Nature and

06
Scope of Understanding
Module 1 Self-Learning Sessio
Managerial Level
ns
Economics
Managerial Economics - meaning, nature and scope - Managerial Economics
and business decision making - Role of Managerial Economist – Economic
Principles relevant to Managerial Decisions. Concept of scarcity and
opportunity cost, Production Possibility curve.

Introduction

In his landmark essay on the nature of economics, Lionel Robbins defined economics as “the
science which studies human behaviour as a relationship between ends and scarce means which
have alternative uses” (Robbins, 1935, p. 16). In this context, economics can be deemed as
science that provides principles for constrained optimization in connection with resource use
to meet human wants. The branch of economics that deals with behaviour of individual actors
like firms and individuals either on their own space or in their interactions with each other on
the economic stage is termed as Microeconomics. Therefore, it proposes principles that guides
these micro entities of an economic system to optimize their resource use and satisfaction
derived therefrom. On the other hand, it is the aggregate reflection of each of these individual
entities and their interactions, that is dealt in the other branch of economics which is termed as
Macroeconomics.

In an economy, individuals and firms interact in both the product and factor market. In a free
market system, pries of output and inputs are determined in these markets and it guides the
decision of all market participants. The firm as an entity organizes factors of production in
order to produce goods and services to meet the demands of consumer sand other firms. Thus,
the interplay of individual and firms is not subject to central control.

Within a firm, transaction and the organization of productive factors are generally
accomplished by the central control of one or more managers. Firms exist, in this form, as
organisations because the total cost of producing any level of output is lower that if it is not
done in the absence of firms. The reason for the lower cost is due to various reasons. The cost
of obtaining information on prices and cost of negotiating and concluding separate contracts at
every stage of production with resource owners are more expensive and complex which firm
as an entity tackle this through one time contract with the participants such as labour force and
other resource owners. Production activity in an organised manner by the firm also reduces the
cost due to intervention of government through taxation as the later mostly affect transaction
between economic entities than within an entity. Existence of firms also justified on the basis
of very micro level specialisations that can be implemented within and between firms which
ultimately results in lower cost and higher productivity.

Thus, in the economic sense, the existence of a firm as an entity is based on the goal of
optimized resource use within the constraints. In general, constraints involve legal, moral,
contractual, financial and technological consideration. Therefore, manager of a firm or any
entity that engage in value addition, is a constrained optimizer as in the case of an economist

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as the essence of the economics is in determining optimum behaviour where that behaviour is
subject to constraints.

The term constrained optimization here implies attaining the objectives of the firms within the
constraints in the most efficient way possible. The major objectives of the firm are: i) to achieve
the Organizational Goal, ii) to maximize the Output, iii) to maximize the Sales, iv) to maximize
the Profit of the Organization, v) to maximize the Customer and Stakeholders Satisfaction, vi)
to maximize Shareholder’s Return on Investment, vii) to maximize the Growth of the
Organization.

A Manager is a person who directs resources to achieve a stated goal and he/she has the
responsibility for his/her own actions as well as for the actions of individuals, machines and
other inputs under the manager’s control. In this line, Managerial economics is the study of
how scarce resources are directed most efficiently to achieve managerial goals. It is a valuable
tool for analysing business situations to take better decisions.

Therefore, as it is mostly concerned with the functioning of an individual economic entity,

managerial economics can be viewed as an application of that part of the principles of
microeconomics, that focus on such issues as risk, demand, production, cost, pricing and
market structure. Thus, understanding these principles will help to develop a rational decision-
making perspective and will sharpen the analytical framework that the manager must bring to
bear on managerial decisions.

Definitions of Managerial Economics

Henry and Heynes defines “Managerial economics is the study of allocation of limited
resources available to a firm or other unit of management among the various possible activities
of that unit.”

Prof. Evan J Douglas defines Managerial Economics as “Managerial Economics is concerned

with the application of economic principles and methodologies to the decision-making process
within the firm or organization under the conditions of uncertainty”.

According to Milton H Spencer and Louis Siegelman “Managerial Economics is the integration
of economic theory with business practices for the purpose of facilitating decision making and
forward planning by management”.

Domenic Salvatore defines “Managerial economics refers to the application of economic

theory and the tools of analysis of decision science to examine how an organization can
achieve its objectives most effectively.”

