SECTION C - GENERAL ECONOMICS - CHAPTER 2

CCCCCHHHHHAAAAAPPPPPTTTTTEEEEERRRRR ––––– 22222 THEORY OF DEMAND AND SUPPLY Unit 1 Law of Demand and Elasticity of Demand Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY Learning Objectives At the end of this unit, you will be able to : (cid:2) understand the meaning of demand. (cid:2) understand what determines demand. (cid:2) get an insight into the law of demand. (cid:2) understand the difference between movement in the demand curve and shift of the demand curve. (cid:2) know various types of elasticity of demand. Have you ever wondered why diamonds are very expensive although basically inessential, while water is important but cheap? Or why does land in Delhi or Mumbai command very high prices, while desert land in Rajasthan is virtually worthless? The answers to these and a thousand other questions can be found in the theory of demand and supply. This theory shows how consumer preferences determine consumer demand for commodities while business costs determine the supply of commodities. We shall take up the topic of demand in this Unit while supply will be discussed in Unit-3. 1.0 MEANING OF DEMAND The concept ‘demand’ refers to the quantity of a good or service that consumers are willing and able to purchase at various prices during a period of time. It is to be noted that demand in Economics is something more than desire to purchase though desire is one element of it. A beggar, for instance, may desire food, but due to lack of means to purchase it, his demand is not effective. Thus effective demand for a thing depends on (i) desire (ii) means to purchase and (iii) on willingness to use those means for that purchase. Unless demand is backed by purchasing power or ability to pay, it does not constitute demand. Two things are to be noted about quantity demanded. One is that quantity demanded is always expressed at a given price. At different prices different quantities of a commodity are generally demanded. The second thing is that 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 – one thousand dozens oranges per day, seven thousand dozen 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 in a given period of time, at various prices, or at various incomes, or at various prices of related goods”. 1.1 WHAT DETERMINES DEMAND? There are a number of factors which influence household demand for a commodity. Important among these are : (i) Price of the commodity : Ceteris paribus i.e. other things being equal, the demand of a commodity is inversely related to its price. It implies that a rise in price of a commodity 3 8 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India brings about a fall in its purchase and vice-versa. This happens because of income and substitution effects. (ii) Price of related commodities : Related commodities are of two types : (a) complementary goods and (ii) competing goods or substitutes. Complementary goods are those goods which are consumed together or simultaneously. For example, tea and sugar, automobiles and petrol, pen and ink are used together. When commodities are complements, a fall in the price of one (other things being equal) will cause the demand of the other to rise. For example, a fall in the price of cars would lead to a rise in the demand for petrol. Similarly, a fall in the price of pens, will cause a rise in the demand for ink. The reverse will be the case when the price of a complement rises. Competing goods or substitutes are those goods which can be used with ease in place of one another. For example, tea and coffee, ink pen and ball pen, are substitutes for each other and can be used in place of, one another easily. When goods are substitutes, a fall in the price of one (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 fall. (iii) Level of income of the household : Other things being equal, the demand for a commodity depends upon the money income of the household. In most cases, the larger the average money income of the household, the larger is the quantity demanded of a particular good. However, there are certain commodities for which quantities demanded decrease with an increase in money income. These goods are called inferior goods. Even in the case of other goods, the response of quantities demanded to changes in their prices is not of same proportions. If goods are such that they satisfy the basic necessities (food, clothing, shelter) of life, a change in their prices although will cause an increase in demand for these necessities 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 importance of food and other non durable goods in the over all consumption pattern and a rise in importance of durable goods such as a TV, car, house etc. (iv) Tastes and preferences of consumers : The demand for a commodity also depends upon tastes and preferences of consumers and changes in them over a period of time. Goods which are more in fashion command higher demand than goods which are out of fashion. Consumers may even discard a good even before it is fully utilised and prefer another good which is in fashion. For example, there is a greater demand for coloured television and more and more people are discarding their black and white television even though they could have still used it for some more years. ‘Demonstration effect’ plays an important role in affecting the demand for a product. An individual’s demand for colour television may be affected by his seeing one in neighbour’s or friend’s house, either because he likes what he sees or because he figures out that if his neighbour or friend can afford it, he too can. A person may develop a taste or preference for wine after tasting some, but he may also develop it after discovering that serving it enhances his prestige. In any case, people have tastes and preferences and these change, sometimes due to external and sometimes due to internal causes. GENERAL ECONOMICS 3 9 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY (v) 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, greater is the demand for commodities in general. (b) Composition of population : If there are more old people in a region, the demand for spectacles, walking sticks, etc. will be high. Similarly, if the population consists of more of children, demand for toys, baby foods, toffees, will be more. (c) Distribution of income : The wealth of a country may be so distributed that there are a few very rich people while the majority are very poor. Under such conditions the propensity to consume of the country will be relatively less, for 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. Apart from above, factors such as class, group, education, marital status, consumer’s expectations with regard to future price and weather conditions, also play an important role in influencing household demand. 1.2 LAW OF DEMAND The law of demand is one of the most important laws of economic theory. According to law of demand, other things being equal, if the price of a commodity falls, the quantity demanded of it will rise and if the price of a commodity rises, its quantity demanded will decline. Thus, there is an inverse relationship between price and quantity demanded, other things being same. 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 such other factors which influence demand. 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 law of demand may be illustrated with the help of a demand schedule and a demand curve. 1.2.0 Demand Schedule : To illustrate the relation between the quantity of a commodity demanded and its price, we may take hypothetical data for prices and quantities of a commodity X. 4 0 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Table 1 : Demand schedule of an individual consumer Price Quantity demanded (Rs.) (Units) A 5 10 B 4 15 C 3 20 D 2 35 E 1 60 When price of commodity X is Rs. 5 per unit, a consumer purchases 10 units of the commodity. When the price falls to Rs. 4, he purchases 15 units of the commodity. Similarly, when the price further falls, quantity demanded by him goes on rising until at price Re. 1, the quantity demanded by him rises to 60 units. The above table depicts an inverse relationship between price and quantity demanded as the price of the commodity X goes on rising, its demand goes on falling. Demand curve : We can now plot the data from Table 1 on a graph with price on the vertical axis and quantity on the horizontal axis. In Fig. 1, we have shown such a graph and plotted the five points corresponding to each price-quantity combination shown in Table 1. Point A, shows the same information as the first row of Table 1, that at Rs. 5 per unit, only 10 units of X will be demanded. Point E shows the same information as does the last row of the table, when the price is Re. 1, the quantity demanded will be 60 units. Fig. 1 : Demand Curve We now draw a smooth curve through these points. The curve is called the demand curve for commodity ‘X’. The curve shows the quantity of ‘X’ that a consumer would like to buy at a each price; its downward slope indicates that the quantity of ‘X’ demanded increases as its GENERAL ECONOMICS 4 1 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY price falls. Thus the downward sloping demand curve is in accordance with the law of demand which as stated above, describes an inverse price-demand relationship. 1.2.1 Market Demand Schedule : When we add up the various quantities demanded by the number of consumers in the market we can obtain the market demand schedule. How the summation is done is illustrated in Table 2. Suppose there are three individual buyers of the goods in the market. The Table 2 shows their individual demands at various prices. Table 2 : Market Demand Schedule Quantity demanded by Price (Rs.) P Q R Total market demand 5 10 8 12 30 4 15 12 18 45 3 20 17 23 60 2 35 25 40 100 1 60 35 45 140 When we add quantities demanded at each price by consumers P, Q, R we get total market demand. Thus when price is Rs. 5 per unit, the demand for commodity ‘X’ in the market is 30 units (i.e. 10+8+12). When price falls to Rs. 4, market demand is 45 units. At Re. 1, 140 units are demanded in the market. The market demand schedule also indicates inverse relationship between price and quantity demanded of ‘X’. Fig. 2 : Market Demand Curve Market Demand Curve : If we plot market demand schedule on a graph we get market demand curve. Figure 2 shows market demand curve for commodity ‘X’. The market demand curve, like individual demand curve, slopes downwards to the right because it is nothing but lateral summation of individual demand curves. Besides, as the price of the good falls, it is very likely that new buyers will enter the market which will further raise the quantity demanded of the goods. 