but AFC curve still falls steeply, ATC curve continues to
fall. This is because, during this stage, the fall in AFC curve is greater than the rise in the
AVC curve, but as output increases further, there is a sharp rise in AVC which more than
offsets the fall in AFC. Therefore, ATC curve first falls, reaches its minimum and then rises.
Thus, the average total cost curve is a “U” shaped curve. (Fig. 10)

Marginal cost: Marginal cost is the addition made to the total cost by the production of an
additional unit of output. In other words, it is the total cost of producing t units instead of t-1
units, where t is any given number. For example, if we are producing 5 units at a cost of ` 200
and now suppose the 6th unit is produced and the total cost is ` 250, then the marginal cost is
` 250 - 200 i.e., ` 50. And marginal cost will be ` 24, if 10 units are produced at a total cost of
` 320 [(320-200) / (10-5)]. It is to be noted that marginal cost is independent of fixed cost.
This is because fixed costs do not change with output. It is only the variable costs which
change with a change in the level of output in the short run. Therefore, marginal cost is in fact
due to the changes in variable costs. Symbolically marginal cost may be written as:

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 22

MC= ∆TC/ ∆Q

OR

MCn = TCn – TCn-1

∆TC= Change in Total Cost

∆Q= Change in quantity

Marginal cost curve falls as output increases in the beginning. It starts rising after a certain
level of output. This happens because of the influence of the law of variable proportions. The
MC curve becomes minimum corresponding to the point of inflexion on the total cost curve.
The fact that marginal product rises first, reaches a maximum and then declines ensures that
the marginal cost curve of a firm declines first, reaches its minimum and then rises. In other
words marginal cost curve of a firm is “U” shaped (see Figure 10).

The behaviour of these costs has also been shown in Table 3.

Table 3 : Various Costs

Unit of Total Total Total Average Average Average Marginal

output Fixed variable cost fixed variable total cost
Cost cost cost cost cost
0 1000 0 1000 - - - -
1 1000 50 1050 1000.00 50.00 1050 50
2 1000 90 1090 500.00 45.00 545.00 40
3 1000 140 1140 333.33 46.67 380.00 50
4 1000 196 1196 250.0 49.00 299.00 56
5 1000 255 1255 200.00 51.00 251.00 59
6 1000 325 1325 166.67 54.17 220.00 70
7 1000 400 1400 142.86 57.14 200.00 75
8 1000 480 1480 125.00 60.00 185.00 80
9 1000 570 1570 111.11 63.33 174.44 90
10 1000 670 1670 100.00 67.00 167.00 100
11 1000 780 1780 90.91 70.91 161.82 110
12 1000 1080 2080 83.33 90.00 173.33 300

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The above table shows that:

(i) Fixed costs do not change with increase in output upto a given level. Average
fixed cost, therefore, comes down with every increase in output.
(ii) Variable costs increase, but not necessarily in the same proportion as the increase
in output. In the above case, average variable cost comes down gradually till 4
units are produced. Thereafter it starts increasing.
(iii) Marginal cost is the additional cost divided by the additional units produced. This
also comes down first and then starts increasing.

Relationship between Average Cost and Marginal Cost: The relationship between
marginal cost and average cost is the same as that between any other marginal-average
quantities. The following are the points of relationship between the two.

(1) When average cost falls as a result of an increase in output, marginal cost is less than
average cost.

(2) When average cost rises as a result of an increase in output, marginal cost is more than
average cost

(3) When average cost is minimum, marginal cost is equal to the average cost. In other
words, marginal cost curve cuts average cost curve at its minimum point (i.e. optimum
point).

LONG RUN AVERAGE COST CURVE

As stated above, long run is a period of time during which the firm can vary all of its
inputs; unlike short run in which some inputs are fixed and others are variable. In other
words, whereas in the short run the firm is tied with a given plant, in the long run the firm
can build any size or scale of plant and therefore, can move from one plant to another; it
can acquire a big plant if it wants to increase its output and a small plant if it wants to
reduce its output. The long run being a planning horizon, the firm plans ahead to build the
most appropriate scale of plant to produce the future level of output. It should be kept in
mind that once the firm has built a particular scale of plant, its production takes place in
the short run. Briefly put, the firm actually operates in the short run and plans for the long

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 24

run. Long run cost of production is the least possible cost of producing any given level of
output when all individual factors are variable. A long run cost curve depicts the
functional relationship between output and the long run cost of production.

In order to understand how the long run average cost curve is derived, we consider three
short run average cost curves as shown in Figure 11. These short run average cost curves
(SACs) are also called ‘plant curves’. In the short run, the firm can be operating on any
short run average cost curve, given the size of the plant. Suppose that there are the only
three plants which are technically possible. Given the size of the plant, the firm will be
increasing or decreasing its output by changing the amount of the variable inputs. But in
the long run, the firm chooses among the three possible sizes of plants as depicted by
short run average curves (SAC1 , SAC2 , and SAC3). In the long run, the firm will
examine with which size of plant or on which short run average cost curve it should
operate to produce a given level of output, so that the total cost is minimum. It will be
seen from the diagram that up to OB amount of output, the firm will operate on the SAC1
, though it could also produce with SAC2 . Up to OB amount of output, the production on
SAC1 results in lower cost than on SAC2 . For example, if the level of output OA is
produced with SAC1 , it will cost AL per unit and if it is produced with SAC2 it will cost
AH and we can see that AH is more than AL. Similarly, if the firm plans to produce an
output which is larger than OB but less than OD, then it will not be economical to
produce on SAC1 . For this, the firm will have to use SAC2 . Similarly, the firm will use
SAC3 for output larger than OD. It is thus clear that, in the long run, the firm has a choice
in the employment of plant and it will employ that plant which yields minimum possible
unit cost for producing a given output.

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 25

Suppose, the firm has a choice so that a plant can be varied by infinitely small gradations so
that there are infinite number of plants corresponding to which there are numerous average
cost curves. In such a case the long run average cost curve will be a smooth curve enveloping
all these short run average cost curves.

As shown in Figure 12, the long run average cost curve is so drawn as to be tangent to each
of the short run average cost curves. Every point on the long run average cost curve will be a
tangency point with some short run AC curve. If a firm desires to produce any particular
output, it then builds a corresponding plant and operates on the corresponding short run
average cost curve. As shown in the figure, for producing OM, the corresponding point on the
LAC curve is G and the short run average cost curve SAC2 is tangent to the long run AC at
this point. Thus, if a firm desires to produce output OM, the firm will construct a plant
corresponding to SAC2 and will operate on this curve at point G. Similarly, the firm will
produce other levels of output choosing the plant which suits its requirements of lowest
possible cost of production. It is clear from the figure that larger output can be produced at
the lowest cost with larger plant whereas smaller output can be produced at the lowest cost
with smaller plants. For example, to produce OM, the firm will be using SAC2 only; if it uses
SAC3, it will result in higher unit cost than SAC2. But, larger output OV can be produced
most economically with a larger plant represented by the SAC3. If we produce OV with a
smaller plant, it will result in higher cost per unit. Similarly, if we produce larger output with
a smaller plant it will involve higher costs because of its limited capacity.

It is to be noted that LAC curve is not tangent to the minimum points of the SAC curves.
When the LAC curve is declining, it is tangent to the falling portions of the short run cost
curves and when the LAC curve is rising, it is tangent to the rising portions of the short run
cost curves. Thus, for producing output less than “OQ” at the lowest possible unit cost, the
firm will construct the relevant plant and operate it at less than its full capacity, i.e., at less
than its minimum average cost of production. On the other hand, for outputs larger than OQ
the firm will construct a plant and operate it beyond its optimum capacity. “OQ” is the
optimum output. This is because “OQ” is being produced at the minimum point of LAC and
corresponding SAC i.e., SAC4. Other plants are either used at less than their full capacity or
more than their full capacity. Only SAC4 is being operated at the minimum point.

The long run average cost curve is often called as ‘planning curve’ because a firm plans to
produce any output in the long run by choosing a plant on the long run average cost curve

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 26

corresponding to the given output. The long run average cost curve helps the firm in the
choice of the size of the plant for producing a specific output at the least possible cost

Explanation of the “U” shape of the long run average cost curve: As has been seen in the
diagram LAC curve is a “U” shaped curve. This shape of LAC curve has nothing to do with
the U shaped SAC which is due to variable factor ratio because in the long run all factors are
variable. U shaped LAC arises due to returns to scale. As discussed earlier, when the firm
expands, returns to scale increase. After a range of constant returns to scale, the returns to
scale finally decrease. On the same line, the LAC curve first declines and then finally rises.
Increasing returns to scale cause fall in the long run average cost and decreasing returns to
scale result in rise in long run average cost. Falling long run average cost and increasing
economies of scale result from internal and external economies of scale and rising long run
average cost and diminishing returns to scale result from internal and external diseconomies
of scale

The long run average cost curve initially falls with increase in output and after a certain point
it rises making a boat shape. The long-run average cost (LAC) curve is also called the
planning curve of the firm as it helps in choosing an appropriate a plant on the decided level
of output. The long-run average cost curve is also called “Envelope curve”, because it
envelopes or supports a family of short run average cost curves from below.

The above figure depicting long-run average cost curve is arrived at on the basis of traditional
economic analysis. It is flattened ‘U’ shaped. This type of curve could exist only when the
state of technology remains constant. But, empirical evidence shows modern firms face ‘L-
shaped’ cost curve over a considerable quantity of output. The L-shaped long run cost curve
implies that initially when the output is increased due to increase in the size of plant (and
associated variable factors), per unit cost falls rapidly due to economies of scale. The long-
run average cost curve does not increase even after a sufficiently large scale of output as it
continues to enjoy economies of scale.

ECONOMIES AND DISECONOMIES OF SCALE

The Scale of Production

Production on a large scale is a very important feature of modern industrial society. As a

consequence, the size of business undertakings has greatly increased. Large-scale production

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offers certain advantages which help in reducing the cost of production. Economies arising
out of large-scale production can be grouped into two categories; viz., internal economies and
external economies. Internal economies are those economies of production which accrue to
the firm when it expands its output, so that the cost of production would come down
considerably and place the firm in a better position to compete in the market effectively.
Internal economies arise purely due to endogenous factors relating to efficiency of the
entrepreneur or his managerial talents or the type of machinery used or the marketing strategy
adopted. These economies arise within the firm and are available exclusively to the
expanding firm. On the other hand, external economies are the benefits accruing to each
member firm of the industry as a result of expansion of the industry.

Internal Economies and Diseconomies: We saw that returns to scale increase in the initial
stages and after remaining constant for a while, they decrease. The question arises as to why
we get increasing returns to scale due to which cost falls and why after a certain point we get
decreasing returns to scale due to which cost rises. The answer is that initially a firm enjoys
internal economies of scale and beyond a certain limit it suffers from internal diseconomies
of scale. Internal economies and diseconomies are of the following main kinds:

(i) Technical economies and diseconomies: Large-scale production is associated

with economies of superior techniques. As the firm increases its scale of
operations, it becomes possible to use more specialised and efficient form of all
factors, specially capital equipment and machinery. For producing higher levels of
output, there is generally available a more efficient machinery which when
employed to produce a large output yields a lower cost per unit of output. The
firm is able to take advantage of composite technology whereby the whole process
of production of a commodity is done as one composite unit. Secondly, when the
scale of production is increased and the amount of labour and other factors
become larger, introduction of greater degree of division of labour and
specialisation becomes possible and as a result cost per unit declines. There are
some advantages available to a large firm on account of performance of a number
of linked processes. The firm can reduce the inconvenience and costs associated
with the dependence on other firms by undertaking various processes from the
input supply stage to the final output stage.

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 However, beyond a certain point, a firm experiences net diseconomies of scale.
This happens because when the firm has reached a size large enough to allow
utilisation of almost all the possibilities of division of labour and employment of
more efficient machinery, further increase in the size of the plant will bring about
high long-run cost because of difficulties of management. When the scale of
operations becomes too large, it becomes difficult for the management to exercise
control and to bring about proper coordination.
(ii) Managerial economies and diseconomies: Managerial economies refer to
reduction in managerial costs. When output increases, specialisation and division
of labour can be applied to management. It becomes possible to divide its
management into specialised departments under specialised personnel, such as
production manager, sales manager, finance manager etc. If the scale of
production increases further, each department can be further sub-divided; for e.g.
sales can be split into separate sections such as for advertising, exports and
customer service. Since individual activities come under the supervision of
specialists, management’s efficiency and productivity will greatly improve.
Decentralisation of decision making and mechanisation of managerial functions
further enhance the efficiency and productivity of managers. Thus, specialisation
of management enables large firms to achieve reduction in managerial costs.

However, as the scale of production increases beyond a certain limit, managerial

diseconomies set in. Communication at different levels such as between the
managers and labourers and among the managers become difficult resulting in
delays in decision making and implementation of decisions already made.
Management finds it difficult to exercise control and to bring in coordination
among its various departments. The managerial structure becomes more complex
and is affected by greater bureaucracy, red tapism, lengthening of communication
lines and so on. All these affect the efficiency and productivity of management
and that of the firm itself.

(iii) Commercial economies and diseconomies: Production of large volumes of

goods requires large amount of materials and components. A large firm is able to
place bulk orders for materials and components and enjoy lower prices for them.

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 Economies can also be achieved in marketing of the product. If the sales staff is
not being worked to full capacity, additional output can be sold at little or no extra
cost. Moreover, large firms can benefit from economies of advertising. As the
scale of production increases, advertising costs per unit of output fall. In addition,
a large firm may also be able to sell its by-products or process it profitably;
something which might be unprofitable for a small firm. There are also economies
associated with transport and storage. These economies become diseconomies
after an optimum scale. For example, advertisement expenditure and other
marketing overheads will increase more than proportionately after the optimum
scale.
(iv) Financial economies and diseconomies: A large firm has advantages over small
firms in matters related to procurement of finance for its business activities. It can,
for instance, offer better security to bankers and avail of advances with greater
ease. On account of the goodwill enjoyed by large firms, investors have greater
confidence in them and therefore would prefer their shares which can be readily
sold on the stock exchange. A large firm can thus raise capital at lower cost.
However, these costs of raising finance will rise more than proportionately after
the optimum scale of production. This may happen because of relatively greater
dependence on external finances.
(v) Risk bearing economies and diseconomies: It is said that a large business with
diverse and multiproduction capability is in a better position to withstand
economic ups and downs, and therefore, enjoys economies of risk bearing.
However, risk may increase if diversification, instead of giving a cover to
economic disturbances, increases these.

External Economies and Diseconomies: Internal economies are economies enjoyed by a

firm on account of use of greater degree of division of labour and specialised machinery
at higher levels of output. They are internal in the sense that they accrue to the firm due to
its own efforts. Besides internal economies, there are external economies which are very
important for a firm. External economies and diseconomies are those economies and
diseconomies which accrue to firms as a result of expansion in the output of the whole
industry and they are not dependent on the output level of individual firms. They are

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 30

external in the sense that they accrue to firms not out of their internal situation but from
outside i.e. due to expansion of the industry. These are available to one or more of the
firms in the form of:

1. Cheaper raw materials and capital equipment: The expansion of an industry may
result in exploration of new and cheaper sources of raw material, machinery and other
types of capital equipments. Expansion of an industry results in greater demand for
various kinds of materials and capital equipments required by it. The firm can procure
these on a large scale at competitive prices from other industries. This reduces their
cost of production and consequently the prices of their output.
2. Technological external economies: When the whole industry expands, it may result
in the discovery of new technical knowledge and in accordance with that, the use of
improved and better machinery and processes than before. This will change the
technical co-efficient of production and enhance productivity of firms in the industry
and reduce their cost of production.
3. Development of skilled labour: When an industry expands in an area, the labourers
in that area are well accustomed with the different productive processes and tend to
learn a good deal from experience. As a result, with the growth of an industry in an
area, a pool of trained labour is developed which has a favourable effect on the level
of productivity and cost of the firms in that industry.
4. Growth of ancillary industries: Expansion of industry encourages the growth of a
number of ancillary industries which specialise in the production and supply of raw
materials, tools, machinery, components, repair services etc. Input prices go down in a
competitive market and the benefits of it accrue to all firms in the form of reduction in
cost of production. Likewise, new units may come up for processing or recycling of
the waste products of the industry. This will tend to reduce the cost of production in
general.
5. Better transportation and marketing facilities: The expansion of an industry
resulting from entry of new firms may make possible the development of an efficient
transportation and marketing network. These will greatly reduce the cost of
production of the firms by avoiding the need for establishing and running these
services by themselves. Similarly, communication systems may get modernised
resulting in better and speedy information dissemination.