Nature Of Managerial Economics:

1. Managerial economics is concerned with the analysis of finding optimal solutions to

decision making problems of businesses/firms (micro economic in nature).
2. Managerial economics is a practical subject therefore it is pragmatic.
3. Managerial economics describes, what is the observed economic phenomenon (positive
economics) and prescribes what ought to be (normative economics).
4. Managerial economics is based on strong economic concepts. (Conceptual in nature)

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5. Managerial economics analyses the problems of the firms in the perspective of the
economy as a whole (knowledge of macroeconomic environment is essential).
6. It helps to find optimal solution to the business problems (problem solving)
7. Managerial economics is only a part of the economic science. It focuses mainly on
decision making at managerial cadre of a producing unit or firm. But economics deals
with issues like, welfare, public finance, development, inequality, poverty, inflation,
international trade and foreign exchange, monetary policy etc.

Scope of Managerial Economics

Managerial economics is the study of allocation of scarce resources available to a firm

(financial, human, machines, etc.) among alternative uses in order to realize the objective
of profit maximization or other specified objectives. Managerial economics comprises of
both microeconomic theories and macroeconomic theories as both of these are applied to
business decision-making and analysis in one way or the other. The scope of managerial
economics comprises all the areas of business issues to which economic theories could be
applied in one way or the other. The important among these can be enlisted as follows.

 Allocation of resources: A business manager has to decide how to allocate the scarce
available resources to their respective uses within the firm in order to achieve the desired
objectives.

 Management of Inventory: Inventory problems relate to the issue of holding an

optimum stock of both finished goods and raw materials. Along with it, queuing problems
also arise in which decisions have to be taken about installing new machines or employing
extra labour so as to balance the business requirements.

 Pricing and sales promotion: How to fix the prices for the products, how to face price
competition and how to promote sales are important business decisions to be undertaken
with regard to the pricing policy of the firm. Evaluating the possibility and feasibility of
price discrimination and advertisement for expansion of sales of a given commodity also
comes under it purview.

 Investment Issues: Decisions regarding investment problems are crucial to a firm- how
to decide on investing in new plants, how much to invest, how to manage capital and profits.
The theory of capital and investment decisions helps in making investment decisions,
choice of projects, capital budgeting for investment decisions, etc for the business firm.

Demand Analysis: The theory of demand helps in making the choice of products,
determining their price and optimum level of production.

Product Analysis and cost analysis: The theory of production and production decisions
is very helpful in determining the size of the firm, its total output & factors of production
to be employed in order to attain the given objectives of the firm.

Profit Analysis: The theory of profit helps the firms to measure and manage their profits
keeping in view the uncertainties and the risk involved

Along with these microeconomic related concerns, the managerial consideration of

macroeconomic environment is also relevant in order to make rational business decisions:

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Since the general business environment of the economy related to the economic, social and
political set-up of the country influence the business and the functioning of the firms, the
business managers have to give due consideration to these external environmental factors
also in the process of decision making.

These external environmental factors may be broadly classified as follows:

 The economic system in the country; socialist, capitalistic or mixed economy etc.
 Major Macroeconomic Parameters: Issues concerning the trends in
macroeconomic variables like national income, output, employment, prices,
investment etc. are extremely helpful in forward planning like setting up a new plant
or expanding the existing plant size for business expansion. The study of these
macroeconomic variables help the firms to make crucial decisions regarding
business expansion keeping in mind the external conditions prevalent in the
economy.
 Foreign trade: Trade - internal and/or external is an important outcome all business
activity undertaken by the firms. Trade links with the rest of the world influence the
functioning of business firms directly or indirectly. Study of monetary mechanism
and international trade help the managers understand international trade, prices,
exchange rates, fluctuations in the foreign markets, capital flows, etc.
 Government policies: Regulatory government policies have a huge impact on the
working of business undertakings. Government tries to regulate and control all
types of business activities through its policy measures. Any business activity which
goes against the social well being or disturbs the welfare of the society have to be
and are checked by the government through regulatory policies directed towards the
concerned business activities.