4 2 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India 1.2.2 Rationale for the Law of Demand : Why does demand curve slope downwards? (1) When the price of a commodity falls, it becomes relatively cheaper than other commodities. It induces consumers to substitute the commodity whose price has fallen for other commodities which have now become relatively expensive. The result is that total demand for the commodity whose price has fallen increases. This is called substitution effect. (2) When the price of a commodity falls, the consumer can buy the same quantity of the commodity with lesser money or he can buy more of the same commodity with the same money. In other words, as a result of fall in the price of the commodity, consumer’s real income or purchasing power increases. This increase in the real income induces him to buy more of that commodity. Thus, demand for that commodity (whose price has fallen) increases. This is called income effect. (3) When the price of a commodity falls, more consumers start buying it because some of those who could not afford to buy it previously may now afford 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. 1.2.3 Exceptions to the Law of Demand : According to the law of demand, more of a commodity will be demanded at lower prices than at higher prices, other things being equal. The law of demand is valid in most of the cases; 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 demanded only by the rich people and these articles become more attractive if their prices go up. Such articles will not conform to the usual law of demand. 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 example of this case. Higher the price of diamonds, higher is the prestige value attached to them and hence higher is the demand for them. (ii) Giffen goods : Sir Robert Giffen, an economist, 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 considered inferior by the consumers and which occupy a substantial place in consumer’s budget are called ‘Giffen goods’. Examples of such goods are coarse grains like bajra, low quality of 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 GENERAL ECONOMICS 4 3 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY goods, due to their constant usage, have become necessities of life. For example, in spite of the fact that the prices of television sets, refrigerators, coolers, cooking gas etc. have been continuously rising, their demand does not show any tendency to fall. (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 still higher, tend to buy larger quantities of the commodities. For example, when there is wide-spread drought, people expect that prices of foodgrains would rise in future. They demand greater quantities of foodgrains as their price rise. But it is to be noted that here it is not the law of demand which is invalidated but 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) The law has been derived assuming consumers to be rational and knowledgeable about market-conditions. However, at times consumers tend to be irrational and make impulsive purchases without any cool calculations about 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. 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. (vii)Speculative goods: In the speculative market, particularly in stock and shares, more will be demanded when the prices are rising and less will be demanded when the price declines. 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 prices of the related commodities or in tastes and fashion etc. the inverse demand and price relation may not hold good. 1.3 EXPANSION AND CONTRACTION IN DEMAND 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, quantity demanded decreases we say that there is contraction of demand. For example, suppose the price of apples at any time is Rs. 10 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 same but the price of apples falls to Rs. 8 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. 15 per kilogram and consumer buys only half a kilogram, we say that there is a contraction of demand. The phenomena of expansion and contraction in demand are shown in Figure 3. The figure shows that when price is OP quantity demanded is OM, given other things equal. If as a result of increase in price (OP”), the quantity demanded falls to OL we say there is ‘a fall in quantity 4 4 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India demanded’ or ‘contraction of demand’ or ‘an upward movement along the same curve’. Similarly, as a result of fall in price to OP’ the quantity demanded rises to ON, we say that there is ‘expansion of demand’ or ‘a rise in quantity demanded’ or ‘a downward movement on the same demand curve.’ Fig. 3 : Expansion and Contraction in Demand 1.4 INCREASE AND DECREASE IN DEMAND Till now we have assumed that other determinants remain constant when we are analysing demand for a commodity. It should be noted that expansion and contraction in 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. These other factors remaining constant means that the position of the demand curve remains the same and the consumer moves downwards or upwards on it.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? Let us consider the demand for commodity X : Table 3 shows for our example of commodity X, the possible effect of an increase in income of the consumer. Table 3 : Two demand schedules for commodity X Price Quantity of ‘X’ demanded when Quantity of ‘X’ demanded when (Rs.) average household income is average household income is Rs. 4,000 per month Rs. 5,000 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 GENERAL ECONOMICS 4 5 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY Fig. 4 : Figure showing two demand curves with different incomes These new data are plotted in Figure 4 as demand curve D’D’ along with the original demand curve DD. We say that the demand curve for X has shifted [in this case it has shifted to 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. 4,000 per month. When the average household income rises to Rs. 5,000 per month, 20 units of X are demanded at price Rs. 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. Fig. 5(a) : Rightward shift in the Fig. 5(b) : Leftward shift in the demand Curve demand curve. 4 6 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India (i) A rightward shift in the demand curve : (when more is demanded at each price) can be caused by a rise in income, a rise in the price of a substitute, a fall in the price of a complement, a change in tastes in favour of this commodity, an increase in population, and a redistribution of income to groups who favor this commodity. (ii) A leftward shift in the demand curve : (when less is demanded at each price) can be caused by a fall in income, a fall in the price of a substitute, a rise in the price of a complement, a change in tastes against this commodity, a decrease in population, and a redistribution of income away from groups who favour this commodity. 1.5 MOVEMENTS ALONG DEMAND CURVE VS. SHIFT OF CURVE It is important in Economics to make a 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 economist speaks 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 price of the commodity. 1.6 ELASTICITY OF DEMAND Till now we were concerned with the direction of the changes in prices and quantities demanded. Now we will try to measure these changes or to say we will try to answer the question “by how much”? Consider the following situations : (1) As a result of a fall in the price of radio from Rs. 500 to Rs. 400, the quantity demanded increases from 100 radios to 150 radios. (2) As a result of fall in the price of wheat from Rs. 10 per kilogram to Rs. 9 per kilogram the demand increases from 500 kilograms to 520 kilograms. (3) As a result of fall in the price of salt from Rs. 3 per kilogram to Rs. 2.50, the quantity demanded increases from 1000 kilogram to 1005 kilograms. What do you notice? You notice that as a result of fall in the price of radios, the demand for radios increases. But same is the case with wheat and salt. Thus we can say that demand for the radios, wheat and salt all respond to price changes. Then where is the difference? The GENERAL ECONOMICS 4 7 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY difference lies in the degree of response of demand which can be found out by comparing percentage changes in prices and quantities demanded. Here lies the concept of elasticity. Definition : 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 or we can say that it is the percentage change in quantity demanded divided by the percentage in one of the variables on which demand depends. These variables are price of the commodity, prices of the related commodities, income of the consumers and other various factors on which demand depends. Thus we have price elasticity, cross elasticity, elasticity of substitution and income elasticity. It is to be noted that when we talk of elasticity of demand, unless and until otherwise mentioned, we talk of price elasticity of demand. In other words, it is price elasticity of demand which is usually referred to as elasticity of demand. 