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6. Economies of Information: Necessary information regarding technology, labour,
prices and products may be easily and cheaply made available to the firms on account
of publication of information booklets and bulletins by industry associations or by
governments in public interest.
However, external economies may cease if there are certain disadvantages which may
neutralise the advantages of expansion of an industry. We call them external
diseconomies. External diseconomies are disadvantages that originate outside the
firm, especially in the input markets. An example of external diseconomies is rise in
various factor prices. When an industry expands the requirement of various factors of
production, such as raw materials, capital goods, skilled labour etc increases.
Increasing demand for inputs puts pressure on the input markets. This may result in an
increase in the prices of factors of production, especially when they are short in
supply. Moreover, too many firms in an industry at one place may also result in
higher transportation cost, marketing cost and high pollution control cost. The
government may also, through its location policy, prohibit or restrict the expansion of
an industry at a particular place.

Reference
[Link]

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 Module -4

PRICING PRACTICES AND STRATEGIES

Determinants Of Pricing Policy, Pricing Methods, Marginal Cost Pricing, Target Rate
Pricing, Product Line Pricing, Administered Pricing, Competitive Bidding, Dual
Pricing, Transfer Pricing, Price Discrimination: Requirements, Types And Dumping
Strategies. Pricing Over Product Life Cycle, Skimmed Pricing, Penetration Pricing,
Product Line Pricing And Price Leadership. Impact Of Pricing On Business Decision.

Pricing Objectives

Pricing is not an end in itself. It is a means to survive in the market. Therefore, firms h set
clear-cut pricing objectives. Some of the most important pricing objectives are the following

1. Price leadership: Firms need to establish leadership in the market, eg, ITO cigarettes,
Bata in leather shoes, Ponds in talcum powder, etc. Other competitors the industry
follow the price decisions of the leader firm.
2. Profit-maximization: Firms decide appropriate pricing strategy to maximize profit.
Profit Maximization is achieved, when difference between total revenue and total cost
is maximum.
3. Market share: Sometimes firms plan to increase market share by reducing price,
necessary. For example, newspapers and magazines increase circulation by lowering
price, assuming that increased circulation will result more revenue from advertising
Retention of market share is another objective of pricing. An appropriate pricing
polies enable the firm to capture larger market share and establish dominance in the
mar Target achievement and market penetration are equally important objectives in
pricing policy.
4. Survival: Firms are always concerned with the objective of survival in the market
5. Sales maximization: Price policy help firms to rapidly expand firm's business sales
6. Return on investment: Firms, may have a predetermined target of return investment
while setting the price. Service motive: Firms may also set price to serve community's
welfare.
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 7. Price stability: Oligopoly firms prefer price stability to avoid competition, price and
uncertainty in business.
8. Service motive: Firms may also set price to serve community’s welfare.
9. Competition: Sometimes price differentials are considered important in price
segment. This is notable in monopolistic market where products are differentiated.

Factors Involved in Formulating Pricing Policy strategy.

1. Market Structure: Pricing policy is decided according to competitive situations d

market demand. Firms operating in perfect competition, accept the market price
However, monopoly firm is a price maker. According to Prof. Joel Dean the follow
market conditions influence a price decision of firms.
 The number of competitors, relative size and product lines, and availability of
substitutes in the market.
 Likelihood of potential competition depending on entry of new firms into
industry and relative entry barriers.
 The stages of customer acceptance of the product.
 The degree of potential market segmentation and opportunity of price
discrimination.
 The nature of product differentiation adopted by firm in the market.
 The mixture of services, advertisement, sales promotion and product
improvement.
 The degree of cross elasticity of demand.
2. Costs: Cost of production is an important element in price decision. Price that are set
below average cost leads to business loss. Variable cost has great influence in
deciding price in the short-run. Price should be able to cover at least average variable
cost.
3. Profit and Sales: Although profit is a significant consideration in pricing policy, in
practice, profit maximisation is rarely followed. Price rigidity is a common norm in
pricing of oligopoly firms. Sales maximization is an alternative goal followed by
modem jointstock firms.
4. Demand and Consumer Psychology: Pricing policy also depends on demand
elasticity for the product. If demand is highly inelastic, increasing price policy would

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 be rewarding to firms. On the contrary, if product demand is elastic, increase in price
reduces sales and revenue. Consumers postpone their purchase decisions when price
rises. If demand for product is price elastic, reduction in price is beneficial in boosting
the sales.
5. Government Policy: When government introduces price controls and administered
pricing policies, firms have no other choice but follow these guidelines.
6. Long-run Welfare of the Firm: Price is set to promote long-run welfare and
establish brand name in the market. Firms discourage entry of rival firms through
limit pricing strategy.
7. Flexibility: The pricing policy should be flexible enough to meet changing demand
conditions of the market.
8. Miscellaneous Considerations: Price decisions are adopted in accordance with the
diverse competitive situations encounters by the product. Special attention should be
made in pricing of new products that are introduced by a frim. Price is viewed,in
relation to quality of product, and promotional policies.

Marginal-cost pricing

Marginal-cost pricing is based on variable cost. It does not take fixed cost into account.
Marginal cost pricing facilitates aggressive pricing policy to achieve more sales. Marginal
cost pricing is particularly useful in stiff competitive markets. It makes use of unutilized
capacity and eliminate weak competitors.

Product line pricing

Product line pricing refers to the practice of reviewing and setting prices for multiple
products that a company offers in coordination with one another. Rather than looking at each
product separately and setting its price, product-line pricing strategies aim to maximize the
sales of different products by creating more complementary, rather than competitive,
products. If you offer more than one product or service, consider the impact that one
product's or service's price will have on the others.

There are five common product line pricing strategies - captive pricing, leader pricing, bait
pricing, price lining, and price bundling. There will be examples with each type of strategy.

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Captive Pricing

The idea behind captive pricing is that a company will have a basic product that they sell at a
low price or given away for free. However, in order to receive the full benefit of the item they
received, they have to buy additional products. The company might lose money on the base
product, but they make a fairly good profit on the additional products. Captive pricing works
best when there are no other products of similar quality available in the same price range.

Leader Pricing

The idea behind leader pricing is to generate store traffic. The items used to get customers
into the store are known as loss leaders. When customers come into the store to purchase the
loss leaders, they usually end up purchasing extra items at full retail price. The retailer makes
their profit off of the unplanned purchases bought with the loss leaders.

Example

• Walmart: Using their "ad match" deal, Walmart gets customers to come into their store to
purchase their groceries at discounted prices. When a customer finds a grocery item they
need but at full retail price, they are more likely to purchase it even if it could be found in
store elsewhere for less expensive simply because of convenience.

Bait Pricing

This type of strategy is usually viewed as unethical and sometimes illegal, but retailers will
still use it. It involves advertising something at a very low price to entice a consumer, but the
item is usually offered with a limited supply. Sometimes the company does not even actually
possess the item. The customer will then come into the store to purchase the advertised item
then find the exact item is out of stock. They will then be encouraged to purchase a similar,
higher priced item that is available in store. A process known as "bait and switch," in which
the advertised product usually has to be specially ordered, is often considered illegal.

Bait pricing isn't always shady or illegal. Just proceed with caution to make sure you're being
fair and honest with your customers.

Price Lining

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Price lining is a strategy retailers use when pricing different items at one specific price point.
The items are usually at a different level of quality or have different features. This strategy
usually makes it easier for a retailer to buy specific products, predict what their profits will
be, and market to a certain consumer.

Example

• Dollar Stores: all merchandise is $1. Some dollar stores also offer merchandise that is less
than $1.

Another type of price lining involves a line of products released by a company that are all
similar in most ways but offer extra features. Each version of the item will have a different
price to emphasize the versions. A good example of this would be Apple's iPads. The basic
iPad with wifi and limited storage costs $499. The next iPad is one with 4G and the same
limited storage, but it costs somewhere around $150 more. The prices continue to rise as you
go down the line of products.

Bundled Pricing

Products that have several different options or accessories available are sold using bundled
pricing. Instead of a consumer having to purchase each item separately, the items are
packaged together and priced as one item. This is usually at a discount than what it would
have been priced at when purchasing each item separately.

Administered Pricing

The term administered-price was introduced by Prof. Keynes, to mean price charged by
monopolists by considerations other than marginal cost. A monopolist being the price maker
consciously administers higher price for his product by restricting output. According to
Indian economists, administered price is one, which is arbitrarily fixed by government. The
administered prices are the result of government intervention. These are corrective measures
followed by government to control price of essential goods (medicine) and industrial inputs
(steel), when market mechanism fails. Administered pricing is opposite of market-oriented
pricing technique, which involves consideration of cost, competition, nature of demand,
company objectives and types of distribution channel through which a product passes before
reaching the consumption point.

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Competitive Bid

A competitive bid is most commonly associated with a proposal and price submitted by a
vendor or service provider to a soliciting firm for a business opportunity involving products
or services. Comprehensively it can also potentially be associated with any variety of
business opportunities in which a company presents a proposal involving a business deal.

Dual Pricing

Dual pricing is the practice of setting different prices in different markets for the same
product or service. This tactic may be used by a business for a variety of reasons, but it is
most often an aggressive move to take market share away from competitors.

Dual pricing refers to two sets of prices for the same commodity controlled prices for weaker
sections and higher open market prices for the others.

The intent is to drive out other competitors and then raise its prices once the other parties are
no longer selling in the market. It is fixed by the government. Hence dual pricing is a
situation in which the same product or service is sold at different prices in a different market.

Example:

The ticket for visiting Taj Mahal (one of the Seven Wonders of the World, located in Agra),
is different for Indian citizens and different for foreign visitors.

AIRLINE Industry is a prime example of Dual Pricing. Companies offer lower prices if you
book your flight tickets well in advance. The demand for this category of customers is elastic
and varies inversely with price. As time passes the flight fares start increasing exponentially
to get high prices from the customers whose demands are inelastic.

Transfer Price

Transfer price, also known as transfer cost, is the price at which related parties transact with
each other, such as during the trade of supplies or labor between departments. Transfer prices
may be used in transactions between a company and its subsidiaries, or between divisions of
the same company in different countries.

Transfer pricing refers to the prices of goods and services that are exchanged between
companies under common control. For example, if a subsidiary company sells goods or

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renders services to its holding company or a sister company, the price charged is referred to
as the transfer price.

Price Discrimination

Price discrimination is when a seller sells a specific commodity or service to different buyers
at different prices for reasons not concerning differences in costs. In this article, we will look
at the conditions, objectives, and equilibrium under price discrimination.

Examples:

A local physician charges more to rich patients as compared to poor patients for the same
service.

Electricity companies sell electricity at a cheaper rate in rural areas as compared to urban
areas.

Conditions for Price Discrimination

Price discrimination is possible under the following conditions:

1. The seller must have some control over the supply of his product. Such monopoly
power is necessary to discriminate the price.
2. The seller should be able to divide the market into at least two sub-markets (or more).
3. The price-elasticity of the product must be different in different markets. Therefore,
the monopolist can set a high price for those buyers whose price-elasticity of demand
for the product is less than 1. In simple words, even if the seller increases the price,
such buyers do not reduce the purchase volume.
4. Buyers from the low-priced market should not be able to sell the product to buyers
from the high-priced market.

Types of Price Discrimination

There are three types of price discrimination: first-degree or perfect price discrimination,
second-degree, and third-degree. These degrees of price discrimination are also known as
personalized pricing (1st-degree pricing), product versioning or menu pricing (2nd-degree
pricing), and group pricing (3rd-degree pricing).

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First-Degree Price Discrimination

First-degree discrimination, or perfect price discrimination, occurs when a business charges

the maximum possible price for each unit consumed. Because prices vary among units, the
firm captures all available consumer surplus for itself or the economic surplus. Many
industries involving client services practice first-degree price discrimination, where a
company charges a different price for every good or service sold.

Second-Degree Price Discrimination

Second-degree price discrimination occurs when a company charges a different price for
different quantities consumed, such as quantity discounts on bulk purchases.

Third-Degree Price Discrimination

Third-degree price discrimination occurs when a company charges a different price to

different consumer groups. For example, a theater may divide moviegoers into seniors,
adults, and children, each paying a different price when seeing the same movie. This
discrimination is the most common.

Dumping

Dumping in the financial world occurs when a company or a country exports its products at a
price lower than its domestic price. Exporters dump to compete with the producers and sellers
in the importing country.

1. Sporadic dumping

Companies dump excess unsold inventories to avoid price wars in the home market and
preserve their competitive position. They can either dump by destroying excess supplies or
export them to a foreign market where the products are not sold.

2. Predatory dumping

Unlike sporadic dumping, which is occasional, predatory dumping is permanent. It involves

the sale of goods in a foreign market at a price lower than the home market. Predatory
dumping is done to gain access to the foreign market and eliminate competition. It creat
monopoly in the market.

3. Persistent dumping
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When a country consistently sells products at a lower price in the foreign market than the
local prices, it is called persistent dumping. It happens when there is a constant demand for
the product in the foreign market.

4. Reverse dumping

Reverse dumping happens when the demand for the product in the foreign market is less
elastic. It means that price changes do not impact demand. Therefore, the company can
charge a higher price in the foreign market and a lower price in the local market.

Pricing in Life Cycle of a Product

The life cycle of a product is divided into five stages: (i) Introduction or initial stage, (ii)
Growth stage, (iii) Maturity stage, (iv) Saturation stage, and (v) Decline stage. The
introduction stage is the period in which product's introduced into the market. It is a trial
period with lower sales and considerable advertisement. During growth stage, the product
gains popularity among consumers and sales increase as a result of cumulative effect of
advertisement. In maturity stage, sales continue to increase, but at a lower rate and total sales
becomes eventually constant. During saturation stage, there is neither increase nor decrease in
sales volume. In decline stage, total sales tend to decline due to availability of substitutes, and
loss of distinctiveness of the product. Pricing strategy varies over the cycle of a product,
depending on the market conditions.

Skimming Pricing

Skimming price policy is adopted, where close substitutes are not available for the new
product. This policy is intended to skim the cream of the market, i.e., consumer surplus, by
setting a very high initial price, three or four times the factory cost. Subsequently, price is
lowered in a series of price reduction, especially in case of consumer durables. The high price
initially is accompanied by high advertisement.

The firm introduces the products with high price for customers who can afford to buy goods
of snob appeal. The price is gradually decreased to increase the number of customers.
Skimming price policy succeeds due to following reasons:

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In the product introduction stage, demand is relatively inelastic. Cross-elasticity for the
product is very low as there are no close substitutes. Step-by-step price-cut helps in skimming
the consumer surplus from lower segments of the market. High initial price is helpful in
recouping the product development cost.

Penetration Pricing

Penetration pricing policy is the opposite of skimming strategy. This strategy is followed case
of a new product which has close substitutes available in the market. The policy requins
fixing a lower initial price, in order to penetrate the market as quickly as possible. Intention is
to maximise profit in the long-run. Therefore, firms pursuing penetration price policy set a
lower price in the initial stage. As product catches the market share, price is gradually raised
The motive is to establish market share first and gradually move to a more profitable price
This requires demand for a particular product to be highly price elastic. Penetration pricing is
successful when following conditions are fulfilled.

Short-run demand elasticity for the product is greater than unity. Economies of large-scale
production are available to firm with increase in sales. Potential market for the product is
sufficiently large. The product has high cross-elasticity. Product is easily accepted by
consumers.

The choice between skimming price and penetration price depend on (i) rate of market
growth, (ii) rate of erosion of distinctiveness, and (iii) cost-structure of firms. If market
growth rate for a product is slow, penetration price is not suitable. In this case, lowering of
price will not increase sales. If product loses distinctiveness at a faster rate, skimming price is
unsuitable. If cost-structure indicates increasing returns, penetration policy is suitable.

Pricing Strategies

Skimming price strategy is followed in product introduction stage. Product is initially

marketed to high-income segments, that are relatively price insensitive. Later, price is
lowered in different market segments, e.g., international book publishers come out initially
with hardcover editions, which are priced high. After skimming the high-income market,
paperback editions are introduced at a lower price.

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Penetration pricing strategy is followed by a new firm entering into an industry where close
substitutes are already existing in the market. It sets a lower initial price, to acquire market
share immediately.

Price discrimination strategy is followed by monopoly firms. It implies that firm sells the
same product at different prices. Price discrimination succeeds only when market is clearly
segmented and when resale is not possible from low priced market to high priced market,e.g.,
hospitals charge consultation fee based on income levels of the patients. Dual pricing of
essential commodities like sugar, kerosene to BPL families and concessions in subscription
of magazines are examples for price discrimination.