Managerial Economics and Other Disciplines

Essentially managerial economics involves the study of economic tools, logic and analysis
applied to the decision-making process of business firms. However, besides
microeconomics and macroeconomics, managerial economics is also associated with
various other disciplines. These related fields of study include the following:
 Operations research: This field of study is an inter disciplinary solution finding
technique used to find an optimum solution to the managerial problems subject to the
given constraints. These problems are solved using models built with the help of
economics, mathematics and statistics. Linear programming and goal programming are
two important techniques studied under operations research which are useful in
business decision making.
 Mathematical and Statistical Tools: Mathematical logic and tools are very helpful in
economic analysis as most of the concepts dealt by the managers of business firms are
quantitative in nature like cost, price, demand, profit, interest, wages, stock etc.
Advanced optimization techniques and mathematical tools, thus, form an integral part
of managerial economics. Similarly statistical tools prove extremely helpful in
collecting, processing and analyzing data for business firms. Regression analysis

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 probability theory, forecasting techniques, etc. help in forecasting the future values of
economic variables and the probable outcome of the business decisions undertaken.
 Management Theory and Accounting: These disciplines have a close link with the study
of managerial economics. Various management theories make an attempt to study the
behaviour of the business firms which in turn are working to attain certain desired and
pre stated objectives. Hence, a business manager needs to have sufficient knowledge of
management theory in order to ascertain changes in the behaviour and objectives of the
firms with change in the conditions- internal and/or external. On the other hand
accounting data and statements help in reflecting the working the firm and evaluating
its performance.
 Psychology and Organisation Behaviour: Managerial economics helps the business
managers to make rational business decisions by studying the behaviour of individual
buyers and sellers. This involves the study of the psychological factors influencing the
demand and supply patterns, needs, expectations and aspirations of the market players-
the buyers and sellers. In fact, psychology studies in economics has emerged as recent
field of study for the psychological analysis of the buying behaviour of the consumer.
In addition to the study of individual buyers, various behavioural models studying
organizational psychology have been developed of late to analyse the economic
behaviour of a firm.

Role of Managerial Economist in Business Decision-Making

The role of business managers in business decision making is to select the best possible
alternative out of the opportunities available to the business firm. The process of business
decision making primarily comprises of the following stages: to determine and define the
objective to be achieved, to collect and analyse data and information regarding economic,
social, political, and technological environment. to invent, develop and analyse the possible
alternatives to achieve the desired objectives, to rationally select the best possible
alternative.
Managerial economist has to carry out a in depth study of business environment, analyse
operations of business, demand estimation and forecasting, timing and location in product
planning, performance of investment, impact of government policies on business, market
strength and level of competitions, sensitivity of business to external shocks, changes in
both domestic and international socio-political and economic scenario etc.

Therefore, it is essential to make the right business decision and it involves a need for in
depth knowledge of economic theories and tools, concepts and logic along with individual
skills of the business managers. For example, say a firm plans to launch a new product in
the market and many close substitutes of that product are already available in the market.
The foremost business decision to be taken would whether to launch the product or not. In
order to do so the business manager will have to carefully study the market; the product
and all issues relating to it; and issues relating to the sales.

Here comes the role of the different economic concepts, including demand, supply, cost,
price, etc., that can be and are used by the business managers in business analysis. Various
economic theories, tools, concepts and logic help in arriving at appropriate and right
conclusions as regards the business problem.

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The primary responsibility of the manager of a business firm is the attainment of the desired
objectives. A managerial decision can be evaluated only in the context of its objective. For
this the objectives of the firm should be clearly stated which may be various and conflicting.
The conventional theory of firm takes profit maximization as the primary objective of a
business firm. This is defended on the basis of the argument that making profit is
indispensable for the survival of the firm in the long run. Further, the achievement of
alternative objectives of the firm like maximizing long run growth, maximizing sales
revenue, increasing market share and such like are themselves dependent more or less on
the profit objective, as profit is a relatively more reliable measure of a firm’s efficiency.
Moreover, profit maximization hypothesis is a time- tested one and is largely used to
explain the price and output decisions of the business firms.

However, whatever may be the objective of a firm, all the business decisions taken by the
managers aim at the attainment of pre-determined objective(s). Traditionally the process of
business decision making relied on the rule of thumb technique. Such a technique evolved
out of traditional business practices, serves the purpose where simple business decisions
are involved. However, complex issues in business decision-making involve the use of
some basic economic concepts.