1.6.0 Price Elasticity : Price elasticity of demand expresses the response 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 percentage change in quantity demanded divided by the percentage change in price, other things remaining equal. That is %changeinquantitydemanded = = Price Elasticity Ep %changeinPrice Or Changeinquantity x 100 OriginalQuantity ChangeinQuantity OriginalPrice = = Ep OR Ep x Changeinprice OriginalQuantity ChangeinPrice x 100 OriginalPrice Or in symbolic terms Δ Δ q p q p = = Ep x x Δ Δ q p p q Where Ep stands for price elasticity q stands for quantity p stands for price Δ stands for a very small change. Strictly speaking the value of price elasticity varies from minus infinitity to approach zero from Δ q the negative sign, because Δ has a negative sign. In other words, since price and quantity are p inversely related (with a few exceptions) price elasticity is negative. But for the sake of convenience, we ignore the negative sign and consider only the numerical value of the elasticity. 4 8 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India 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 A. Had we considered minus signs, we would have concluded that A is more elastic than B, which is not correct. Hence by convention we take absolute value of price elasticity and draw conclusions. A numerical example for the price elasticity of demand: The price of a commodity decreases from Rs.6 to Rs. 4 and quantity demanded for good increases from 10 units to 15 units. Find the coefficient of price elasticity. Solution : Point elasicity = (cid:2) (cid:2) (-) q / p × p/q = 5/2 × 6/10 = (-) 1.5 Point elasticity : In point elasticity, we measure elasticity at a given point on a demand curve. Point elasticity makes use of derivative rather than finite changes in price and quantity. It may be defined as : − dq p x dp q dq where is the derivative of quantity with respect to price at a point on the demand curve, dp and p and q are the price and quantity at that point. It is to be noted that elasticity is different at different points on the same demand curve. Given a straight line demand curve tT, point elasticity at any point say R can be found by using formula RT lowersegment = Rt uppersegment Fig. 6 : Elasticity at a point on the demand curve Using the above formula we can get elasticity at various points on the demand curve. GENERAL ECONOMICS 4 9 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY Y A P 1 arc elasticity B P 2 D Q X Q 1 Q 2 Quantity demanded Fig.: 6(a) : Elasticity at different Fig. 7 : Arc Elasticity points on the demand curve 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 t it is infinity and at T it is zero. Arc-elasticity : When the price change is some what larger or when price elasticity is to be found between the two prices [or two points on the demand curve say A and B in figure 7], the question arise 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, generally averages of the two prices and quantities are taken as (i.e. original and new) base. The arc elasticity can be found out by using the formula : − + q q p p Ep = 1 2 x 1 2 + − q q p p 1 2 1 2 where p , q are the original price and quantity and p , q are the new ones. 1 1 2 2 Thus if we have to find elasticity of radios between : p = Rs. 500 q = 100 1 1 p = Rs. 400 q = 150 2 2 We will use the formula + q - q p p Ep = 1 2 x 1 2 + − q q p p 1 2 1 2 50 900 = = or Ep x or Ep 1.8 250 100 Interpreting numerical values of elasticity of demand The numerical value of elasticity of demand can assume any value between zero and infinity. Elasticity is zero, if there is no change at all in quantity demanded when price changes i.e. when quantity demanded does not respond to a price change. 5 0 COMMON PROFICIENCY TEST ecirP Copyright -The Institute of Chartered Accountants of India Elasticity is one, or unitary, if the percentage change in quantity demanded is equal to the percentage change in price. Elasticity is greater than one 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. Elasticity is less than one 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. Elasticity is infinite, when some ‘small price reduction raises the demand from zero to infinity. Under such a case consumers will buy all that they can obtain of the commodity at some price. If there is a slight increase in price, they would not buy anything from the particular seller. This type of demand curve is found in perfectly competitive market Fig. 8 : Demand curve of zero, unitary, and infinite elasticity Table 4 : Elasticity measures, meaning and nomenclature Numerical measure of elasticity Verbal description Terminology Zero Quantity demanded does not Perfectly (or change as price changes completely) inelastic Greater than zero, but less Quantity demanded changes by a Inelastic than one smaller percentage than does price One Quantity demanded changes by Unit elasticity exactly the same percentage as does price Greater than one, Quantity demanded changes by Elastic but less than infinity a larger percentage than does price Infinity Purchasers are prepared to buy all Perfectly (or they can obtain at some price and infinitely) elastic none at all at an even slightly higher price GENERAL ECONOMICS 5 1 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY Now that we are able to classify goods according to their price elasticity, let us see whether the goods which we considered in our example on page 39, are price elastic or inelastic. Sl. No. Name of the Commodity Calculation of Elasticity Nature of Elasticity − + (q q ) (p p ) 1 2 x 1 2 + − (q q ) (p p ) 1 2 1 2 − + 100 150 500 400 x 1. Radios + − Elastic 100 150 500 400 = 1.8 > 1 − + 500 520 10 9 x 2. Wheat + − Inelastic 500 520 10 9 = 0.37< 1 − + 1000 1005 3 2.50 x 3. Common Salt + − Inelastic 1000 1005 3 2.50 = 0.000014 < 1 What do we note in the above hypothetical example? We note that demand for radios is quite elastic, while demand for wheat is quite inelastic and demand for salt is almost same even after a reduction in price. Generally, in real world situation also, we find that demand for goods like radios, TVs, refrigerators, fans, etc. is elastic, demand for goods like wheat and rice is inelastic, and demand for salt is highly inelastic or perfectly inelastic. Why do we find such a difference in the behaviour of consumers vis-a-vis different commodities? We shall explain later at length those factors which are responsible for the differences in elasticity of demand of various goods. First we will consider another method of calculating price-elasticity which is called total outlay method. 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 greatly related to each other. By analysing the changes in total expenditure or outlay we can know the price elasticity of demand for the good. However, it should be noted that by this method we can only say whether a good is elastic or inelastic; we can not find out the exact coefficient of elasticity. When as a result of the change in price of a good, the total expenditure on the good remains the same, the price elasticity for the good is equal to unity. This is because 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 100% increase in price of a good and if the price elasticity is unitary, total expenditure of the buyer on the good will remain unchanged. When as a result of increase in price of a good, total expenditure made on the good falls or when as a result of decrease in price, the total expenditure made on the good increases, we say 5 2 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India that price elasticity of demand is greater than unity. In our example of radios, as a result of fall in price of radios from Rs. 500 to Rs. 400, the total expenditure on radios increases from Rs. 50,000 (500 x 100) to Rs. 60,000 (400 x 150), indicating elastic demand for radios. Similarly, had the price of radios increased from Rs. 400 to Rs. 500, the demand would have fallen from 150 radios to 100 radios indicating a fall in the total outlay from Rs. 60,000 to Rs. 50,000 and showing elastic demand for radios. When as a result of increase in price of a good, the total expenditure made on the good increases or when as a result of decrease in price, the total expenditure made on the good falls, we say that price elasticity of demand is less than unity. In our example of wheat, as a result of fall in price of wheat from Rs. 10 per kg. to Rs. 9 per kg., the total outlay or expenditure falls from 5,000 (10 x 500) to Rs. 4,680 (9 x 520) indicating inelastic demand for wheat. Similarly we can show that as a result of increase in price of wheat from Rs. 9 to Rs. 10 per kg. the total outlay increase from Rs. 4,680 to Rs. 5,000 indicating inelastic demand for wheat. Determinants of Price Elasticity of Demand : In the above Section we have explained what is price elasticity and how it is measured. Now an important question is : what are the factors which determine whether the demand for a good is elastic or inelastic? We will consider the following important determinants of price elasticity. (1) Availability of substitutes : One of the most important determinants of elasticity is the degree of availability of close substitutes. Some commodities like butter, cabbage, Maruti, Coca Cola, have close substitutes – margarine, other green vegetables, Santro or other cars, Pepsi or any other cold drink. A change in 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. Other 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. 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 demand for petrol is 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 for a nurse. Likewise, the demand for common salt is inelastic because good substitutes for common salt are not available. (2) Position of a commodity in a consumer’s budget : The greater the proportion of income spent on a commodity, the greater will be generally its elasticity of demand and vice- versa. The demand for goods like common salt, matches, buttons, etc. tend to be highly inelastic because a households spend only a fraction of their income on each of them. On the other hand, demand for goods like clothing, tends to be elastic since households generally spend a good part of their income on clothing. (3) Nature of the need that a commodity satisfies : In general, luxury goods are price elastic while necessities are price inelastic. Thus while the demand for television is relatively elastic the demand for food and housing, in general, is inelastic. GENERAL ECONOMICS 5 3 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY (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. 