Price Leadership

Price leadership occurs when a leading firm in a given industry is able to exert enough
influence in the sector that it can effectively determine the price of goods or services for the
entire market. This type of firm is sometimes referred to as the price leader.

Types of Price Leadership

There are three primary models of price leadership: barometric, collusive, and dominant.

Barometric

The barometric price leadership model occurs when a particular firm is more adept than
others at identifying shifts in applicable market forces, such as a change in production costs.
This allows the firm to respond to market forces more efficiently. For instance, the firm may
initiate a price change.

It is possible for a firm with a small market share to act as a barometric price leader if it's a
good producer and if the firm is attuned to trends in its market. Other producers may follow
its lead, assuming that the price leader is aware of something that they have yet to realize.
However, because a barometric leader has very little power to impose its decisions on other
firms in the industry, its leadership might be short-lived.

Collusive

The collusive price leadership model may emerge within markets that have oligopolistic
conditions. Collusive price leadership occurs as a result of an explicit or implicit agreement
among a handful of dominant firms to keep their prices in mutual alignment.
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Smaller firms within the market are effectively forced into following the price change
initiated by the dominant firms. This practice is most common in industries where the cost of
entry is high, and the costs of production are known.

These agreements between firms–either explicit or implicit–may be considered illegal if the

effort is designed to defraud the public. There is a fine line between price leadership and
illegal acts of collusion. Price leadership is more likely to be considered collusive–and
potentially illegal–if the changes in the price of a good are not related to changes in the
operating costs of the firm.

Dominant

The dominant price leadership model occurs when one firm controls the vast majority of the
market share in its industry. Within the industry, there are other, smaller firms that provide
the same products or services as the leading firm. However, in this model, these smaller firms
cannot influence prices.

A dominant price leadership model is sometimes referred to as a partial monopoly. In this

type of model, the price leader might engage in predatory pricing, which refers to the practice
of lowering prices to levels that make it impossible for smaller, competing firms to remain in
business. In most countries, business decisions that enact predatory pricing and are aimed at
hurting smaller companies are illegal

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 Module 5

Demand Analysis & Consumer choice

Individual and Market demand functions, Law of demand, determinants of

demand, Elasticity of demand- its meaning and importance, price elasticity,
income elasticity and cross elasticity- using elasticity in managerial decisions,
numerical problems and case studies. Introduction to consumer choice,
sovereignty, cardinal and ordinal utility approach, indifference approach,
revealed preference and theory of consumer choice under risk, demand
estimation for major consumer durables and non-durable products, demand
forecasting techniques, numerical problems and case studies.

Demand Introduction

The term ‘demand’ refers to the quantity of a good or service that buyers are willing and able
to purchase at various prices during a given period of time. It is to be noted that demand, in
Economics, is something more than the desire to purchase, though desire is one element of it.
For example, people may desire much bigger houses, luxurious cars etc. But there are also
constraints that they face such as prices of products and limited means to pay. Thus, wants or
desires together with the real world constraints determine what they buy.

The effective demand for a thing depends on:

(i) desire
(ii) means to purchase and
(iii) willingness to use those means for that purchase.

Unless desire is backed by purchasing power or ability to pay and willingness to pay, it does
not constitute demand. Effective demand alone would figure in economic analysis and
business decisions.

Two things are to be noted about the quantity demanded.

(i) The quantity demanded is always expressed at a given price. At different prices
different quantities of a commodity are generally demanded.
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(ii) The quantity demanded is a flow. We are concerned not with a single isolated
purchase, but with a continuous flow of purchases and we must therefore express
demand as ‘so much per period of time’ i.e., one thousand dozens of oranges per day,
seven thousand dozens of oranges per week and so on.

In short “By demand, we mean the various quantities of a given commodity or service which
consumers would buy in one market during a given period of time, at various prices, or at
various incomes, or at various prices of related goods”

Determinants Of Demand

Determinants of demand for a product or service and the nature of relationship between
demand and its determinants are essential for a business firm for estimating the market
demand for its products. There are a number of factors which influence the demand for a
commodity. All these factors are not equally important. Moreover, some of these factors
cannot be easily measured or quantified. The important factors that determine demand are
given below.

(i) Price of the commodity: Obviously, the good’s own price is a key determinant of its
demand. Ceteris paribus i.e. other things being equal, the demand for a commodity is
inversely related to its price. It implies that a rise in the price of a commodity brings
about a fall in the quantity purchased and vice-versa. This happens because of income
and substitution effects.
(ii) Price of related commodities: Related commodities are of two types:
(i) complementary goods and
(ii) competing goods or substitutes.
Complementary goods and services are those that are bought or consumed together
or simultaneously. Examples are: tea and sugar, automobile and petrol and pen and
ink. The increase in the demand for one causes an increase in the demand for the
other. When two commodities are complements, a fall in the price of one (other
things being equal) will cause the demand for the other to rise. For example, a fall in
the price of petrol-driven cars would lead to a rise in the demand for petrol. Similarly,
computers and computer software are complementary goods. A fall in the price of
computers will cause a rise in the demand for software. The reverse will be the case
when the price of a complement rises. An increase in the price of a complementary

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 good reduces the demand for the good in question. Thus, we find that, there is an
inverse relation between the demand for a good and the price of its complement.
Two commodities are called competing goods or substitutes when they satisfy the
same want and can be used with ease in place of one another. For example, tea and
coffee, ink pen and ball pen, different brands of toothpaste etc. are substitutes for
each other and can be used in place of one another easily. When goods are
substitutes, if the price of a product being purchased goes up, buyers may switch to a
cheaper substitute. This decreases the demand for the product at a given price, but
increases the demand for the substitute. Similarly, a fall in the price of a product
(ceteris paribus) leads to a fall in the quantity demanded of its substitutes. For
example, if the price of tea falls, people will try to substitute it for coffee and demand
more of it and less of coffee i.e. the demand for tea will rise and that of coffee will
fall. Therefore, there is direct or positive relation between the demand for a product
and the price of its substitutes.
(iii) Disposable Income of the consumer: The purchasing power of a buyer is
determined by the level of his disposable income. Other things being equal, the
demand for a commodity depends upon the disposable income of the potential
purchasers. In general, increase in disposable income tends to increase the demand
for particular types of goods and services at any given price. A decrease in disposable
income generally lowers the quantity demanded at all possible prices.
The nature of relationship between disposable income and quantity demanded
depends upon the nature of goods. A basic description of the nature of goods is useful
in describing the effect of income on demand.
Normal goods are those that are demanded in increasing quantities as consumers’
income increases. Most goods and services fall under the category of normal goods.
Household furniture, clothing, automobiles, consumer durables and semi durables etc.
fall in this category. When income is reduced (for example due to recession), demand
for normal goods falls.
There are some commodities for which the quantity demanded rises only up to a
certain level of income and decreases with an increase in money income beyond this
level. These goods are called inferior goods.

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 Essential consumer goods such as food grains, fuel, cooking oil, necessary clothing
etc. satisfy the basic necessities of life and are consumed by all individuals in a
society. A change in consumers’ income, although will cause an increase in demand
for these necessities, but this increase will be less than proportionate to the increase in
income. This is because as people become richer, there is a relative decline in the
importance of food and other non durable goods in the overall consumption basket
and a rise in the importance of durable goods such as a TV, car, house etc. Demand
for luxury goods and prestige goods arise beyond a certain level of consumers’
income and keep rising as income increases.

Business managers should be fully aware of the nature of goods which they produce
(or the nature of need which their products satisfy) and the nature of relationship of
quantities demanded with changes in buyers’ incomes. For assessing the current as
well as future demand for their products, they should also recognize the movements
in the macro economic variables that affect buyers’ incomes.

(iv) Tastes and preferences of buyers: The demand for a commodity also depends upon
the tastes and preferences of buyers and changes in them over a period of time.
Goods which are modern or more in fashion command higher demand than goods
which are of old design or are out of fashion. Consumers may perceive a product as
obsolete and discard it before it is fully utilised and then prefer another good which is
currently in fashion. For example, there is greater demand for the latest digital
devices and trendy clothing and we find that more and more people are discarding
these goods currently in use even though they could have used it for some more
years.

External effects on utility such as' demonstration effect',' bandwagon effect’, Veblen
effect and ‘snob effect’ do play important roles in determining the demand for a
product. Demonstration effect, a term coined by James Duesenberry, refers to the
desire of people to emulate the consumption behaviour of others. In other words,
people buy or have things because they see that other people are able to have them.
For example, an individual’s demand for cell phone may be affected by his seeing a
new model of cell phone in his neighbour’s or friend’s house, either because he likes

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 what he sees or because he figures out that if his neighbour or friend can have it, he
too can.

Bandwagon effect refers to the extent to which the demand for a commodity is
increased due to the fact that others are also consuming the same commodity. It
represents the desire of people to purchase a commodity in order to be fashionable or
stylish or to conform to the people they wish to be associated with.

By ‘snob effect’ we refer to the extent to which the demand for a consumers' good is
decreased owing to the fact that others are also consuming the same commodity. This
represents the desire of people to be exclusive; to be different; to dissociate
themselves from the "common herd." For example, when a product becomes common
among all, some people decrease or altogether stop its consumption.

Highly priced goods are consumed by status seeking rich people to satisfy their need
for conspicuous consumption. This is called ‘Veblen effect’ (named after the
American economist Thorstein Veblen).For example, expensive cars and jewels. The
distinction between the snob effect and the Veblen effect is that the former is a
function of the consumption of others and the latter is a function of [Link]
conclude that people have tastes and preferences and these do change - sometimes,
due to external and sometimes due to internal causes - and influence demand.

Knowledge regarding tastes and preferences is extremely valuable for the

manufacturers and marketers as it would help them appropriately design new models
of products and services and plan production to suit the changing tastes and needs of
the customers.

(v) Consumers’ Expectations

Consumers’ expectations regarding future prices, income, supply conditions etc.
influence current demand. If the consumers expect increase in future prices, increase
in income and shortages in supply, more quantities will be demanded. If they expect a
fall in price or fall in income they will postpone their purchases of nonessential
commodities and therefore, the current demand for them will [Link] of consumer

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and business confidence about their future economic situations also affect spending
and demand.

Other factors: Apart from the above factors, the demand for a commodity depends
upon the following factors:
(a) Size of population: Generally, larger the size of population of a country or a
region, larger would be the number of buyers and the quantity demanded in the
market would be higher at every price. The opposite is the case when population
is less.
(b) Age Distribution of population: If a larger proportion of people belong to older
age groups relative to younger age groups, there will be increased demand for
geriatric care services, spectacles, walking sticks, etc and less demand for
children’s books. Similarly, if the population consists of more of children,
demand for toys, baby foods, toffees, etc. will be more. Likewise, if there is
migration from rural areas to urban areas, there will be decrease in demand for
goods and services in rural areas.
(c) The level of National Income and its Distribution: The level of national
income is a crucial determinant of market demand. Higher the national income,
higher will be the demand for all normal goods and services. The wealth of a
country may be unevenly distributed so that there are a few very rich people
while the majority is very poor. Under such conditions, the propensity to consume
of the country will be relatively less, because the propensity to consume of the
rich people is less than that of the poor people. Consequently, the demand for
consumer goods will be comparatively less. If the distribution of income is more
equal, then the propensity to consume of the country as a whole will be relatively
high indicating higher demand for goods.
(d) Consumer-credit facility and interest rates: Availability of credit facilities
induces people to purchase more than what their current incomes permit them.
Credit facilities mostly determine the demand for investment and for durable
goods which are expensive and require bulk payments at the time of purchase.
Low rates of interest encourage people to borrow and therefore demand will be
more.

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 (e) Government policies and regulations; The governments influence demand
through its taxation, purchases, expenditure, and subsidy policies. While taxes
increase prices and decrease the quantity demanded, subsidies decrease the prices
and increase the quantity demanded. For example taxes on luxurious goods and
subsidies for solar panels. Similarly total bans, restrictions and higher taxes may
be used by government to restrict the demand for socially undesirable goods and
services. Government’s policy on international trade also will affect the domestic
demand for goods and services.

Apart from above, factors such as weather conditions, business conditions, stage of
business cycle, wealth, levels of education, marital status, socioeconomic class, group
membership, habits of the consumer, social customs and conventions, salesmanship
and advertisements also play important roles in influencing demand.

DEMAND FUNCTION

Demand Function is a symbolic statement of a relationship between the dependent

and the independent variables.

The demand function states in equation form, the relationship between the demand
for a product (the dependent variable) and its determinants (the independent or
explanatory variables). Any other factors that are not explicitly listed in the demand
function are assumed to be irrelevant or held constant. A simple demand function
may be expressed as follows:

Qx = f (Px, Y, Pr)

Where Qx is the quantity demanded of product X

Px is the price of the commodity

Y is the money income of the consumer, and

Pr is the price of related goods

The demand function stated as above does not indicate the exact quantitative relationship
between Qx and PX, M and Pr,. For this, we need to write the demand function in a particular
form with specified values of the explanatory variables appearing on the right-hand side. For

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 7

example; we may write Qx = 45 + 2y + 1 Pr, – 2 P. In this unit, we will be studying demand
as a function of only price, keeping everything else constant.

THE LAW OF DEMAND

The law of demand is one of the most important laws of economic theory. The law states the
nature of relationship between the quantity demanded of a product and its price. Prof. Alfred
Marshall defined the Law thus: “The greater the amount to be sold, the smaller must be
the price at which it is offered in order that it may find purchasers or in other words the
amount demanded increases with a fall in price and diminishes with a rise in price”

The law of demand states that other things being equal, when the price of a good rises the
quantity demanded of the good will fall. Thus, there is an inverse relationship between price
and quantity demanded, ceteris paribus. The ‘other things’ which are assumed to be equal or
constant are the prices of related commodities, income of consumers, tastes and preferences
of consumers, and all factors other than price which influence demand. (Refer section 1.1
above). If these factors which determine demand also undergo a change, then the inverse
price-demand relationship may not hold good. For example, if incomes of consumers
increase, then an increase in the price of a commodity, may not result in a decrease in the
quantity demanded of it. Thus, the constancy of these ‘other factors’ is an important
assumption of the law of demand.

The quantity demanded is the amount of a good or service that consumers are willing to buy
at a given price, holding constant all the other factors that influence purchases. The quantity
demanded of a good or service can exceed the quantity actually sold.

The Law of Demand may be illustrated with the help of a demand schedule and a demand
curve.

The Demand Schedule

A demand schedule is a table showing the quantities of a good that buyers would choose to
purchase at different prices, per unit of time, with all other variables held constant. To
illustrate the relation between the quantity of a commodity demanded and its price, we may
take a hypothetical data for prices and quantities of ice-cream. A demand schedule is drawn
COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 8
upon the assumption that all the other influences remain unchanged. It thus attempts to isolate
the influence exerted by the price of the good upon the amount sold.

Table 1: Demand Schedule of an Individual Buyer

Price per scoop of ice Quatitu of ice creame

cream demanded (per week)
(in Rupees) (scoops)
A 60 0
B 50 2
C 40 4
D 30 6
E 20 8
F 10 10
G 0 12
Table 1 shows how many scoops of ice-cream this particular buyer buys each week at
different prices of ice-cream, holding constant everything else that influences how much of
ice-cream this particular consumer wants to buy. If ice-cream is free (price =0), she consumes
12 cups of ice-cream per week. As the price rises, she buys fewer and fewer cups of ice-
cream. When the price reaches 60 per cup, she does not buy ice-cream at all. The above table
depicts an inverse relationship between price and quantity of ice-cream demanded. We may
note that that the demand schedule obeys the law of demand: As the price of ice-cream
increases, ceteris paribus, the quantity demanded falls.

The Demand Curve

A demand curve is a graphical presentation of the demand schedule. By convention, the

vertical axis of the graph measures the price per unit of the good. The horizontal axis
measures the quantity of the good, which is usually expressed in some physical measure per
time period. By plotting each pair of values as a point on a graph and joining the resulting
points, we get the individual’s demand curve for a commodity. It shows the relationship
between the quantities of a good that buyers are willing to buy and the price of the good. We
can now plot the data from Table 1 on a graph.