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) The period : The longer the time-period one has, the more completely one can adjust. A homely 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. Hence one’s demand for petrol falls by more when one has made long term adjustment to higher prices. (6) Consumer habits : If a consumer is a habitual consumer of a commodity no matter how much its price change, the demand for the commodity will be inelastic. (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. (8) Price range : Goods which are in very high range or in very low price range have inelastic demand but those in the middle range have elastic demand. 1.6.1 Income Elasticity of Demand : Income elasticity of demand is the degree of responsiveness of quantity demanded of a goods to a small change in the income of consumers. In symbolic form, Percentagechangeinquantitydemanded = E i Percentagechangeonincome There is a useful relationship between income elasticity for a goods and 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 goods remains the same as income increases, then income elasticity for the goods is equal to one. 2. If the proportion of income spent on a goods increases as income increases, then the income elasticity for the goods is greater than one. 3. If the proportion of income spent on a goods decreases as income rises, then income elasticity for the goods is less than one. 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 quantity demanded of the goods 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 quantity demanded of the goods. This happens in case of most of the goods and such goods are called normal goods. On the other hand, goods having negative income elasticity are known as inferior goods and their demand falls as income increases. Another significant value of income elasticity is that of unity. When income elasticity of demand is equal to one, then 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 5 4 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India a goods is greater than one it shows the goods 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 goods is relatively less important in consumer’s eye and, therefore, is called 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%. (e) The income of a household rises by 5%, the demand for buttons does not change at all. Using formula for income elasticity, Percentagechangeinquantitydemanded i.e. E = i Percentagechangeonincome we will find income-elasticity for various goods. The results are as follows : S. No. Commodity Income-elasticity for the Remarks household 5% = a Wheat .5 (E <1) since 0 < .5 < 1, wheat is a normal good 10% i and fulfills a necessity. 20% = b T.V. 2 (E >1) since 2 > 1, T.V. is a luxurious 10% i commodity. (-)2% c Bajra = ( −).4 (E <0) since –.4 < 0, Bajra is an inferior 5% i commodity in the eyes of household. 7% = d X 1 (E = 1) since income elasticity is 1, X has unitary 7% i income elasticity. 0% = e Buttons 0 (E = 0) Buttons have zero income-elasticity. 5% i GENERAL ECONOMICS 5 5 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY The various types of income elasticity explained above are in shown in the following diagram. a b c 1 d < Income 0 0 = iE Ei Ei =1 < iE Ei >1 e a Quantity Demanded Fig. 9 : Income elasticity Income elasticity of demand will vary widely with different commodities. Generally luxuries like jewellery and fancy articles will have high income elasticities of demand, whereas ordinary household goods will have low income elasticity of demand. It is to be noted that the words luxury, necessity, inferior goods do not signify strict dictionary meanings here. In economic theory we distinguish them in the manner shown above. 1.6.2 Cross Elasticity : Price of Related Goods and Demand: The demand for a particular commodity may change due to the changes of 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, not of that particular commodity, but of other inter-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’ is the assumption which means that the income of the consumer and also the price of the commodity in question will remain constant. Substitutes Product: In the substitute commodities the cross demand curve slopes upwards (i.e. is positive) showing that more quantities of a commodity will be demanded whenever there is a rise in price of a substitute commodity. In the figure, quantity demanded of Tea is given on the X axis. Y axis represents the price of coffee which is a substitute for a tea. When the price of coffee increases, the demand for coffee becomes less due to the operation of the law of demand. But the consumers will go in for ‘tea’ to substitute in the place of coffee. The price of tea is assumed to be constant. So whenever there is an increase in price of one commodity, the demand for the substitute commodity will increase. 5 6 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India y Substitutes D p 1 Price of p Coffee D x O m m 1 Quantity Demanded of Tea Fig. 10 : Substitutes Complementary Goods In the case of complementary goods, as shown in the figure, a change in price of a good will have an opposite reaction on the demand of other commodity which is closely related or complementary. For instance, an increase in demand for pen will necessarily increase the demand for ink; so also bread and butter; horse and carriages, etc. Whenever there is a fall in demand of fountain pens due to the rise in prices of fountain pens, the demand for ink will fall down, not that the price of ink has gone up, but because the price of fountain pen has gone up. So we find that there is an inverse relationship between price of a commodity and demand for its complementary good (other things remaining the same). y D P Complementary Price of Pen P 1 D O M M X 1 Quantity Demanded of Ink Fig. 11 : Complementary Goods GENERAL ECONOMICS 5 7 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY A change in the demand for one goods in response to a change in the price of another goods represents cross elasticity of demand of the former goods for the latter goods. Symbolically, Δ q p Ec = x x y Δ p q y x Where Ec stands for cross elasticity. q stands for original quantity demanded of X. x Δ q stands for change in quantity demanded of X x p stands for the original price of good Y. y Δ p stands for a small change in the price of Y. y If two goods are perfect substitutes for each other cross elasticity is infinite and if two goods are totally unrelated, cross elasticity between them is zero. If the two goods are substitutes (like tea and coffee) the cross elasticity is positive, that is, in response to a rise in price of one goods the demand for the other goods rises. On the other hand, 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. However, one need not base the classification of goods on 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 on the price change is very strong. 1.7 DEMAND DISTINCTIONS Certain important demand distinctions are as follows: a. Producers goods and Consumer’s goods b. Durable goods and Non-durable goods c. Derived demand and Autonomous demand d. Industry demand and Company demand e. Short-run demand and Long-run demand a. Producer’s goods and Consumer’s goods: Producer’s goods are those which are used for the production of other goods- either consumer goods or producer goods themselves. Examples of such goods are machines, locomotives, ships etc. Consumer’s goods are those which are used for final consumption. Examples of consumer’s goods can be readymade clothes, prepared food, residential houses, etc. b. Durable goods and Non-durable goods: Consumer’s goods may be further sub-divided into durable and non-durable goods. The non-durable consumer goods are those which cannot be consumed more than once; for 5 8 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India example bread, milk etc. These will meet only the current demand. On the other hand, durable consumer goods are those which can be consumed more than once over a period of time, example, a car, a refrigerator, a ready-made shirt, and umbrella. The demand for durable goods is likely to be a derived demand. c. Derived demand and Autonomous demand When a product is demanded consequent on the purchase, of a parent product, its demand is called derived demand. For example, the demand for cement is derived demand, being directly related to building activity. If the demand for a product is independent of demand for other goods, then it is called autonomous demand. But this distinction is purely arbitrary and it is very difficult to find out which product is entirely independent of other products. d. Industry demand and Company demand The term industry demand is used to denote the total demand for the products of a particular industry, e.g. the total demand for steel in the country. On the other hand, the term company demand denotes the demand for the products of a particular company, e.g. demand for steel produced by the Tata Iron and Steel Company. e. Short –run demand and Long-run demand Short run demand refers to demand with its immediate reaction to price changes, income fluctuations, etc., whereas long-run demand is that which will ultimately exists as a result of the changes in pricing, promotion or product improvement, after enough time is allowed to let the market adjust to the new situation. For example, if electricity rates are reduced, in the short run, the existing users will make greater use of electric appliances. In the long run more and more people will be induced to use electric appliances. SUMMARY An individual’s demand for a product depends upon the price of the product, income of the individual and the prices of related goods. But amongst these determinants of demand, economists single out price of the goods in question as the most important factor governing the demand for it. Indeed, the function of a theory of demand is to establish a relationship between price and the quantity demanded of a goods and to provide explanation for it. This relationship is illustrated graphically by a demand curve that shows how much will be demanded at each