In Fig. 1, we have shown such a graph and plotted the seven points corresponding to each
price-quantity combination shown in Table 1. The demand curve hits the vertical axis at price

COMPILED BY SUSHMITHA.I, RESEARCH SCHOLAR, DEPT OF COMMERCE, BCU 9

` 60 indicating that no quantity is demanded when the price is ` 60 (or higher). The demand
curve hits the horizontal quantity axis at 12, the amount ice-cream that the consumer wants if
the price is zero. Point A shows the same information as the first row of Table 1, and Point G
shows the same information as does the last row of the table.

The curve is called the demand curve for ice-cream and shows the quantity of ice-cream that
the consumer would like to buy at each price. The negative or downward slope indicates that
the quantity demanded increases as the price falls. Consumers are usually ready to buy more
if the price is lower. Briefly put, more of a good will be purchased at lower prices. Thus, the
downward sloping demand curve is in accordance with the law of demand which, as stated
above, describes an inverse price-demand relationship.

The slope of a demand curve is - ∆P/∆Q (i.e the change along the vertical axis divided by the
change along the horizontal axis). The negative sign of this slope is consistent with the law of
demand.

The demand curve for a good does not have to be linear or a straight line; it can be
curvilinear- meaning its slope may vary along the curve. If the change in quantity demanded
does not follow a constant proportion, then the demand curve will be nonlinear. However,
linear demand curves provide a convenient tool for analysis.

Market Demand Schedule

The market demand for a commodity gives the alternative amounts of the commodity
demanded per time period, at various alternative prices, by all the buyers in the market. In
other words, it is the total quantity that all the buyers of a commodity are willing to buy per

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unit of time at a given price, other things remaining constant. The market demand for a
commodity thus depends on all the factors that determine the individual’s demand and, in
addition, on the number of buyers of the commodity in the market.

When we add up the various quantities demanded by different consumers in the market, we
can obtain the market demand schedule. How the summation is done is illustrated in Table 2.
Suppose there are only two individual buyers of good X in the market namely, A and B. The
Table 2 shows their individual demand at various prices.

Table 2: Market Demand Schedule of Good X (per day)

Quantity demanded by
Price of Good X in A B Total Market
(Rs) Demand
0 3 2 5
10 2 1 3
20 1 0 1
30 0 0 0

When we add the quantities demanded at each price by consumers A and B, we get the total
market demand. Thus, when good X is free or price is zero per unit, the market demand for
commodity ‘X’ is 5 units (i.e.3+2). When price rises to Rs 10, the market demand is 3 units.
At a price of Rs. 20, only one unit is demanded in the market. At price Rs 30, both A and B
do not buy good X and therefore, market demand is zero. The market demand schedule also
indicates inverse relationship between price and quantity demanded of ‘X’.

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Market Demand Curve

The market demand curve for good X represents the quantities of good X demanded by all
buyers in the market for good X. The market demand curve is obtained by horizontal
summation of all individual demand curves.

If we plot the market demand schedule on a graph, we get the market demand curve. Figure 2
shows the market demand curve for commodity ‘X’. The two consumers A and B have
different individual demand curves corresponding to their different preferences for good X.
The two individual demand curves are shown in Figure 2 along with the market demand
curve for good X. When there are more than two consumers in the market for some good, the
same principle continues to apply and the market demand curve would be the horizontal
summation of all the market participants' individual demand curves. The market demand
curve, like the individual demand curve, slopes downwards to the right because it is nothing
but the lateral summation of individual demand curves.

In addition to the demand schedule and the demand curve, the buyers' demand for a good can
also be expressed algebraically, using a demand equation. The demand equation relates the
price of the good, denoted by P, to the quantity of the good demanded, denoted by Q.

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The straight-line demand curve where we hold everything else constant is described by
alineardem and function. We can write a demand function as follows:

Q = a – bP

Where ‘a’ is the vertical intercept and ‘b’ is the slope.

Rationale of the Law of Demand

Normally, the demand curves slope downwards. This means people buy more at lower prices.
We shall now try to understand why do demand curves slope downwards? Put in other words,
why do people buy more at lower prices? Different economists have given different
explanations for the operation of the of law of demand. These are given below :

(1) Price Effect of a fall in price: The price effect which indicates the way the
consumer's purchases of good X change, when its price changes, is the sum of its
two components namely: substitution effect and income effect.
(a) Substitution effect: Hicks and Allen have explained the law in terms of
substitution effect and income effect. The substitution effect describes the
change in demand for a product when its relative price changes. When the
price of a commodity falls, the price ratio between items change and it
becomes relatively cheaper than other commodities. Assuming that the
prices of all other commodities remain constant, it induces consumers to
substitute the commodity whose price has fallen for other commodities
which have now become relatively expensive. The result is that the total
demand for the commodity whose price has fallen increases. This is called
substitution effect. When the price falls, the substitution effect is always
positive; i.e it will always cause more to be demanded. The substitution
effect will be stronger when:
(a) the goods are closer substitutes
(b) there is lower cost of switching to the substitute good
(c) there is lower inconvenience while switching to the substitute good.

(b) Income effect: The increase in demand on account of an increase in real

income is known as income effect. When the price of a commodity falls, the
consumer can buy the same quantity of the commodity with lesser money or

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 he can buy more of the same commodity with the same amount of money. In
other words, as a result of fall in the price of the commodity, consumer’s real
income or purchasing power increases. A part or whole of the resulting
increase in real income can now be used to buy more of the commodity in
question, given that the good is normal. Therefore, the demand for that
commodity (whose price has fallen) increases. However, there is one
exception. In the case of inferior goods, the income effect works in the
opposite direction to the substitution effect. In the case of inferior goods, the
expansion in demand due to a price fall will take place only if the substitution
effect outweighs the income effect.

(2) Utility maximising behaviour of Consumers: A consumer is in equilibrium (i.e.

maximises his satisfaction) when the marginal utility of the commodity and its price equalize.
According to Marshall, the consumer has diminishing utility for each additional unit of a
commodity and therefore, he will be willing to pay only less for each additional unit. A
rational consumer will not pay more for lesser satisfaction. He is induced to buy additional
units only when the prices are lower. The operation of diminishing marginal utility and the
act of the consumer to equalize the utility of the commodity with its price result in a
downward sloping demand curve.

(3) Arrival of new consumers: When the price of a commodity falls, more consumers start
buying it because some of those who could not afford to buy it earlier may now be able to
buy it. This raises the number of consumers of a commodity at a lower price and hence the
demand for the commodity in question increases.

(4) Different uses: Many commodities have multiple uses. When the price of such
commodities are high (or rises) they will be put to limited uses only. If the prices of such
commodities fall, they will be put to more number of uses and therefore their demand will
increase. Thus, the increase in the number of uses consequent to a fall in price make the
buyer demand more of such commodities making the demand curve slope downwards. For
example: Electricity.

Exceptions to the Law of Demand

According to the law of demand, other things being equal, more of a commodity will be
demanded at lower prices than at higher prices. The law of demand is valid in most cases;
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however there are certain cases where this law does not hold good. The following are the
important exceptions to the law of demand.

I. Conspicuous goods: Articles of prestige value or snob appeal or articles of

conspicuous consumption are used by the rich people as status symbol for enhancing
their social prestige or /and for displaying wealth. These articles will not conform to
the usual law of demand as they become more attractive only if their prices are high
or keep going up. This was found out by Veblen in his doctrine of “Conspicuous
Consumption” and hence this effect is called Veblen effect or prestige goods effect.
Veblen effect takes place as some consumers measure the utility of a commodity by
its price i.e., if the commodity is expensive they think that it has got more utility. As
such, they buy less of this commodity at low price and more of it at high price.
Diamonds are often given as an example of this case. Higher the price of diamonds,
higher is the prestige value attached to them and hence higher is the demand.
II. Giffen goods: Sir Robert Giffen, a Scottish economist and statistician, was surprised
to find out that as the price of bread increased, the British workers purchased more
bread and not less of it. This was something against the law of demand. Why did this
happen? The reason given for this is that, when the price of bread went up, it caused
such a large decline in the purchasing power of the poor people that they were forced
to cut down the consumption of meat and other more expensive foods. Since bread,
even when its price was higher than before, was still the cheapest food article, people
consumed more of it and not less when its price went up.
Such goods which exhibit direct price-demand relationship are called ‘Giffen goods’.
Generally those goods which are inferior, with no close substitutes available and
which occupy a substantial place in consumers’ budget are called ‘Giffen goods’. All
Giffen goods are inferior goods; but all inferior goods are not Giffen goods. Examples
of Giffen goods are coarse grains like bajra, low quality rice and wheat etc.
III. Conspicuous necessities: The demand for certain goods is affected by the
demonstration effect of the consumption pattern of a social group to which an
individual belongs. These goods, due to their constant usage, become necessities of
life. For example, in spite of the fact that the prices of television sets, refrigerators,
air-conditioners etc. have been continuously rising, their demand does not show any
tendency to fall.

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IV. Future expectations about prices: It has been observed that when the prices are rising,
households, expecting that the prices in the future will be even higher, tend to buy
larger quantities of such commodities. For example, when there is wide-spread
drought, people expect that prices of food grains would rise in future. They demand
greater quantities of food grains even as their price rises. On the contrary, if prices are
falling and people anticipate further fall, rather than buying more, they postpone their
purchases. However, it is to be noted that here it is not the law of demand which is
invalidated. There is a change in one of the factors which was held constant while
deriving the law of demand, namely change in the price expectations of the people.
V. Incomplete information and irrational behaviour: The law has been derived assuming
consumers to be rational and knowledgeable about market-conditions. However, at
times, consumers have incomplete information and therefore make inconsistent
decisions regarding purchases. Similarly, in practice, a household may demand larger
quantity of a commodity even at a higher price because it may be ignorant of the
ruling price of the commodity. Under such circumstances, the law will not remain
valid.
Sometimes, consumers tend to be irrational and make impulsive purchases without
any rational calculations about the price and usefulness of the product and in such
contexts the law of demand fails.
VI. Demand for necessaries: The law of demand does not apply much in the case of
necessaries of life. Irrespective of price changes, people have to consume the
minimum quantities of necessary commodities.
VII. Speculative goods: In the speculative market, particularly in the market for stocks and
shares, more will be demanded when the prices are rising and less will be demanded
when prices decline.

The law of demand will also fail if there is any significant change in other factors on which
demand of a commodity depends. If there is a change in income of the household, or in the
prices of related commodities or in tastes and fashion etc., the inverse demand and price
relation may not hold good.

EXPANSION AND CONTRACTION OF DEMAND

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The demand schedule, demand curve and the law of demand all show that when the price of a
commodity falls, its quantity demanded increases, other things being equal. When, as a result
of decrease in price, the quantity demanded increases, in Economics, we say that there is an
expansion of demand and when, as a result of increase in price, the quantity demanded
decreases, we say that there is a contraction of demand. For example, suppose the price of
apples is Rs 100/ per kilogram and a consumer buys one kilogram at that price. Now, if other
things such as income, prices of other goods and tastes of the consumers remain the same but
the price of apples falls to Rs 80 per kilogram and the consumer now buys two kilograms of
apples, we say that there is a change in quantity demanded or there is an expansion of
demand. On the contrary, if the price of apples rises to Rs 150 per kilogram and the consumer
then buys only half a kilogram, we say that there is a contraction of demand.

The phenomena of expansion and contraction of demand are shown in Figure 3. The figure
shows that when price is OP, the quantity demanded is OM, given other things equal. When
as a result of increase in price (O PII), the quantity demanded falls to OL, we say that there is
‘a fall in quantity demanded’ or ‘contraction of demand’ or ‘an upward movement along the
same demand curve’. Similarly, as a result of fall in price to OPI , the quantity demanded
rises to ON, we say that there is an ‘expansion of demand’ or ‘a rise in quantity demanded’ or
‘a downward movement on the same demand curve.’

Increase and Decrease in Demand

Till now we have assumed that the other determinants of demand remain constant when we
are analysing the demand for a commodity. It should be noted that expansion and contraction

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of demand take place as a result of changes in the price while all other determinants of price
viz. income, tastes, propensity to consume and price of related goods remain constant. The‘
other factors remaining constant’ means that the position of the demand curve remains the
same and the consumer moves downwards or upwards on it.

There are factors other than price (non-price factors) or conditions of demand which might
cause either an increase or decrease in the quantity of a particular good or service that buyers
are prepared to demand at a given price. What happens if there is a change in consumers’
tastes and preferences, income, the prices of the related goods or other factors on which
demand depends? As an example, let us consider what happens to the demand for commodity
X if the consumer’s income increases:

Table 3 shows the possible effect of an increase in income of the consumer on the quantity
demanded of commodity X

Table 3 : Two demand schedules for commodity X

Price Quatity of ‘X’ demanded Quantity of ‘X’ demanded when

(Rs) when avg household income avg household income is Rs
is Rs 5000 per month 10000 per month
A 5 10 15 A1
B 4 15 20 B1
C 3 20 25 C1
D 2 35 40 D1
E 1 60 65 E1

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The two sets of data are plotted in Figure 4 as DD pertaining to demand when average
household income is Rs 5000/ and D’D’ when income is Rs.10, 000/. We find that with
increase in income, the demand curve for X has shifted [in this case it has shifted to the
right]. The shift from DD to D’D’ indicates an increase in the desire to purchase ‘X’ at each
possible price. For example, at the price of Rs 4 per unit, 15 units are demanded when
average household income is Rs 5,000 per month. When the average household income rises
to Rs 10,000 per month, 20 units of X are demanded at price Rs 4. You can find similar
increase in demand at each price. Since this increase would occur regardless of what the
market price is, the result would be a shift to the right of the entire demand curve.

Alternatively, we can ask what price consumers would be willing to pay to purchase a given
quantity, say 15 units of X. With greater income, they should be willing to pay a higher price
of Rs 5 instead of 4. A rise in income thus shifts the demand curve to the right, whereas a fall
in income will have the opposite effect of shifting the demand curve to the left.

Any change that increases the quantity demanded at every price shifts the demand curve to
the right and is called an increase in demand. Any change that decreases the quantity
demanded at every price shifts the demand curve to the left, and is called a decrease in
demand.

Figure 5(a) and (b) illustrate increase and decrease in demand respectively. When there is an
increase in demand, the demand curve shifts to the right and more quantity will be purchased

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at a given price (Q1 instead of Q at price P). A decrease in demand causes the entire demand
curve to shift to the left and we find that less quantity is bought at the same price P.

The table below summarises the effect of non - price determinants on demand

Changes in determinants other than price Changes in determinants other than price
that cause increase in demand (Rightward that cause Decrease in Demand (Leftward
shift of demand curve when more is shift of demand curve when less is
demanded at each price) demanded at each price)
Rise in income in the case of normal goods A fall in income in case of normal goods,
and a rise in income in case of inferior
goods
Increase in wealth in the case of normal Decrease in wealth in case of normal goods,
goods and an increase in wealth in case of inferior
goods
Rise in the price of a substitute good Fall in the price of a substitute good
Fall in the price of a complement Rise in the price of a complement
An increase in the number of buyers A decrease in the number of buyers
A change in tastes in favour of the A change in tastes against the commodity
commodity
A redistribution of income to groups of Redistribution of income away from groups
people who favour the commodity of people who favour the commodity

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 An expectation that price will rise in the An expectation that price will fall in the
future future
Government policies encouraging Government regulations discouraging
consumption of the good . Eg. Grant of consumption e.g. ban on cigarette smoking /
consumer subsidies ban on consumption.

Movements along the Demand Curve vs. Shift of Demand Curve

It is important for the business decision-makers to understand the distinction between a

movement along a demand curve and a shift of the whole demand curve.

A movement along the demand curve indicates changes in the quantity demanded because of
price changes, other factors remaining constant. A shift of the demand curve indicates that
there is a change in demand at each possible price because one or more other factors, such as
incomes, tastes or the price of some other goods, have changed.

Thus, when an economist speaks of an increase or a decrease in demand, he refers to a shift

of the whole curve because one or more of the factors which were assumed to remain
constant earlier have changed. When the economists speak of change in quantity demanded
he means movement along the same curve (i.e., expansion or contraction of demand) which
has happened due to fall or rise in price of the commodity.

In short ‘change in demand’ represents shift of the demand curve to right or left resulting
from changes in factors such as income, tastes, prices of other goods etc. and ‘change in
quantity demanded’ represents movement upwards or downwards on the same demand curve
resulting from a change in the price of the commodity.

When demand increases due to factors other than price, firms can sell more at the existing
prices resulting in increased revenue. The objective of advertisements and all other sales
promotion activities by any firm is to shift the demand curve to the right and to reduce the
elasticity of demand. (The latter will be discussed in the next section). However, the
additional demand is not free of cost as firms have to incur expenditure on advertisement and
sales promotion devices.