market price. The demand curve will shift to right by a rise in income (unless the goods is an inferior one), a rise in the price of a substitute, a fall in the price of a complement, a rise in population and a change in tastes in favour of this commodity. The opposite changes will shift the demand curve to the left. As against these when the price of the commodity rises, the consumer goes up the demand curve and when the price falls, consumer goes down the demand curve. Price elasticity of demand is a measure of the extent to which the quantity demanded of a goods responds to a change in its price. When the numerical measure is less than one, we say that the demand is inelastic when it is greater than one, we say demand is elastic and when it is equal to one we say demand is unitary. Two special cases are when elasticity equals zero or GENERAL ECONOMICS 5 9 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY infinity. When elasticity is equal to zero, the quantity demanded does not change at all as price changes, and when elasticity equals infinity, a very small reduction in price increases the quantity demanded from zero to an infinitely large number. Price elasticity can be measured at a point or between two points. Here we use the concepts of point elasticity and arc elasticity respectively. The main determinants of elasticity are the availability of substitutes for the commodity, number of uses of the commodity, nature of commodity, etc. Income elasticity measures the response of quantity demanded to a percentage change in income of the consumer. Cross elasticity is the percentage change in quantity demanded of a product as a result of change in the price of its related product. 6 0 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India CCCCCHHHHHAAAAAPPPPPTTTTTEEEEERRRRR ––––– 22222 THEORY OF DEMAND AND SUPPLY Unit 2 Theory of Consumer Behaviour Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY Learning Objectives At the end of this unit you will be able to : (cid:2) know the meaning of utility (cid:2) understand how consumers try to maximize their satisfaction by spending on different goods. The demand for a commodity depends on the utility of that commodity to a consumer. If a consumer gets more utility from a commodity, he would be willing to pay a higher price and vice-versa. 2.0 WHAT IS UTILITY? All desires, tastes and motives of human beings are called wants in Economics. Wants may arise due to elementary and psychological causes. Since, the resources are limited; he has to choose between urgent wants and not so urgent wants. All wants of human beings exhibit some characteristic features. 1. Wants are unlimited 2. Every wants is satiable 3. Wants are competitive 4. Wants are complementary 5. Wants are alternative 6. Wants vary with time, place, and person 7. Some wants recur again 8. Wants are influenced by advertisement 9. Wants become habits and customs In Economics wants are classified into three categories, viz., necessaries, comforts and luxuries. Necessaries: Necessaries are those which are essential for living. Man cannot do well with barest necessaries of life alone. He requires some more necessaries to keep him fit for taking up productive activities. These are called necessaries of efficiency. There is another type of necessaries are called conventional necessaries. By custom and tradition, people require some wants to be satisfied. Comforts: Comforts refer to those goods and services which are not essential for living but which are required for a happy living. It lies between the ‘necessaries’ and ‘luxuries’. Luxuries: Luxuries are those wants which are superfluous and expensive. They are not essential for living, however, they may add efficiency to the consumer. Utility is the want satisfying power of a commodity. It is a subjective entity and varies from person to person. It should be noted that utility is not the same thing as usefulness. Even 6 2 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India harmful things like liquor, may be said to have utility from the economic stand point because people want them. Thus in Economics, the concept of utility is ethically neutral. Utility is an anticipated satisfaction by the consumer, and the satisfaction is the actual satisfaction derived. Utility hypothesis forms the basis for the theory of consumer’s behaviour. From time to time different theories have been advanced to explain consumer’s behaviour and thus to explain his demand for the product. Two important theories are (i) Marginal Utility Analysis propounded by Marshall, and (ii) Indifference Curve Analysis propounded by Hicks and Allen. 2.1 MARGINAL UTILITY ANALYSIS This theory which is formulated by Alfred Marshall, a British economist, seeks to explain how a consumer spends his income on different goods and services so as to attain maximum satisfaction. This theory is based on certain assumptions. But before stating the assumptions, let us understand the meaning of total utility and marginal utility. Total Utility is otherwise known as “Full Satiety”. Marginal Utility is also known as marginal satiety. Total utility : It is the sum of the utility derived from an different units of a commodity consumed by a consumer. Marginal utility : It is the additional utility derived from additional unit of a commodity. 2.1.0 Assumptions of Marginal Utility Analysis (1) The Cardinal Measurability of Utility : According to this theory, utility is a cardinal concept i.e., utility is a measurable and quantifiable entity. Thus a person can say that he derives utility equal to 10 units from the consumption of 1 unit of commodity A and 5 from the consumption of 1 unit of commodity B. Since, he can express his satisfaction quantitatively, he can easily compare different commodities and express which commodity gives better utility or satisfaction and by how much. 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. (2) Constancy of the Marginal Utility of Money : 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. (3) The Hypothesis of Independent Utility : 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. 2.1.1 The Law of Diminishing Marginal Utility One of the important laws under Marginal Utility analysis is the Law of Diminishing Marginal Utility. GENERAL ECONOMICS 6 3 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY The law of diminishing marginal utility 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. 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 stock of a thing diminishes with every increase in the stock that he already has.” This law describes a very fundamental tendency of human nature. In simple words it says that as a consumer takes 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. Table 5 : Total and marginal utility schedules Quantity of tea consumed Total utility Marginal utility (cups per day) 1 30 30 2 50 20 3 65 15 4 75 10 5 83 8 6 89 6 7 93 4 8 96 3 9 98 2 10 99 0 11 95 –4 Let us illustrate the law with the help of an example. Consider Table 5, in which we have presented the total utility and marginal utility derived by a person from cups of tea consumed per day. When one cup of tea is taken per day, the total utility derived by the person is 30 utils (unit of utility) and marginal utility derived is also 30 utils with the consumption of 2nd cup per day the total utility rises to 50 but marginal utility falls to 20. We see as the consumption of tea increases to 10 cups per day, marginal utility from the additional cups goes on diminishing (i.e., the total utility goes on increasing at a diminishing rate). However, when the cups of tea consumed per day increases to 11, then instead of giving positive marginal utility, the eleventh cup gives negative marginal utility because it may cause him sickness. We have graphically represented the data of the above table in Figure 13. Graphically we can represent the relationship between the total utility and marginal utility. From the above diagram we can conclude the three important relationships between total utility and marginal utility 6 4 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India 1. When the total utility rises the marginal utility diminishes. 2. When the total utility is maximum then the marginal utility is zero. 3. When the total utility is diminishing then the marginal utility is negative. Y TU Utility X O Consumption MU Fig. 12 : Total Utility and Marginal Utility Fig. 13 : Marginal utility of tea consumed GENERAL ECONOMICS 6 5 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY As will be seen from the figure, the marginal utility curve goes on declining throughout. The diminishing marginal utility curve applies almost to all commodities. A few exceptions however, have been pointed out by some economists. According to them, this law does not apply to money, music and hobbies. While this may be true in initial stages, beyond a certain limit these will also be subjected to diminishing utility. Limitations of the Law The law of diminishing marginal utility is applicable only under certain assumptions. (i) The different units consumed should be identical in all respects. The habit, taste, treatment and income of the consumer also remain unchanged. (ii) The different units consumed should consist of standard units. If a thirsty man is given water by successive spoonfuls, the utility of second spoonful may conceivably be greater than the utility of the first. (iii) There should be no time gap or interval between the consumption of one unit and another unit i.e. there should be continuous consumption. (iv) The law may not apply to articles like gold, cash where a greater quantity may increase the lust for it. (v) 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. 