ELASTICITY OF DEMAND

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From the point of view of a business firm, it is more important to know the extent of the
relationship or the degree of responsiveness of demand to changes in its determinants.

Often, we would want to know how sensitive is the demand for a product to its price; for
example, if price increases by 5 percent, how much will the quantities demanded change?
Also, how much change in demand will be there if the average income rises by 5 percent?
What effect will an advertising campaign have on sales? Economists use a number of
different types of elasticities to answer questions like these so as to make demand predictions
and to recommend changes in strategies.

Consider the following situations:

(1) As a result of a fall in the price of headphones from Rs 500 to Rs 400, the quantity
demanded increases from 100headphones to 150 headphones.

(2) As a result of fall in the price of wheat from Rs 20 per kilogram to Rs 18 per kilogram,
the quantity demanded increases from 500 kilograms to 520 kilograms.

(3) As a result of fall in the price of salt from Rs 9 per kilogram to Rs 7.50, the quantity
demanded increases from 1000 kilogram to 1005 kilograms.

We can notice that the demand for headphones, wheat and salt responds in the same direction
to price changes. The difference lies in the degree of response of demand. The differences in
responsiveness of demand can be found out by comparing the percentage changes in prices
and quantities demanded. Here lies the concept of elasticity.

The amount of a commodity purchased is a function of many variables such as price of the
commodity, prices of the related commodities, income of the consumers and other factors on
which demand depends. A change in one of these independent variables will cause a change
in the dependent variable, namely, the amount purchased per unit of time. The elasticity of
demand measures the relative responsiveness of the amount purchased per unit of time to a
change in any one of these independent variables while keeping others constant. In general,
the coefficient of elasticity is defined as the proportionate change in the dependent variable
divided by the proportionate change in the independent variable.

Elasticity of demand is defined as the responsiveness of the quantity demanded of a

good to changes in one of the variables on which demand depends. More precisely,

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elasticity of demand is the percentage change in quantity demanded divided by the
percentage change in one of the variables on which demand depends.

There different measures of elasticity such as price elasticity, cross elasticity, income
elasticity, advertisement elasticity and elasticity of substitution. It is to be noted that when we
talk of elasticity of demand, unless and until otherwise mentioned, we talk of price elasticit y
of demand. In other words, it is price elasticity of demand which is usually referred to as
elasticity of demand.

Price Elasticity of Demand

The most important measure of elasticity of demand is the price elasticity of demand which
measures the sensitivity of quantity demanded to ‘own price’ or the price of the good itself.
The concept of price elasticity of demand is important for a firm for two reasons.

 Knowledge of the nature and degree of price elasticity allows firms to predict the
impact of price changes on its sales.
 Price elasticity guides the firm’s profit-maximizing pricing decisions.

Price elasticity of demand expresses the responsiveness of quantity demanded of a good to a

change in its price, given the consumer’s income, his tastes and prices of all other goods. In
other words, it is measured as the percentage change in quantity demanded divided by the
percentage change in price, other things remaining equal. The price elasticity of demand (also
referred to as PED) tells us the percentage change in quantity demanded for each one percent
(1%) change in price. That is,

The percentage change in a variable is just the absolute change in the variable divided by the
original level of the variable. Therefore,

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In symbolic terms

Where Ep stands for price elasticity

q stands for original quantity

p stands for original price

∆ stands for a change.

A negative sign on the elasticity of demand illustrates the law of demand: less quantity is
demanded as the price rises. Notice that the change in quantity was due solely to the price
change. The other factors that potentially could affect sales (income and the competitor’s
price) did not change

The greater the value of elasticity, the more sensitive quantity demanded is to price. Strictly
speaking, the value of price elasticity varies from minus infinity to approach zero. This is
because ∆ q/∆p has a negative sign. In other words, since price and quantity are inversely
related (with a few exceptions) price elasticity is negative.

While interpreting the coefficient of price elasticity, we consider only the magnitude of the
price elasticity- i.e. its absolute size. For example, if Ep = -1.22, we say that the elasticity is
1.22 in magnitude. That is, we ignore the negative sign and consider only the numerical value
of the elasticity. Thus if a 1% change in price leads to 2% change in quantity demanded of
good A and 4% change in quantity demanded of good B, then we get elasticity of A and B as
2 and 4 respectively, showing that demand for B is more elastic or responsive to price
changes than that of A. Had we considered minus signs, we would have concluded that the
demand for A is more elastic than that for B, which is not correct. Hence, by convention, we
take the absolute value of price elasticity and draw conclusions.

A numerical example for price elasticity of demand:

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a) The price of a commodity decreases from Rs 6 to Rs 4 and quantity demanded of the
good increases from 10 units to 15 units. Find the coefficient of price elasticity.
Solution :
Price elasticity = (-) ∆ q / ∆ p × p/q = 5/2 × 6/10 = (-) 1.5
b) A 5% fall in the price of a good leads to a 15% rise in its demand. Determine the
elasticity and comment on its value.
Solution :

c) The price of a good decreases from ` 100 to ` 60 per unit. If the price elasticity of
demand for it is 1.5 and the original quantity demanded is 30 units, calculate the new
quantity demanded.
Solution:

Point Elasticity

The point elasticity of demand is the price elasticity of demand at a particular point on
the demand curve. The concept of point elasticity is used for measuring price
elasticity where the change in price is infinitesimal. Price elasticity is a key element in
applying marginal analysis to determine optimal prices. Since marginal analysis
works by evaluating “small” changes taken with respect to an initial decision, it is
useful to measure elasticity with respect to an infinitesimally small change in price.
Point elasticity makes use of derivative rather than finite changes in price and
quantity. It may be defined as:

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Where dq /dp is the derivative of quantity with respect to price at a point on the
demand curve, and p and q are the price and quantity at that point. Economists
generally use the word “elasticity” to refer to point elasticity.

Point elasticity is, therefore, the product of price quantity ratio at a particular point on
the demand curve and the reciprocal of the slope of the demand line.

Measurement of Elasticity on a Linear Demand Curve – Geometric

Method

The price elasticity of demand is the change in quantity associated with a change in
price (∆Q/∆P) times the ratio of price to quantity (P/Q) Therefore, .the price elasticity
of demand depends not only on the slope of the demand curve but also on the price
and quantity. The elasticity, therefore, varies along the curve as price and quantity
change. The slope of a linear demand curve is constant. However, the elasticity at
different points on a linear demand curve would be different. When price is high price
is high and quantity is small, the elasticity is high. The elasticity becomes smaller as
we move down the curve.
Given a straight line demand curve tT, (Fig.6 above) point elasticity at any point say
R can be found by using the formula

Using the above formula we can get elasticity at various points on the demand curve.

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Thus, we see that as we move from T towards t, elasticity goes on increasing. At the
mid-point it is equal to one, at point t, it is infinity and at T it is zero.

Arc-Elasticity
Often we may be required to calculate price elasticity over some portion of the
demand curve rather than at a single point. In other words, the elasticity may be
calculated over a range of prices. When price and quantity changes are discrete and
large we have to measure elasticity over an arc of the demand curve.
When price elasticity is to be found between two prices (or two points on the demand
curve say, A and B in figure 8) the question arises as to which price and quantity
should be taken as base. This is because elasticities found by using original price and
quantity figures as base will be different from the one derived by using new price and
quantity figures. Therefore, in order to avoid confusion, rather than choose the initial
or the final price and quantity, the mid-point method is used i.e. the averages of the
two prices and quantities are taken as (i.e. original and new) base. The midpoint
formula is an approximation to the actual percentage change in a variable, but it has
the advantage of consistent elasticity values when price moves in either directions.

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The arc elasticity can be found out by using the formula: We drop the minus sign and
use the absolute value.

Where P1, Q1are the original price and quantity and P2, Q2are the new ones.
Thus, if we have to find elasticity of demand for headphones between:
P1 = Rs.500 Q1 = 100
P2 = Rs.400 Q2 = 150
We will use the formula

The arc elasticity will always lie somewhere (but not necessarily in the middle)
between the point elasticities calculated at the lower and the higher prices.

Interpretation of the Numerical Values of Elasticity of Demand

Economists have found it useful to divide the demand behaviour into different
categories, based on values of price elasticity. Since we draw demand curves with
price on the vertical axis and quantity on the horizontal axis, ∆Q/∆P = (1/slope of

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curve). As a result, for any price and quantity combination, the steeper the slope of the
curve, the less elastic is demand.

The numerical value of elasticity of demand can assume any value between zero and
infinity.
Elasticity is zero, (Ep= 0) if there is no change at all in the quantity demanded when
price changes i.e. when the quantity demanded does not respond at all to a price
change. In other words, any change in price leaves the quantity demanded unchanged
and consumers will buy a fixed quantity of a good regardless of its price. Perfectly
inelastic demand is as an extreme case of price insensitivity and is therefore only a
theoretical category with less practical significance. The vertical demand curve in
figure 8(a) represents perfectly or completely inelastic demand.

Elasticity is one, or unitary, (Ep= 1) if the percentage change in quantity demanded is

equal to the percentage change in price. Figure 8 (b) shows special case of unit-elastic
demand, where the demand curve is a rectangular hyperbola.

Elasticity is greater than one (Ep > 1) when the percentage change in quantity
demanded is greater than the percentage change in price. In such a case, demand is
said to be elastic. [Figure8 (d)]. In other words, the quantity demanded is relatively
sensitive to price changes. When drawn, the elastic demand line is fairly flat.

Elasticity is less than one (Ep < 1) when the percentage change in quantity demanded
is less than the percentage change in price. In such a case, demand is said to be
inelastic.[Figure 8 (e)]In this situation, when price falls the buyers are unable or
unwilling to significantly contract demand. In other words, the quantity demanded is
relatively insensitive to price changes. When drawn, the inelastic demand line is fairly
steep.

Elasticity is infinite, (Ep= ∞) when a ‘small price reduction raises the demand from
zero to infinity. The demand curve is horizontal at the price level (where the demand
curve touches the vertical axis).As long as the price stays at one particular level any
quantity might be demanded. Moving back and forth along this line, we find that there

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is a change in the quantity demanded but no change in the price. If there is a slight
increase in price, they would not buy anything from the particular seller. That is, even
the smallest price rise would cause quantity demanded to fall to zero. Roughly
speaking, when you divide a number by zero, you get infinity, denoted by the
symbol∞. So a horizontal demand curve implies an infinite price elasticity of demand.
This type of demand curve is found in a perfectly competitive market. The horizontal
demand curve in figure 8 (c) represents perfectly or infinitely elastic demand.

Total Outlay Method of Calculating Price Elasticity

The price elasticity of demand for a commodity and the total expenditure or outlay
made on it are significantly related to each other. As the total expenditure (price of the
commodity multiplied by the quantity of that commodity purchased) made on a
commodity is the total revenue received by the seller (price of the commodity
multiplied by quantity of that commodity sold of that commodity), we can say that the
price elasticity and total revenue received are closely related to each other. By

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analysing the changes in total expenditure (or total revenue) in response to a change in
the price of the commodity, we can know the price elasticity of demand for it.

Price Elasticity of demand equals one or Unity: When, as a result of the change in
price of a good, the total expenditure on the good or the total revenue received from
that good remains the same, the price elasticity for the good is equal to unity. This is
because the total expenditure made on the good can remain the same only if the
proportional change in quantity demanded is equal to the proportional change in price.
Thus, if there is a given percentage increase (or decrease) in the price of a good and if
the price elasticity is unitary, total expenditure of the buyer on the good or the total
revenue received from it will remain unchanged.

Price elasticity of demand is greater than unity: When, as a result of increase in the
price of a good, the total expenditure made on the good or the total revenue received
from that good falls or when as a result of decrease in price, the total expenditure
made on the good or total revenue received from that good increases, we say that
price elasticity of demand is greater than unity. In our example of headphones, as a
result of fall in price of headphones from Rs 500 to Rs 400, the total revenue received
from headphones increases from Rs 50,000 (500 x 100) to Rs 60,000 (400 x 150),
indicating elastic demand for headphones. Similarly, had the price of headphones
increased from Rs 400 to Rs 500, the demand would have fallen from 150 to 100
indicating a fall in the total revenue received from Rs 60,000 to Rs 50,000 showing
elastic demand for headphones.

Price elasticity of demand is less than unity: When, as a result of increase in the
price of a good, the total expenditure made on the good or the total revenue received
from that good increases or when as a result of decrease in its price, the total
expenditure made on the good or the total revenue received from that good falls, we
say that the price elasticity of demand is less than unity. In the example of wheat
above, as a result of fall in the price of wheat from Rs 20 per kg. to Rs 18 per kg. the
total revenue received from wheat falls from Rs 10,000 (20 x 500) to Rs 9360 (18 x
520) indicating inelastic demand for wheat. Similarly, we can show that as a result of
increase in the price of wheat from Rs 18 to Rs 20 per kg, the total revenue received

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from wheat increase from Rs 9360 to Rs 10,000 indicating inelastic demand for
wheat.

The main drawback of this method is that by using this we can only say whether the
demand for a good is elastic or inelastic; we cannot find out the exact coefficient of
price elasticity.

Why should a business firm be concerned about elasticity of demand? The reason is
that the degree of elasticity of demand predicts how changes in the price of a good
will affect the total revenue earned by the producers from the sale of that good. The
total revenue is defined as the total value of sales of a good or service. It is equal to
the price multiplied by the quantity sold.

Determinants of Price Elasticity of Demand

(1) Availability of substitutes: One of the most important determinants of elasticity is

the degree of substitutability and the extent of availability of substitutes. Some
commodities like butter, cabbage, car, soft drink etc. have close substitutes. These
are margarine, other green vegetables, other brands of cars, other brands of cold
drinks respectively. A change in the price of these commodities, the prices of the
substitutes remaining constant, can be expected to cause quite substantial
substitution – a fall in price leading consumers to buy more of the commodity in
question and a rise in price leading consumers to buy more of the substitutes.
Commodities such as salt, housing, and all vegetables taken together, have few, if
any, satisfactory substitutes and a rise in their prices may cause a smaller fall in
their quantity demanded. Thus, we can say that goods which typically have close
or perfect substitutes have highly elastic demand curves. Moreover, wider the
range of substitutes available, the greater will be the elasticity. For example, toilet
soaps, toothpastes etc have wide variety of brands and each brand is a close
substitute for the other.
It should be noted that while as a group, a good or service may have inelastic
demand, but when we consider its various brands, we say that a particular brand
has elastic demand. Thus, while the demand for a generic good like petrol is
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 inelastic, the demand for Indian Oil’s petrol is elastic. Similarly, while there are
no general substitutes for health care, there are substitutes for one doctor or
hospital. Likewise, the demand for common salt and sugar is inelastic because
good substitutes are not available for these.
(2) Position of a commodity in the consumer’s budget: The greater the proportion
of income spent on a commodity; generally the greater will be its elasticity of
demand and vice- versa. The demand for goods like common salt, matches,
buttons, etc. tend to be highly inelastic because a household spends only a fraction
of their income on each of them. On the other hand, demand for goods like rental
apartments and clothing tends to be elastic since households generally spend a
good part of their income on them. When the good absorbs a significant share of
consumers’ income, it is worth their time and effort to find a way to reduce their
demand when the price goes up.
(3) Nature of the need that a commodity satisfies: In general, luxury goods are
price elastic because one can easily live without a luxury. In contrast, necessities
are price inelastic. Thus, while the demand for a home theatre is relatively elastic,
the demand for food and housing, in general, is inelastic. If it is possible to
postpone the consumption of a particular good, such good will have elastic
demand. Consumption of necessary goods cannot be postponed and therefore,
their demand is inelastic.
(4) Number of uses to which a commodity can be put: The more the possible uses
of a commodity, the greater will be its price elasticity and vice versa. When the
price of a commodity which has multiple uses decreases, people tend to extend
their consumption to its other uses. To illustrate, milk has several uses. If its price
falls, it can be used for a variety of purposes like preparation of curd, cream, ghee
and sweets. But, if its price increases, its use will be restricted only to essential
purposes like feeding the children and sick persons.
(5) Time period: The longer the time-period one has, the more completely one can
adjust. Time gives buyers the opportunity to find alternatives or substitutes, or
change their habits. A simple example of the effect can be seen in motoring habits.
In response to a higher petrol price, one can, in the short run, make fewer trips by
car. In the longer run, not only can one make fewer trips, but he can purchase a car
with a smaller engine capacity when the time comes for replacing the existing one.

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 Hence one’s demand for petrol falls by more when one has made long term
adjustments to higher prices.
(6) Consumer habits: If a person is a habitual consumer of a commodity, no matter
how much its price change, the demand for the commodity will be inelastic. If
buyers have rigid preferences demand will be less price elastic.
(7) Tied demand: The demand for those goods which are tied to others is normally
inelastic as against those whose demand is of autonomous nature. For example
printers and ink cartridges.
(8) Price range: Goods which are in very high price range or in very low price range
have inelastic demand, but those in the middle range have elastic demand.
(9) Minor complementary items: The demand for cheap, complementary items to be
used together with a costlier product will tend to have an inelastic demand.

Knowledge of the price elasticity of demand and the factors that may change it is
of key importance to business managers because it helps them recognise the effect
of a price change on their total sales and revenues. Firms aim to maximise their
profits and their pricing strategy is highly decisive in attaining their goals.
Knowledge of the price elasticity of demand for the goods they sell helps them in
arriving at an optimal pricing strategy.

If the demand for a firm’s product is relatively elastic, the managers need to
recognize that lowering the price would expand the volume of sales and result in
an increase in total revenue. On the contrary, when the demand is elastic, they
have to be very cautious about increasing prices because a price increase will lead
to a decline in total revenue as fall in sales would be more than proportionate. If
the firm finds that the demand for their product is relatively inelastic, the firm may
safely increase the price and thereby increase its total revenue as they can be
assured of the fact that the fall in sales on account of a price rise would be less
than proportionate.

Knowledge of price elasticity of demand is important for governments while

determining the prices of goods and services provided by them, such as, transport
and telecommunication. Further, it also helps the governments to understand the

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 nature of responsiveness of demand to increase in prices on account of additional
taxes and the implications of such responses on the tax revenues. Elasticity of
demand explains why the governments are inclined to raise the indirect taxes on
those goods that have a relatively inelastic demand, such as alcohol and tobacco
products.

Income Elasticity of Demand

The income elasticity of demand is a measure of how much the demand for a good
is affected by changes in consumers’ incomes. Estimates of income elasticity of
demand are useful for businesses to predict the possible growth in sales as the
average incomes of consumers grow over time.
Income elasticity of demand is the degree of responsiveness of the quantity
demanded of a good to changes in the income of consumers. In symbolic form,

There is a useful relationship between income elasticity for a good and the
proportion of income spent on it. The relationship between the two is described in
the following three propositions:
1. If the proportion of income spent on a good remains the same as income increases,
then income elasticity for that good is equal to one.

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2. If the proportion of income spent on a good increase as income increases, then the
income elasticity for that good is greater than one. The demand for such goods
increase faster than the rate of increase in income
3. If the proportion of income spent on a good decrease as income rises, then income
elasticity for the good is positive but less than one. The demand for income-inelastic
goods rises, but substantially slowly compared to the rate of increase in income.
Necessities such as food and medicines tend to be income- inelastic
Income elasticity of goods reveals a few very important features of demand for the
goods in question.
If income elasticity is zero, it signifies that the demand for the good is quite
unresponsive to changes in income. When income elasticity is greater than zero or
positive, then an increase in income leads to an increase in the demand for the good.
This happens in the case of most of the goods and such goods are called normal
goods. For all normal goods, income elasticity is positive. However, the degree of
elasticity varies according to the nature of commodities.
When the income elasticity of demand is negative, the good is an inferior good. In
this case, the quantity demanded at any given price decreases as income increases.
The reason is that when income increases, consumers choose to consume superior
substitutes.
Another significant value of income elasticity is that of unity. When income elasticity
of demand is equal to one, the proportion of income spent on goods remains the same
as consumer’s income increases. This represents a useful dividing line. If the income
elasticity for a good is greater than one, it shows that the good bulks larger in
consumer’s expenditure as he becomes richer. Such goods are called luxury goods.
On the other hand, if the income elasticity is less than one, it shows that the good is
either relatively less important in the consumer’s eye or, it is a good which is a
necessity.
The following examples will make the above concepts clear:
(a) The income of a household rises by 10%, the demand for wheat rises by 5%.
(b) The income of a household rises by 10%, the demand for T.V. rises by 20%.
(c) The incomes of a household rises by 5%, the demand for bajra falls by 2%.
(d) The income of a household rises by 7%, the demand for commodity X rises by
7%.

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(e) The income of a household rises by 5%, the demand for buttons does not change
at all. Using formula for income elasticity.

We will find income-elasticity for various goods. The results are

It is to be noted that the words ‘luxury’, ‘necessity’, ‘inferior good’ do not signify the
strict dictionary meanings here. In economic theory, we distinguish them in the
manner shown above.
An important feature of income elasticity is that income elasticities differ in the short
run and long run. For nearly all goods and services the income elasticity of demand is
larger in the long run than in the short run
Knowledge of income elasticity of demand is very useful for a business firm in
estimating the future demand for its products. Knowledge of income elasticity of
demand helps firms measure the sensitivity of sales for a given product to incomes in
the economy and to predict the outcome of a business cycle on its market demand.
For instance, if EY = 1, sales move exactly in step with changes in income. If EY >1,
sales are highly cyclical, that is, sales are sensitive to changes in income. For an
inferior good, sales are countercyclical, that is, sales move in the opposite direction of
income and EY < 0. This knowledge enables the firm to carry out appropriate
production planning and management

Income Elasticity of Demand

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A car dealer sells new as well as used cars. Sales during the previous year were as
follows

During the previous year, other things remaining the same, the real incomes of the
customers rose on average by 10%. During the last year sales of new cars increased
to 500, but sales of used cars declined to 3,850.
What is the income elasticity of demand for the new as well as used cars? What
inference do you draw from these measures of income elasticity?
Solution

Income Elasticity of demand for new cars

Percentage change in income = 10%, given
Percentage change in quantity of new cars demanded = (∆ Q/Q) X 100 = (100/400 )
X100 = 25%
Income elasticity of demand = 25%/ 10% = + 2.5
New car is therefore income elastic. Since income elasticity is positive, new car is a
normal good.
Income Elasticity of demand for used cars
Percentage change in income = 10%, given
% change in quantity of used cars demanded = (∆ Q/Q )X 100 =( -1 50/4000 ) x100
= - 3.75%Income elasticity of demand = – 3.75/ 10= –.375
Since income elasticity is negative, used car is an inferior good.

CROSS - PRICE ELASTICITY OF DEMAND

Price of Related Goods and Demand

The demand for a particular commodity may change due to changes in the prices of
related goods. These related goods may be either complementary goods or substitute
goods. This type of relationship is studied under ‘Cross Demand’. Cross demand
refers to the quantities of a commodity or service which will be purchased with
reference to changes in price, not of that particular commodity, but of other inter-

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related commodities, other things remaining the same. It may be defined as the
quantities of a commodity that consumers buy per unit of time, at different prices of a
‘related article’, ‘other things remaining the same’. The assumption ‘other things
remaining the same’ means that the income of the consumer and also the price of the
commodity in question will remain constant.

a) Substitute Products and Demand

In the case of substitute commodities, the cross demand curve slopes upwards (i.e.
positively) showing that more quantities of a commodity, will be demanded
whenever there is a rise in the price of a substitute commodity. In figure 10, the
quantity demanded of tea is given on the X axis. Y axis represents the price of
coffee which is a substitute for tea. When the price of coffee increases, due to the
operation of the law of demand, the demand for coffee falls. The consumers will
substitute tea in the place of coffee. The price of tea is assumed to be constant.
Therefore, whenever there is an increase in the price of one commodity, the
demand for the substitute commodity will increase.

b) Complementary Goods
In the case of complementary goods, as shown in the figure 11 below, a change in
the price of a good will have an opposite reaction on the demand for the other
commodity which is closely related or complementary. For instance, an increase
in demand for solar panels will necessarily increase the demand for batteries. The
same is the case with complementary goods such as bread and butter; car and
petrol, electricity and electrical gadgets etc. Whenever there is a fall in the
demand for solar panels due to a rise in their prices, the demand for batteries will
fall, not because the price of batteries has gone up, but because the price of solar
panels has gone up. So, we find that there is an inverse relationship between price
of a commodity and the demand for its complementary good (other things
remaining the same).
The cross-price elasticity of demand between two goods measures the effect of the
change in one good’s price on the quantity demanded of the other good. Here, we
consider the effect of changes in relative prices within a market on the pattern of
demand. A change in the demand for one good in response to a change in the price

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 of another good represents cross elasticity of demand of the former good for the
latter good. It is equal to the percentage change in the quantity demanded of one
good divided by the percentage change in the other good’s price.

Where Ec stands for cross elasticity.

qx stands for original quantity demanded of X.
∆qx stands for change in quantity demanded of X
py stands for the original price of good Y.
∆py stands for a small change in the price of Y.

In the case of the cross-price elasticity of demand, the sign (plus or minus) is very
important: it tells us whether the two goods are complements or substitutes.
When two goods X and Y are substitutes, the cross-price elasticity of demand is
positive: a rise in the price of Y increases the demand for X and causes a
rightward shift of the demand curve. When the cross-price elasticity of demand is
positive, its size is a measure of how closely substitutable the two goods are.
Greater the cross elasticity, the closer is the substitute. Higher the value of cross
elasticity, greater will be the substitutability.
 If two goods are perfect substitutes for each other, the cross elasticity
between them is infinite.
 If two goods are close substitutes, the cross-price elasticity will be
positive and large.
 If two goods are not close substitutes, the cross-price elasticity will be
positive and small.
 If two goods are totally unrelated, the cross-price elasticity between them
is zero.

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When two goods are complementary (tea and sugar) to each other, the cross elasticity
between them is negative so that a rise in the price of one leads to a fall in the quantity
demanded of the other causing a leftward shift of the demand curve. The size of the cross-
price elasticity of demand between two complements tells us how strongly complementary
they are: if the cross-price elasticity is only slightly below zero, they are weak complements;
if it is negative and very high, they are strong complements.

However, one need not base the classification of goods on the basis of the above definitions.
While the goods between which cross elasticity is positive can be called substitutes, the
goods between which cross elasticity is negative are not always complementary. This is
because negative cross elasticity is also found when the income effect of the price change is
very strong.

The concept of cross elasticity of demand is useful for a manager while making decisions
regarding changing the prices of his products which have substitutes and complements. If
cross elasticity to change in the price of substitutes is greater than one, the firm may lose by
increasing the prices and gain by reducing the prices of his products. With proper knowledge
of cross elasticity, the firm can plan policies to safeguard against fluctuating prices of
substitutes and complements.

DEMAND FORECASTING

Meaning

Forecasting, in general, refers to knowing or measuring the status or nature of an event or

variable before it occurs. Forecasting of demand is the art and science of predicting the
probable demand for a product or a service at some future date on the basis of certain past
behaviour patterns of some related events and the prevailing trends at present. It should be
kept in mind that demand forecasting is not simple guessing, but it refers to estimating
demand scientifically and objectively on the basis of certain facts and events relevant to
forecasting.

Types of Forecasts

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 (i) Macro-level forecasting deals with the general economic environment prevailing
in the economy as measured by the Index of Industrial Production (IIP), national
income and general level of employment etc.
(ii) Industry- level forecasting is concerned with the demand for the industry’s
products as a whole. For example, demand for cement in India.
(iii) Firm- level forecasting refers to forecasting the demand for a particular firm’s
product, say, the demand for ACC cement

Based on time period, demand forecasts may be short term demand forecasting and long
term demand forecasting.

(i) Short term demand forecasting covers a short span of time, depending of the
nature of industry. It is done usually for six months or less than one year and is
generally useful in tactical decisions.
(ii) Long term forecasts are for longer periods of time, say two to five years and more.
It provides information for major strategic decisions of the firm such as expansion
of plant capacity.

Methods of Demand Forecasting

There is no easy method or simple formula which enables an individual or a business to

predict the future with certainty or to escape the hard process of thinking. The firm has to
apply a proper mix of judgment and scientific formulae in order to correctly predict the future
demand for a product. The following are the commonly available techniques of demand
forecasting:

(i) Survey of Buyers’ Intentions: The most direct method of estimating demand in the
short run is to ask customers what they are planning to buy during the forthcoming
time period, usually a year. This method involves direct interview of potential
customers. Depending on the purpose, time available and costs to be incurred, the
survey may be conducted by any of the following methods:
 Complete enumeration method where nearly all potential customers are
interviewed about their future purchase plans
 Sample survey method under which only a scientifically chosen sample of
potential customers are interviewed

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  End–use method, especially used in forecasting demand for inputs,
involves identification of all final users, fixing suitable technical norms of
consumption of the product under study, application of the norms to the
desired or targeted levels of output and aggregation.

Thus, under this method the burden of forecasting is put on the customers. However, it would
not be wise to depend wholly on the buyers’ estimates and they should be used cautiously in
the light of the seller’s own judgement. A number of biases may creep into the surveys. The
customers may themselves misjudge their requirements, may mislead the surveyors or their
plans may alter due to various factors which are not identified or visualised at the time of the
survey.

This method is useful when bulk of sale is made to industrial producers who generally have
definite future plans. In the case of household customers, this method may not prove very
helpful for several reasons viz. irregularity in customers’ buying intentions, their inability to
foresee their choice when faced with multiple alternatives, and the possibility that the buyers’
plans may not be real, but only wishful thinking.

(ii) Collective opinion method: This method is also known as sales force opinion
method or grass roots approach. Firms having a wide network of sales personnel
can use the knowledge, experience and skills of the sales force to forecast future
demand. Under this method, salesmen are required to estimate expected sales in
their respective territories. The rationale of this method is that salesmen being
closest to the customers are likely to have the most intimate feel of the reactions
of customers to changes in the market.
These estimates of salesmen are consolidated to find out the total estimated sales.
These estimates are reviewed to eliminate the bias of optimism on the part of
some salesmen and pessimism on the part of others. These revised estimates are
further examined in the light of factors like proposed changes in selling prices,
product designs and advertisement programmes, expected changes in competition
and changes in secular forces like purchasing power, income distribution,
employment, population, etc. The final sales forecast would emerge after these
factors have been taken into account.
Although this method is simple and based on first hand information of those who
are directly connected with sales, it is subjective as personal opinions can possibly
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 influence the forecast. Moreover salesmen may be unaware of the broader
economic changes which may have profound impact on future demand. Therefore,
forecasting could be useful in the short run, for long run analysis however, a better
technique is to be applied.

(iii) Expert Opinion method: In general, professional market experts and consultants
have specialised knowledge about the numerous variables that affect demand.
This, coupled with their varied experience, enables them to provide reasonably
reliable estimates of probable demand in future. Information is elicited from them
through appropriately structured unbiased tools of data collection such as
interview schedules and questionnaires.
The Delphi technique, developed by Olaf Helmer at the Rand Corporation of the
USA, provides a useful way to obtain informed judgments from diverse experts by
avoiding the disadvantages of conventional panel meetings. Under this method,
instead of depending upon the opinions of buyers and salesmen, firms solicit the
opinion of specialists or experts through a series of carefully designed
questionnaires. Experts are asked to provide forecasts and reasons for their
forecasts. Experts are provided with information and opinion feedbacks of others
at different rounds without revealing the identity of the opinion provider. These
opinions are then exchanged among the various experts and the process goes on
until convergence of opinions is arrived at. The following chart shows the Delphi
process.

The Delphi method is best suited in circumstances where intractable changes are
occurring and the relevant knowledge is distributed among experts spread over
different geographical locations. For example, the method may be used for
forecasting national energy demand 50 years from now, long term transportation
needs, environmental issues and long term human resource forecasting to mention

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 a few. Delphi technique is widely accepted due to its broader applicability,
absence of group pressure, capability to tap collective human expertise and
intelligence and ability to address complex questions. It also has the advantages of
speed and cheapness.
(iv) Statistical methods: statistical methods have proved to be very useful in
forecasting demand. Forecasts using statistical methods are considered as superior
methods because they are more scientific, reliable and free from subjectivity. The
important statistical methods of demand forecasting are:

a) Trend Projection method: This method, also known classical method, is

considered as a ‘naive’ approach to demand forecasting. A firm which has
been in existence for a reasonably long time would have accumulated
considerable data on sales pertaining to different time periods. Such data,
when arranged chronologically, yield a ‘time series’. The time series relating
to sales represent the past pattern of effective demand for a particular product.
Such data can be used to project the trend of the time series.
The trend projection method assumes that factors responsible for the past trend
in demand will continue to operate in the same manner and to the same extent
as they did in the past in determining the magnitude and direction of demand
in future. The popular techniques of trend projection based on time series data
are; graphical method and fitting trend equation or least square method.
 Graphical Method: This method, also known as ‘free hand projection
method’ is the simplest and least expensive. This involves plotting of
the time series data on a graph paper and fitting a free-hand curve to it
passing through as many points as possible. The direction of the curve
shows the trend. This curve is extended into the future for deriving the
forecasts. The direction of this free hand curve shows the trend. The
main draw-back of this method is that it may show the trend but the
projections made through this method are not very reliable.
 Fitting trend equation: Least Square Method: It is a mathematical
procedure for fitting a line to a set of observed data points in such a
manner that the sum of the squared differences between the calculated
and observed value is minimised. This technique is used to find a trend

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 line which best fit the available data. This trend is then used to project
the dependant variable in the future. This method is very popular
because it is simple and in-expensive. Moreover, the trend method
provides fairly reliable estimates of future demand.