2.1.2 Consumer’s Surplus : The concept of consumer’s surplus was evolved by Alfred Marshall. This concept occupies an important place not only in economic theory but also in economic policies of government and decision-making of monopolists. It has been seen that consumers generally are ready to pay more for the goods than they actually pay for them. This extra satisfaction which consumers get from their purchase of goods is called by Marshall as consumer’s surplus. Marshall defined the concept of consumer’s surplus as “excess of the price which a consumer would be willing to pay rather than go without a thing over that which he actually does pay, is the economic measure of this surplus satisfaction........it may be called consumer’s surplus”. Thus consumer’s surplus = What a consumer is ready to pay - What he actually pays. The concept of consumer’s surplus is derived from the law of diminishing marginal utility. As we know from the law of diminishing marginal utility, the more of a thing we have, the lesser marginal utility it has. In other words, as we purchase more of a good, its marginal utility goes on diminishing. The consumer is in equilibrium when marginal utility is equal to given price i.e., he purchases that many number of units of a good at which marginal utility is equal to price (It is assumed that perfect competition prevails in the market). Since the price is fixed for all the units of the good he purchases except for the one at margin, he gets extra utility; this extra utility or extra surplus for the consumer is called consumer’s surplus. Prof. Hicks has redefined the concepts as the money income gained by a man arising from a fall in price of goods he purchases. 6 6 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India It is often argued that this concept is a theoretical toy. The surplus satisfaction cannot be measured precisely. In case of very essential goods of life; utility is very high but prices paid of them are low giving rise to infinite surplus satisfaction. Further, it is difficult to measure the marginal utilities of different units of a commodity consumed by person. Consider Table 6 in which we have illustrated the measurement of consumer’s surplus in case of commodity X. The price of X is assumed to be Rs. 20. Table 6 : Measurement of Consumer’s Surplus No. of units Marginal Utility Price (Rs.) Consumer’s Surplus 1 30 20 10 2 28 20 8 3 26 20 6 4 24 20 4 5 22 20 2 6 20 20 0 7 18 20 – We see from the above table that when consumer’s consumption increases from 1 to 2 units, his marginal utility falls from Rs. 30 to Rs. 28. His marginal utility goes on diminishing as he increases his consumption of good X. Since marginal utility for a unit of good indicates the price the consumer is willing to pay for that unit, and since price is assumed to be fixed at Rs. 20, the consumer enjoys a surplus at every unit of purchase above 6 units. Thus when the consumer is purchasing 1 unit of X, the marginal utility is worth Rs. 30 and price fixed is Rs. 20, thus he is deriving a surplus of Rs. 10. Similarly when he purchases 2 units of X, he enjoys a surplus of Rs. 8 [Rs. 28 – Rs. 20]. This continues and he enjoys consumer’s surplus equal to Rs. 6, 4, 2 respectively from 3rd, 4th and 5th unit. When he buys 6 units, he is in equilibrium because here his marginal utility is equal to the market price or he is willing to pay a sum equal to the actual market price. Here he enjoys no surplus. Thus, given the price of Rs. 20 per unit, the total surplus which the consumer will get, is Rs. 10 + 8 + 6 + 4 + 2 + 0 = 30. The concept of consumer’s surplus can also be illustrated graphically. Consider figure 10. On the X- axis is measured the amount of the commodity and on the Y-axis the marginal utility and the price of the commodity. MU is the marginal utility curve which slopes downwards, indicating that as the consumer buys more units of the commodity, its marginal utility falls. Marginal utility shows the price which a person Fig. 14 : Marshall’s Measure of is willing to pay for the different units rather than go Consumer’s Surplus GENERAL ECONOMICS 6 7 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY without them. If OP is the price that prevails in the market, then consumer will be in equilibrium when he buys OQ units of the commodity, since at OQ units, marginal utility is equal to the given price OP. The last unit, i.e., Qth unit does not yield any consumer’s surplus because here price paid is equal to the marginal utility of the Qth unit. But for units before Qth unit, marginal utility is greater than the price and thus these units fetch consumer’s surplus to the consumer. In Figure 14, the total utility is equal to the area under the marginal utility curve up to point Q i.e. ODRQ. But given the price equal to OP, the consumer actually pays OPRQ. The consumer derives extra utility equal to DPR which is nothing but consumer’s surplus. Limitations : (1) Consumer’s surplus cannot be measured precisely - because it is difficult to measure the marginal utilities of different units of a commodity consumed by a person. (2) In the case of necessaries, the marginal utilities of the earlier units are infinitely large. In such case the consumer’s surplus is always infinite. (3) The consumer’s surplus derived from a commodity is affected by the availability of substitutes. (4) There is no simple rule for deriving the utility scale of articles which are used for their prestige value (e.g., diamonds). (5) Consumer’s surplus cannot be measured in terms of money because the marginal utility of money changes as purchases are made and the consumer’s stock of money diminishes. (Marshall assumed that the marginal utility of money remains constant. But this assumption is unrealistic). (6) The concept can be accepted only if it is assumed that utility can be measured in terms of money or otherwise. Many modern economists believe that this cannot be done. 2.2 INDIFFERENCE CURVE ANALYSIS In the last section we discussed marginal utility analysis of demand. A very popular alternative and more realistic method of explaining consumer’s demand is the Indifference Curve Analysis. This approach to consumer behaviour is based on consumer preferences. It believes that human satisfaction being a psychological phenomenon cannot be measured quantitatively in monetary terms as was attempted in Marshall’s utility analysis. In this approach it is felt that it is much easier and 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. 2.2.0 Assumptions Underlying Indifference Curve Approach (i) The consumer is rational and possesses full information about all the relevant aspects of economic environment in which he lives. (ii) 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, E he 6 8 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India can rank them as first preference, second preference and so on. If a consumer happens to prefer A to B, he can not tell quantitatively how much he prefers A to B. (iii) 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 behaviour. (iv) If combination A has more commodities than combination B, then A must be preferred to B. 2.2.1 What are Indifference Curves? Ordinal analysis of demand (here we will discuss the one given by Hicks and Allen) is based on indifference curves. An indifference curve is a curve which represents all those combinations of 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 indifferent among them. In other words, since all the combinations provide same level of satisfaction the consumer prefers them equally and does not mind which combination he gets. 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 consumer : Combination A has 1 unit of food and 12 units of clothing, combination B has 2 units of food and 6 units of clothing. Similarly, by 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 below : Table 7 : Indifference Schedule Combination Food Clothing MRS A 1 12 B 2 6 6 C 3 4 2 D 4 3 1 Now if we draw the above schedule we will get the following figure. In Figure 15, an indifference curve IC is drawn by plotting the various combinations of 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, combinations lying on an indifference curve will give the consumer same level of satisfaction. GENERAL ECONOMICS 6 9 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY Fig. 15 : A Consumer’s Indifference Curve 2.2.2 Indifference Map : A set of indifference curves is called indifference map. An indifference map depicts complete picture of consumer’s tastes and preferences. In Figure 16, an indifference map of a consumer is shown which consists of three indifference curves. We have taken 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 IC give same satisfaction, all combinations lying 1 on IC give greater satisfaction than those lying on IC . 2 1 Fig. 16 : Indifference Map 7 0 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India 2.2.3. Marginal Rate of Substitution : Marginal Rate of Substitution (MRS) is the rate at which the consumer is prepared to exchange goods X and Y. Consider Table-7. 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. Like wise which 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, he is prepared to give up less and less units of cloths. There are two reasons for this. 1. The want for a particular good is satiable so that when a consumer has its more quantity, his intensity of want for it decreases. Thus, when consumer in our example, has more units of food, his intensity of desire for additional units of food decreases. 2. Most of the goods are imperfect substitutes of one another. If they could substitute one another perfectly. MRS would remain constant. 