The least square method is based on the assumption that the past rate of
change of the variable under study will continue in the future. The forecast
based on this method may be considered reliable only for the period during
which this assumption holds. The major limitation of this method is that it
cannot be used where trend is cyclical with sharp turning points of troughs
and peaks. Also, this method cannot be used for short term forecasts.

b) Regression analysis: This is the most popular method of forecasting demand.

Under this method, a relationship is established between the quantity
demanded (dependent variable) and the independent variables (explanatory
variables) such as income, price of the good, prices of related goods etc. Once
the relationship is established, we derive regression equation assuming the
relationship to be linear. The equation will be of the form Y = a + bX. There
could also be a curvilinear relationship between the dependent and
independent variables. Once the regression equation is derived, the value of Y
i.e. quantity demanded can be estimated for any given value of X.

v) Controlled Experiments: Under this method, future demand is estimated by

conducting market studies and experiments on consumer behaviour under actual,
though controlled, market conditions. This method is also known as market
experiment method. An effort is made to vary separately certain determinants of
demand which can be manipulated, for example, price, advertising, etc., and conduct
the experiments assuming that the other factors would remain constant. Thus, the
effect of demand determinants like price, advertisement, packaging, etc., on sales can
be assessed by either varying them over different markets or by varying them over
different time periods in the same market. The responses of demand to such changes
over a period of time are recorded and are used for assessing the future demand for
the product. For example, different prices would be associated with different sales and
on that basis the price-quantity relationship is estimated in the form of regression

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 equation and used for forecasting purposes. It should be noted however, that the
market divisions here must be homogeneous with regard to income, tastes, etc.

The method of controlled experiments is used relatively less because this method of
demand forecasting is expensive as well as time consuming. Moreover, controlled
experiments are risky too because they may lead to unfavourable reactions from
dealers, consumers and competitors. It is also difficult to determine what conditions
should be taken as constant and what factors should be regarded as variable so as to
segregate and measure their influence on demand. Besides, it is practically difficult to
satisfy the condition of homogeneity of markets.

Market experiments can also be replaced by ‘controlled laboratory experiments’ or

‘consumer clinics’ under which consumers are given a specified sum of money and
asked to spend in a store on goods with varying prices , packages, displays etc. The
responses of the consumers are studied and used for demand forecasting.

vi) Barometric method of forecasting: The various methods suggested till now are
related with the product concerned. These methods are based on past experience
and try to project the past into the future. Such projection is not effective where
there are economic ups and downs. As mentioned above, the projection of trend
cannot indicate the turning point from slump to recovery or from boom to
recession. Therefore, in order to find out these turning points, it is necessary to
find out the general behaviour of the economy.
Just as meteorologists use the barometer to forecast weather, the economists use
economic indicators to forecast trends in business activities. This information is
then used to forecast demand prospects of a product, though not the actual
quantity demanded. For this purpose, an index of relevant economic indicators is
constructed. Movements in these indicators are used as basis for forecasting the
likely economic environment in the near future.

There are leading indicators, coincidental indicators and lagging indicators. The
leading indicators move up or down ahead of some other series. For example, the
heavy advance orders for capital goods give an advance indication of economic
prosperity. Increase in the number of construction permits for new houses will be

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 reflected in corresponding increase in the number of sheets of glass ordered
several months later.

The coincidental indicators, however, move up and down simultaneously and are
witnessed at around the same time the changes they signal occur. Since these
happen almost in real time, they do not offer much predictive insight, but provide
a fair reading of the current scenario. For example, Figures on retail sales, rate of
unemployment and Index of Industrial Production (IIP).

The lagging indicators follow a change after some time lag. The heavy household
electrical connections confirm the fact that heavy construction work was
undertaken during the past with a lag of some time.

UTILITY
The concept of utility is used in neo classical Economics to explain the operation
of the law of demand. Following Jeremy Bentham, John Stuart Mill, and other
nineteenth-century British economist-philosophers, economists apply the term
utility to "that property in any object, whereby it tends to produce benefit,
advantage, pleasure, good, or happiness”. Utility is thus the want satisfying power
of a commodity. The utility of a consumer is a measure of the satisfaction that the
consumer expects to obtain from consumption of goods and services when he
spends money on a stock of commodity which has the capacity to satisfy his want.
Utility is thus the anticipated satisfaction by the consumer, and satisfaction is the
tangible satisfaction derived.

A commodity has utility for a consumer even when it is not consumed. Utility is a
subjective and relative entity and varies from person to person. A commodity has
different levels of utility for the same person at different places or at different
points of time. It should be noted that utility is not the same thing as usefulness.
From the economic standpoint, even harmful things like liquor may be said to
have utility because people want them. Thus, in Economics, the concept of utility
is ethically neutral.
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 Utility hypothesis forms the basis of the theory of consumer behaviour. From time
to time, different theories have been advanced to explain consumer behaviour and
thus to explain consumer’s demand for the product. Two important theories are (i)
Marginal Utility Analysis propounded by Alfred Marshall, and (ii) Indifference
Curve Analysis propounded by J.R. Hicks and [Link].

THE MARGINAL UTILITY ANALYSIS

The marginal utility theory, formulated by Alfred Marshall, a British economist,
seeks to explain how a consumer chooses to spend his income on different goods
and services so as to maximize his utility. Marginal utility theory treats consumers
as striving to maximize utility which is a quantitative measure of the consumer’s
well-being or satisfaction. According to Marshall, utility is the numerical score in
terms of’utils’ representing the satisfaction that a consumer obtains from the
consumption of a particular good. (Utils refer to the hypothetical measuring unit
of utility).

This theory is based on certain assumptions. But before stating the assumptions,
let us understand the meaning of the terms total utility and marginal utility.

(a) Total utility: Assuming that utility is quantitatively measurable and additive,
total utility may be defined as the sum of utility derived from different units of
a commodity consumed by a consumer. Total utility is the sum of marginal
utilities derived from the consumption of different units i.e.
TU= MU1+MU2+.....+MUn
(b) Marginal utility: The marginal utility of a good or service is the change in
total utility generated by consuming one additional unit of that good or
service. In other words, it is the utility derived from the marginal or one
additional unit consumed or possessed by the individual.

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 Marginal utility = the addition made to the total utility by the addition of
consumption of one more unit of a commodity.

Symbolically,
MUn = TUn - TUn-1

Where,

MUn is the marginal utility of the nth unit,

TUn is the total utility of the n th unit, and

TUn-1 is the total utility of the (n-1)th unit.

Assumptions of Marginal Utility Analysis

The marginal utility analysis is stated with respect to certain conditions. It simply
means that this law has certain assumptions and without these, the law may not hold
true.

(1) Rationality: A consumer is rational and attempts to attain maximum satisfaction

from his limited money income.
(2) Cardinal Measurability of Utility: According to the neoclassical economists,
utility is a cardinal concept i.e., utility is a measurable and quantifiable entity. It
implies that utility can be measured in cardinal numbers and may be assigned a
cardinal number like 1, 2, 3 etc. Marshall and some other economists used a
psychological unit of measurement of utility called [Link], a person can say
that he derives utility equal to 10 utils from the consumption of 1 unit of
commodity A and 5 from the consumption of 1 unit of commodity B. Since a
consumer can quantitatively express his utility, he can easily compare different
commodities and express which commodity gives him greater utility and by how
much. Utilities from different units of the commodity can be added as well.
(3) According to this theory, money is the measuring rod of utility. The amount of
money which a person is prepared to pay for a unit of a good, rather than go
without it, is a measure of the utility which he derives from the good.
(4) The theory also assumes all the other factors ‘constant’ such as price of the
commodity, tastes and preferences, income, habits, temperament and fashion. If

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 any of these changes, the marginal utility may not decline and thus the law would
not hold true.
(5) The theory assumes continuity in consumption and that there is no time gap or
interval between consumption of different units.
(6) The different units of the commodity consumed are assumed to be homogeneous
or identical in nature. If the units show variation or differ in taste, quality or any
such similar aspects, then the law may not hold true. If successive units are of
superior quality, diminishing utility may not occur.
(7) The different units consumed should consist of standard units. For instance
spoonfuls of juice or spoonfuls of coffee are too small units and in such cases we
could consider the normal units as a glass of juice or a cup of coffee. Moreover,
the commodity which is consumed by the consumer should be divisible in nature.
(8) The assumption of constancy of the marginal utility of money holds that the
marginal utility of money remains constant throughout when the individual is
spending money on a good. This assumption, although not realistic, has been
made in order to facilitate the measurement of utility of commodities in terms of
money. If the marginal utility of money changes as income changes, the
measuring-rod of utility becomes unstable and therefore would be inappropriate
for measurement.
(9) The hypothesis of independent utility implies that the total utility which a person
gets from the whole collection of goods purchased by him is simply the sum total
of the separate utilities of the goods. The theory ignores complementarity between
goods.

The Law of Diminishing Marginal Utility

The law of diminishing marginal utility which states that each successive unit of a
good or service consumed adds less to total utility than the previous unit, is based on
an important fact that while total wants of a person are virtually unlimited, each single
want is satiable i.e., each want is capable of being satisfied. Since each want is
satiable, as a consumer consumes more and more units of a good, the intensity of his
want for the good goes on decreasing and a point is reached where the consumer no
longer wants it. Thus, the greater the amount of a good a consumer has, the less an
additional unit is worth to him or her.

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Marshall, who was the exponent of the marginal utility analysis, stated the law as
follows:

“The additional benefit which a person derives from a given increase in the stock of a
thing diminishes with every increase in the stock that he already has.”In other words,
‘as a consumer increases the consumption of any one commodity keeping constant the
consumption of all other commodities, the marginal utility of the variable commodity
must eventually decline”.

This law describes a very fundamental tendency of human nature. In simple words, it
says that as a consumer consumes more units of a good, the extra satisfaction that he
derives from an extra unit of a good goes on falling. It is to be noted that it is the
marginal utility and not the total utility which declines with the increase in the
consumption of a good.

We may illustrate the law with the help of an example. Consider Table 6, in which we
have presented the total utility and marginal utility derived by a person from
chocolate bars consumed per day keeping constant all other factors that affect utility.

Table 6 : Total and Marginal Utility Schedule

Quatity of chocolate bar Total Utility Marginal Utility

consumed per day

1 20 20

2 34 14

3 45 11

4 50 5

5 50 0

6 46 -4

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When one chocolate bar is consumed, the total utility derived by the person is 20 utils
(unit of utility) and the marginal utility derived is also 20 utils. With the consumption
of 2nd chocolate bar, the total utility rises to 34 and the corresponding marginal utility
[Link] the second chocolate bar the consumer enjoys greater total utility: but the
extra utility derived from the second is smaller than that he derived from the first.

We see that till the consumption of chocolate bars increases to 4, the marginal utility
from the additional chocolate bars goes on diminishing (i.e., the total utility goes on
increasing at a diminishing rate). The 5th chocolate bar adds no utility and therefore,
the total utility remains the same at 50. At this level of consumption, the consumer
reaches the ‘satiation’ point and gets no extra satisfaction or utility from consuming
more of it. Once this point of satiation is reached, the consumer would refuse any
extra unit of chocolate even if it were free.

However, if the chocolate bars consumed increases to 6, instead of giving positive

marginal utility, the sixth chocolate bar gives negative marginal utility or disutility
and it may cause him discomfort. We find that consuming the 6 th chocolate bar
actually reduces the consumer’s total utility from 50 to 46.

From the above table , we find that for every one-unit increment in chocolate
consumption, the marginal utility is equal to the change in total utility. Total utility
increases every time the consumer consumes more units of chocolate bar till he
reaches the point of satiation, but the additional utility he derives from each
successive chocolate bar gets smaller and smaller as he consumes more. Putting it
differently, the rate at which total utility increases gets smaller and smaller as
consumption increases.

we also find that there are some well defined relationships between total utility and
marginal utility.

(1) Total utility rises as long as MU is positive, but at a diminishing rate because MU
is diminishing

(2) Marginal utility diminishes throughout

(3) When marginal utility is zero, the total utility is maximum. It is the satiation point.

(4) When marginal utility is negative, total utility is diminishing

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 (5) MU is the rate of change of total utility or it is the slope of TU curve

(6) MU can be positive ,zero or negative

The information in Table 6 above can be graphically presented to show the relationship
between total utility and marginal utility

we see that there is a close relationship between the graph of total utility in panel (a) and the
corresponding graph of marginal utility in panel (b). Diminishing marginal utility is seen in
both panels of the figure 13; in panel (a), by the positive but decreasing slope (flattening out)
of the total utility curve and in panel (b), by the downward sloping marginal utility curve.

The marginal utility curve shows how marginal utility depends on the quantity of a good or
service consumed. As can be seen from the figure, the marginal utility curve goes on
declining throughout.

The principle of diminishing marginal utility is not always true. A few exceptions however,
have been pointed out by some economists. But it is true in large majority of cases, so that it
serves as a foundation for the analysis of consumer behaviour.

Limitations and Exceptions of the Law of Diminishing Marginal Utility

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In the consumption of most goods and services, and for most people, the principle of
diminishing marginal utility holds true. However, the law of diminishing marginal utility has
certain exceptions and is valid only under certain conditions.

(1) The law of diminishing marginal utility is based on rigorous assumptions such as
cardinal measurability of utility, constancy of marginal utility of money, continuous
consumption, homogeneity of units consumed. The law would operate only when these
unrealistic assumptions are met.

(2) Utility is not in fact independent. The shape of the utility curve may be affected by the
presence or absence of articles which are substitutes or complements. The utility obtained
from tea may be seriously affected if no sugar is available and the utility of bottled soft drinks
will be affected by the availability of fresh juice.

(3) The law is not universal. There are many instances where the marginal utility does not
fall or quite the opposite may increase with increase in consumption or stock obtained. Such
cases are considered as exceptions to this law. For example, the law may not apply in the
following situations

 The law may not apply in the case of prestigious goods and articles like gold, cash,
diamonds etc. where a greater quantity may increase the utility rather than diminish it.
 The law also may not hold well in the case of hobbies, rare collections etc where, with
every addition to the collection, the marginal utility will go on rising. Similarly,
people who seek greater knowledge and information will be more satisfied with every
additional information secured by them.
 The law may not be operating in cases such as creative art, painting, music, poetry etc
as more of these would generate greater satisfaction.
 The law also fails in the case of people with miserly behaviour as accumulation of
every additional unit of money would give them greater levels of satisfaction.

However, we should keep in mind that in all the above mentioned cases, the fundamental
assumptions necessary for the law to operate are not met and as such they are not exceptions
in the real sense.

Consumer Equilibrium

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The Law of diminishing marginal utility helps us to understand how a consumer reaches
equilibrium in case of a single good. It states that as the quantity of a good with the consumer
increases, marginal utility of the good decreases. In other words, the marginal utility curve is
downward sloping. A consumer will go on buying a good till the marginal utility of the good
becomes equal to the market price. In other words, the consumer will be in equilibrium (will
be deriving maximum satisfaction) in respect of the quantity of one good when marginal
utility of that good is equal to its price.

the consumer is in equilibrium at point E with OQ quantity of commodity. We find that at

point E, the marginal utility of the good for the consumer is equal to its [Link] MUx= Px.

INDIFFERENCE CURVE ANALYSIS

In the last section, we have discussed the marginal utility analysis of demand. A very popular
alternative and a more realistic method of explaining consumer demand is the ordinal utility
approach. This approach uses a different tool namely indifference curve to analyse consumer
behaviour and is based on consumer preferences. The approach is based on the belief that that
human satisfaction, being a psychological phenomenon, cannot be measured quantitatively in
monetary terms as was attempted in Marshall’s utility analysis. Therefore, it is scientifically
more sound to order preferences than to measure them in terms of money. The consumer
preference approach is, therefore, an ordinal concept based on ordering of preferences
compared with Marshall’s approach of cardinality.

Assumptions Underlying Indifference Curve Approach

(i) The foundation of consumer behaviour theory is the assumption that the consumer knows
his own tastes and preferences and possesses full information about all the relevant aspects of
economic environment in which he lives.
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(ii) The consumer is rational and tends to take rational actions that result in a more preferred
consumption bundle over a less preferred bundle.

(iii) The indifference curve analysis assumes that utility is only ordinally expressible. The
consumer is capable of ranking all conceivable combinations of goods according to the
satisfaction they yield. Thus, if he is given various combinations say A, B, C, D and E, he can
rank them as first preference, second preference and so on. However, if a consumer happens
to prefer A to B, he cannot tell quantitatively how much he prefers A to B.

(iv) Consumer choices are assumed to be transitive. If the consumer prefers combination A to
B, and B to C, then he must prefer combination A to C. In other words, he has a consistent
consumption pattern.

(iv) If combination A has more commodities than combination B, then A must be preferred
to B. This is sometimes referred to as the “more is better” assumption or the assumption of
non-satiation.

Indifference Curves

The ordinal analysis of demand (here we will discuss the one given by Hicks and Allen) is
based on indifference curve which represent the consumer’s preferences graphically. An
indifference curve is a curve which represents all those combinations of two goods which
give same satisfaction to the consumer. Since all the combinations on an indifference curve
give equal satisfaction to the consumer, the consumer is completely indifferent among them.
Or, it represents the set of all bundles of goods that a consumer views as being equally
desirable. In other words, since all the combinations provide the same level of satisfaction the
consumer prefers them equally and does not mind which combination he gets. An
Indifference curve is also called iso-utility curve or equal utility curve.

To understand indifference curves, let us consider the example of a consumer who has one
unit of food and 12 units of clothing. Now, we ask the consumer how many units of clothing
he is prepared to give up to get an additional unit of food, so that his level of satisfaction does
not change. Suppose the consumer says that he is ready to give up 6 units of clothing to get
an additional unit of food. We will have then two combinations of food and clothing giving
equal satisfaction to the consumer: Combination A which has 1 unit of food and 12 units of
clothing, and combination B which has 2 units of food and 6 units of clothing. Similarly, by

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asking the consumer further how much of clothing he will be prepared to forgo for successive
increments in his stock of food so that his level of satisfaction remains unaltered, we get
various combinations as given in table.

Indifference Schedule

Combination Food Clothing MRS

A 1 12 -
B 2 6 6
C 3 4 2
D 4 3 1
an indifference curve IC is drawn by plotting the various combinations given in the
indifference schedule. The quantity of food is measured on the X axis and the quantity of
clothing on the Y axis. As in indifference schedule, the combinations lying on an indifference
curve will give the consumer the same level of satisfaction.

Indifference Curve Map

The entire utility function of an individual can be represented by an indifference curve map
which is a collection of indifference curves in which each curve corresponds to a different

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level of satisfaction. In short, a set of indifference curves is called an indifference curve map.
Each indifference curve is a set of points and each point shares a common level of utility with
the others. Combinations of goods lying on indifference curves which are farther from the
origin are preferred to those on indifference curves which are closer to the origin. Moving
upward and to the right from one indifference curve to the next represents an increase in
utility, and moving down and to the left represents a decrease. An indifference curve map
thus depicts the complete picture of consumer tastes and preferences.

an indifference curve map of a consumer is shown which consists of three indifference

curves.

We have marked good X on X-axis and good Y on Y-axis. It should be noted that while the
consumer is indifferent among the combinations lying on the same indifference curve, he
certainly prefers the combinations on the higher indifference curve to the combinations lying
on a lower indifference curve because a higher indifference curve signifies a higher level of
satisfaction. Thus, while all combinations of IC1 give him the same satisfaction, all
combinations lying on IC2 give him greater satisfaction than those lying on IC1 .

Marginal Rate of Substitution

The Marginal Rate of Substitution (MRS) is the rate at which a consumer is prepared to
exchange goods X and Y, holding the level of satisfaction constant (i.e., moving along an
indifference curve).

The marginal rate of substitution along any segment of an indifference curve refers to the
maximum rate at which a consumer would willingly exchange units of Y for units of X. The

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MRS at any point on the indifference curve is equal to the (absolute value of) the slope of the
curve at that point. When measured at a point, the MRS xy tells us the maximum rate at
which a consumer would willingly trade good Y for a infinitesimal bit more of good X.

In the beginning the consumer is consuming 1 unit of food and 12 units of clothing.
Subsequently, he gives up 6 units of clothing to get an extra unit of food, his level of
satisfaction remaining the same. The MRS here is 6. Likewise when he moves from B to C
and from C to D in his indifference schedule, the MRS are 2 and 1 respectively. Thus, we can
define MRS of X for Y as the amount of Y whose loss can just be compensated by a unit gain
of X in such a manner that the level of satisfaction remains the same.

We notice that MRS is falling i.e., as the consumer has more and more units of food, the trade
–off or rate of substitution becomes smaller and smaller; i.e. he is prepared to give up less
and less units of clothing.( Refer figure 19). When a consumer moves down his indifference
curve, he gains utility from the consumption of additional units of good X, but loses an equal
amount of utility due to reduced consumption of Y. But at each step, the utility levels from
which the consumer begins is different. At point A in figure 19, the consumer consumes only
a small quantity of food; and therefore his marginal utility of food at that point is high. At A,
then, an additional unit of food adds a lot to his total utility. But at A he already consumes a
large quantity of clothing; his marginal utility of clothing at that point is low. This means that
it takes a large reduction in the quantity of clothing consumed to counterbalance the increased
utility he gets from the extra unit of food.

On the contrary, consider point C. we find that the consumer consumes a much larger
quantity of food and a much smaller quantity of clothing than at point A. This means that an
additional unit of food adds only lesser utility, and a unit of clothing forgone costs more
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utility, than at point A. So the consumer is willing to give up less units of clothing in return
for another unit of food at C(he gives up only 2 units of clothing for 1unit of food, whereas he
gives up 6 units of clothing at point A for one unit of food)

Moving down the indifference curve—reducing consumption of clothing and increasing food
consumption—will produce two opposing effects on the consumer’s total utility: reduction in
total utility due to reduced consumption of clothing, and increase in total utility due to higher
food consumption. In order to keep the levels of satisfaction constant, these two effects must
exactly cancel out as the consumer moves down the indifference curve. The principle of
diminishing marginal rate of substitution thus states that the more of good Y a person
consumes in proportion to good X, the less Y he or she is willing to substitute for another unit
of X.

There are two reasons for this.

1. The want for a particular good is satiable so that when a consumer has more of it, his
intensity of want for it decreases. Thus, in our example, when the consumer has more units of
food, his intensity of desire for additional units of food decreases.

2. Most goods are imperfect substitutes of one another. MRS would remain constant if they
could substitute one another perfectly.

We know that along the indifference curve:

(Change in total utility due to lower clothing consumption) = (Change in total utility due to
higher food consumption)

Change in total utility due to a change in clothing consumption = MU c × ΔQ c

Change in total utility due to a change in food consumption = MUf × ΔQf

Therefore, along the indifference curve:−MUc × ΔQc = MUf × ΔQ

Note that the left-hand side of the equation has a minus sign as it represents the loss in total
utility from decreased clothing consumption. This must equal the gain in total utility from
increased food consumption, represented by the right-hand side of the equation. Along the
indifference curve:

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To generalize, the marginal rate of substitution of X for Y (MRSxy) is the slope of the
indifference curve.

Properties of Indifference Curves

The following are the main characteristics or properties of indifference curves:

(i) Indifference curves slope downward to the right: This property implies that the
two commodities can be substituted for each other and when the amount of one
good in the combination is increased, the amount of the other good is reduced.
This is essential if the level of satisfaction is to remain the same on an indifference
curve.
(ii) Indifference curves are always convex to the origin :It has been observed that as
more and more of one commodity (X) is substituted for another (Y), the consumer
is willing to part with less and less of the commodity being substituted (i.e. Y).
This is called diminishing marginal rate of substitution. Thus, in our example of
food and clothing, as a consumer has more and more units of food, he is prepared
to forego less and less units of clothing. This happens mainly because the want for
a particular good is satiable and as a person has more and more of a good, his
intensity of want for that good goes on diminishing. In other words, the subjective
value attached to the additional quantity of a commodity decreases fast in relation
to the other commodity whose total quantity is decreasing. This diminishing
marginal rate of substitution gives convex shape to the indifference curves.
However, there are two extreme situations.

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 (1) When two goods are perfect substitutes of each other, the consumer is
completely indifferent as to which to consume and is willing to exchange one
unit of X for one unit of Y. His indifference curves for these two goods are
therefore straight, parallel lines with a constant slope along the curve, or the
indifference curve has a constant MRS.
(2) Goods are perfect complements when a consumer is interested in consuming
these only in fixed proportions. When two goods are perfect complementary
goods (e.g. left shoe and right shoe), the consumer consumes only bundles like
A and B in figure 20(B) in which both X and Y in equal proportions. With a
bundle like A or B, he will not substitute X for Y because an extra piece of the
other good (here a single shoe) is worthless for him. The reason is that neither
an additional left shoe nor a right shoe without a paired one of each, adds to
his total utility. In such a case, the indifference curve will consist of two
straight lines with a right angle bent which is convex to the origin, or in other
words, it will be L shaped. Avery interesting fact about this is that in the case
of perfect complements, the marginal rate of substitution is undefined because
an individual’s preferences do not allow any substitution between goods.

(iii) Indifference curves can never intersect each other: No two indifference curves
will intersect each other although it is not necessary that they are parallel to each
other. In case of intersection the relationship becomes logically absurd because it
would show that higher and lower levels are equal, which is not possible.

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 In figure21, IC1 and IC2 intersect at A. Since A and B lie on IC1 , they give same
satisfaction to the consumer. Similarly since A and C lie on IC2 , they give same
satisfaction to the consumer. This implies that combination B and C are equal in
terms of satisfaction. But a glance will show that this is an absurd conclusion
because certainly combination C is better than combination B because it contains
more units of commodities X and Y. Thus we see that no two indifference curves
can touch or cut each other.
(iv) A higher indifference curve represents a higher level of satisfaction than the
lower indifference curve: This is because combinations lying on a higher
indifference curve contain more of either one or both goods and more goods are
preferred to less of them.
(v) Indifference curve will not touch either axes :Another characteristic feature of
indifference curve is that it will not touch the X axis or Y axis. This is born out of
our assumption that the consumer is considering different combination of two
commodities. If an indifference curve touches the Y axis at a point P as shown in
the figure 22, it means that the consumer is satisfied with OP units of Y
commodity and zero units of X commodity. This is contrary to our assumption
that the consumer wants both commodities although in smaller or larger
quantities. Therefore an indifference curve will not touch either the X axis or Y
axis.

The Budget Line

From the ordinal utility analysis discussed above, we have understood one part of a
person’s consumption behavior namely, consumer preference. A higher indifference
curve shows a higher level of satisfaction than a lower one. Therefore, a consumer, in his
attempt to maximise satisfaction will try to reach the highest possible indifference curve.
But in his pursuit of buying more and more goods and thus obtaining more and more

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satisfaction, he has to work under two constraints: first, he has to pay the prices for the
goods and, second, he has a limited money income with which to purchase the goods.

Consumers maximize their well-being subject to constraints. The most important

constraint all of us face in deciding what to consume is the budget constraint. In other
words, consumers almost always have limited income, which constrains how much they
can consume. A consumer’s choices are limited by the budget available to him. As we
know, his total expenditure for goods and services can fall short of the budget constraint,
but may not exceed it

Consumption Possibilities

Ice Cream Chocolate

A 0 10
B 1 8
C 2 6
D 3 4
E 4 2
F 5 0

The budget constraint can be explained by the budget line or price line. In simple words, a
budget line shows all those combinations of two goods which the consumer can buy
spending his given money income on the two goods at their given prices. All those
combinations which are within the reach of the consumer (assuming that he spends all his
money income) will lie on the budget line. The consumer could, of course, buy any
bundle that cost less than Rs 100.(e.g. Point K )

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 It should be noted that any point outside the given price line, say H, will be beyond the
reach of the consumer and any combination lying within the line, say K, shows under
spending by the consumer.

The slope of the budget line is determined by the relative prices of the two goods. It is
equal to ‘Price Ratio’ of two goods. i.e. PX /PY i.e. It measures the rate at which the
consumer can trade one good for the other .

The budget line will shift when there is:

 A change in the prices of one or both products with the nominal income of the
buyer (budget) remaining the same.
 A change in the prices of one or both products with the nominal income of the
buyer (budget) remaining the same.
 A change in both income and relative prices.

Consumer Equilibrium

Having explained indifference curves and budget line, we are in a position to explain how a
consumer reaches equilibrium position by choosing his optimal consumption bundle, given
the constraints. A consumer is in equilibrium when he is deriving maximum possible
satisfaction from the goods and therefore is in no position to rearrange his purchases of
goods. We assume that:

(i) The consumer has a given indifference map which shows his scale of preferences
for various combinations of two goods X and Y.
(ii) He has a fixed money income which he has to spend wholly on goods X and Y.

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(iii) Prices of goods X and Y are given and are fixed.
(iv) All goods are homogeneous and divisible, and
(v) The consumer acts ‘rationally’ and maximizes his satisfaction.

To show which combination of two goods X and Y the consumer will buy to be in
equilibrium we bring his indifference map and budget line together.

We know by now, that the indifference map depicts the consumer’s preference scale
between various combinations of two goods and the budget line shows various
combinations which he can afford to buy with his given money income and prices of the
two goods. Consider Figure 24, in which IC1 , IC2 , IC3 , IC4 and IC5 are shown
together with budget line PL for good X and good Y. Every combination on the budget
line PL costs the same. Thus combinations R, S, Q, T and H cost the same to the
consumer. The consumer’s aim is to maximise his satisfaction and for this, he will try to
reach the highest indifference curve.

Since there is a budget constraint, he will be forced to remain on the given budget line,
that is he will have to choose combinations from among only those which lie on the given
price line. Which combination will our hypothetical consumer choose? A consumer’s
optimal choice should satisfy two criteria:

1. It will be a point on his budget line; and

2. It will lie on the highest indifference curve possible

The consumer can arrive this choice moving down his budget line starting from point R
.While doing this, he will pass through a variety of indifference curves (To make the

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diagram simple, we have drawn only a few). Suppose he chooses R. We see that R lies on
a lower indifference curve IC1 , when he can very well afford S, Q or T lying on higher
indifference curves. Similar is the case for other combinations on IC1 , like H. Again,
suppose he chooses combination S (or T) lying on IC2 . But here again we see that the
consumer can still reach a higher level of satisfaction remaining within his budget
constraints i.e., he can afford to have combination Q lying on IC3 because it lies on his
budget line. Now, what if he chooses combination Q? We find that this is the best choice
because this combination lies not only on his budget line but also puts him on the highest
possible indifference curve i.e., IC3 . The consumer can very well wish to reach IC4 or
IC5 , but these indifference curves are beyond his reach given his money income. Thus,
the consumer will be at equilibrium at point Q on IC3 . What do we notice at point Q? We
notice that at this point, his budget line PL is tangent to the indifference curve IC3 . In
this equilibrium position (at Q), the consumer will buy OM of X and ON of Y.

At the tangency point Q, the slopes of the price line PL and the indifference curve IC3 are
equal. The slope of the indifference curve shows the marginal rate of substitution of X for
Y (MRSxy) which is equal to Mux/ MUy while the slope of the price line indicates the
ratio between the prices of two goods i.e., Px/Py.

At equilibrium point Q,

Thus, we can say that the consumer is in equilibrium position when the price line is
tangent to the indifference curve or when the marginal rate of substitution of goods X and
Y is equal to the ratio between the prices of the two goods.

We have seen that the consumer attains equilibrium at the point where the budget line is
tangent to the indifference curve and

In fact the slope of the indifference curve points to the rate at which the consumer is
willing to give up good Y for good X. The slope of the budget line tells us the rate at

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which the consumer is actually able to trade good X and good Y. When both these are
equal, he will be maximizing his satisfaction given the constraints.

The indifference curve analysis is superior to utility analysis:

(i) it dispenses with the assumption of measurability of utility

(ii) it studies more than one commodity at a time
(iii) it does not assume constancy of marginal utility of money
(iv) it segregates income effect from substitution effect.

Reference :

[Link]

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