2.2.4 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 when the amount of one good in 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 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. This diminishing marginal rate of substitution gives convex shape to the indifference curves. However, there are two extreme situations. When two goods are perfect substitutes of each other, the indifference curve is a straight line on which MRS is constant. And when two goods are perfect complementary goods (e.g. gasoline and water in a car), the indifference curve will consist of two straight line with a right angle bent which is convex to the origin or in other words, it will be L shaped. (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. This property will be clear from the following Figure 17. GENERAL ECONOMICS 7 1 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY Fig. 17 : Intersecting Indifference Curves In figure 17, IC and IC intersect at A. Since A and B lie on IC , they give same satisfaction 1 2 1 to the consumer. Similarly since A and C lie on IC , they give same satisfaction to the 2 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 the axis 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 18 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 a smaller or larger quantities. Therefore the indifference curve will not touch either the X axis or Y axis. Y O X 7 2 COMMON PROFICIENCY TEST Y dooG P Good X Fig. 18 : Indifference Curve Copyright -The Institute of Chartered Accountants of India 2.2.5 Budget Line : 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 satisfaction he has to work under two constraints : firstly, he has to pay the prices for the goods and, secondly, he has a limited money income with which to purchase the goods. These constraints are explained by 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. Fig. 19 : Price Line It should be noted that any point outside the given price line, like H, will be beyond the reach of the consumer and any combination lying within the line, like K, shows under spending by the consumer. 2.2.6 Consumer’s Equilibrium : Having explained indifference curves and budget line, we are in a position to explain how a consumer reaches equilibrium position. A consumer is in equilibrium when he is deriving maximum possible satisfaction from the goods and 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. (iii) prices of goods X and Y are given and are fixed for him. (iv) All goods are homogeneous and divisible. (v) The consumers acts ‘rationally’ and maximizes his satisfaction. GENERAL ECONOMICS 7 3 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY Fig. 20 : Consumer’s Equilibrium 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 20, in which IC , IC , IC , IC and IC are shown together with budget line PL for good 1 2 3 4 5 X and good Y. Every combination on 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 highest indifference curve. But since there is a budget constraint he will be forced to remain on the given budget line, that is he will have to choose any combinations from among only those which lie on the given price line. Which combination will he choose? Suppose he chooses R, but we see that R lies on a lower indifference curve IC , when he can very well afford S, Q or T lying on higher indifference 1 curve. Similar is the case for other combinations on IC , like H. Again, suppose he chooses 1 combination S (or T) lying on IC . But here again we see that the consumer can still reach a 2 higher level of satisfaction remaining within his budget constraints i.e., he can afford to have combination Q lying on IC because it lies on his budget line. Now what if he chooses combination 3 Q? We find that this is the best choice because this combination lies not only on his budget line but also puts him on highest possible indifference curve i.e., IC . The consumer can very well 3 wish to reach IC or IC , but these indifference curves are beyond his reach given his money 4 5 income. Thus the consumer will be at equilibrium at point Q on IC . What do we notice at 3 point Q? We notice that at this point, his budget line PL is tangent to the indifference curve IC . 3 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 indifference curve IC are equal. 3 The slope of the indifference curve shows the marginal rate of substitution of X for Y (MRSxy) 7 4 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India MU x which is equal to while the slope of the price line indicates the ratio between the prices MU y P x of two goods i.e., P y At equilibrium point Q, MU P MRS = x = x xy MU P y y Thus, we can say that the consumer is in equilibrium position when 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. SUMMARY The theory of consumer’s behaviour seeks to explain the determination of consumer’s equilibrium. Two famous approaches to consumer’s equilibrium are (i) Marginal Utility Analysis (ii) Indifference Curve Analysis. Marginal utilility analysis is framed within the parameters of two laws : Law of diminishing marginal utility and the law of equi-marginal utility. The law of diminishing marginal utility states that as a consumer increases the consumption of a commodity, every successive unit of the commodity gives lesser and lesser satisfaction to the consumer i.e., marginal utility of the commodity falls. The indifference curve theory which is an ordinal theory shows the household’s preference between alternative bundles of goods by means of indifference curves. A single curve joins all those combinations of goods which give the household equal satisfaction or utility and between which the household is thus indifferent. The household reaches equilibrium when for a given money income and given market price, it has reached the highest attainable level of satisfaction. At such a point, the budget line is tangent to the indifference curve. At the tangency point, the following condition is satisfied : MU MU MU x = y = z P P P x y z 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 money (iv) it segregates income effect from substitution effect. GENERAL ECONOMICS 7 5 Copyright -The Institute of Chartered Accountants of India CCCCCHHHHHAAAAAPPPPPTTTTTEEEEERRRRR ––––– 22222 THEORY OF DEMAND AND SUPPLY Unit 3 Supply Copyright -The Institute of Chartered Accountants of India Learning Objectives At the end of this unit you will be able to : (cid:2) understand the meaning of supply. (cid:2) understand what determines supply. (cid:2) get an insight into the law of supply. (cid:2) know the difference between movements on the supply curve and shift of the supply curve. (cid:2) understand the concept of elasticity of supply. 3.0 INTRODUCTION As the term ‘demand’ refers to the quantity of a good or service that the consumers are willing and able to purchase at various prices during a period of time, the term ‘supply’ refers the amount of a good or service that the producers are willing and able to offer to the market at various prices during a period of time. Two important points apply to supply : (i) The supply refers to what firms offer for sale, not necessarily to what they succeed in selling. (ii) Supply is a flow. The quantity supplied is so much per unit of time, per day, per week, or per year. Supply is defined as “how much of good will be offered for sale at a given time”. Prof. McConnell defines supply in the following term: “Supply may be defined as a schedule which shows the various amounts of a product which a producer is willing to and able to produce and make available for sale in the market at each specific price in a set of possible prices during some given period”. 3.1 DETERMINANTS OF SUPPLY Although price is an important consideration in determining the willingness and desire to part with the commodities, they are many other factors which determine the supply of a product or a service. These are discussed below : (i) Price of the good : Other things being equal, the higher the relative price of a good the greater the quantity of it that will be supplied. This is because goods and services are produced by the firm in order to earn profits and, ceteris paribus, profits rise if the price of its product rises. (ii) Price of the related goods : If the prices of other goods rise, they become relatively more profitable to the firm to produce and sell than the good in question. It implies, that if the price of Y rises, the quantity supplied of X will fall. For example, if price of wheat rises, the farmers may shift lands to wheat production and away from corn and soyabeans. GENERAL ECONOMICS 7 7 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY (iii) Price of the factors of production : A rise in the price of a particular factor of production will cause an increase in the cost of making those goods that use a great deal of that factor than in the costs of producing those that use relatively small amount of the factor. For example, a rise in the cost of land will have a large effect on the cost of producing wheat and a very small effect on the cost of producing automobiles. Thus a change in the price of one factor of production will cause changes in the relative profitability of different lines of production and will cause producers to shift from one line to another and thus supplies of different commodities will change. (iv) State of technology : The supply of a particular product depends upon the state of technology also. Inventions and innovations tend to make it possible to produce more or better goods with the same resources, and thus they tend to increase the quantity supplied of some products and to reduce the quantity supplied of products that are displaced. (v) Government Policy : The production of a good may be subject to the imposition of commodity taxes such as excise duty, sales tax and import duties. These raise the cost of production and so the quantity supplied of a good would increase only when its price in the market rises. Subsidies, on the other hand, reduce the cost of production and thus provide an incentive to the firm to increase supply. (vi) Other Factors : The quantity supplied of a good also depends upon government’s industrial and foreign policies, goals of the firm, infrastructual facilities, market structure, natural factors etc. 3.2 LAW OF SUPPLY This refers to the relationship of quantity supplied of a good with one or more related variables which have an influence on the supply. Normally, the supply is related with price but it can be related with the type of technology used, scale of operations etc. The law of supply can be stated as : Other things remaining constant, the quantity of a good produced and offered for sale will increase as the price of the good rises and decrease as the price falls. This law is based upon common sense, for the higher the price of the good, the greater the profits that can be earned and thus greater the incentives to produce the good and offer it for sale. The law is known to be correct in large number of cases. There is an exception however. If we take the supply of labour at very high wages, we may find that the supply of labour has decreased instead of increasing. Thus, the behaviour of supply depends upon the phenomenon considered and the degree of possible adjustment in supply. The behaviour of supply curve is also affected by the time taken into consideration. In the short run, it may not be easy to increase supply but in the long run supply can be easily adjusted in response to changes in price. The law of supply can be explained through supply schedule and supply curve. Consider the following schedule. 7 8 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Table 8 : Supply Schedule of Good ‘X’ Price (Rs.) Quantity supplied (per kg) (kg) 1 5 2 35 3 45 4 55 5 65 The table shows the quantities of good X that would be produced and offered for sale at a number of alternative prices. At Re. 1, for example, 5 kilograms of good X are offered for sale and at Rs. 3 per kg. 45 kg. would be forthcoming. We can now plot the data from Table 8 on a graph. In Figure 21, price is plotted on vertical axis and quantity on the horizontal axis, and various price-quantity combinations of the schedule 8 are plotted. Fig. 21 : Supply Curve When we draw a smooth curve through the plotted points, what we get is the supply curve for good X. The curve shows the quantity of X that will be offered for sale at each price of X. It slopes upwards towards right showing that as price increases, the supply of X increases and vice-versa. The market supply curve for ‘X’ can be obtained by adding horizontally the various firms’ supply curves. GENERAL ECONOMICS 7 9 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY 3.3 SHIFTS IN THE SUPPLY CURVE – INCREASE OR DECREASE IN SUPPLY When the supply curve bodily shifts towards right as a result of a change in one of the factors that influence the quantity supplied other than the commodity’s own price, we say there is an increase in supply. When these factors cause the supply curve to shift to left we call it decrease in supply [See Figures 22(i) and (ii)]. Fig. 22 : Shifts in supply curves 3.4 MOVEMENTS ON THE SUPPLY CURVE – INCREASE OR DECREASE IN THE QUANTITY SUPPLIED When the supply of a good increases as a result of an increase in its price we say that there is an increase in the quantity supplied and there is a upward movement on the supply curve. The reverse is the case when there is a fall in the price of the good. (See Figure 23). o Fig. 23 : Figure showing change in quantity supplied as a result of a price change 8 0 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India 3.5 ELASTICITY OF SUPPLY The elasticity of supply is defined as the responsiveness of the quantity supplied of a good to a change in its price. Elasticity of supply is measured by dividing the percentage change in quantity supplied of a good by the percentage change in its price i.e., Percentagechangeinquantitysupplied = EP Percentagechangeinprice Changeinquantitysupplied quantitysupplied or changeinprice price Δ q Δ q q p = or x Δ p Δ p q p Where q denotes original quantity supplied. Δ q denotes change in quantity supplied. p denotes original price. Δ p denotes change in price. Example: a. Suppose the price of a commodity X increase from Rs. 2,000 per unit to Rs. 2,100 per unit and consequently the quantity supplied rises from 2,500 units to 3,000 units. Calculate the elasticity of supply. Here Δq = 500 units Δp = Rs. 100 p = Rs. 2000 q = 2500 units 500 2000 ∴Es = × 100 2500 = 4 ∴ Elasticity of Supply = 4. 3.5.0 Type of Supply Elasticity : The elasticity of supply can be classified as under : (i) Perfectly Inelastic supply : If as a result of a change in price, the quantity supplied of a good remains unchanged, we say that the elasticity of supply is zero or the good has perfectly inelastic supply. The vertical supply curve in Figure 24 shows that irrespective of the price change, the quantity supplied remains unchanged. GENERAL ECONOMICS 8 1 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY o Fig. 24 : Supply curves of zero elasticity (ii) Relatively less-elastic supply : If as a result of a change in the price of a good its supply changes less than proportionately, we say that the good is relatively less elastic or elasticity of supply is less than one. Figure 25 shows that the relative change in the quantity supplied Δ Δ ( q) is less than the relative change in the price ( p). Fig. 25 : Showing relatively less elastic supply (iii) Relatively greater-elastic supply : If elasticity of supply is greater than one i.e., when the quantity supplied of a good changes substantially in response to a small change in the price of the good we say that supply in greatly elastic. Figure 26, shows that the relative Δ change in the quantity supplied ( q) is greater than the relative change in the price. 8 2 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Fig. 26 : Showing relatively greater elastic supply (iv) Unit-elastic : If the relative change in the quantity supplied is exactly equal to the relative change in the price, the supply is said to be unitary elastic. Here coefficient of elasticity of Δ supply is equal to one. In Figure 27, the relative change in the quantity supplied ( q) is Δ equal to the relative change in the price ( p). Fig. 27 : Showing unitary elasticity (v) Perfectly elastic supply : The supply elasticity is infinite when nothing is supplied at a lower price but a small increase in price causes supply to rise from zero to an indefinitely large amount indicating that producers will supply any quantity demanded at that price. Figure 28 shows infinitely elastic supply. GENERAL ECONOMICS 8 3 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY o Fig. 28 : Supply curve of infinite elasticity 3.5.1 Measurement of supply-elasticity : The elasticity of supply can be considered with reference to a given point on the supply curve or between two points on the supply curve. Point-elasticity : Just as in demand, point-elasticity can be measured with the help of the following formula : dq p = Es x dp q (Ed) The Supply function is given as q = -100 + 10p. Find the elasticity of supply using point method, when price is Rs. 15. dq p × Es =dp q dq Since = 10, p = Rs. 15, q = - 100 + 10 (15) dp q = 50 15 ∴E =10× s 50 or E = 3 s dq Where is differentiation of the supply function with respect to price and p and q refer dp to price and quantity respectively. Arc-Elasticity : Arc-elasticity i.e. elasticity of supply between two prices can be found out with the help of the following formula : − − q q p p Es = 1 2 ÷ 1 2 + + q q p p 1 2 1 2 or 8 4 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India − + q q p p Es = 1 2 x 1 2 + − q q p p 1 2 1 2 Where p q are original price and quantity and p q are new price and quantity supplied. 1 1 2 2 Thus, if we have to find elasticity of supply when p = Rs. 12, p = Rs. 15, q = 20 units and 1 2 1 q = 50 units. 2 Then using the above formula, we will get supply elasticity as : + 20 - 50 12 15 = Es x + − 20 50 12 15 30 27 = x 70 3 = +3.85 SUMMARY The term ‘Supply’ refers to a schedule of the quantities of a good that will be offered for sale at different prices. The supply curve is a graphic presentation of the supply schedule. The laws of supply explain the relation between the quantity supplied of a good or service and the various factors on which the supply depends like price of the product, technology used, scale of operations etc. Most important is the relation of the quantity supplied of a good with its price. It has been observed that quantity supplied of a good increases with a rise in its price and falls with a fall in its price. Elasticity of supply is the responsiveness of quantity supplied of a good as a result of a change in any of the factors on which supply depends. Most important is the responsiveness of the quantity supplied to a change in the price of the good. Elasticity of supply can be considered with reference to a given point on the supply curve (point elasticity) or between two points (arc elasticity). MULTIPLE CHOICE QUESTIONS 1. Demand for a commodity refers to : (a) desire for the commodity. (b) need for the commodity. (c) quantity demanded of that commodity. (d) quantity of the commodity demanded at a certain price during any particular period of time. 2. Contraction of demand is the result of : (a) decrease in the number of consumers. (b) increase in the price of the good concerned. (c) increase in the prices of other goods. (d) decrease in the income of purchasers. GENERAL ECONOMICS 8 5 Copyright -The Institute of Chartered Accountants of India THEORY OF DEMAND AND SUPPLY 3. All but one of the following are assumed to remain the same while drawing an individual’s demand curve for a commodity. Which one is it? (a) The preference of the individual. (b) His monetary income. (c) Price. (d) Price of related goods. 4. Which of the following pairs of goods is an example of substitutes? (a) Tea and sugar. (b) Tea and coffee. (c) Pen and ink. (d) Shirt and trousers. 5. In the case of a straight line demand curve meeting the two axes, the price-elasticity of demand at the mid-point of the line would be : (a) 0 (b) 1 (c) 1.5 (d) 2 6. The Law of Demand, assuming other things to remain constant, establishes the relationship between : (a) income of the consumer and the quantity of a good demanded by him. (b) price of a good and the quantity demanded. (c) price of a good and the demand for its substitute. (d) quantity demanded of a good and the relative prices of its complementary goods. 7. Identify the factor which generally keeps the price-elasticity of demand for a good low : (a) Variety of uses for that good. (b) Its low price. (c) Close substitutes for that good. (d) High proportion of the consumer’s income spent on it. 8. Identify the coefficient of price-elasticity of demand when the percentage increase in the quantity of a good demanded is smaller than the percentage fall in its price : (a) Equal to one. (b) Greater than one. (c) Smaller than one. (d) Zero. 9. In the case of an inferior good, the income elasticity of demand is : (a) positive. (b) zero. (c) negative. (d) infinite. 8 6 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India