Economic Principles relevant to Managerial Decisions

1. The concept of Economic Profit

Considering the objective of the firm as maximisation of profit, the term profit
conventionally considered in business parlance is the net account profit which is the
difference between explicit cost and revenue. But the concept of profit considered in
economic analysis, termed as economic profit, incorporates implicit costs or opportunity
cost in calculation of profit. Implicit cost or opportunity costs is the returns that could
generated from the next best alternative use of the resource.
For example, if A, a BBA graduate, invests Rs.1000000 in the business of tourism services
and earns annually an accounting profit of Rs. 80000 as the difference between accounting
revenue and cost. Consider the case if A was employed elsewhere could have earned on
average annually Rs.300000 and the banking institutions in the area gives an interest rate
of 8 percentage for the deposits. In such a scenario, even though, based on accounting profit
the enterprise is earning profit of Rs. 80000, in terms of economic profit, A is making an
economic loss of Rs. 300000, ie..., ((80000) – 300000-80000)). Thus, application of the
concept of economic profit gives a totally different positive information in evaluation of
business projects.

2. Principle of opportunity cost:

The business manager needs to sacrifice some alternatives against the selected ones in a
rational manner in almost all aspects of business (the problem of choice). Since human
wants are infinite and means to satisfy them are scarce, it is impossible to satisfy all the
wants. In order to satisfy some wants, it becomes necessary to give up or postpone some
other wants. Similarly, resources – natural and man-made are scarce in relation to their
demand but have alternative uses. This scarcity and possible alternative uses of the
resources leads to the concept of opportunity cost. The opportunity cost or alternative cost
is what has been sacrificed to have a certain thing. It is the benefit foregone of the
alternative that has not been chosen.

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For example, say a worker works in an ice factory and gets a wage of Rs. 4000 per month.
Alternatively, if he gets employment in a shoe factory, he might be getting a wage of Rs.
3000 per month. So, the earning in the next best alternative (Rs. 3000) is the opportunity
cost or alternative cost of his services.

Similarly, a firm has limited resources at its disposal which can be put to alternative uses.
For example, a firm may have different options available to expand its output using a capital
of say Rs. 10 million- setting up a new unit having expected annual return of Rs. 2.5 million
or expanding the existing unit having expected annual return of 1.8 million. A rational
business manager would definitely go in for the first alternative other things remaining the
same. This means that the manager will have to sacrifice Rs. 1.8 million- the annual return
of second option which is not selected, in order to get an annual return of Rs. 2.5 million
(the selected alternative). Hence, the opportunity cost of setting up a new unit in this
example is the sacrifice involved is not expanding the existing unit.
Thus, the opportunity cost is the cost of the next best alternative which is foregone. This
concept of alternative or opportunity cost is applicable to all types of resources involved in
business decision where alternative uses are possible.

3. Marginal Principle

Marginal principle implies judging the impact of a unit change in one variable on the other.
Marginal generally refers to small changes. Marginal revenue is change in total revenue
per unit change in output sold. Marginal cost refers to change in total costs per unit change
in output produced (While incremental cost refers to change in total costs due to change in
total output). The decision of a firm to change the price would depend upon the resulting
impact/change in marginal revenue and marginal cost. If the marginal revenue is greater
than the marginal cost, then the firm should bring about the change in price.

It is widely used in economic theory -marginal utility in utility analysis; marginal cost in
theory of production and marginal revenue in the theory of pricing. As regards business
decision making, marginal principle is applicable in the cases where marginal revenue
(MR) and marginal cost (MC) can be exactly computed. According to marginal analysis,
marginal cost is the change in total cost (TC) due to a unit change in total output.

Marginal Cost = Change in Total Cost /Change in Total Output

Or
Marginal cost of nth unit of output is the total cost (TC)of n units minus total cost of n-1
units. MC n = TCn –TCn-1 where n is the number of units of output. Similarly Marginal
Revenue (MR) is the change in total revenue due to a unit change in total output.

Marginal Revenue= Change in Total Revenue /Change in Total Output

Marginal Revenue of nth unit of output is the total revenue (TR) of n units minus total
revenue of n-1 units. MR n = TRn –TRn-1 where n is the number of units of output.

The decision rule under the marginal principle for a profit maximizing firm is given as MC
= MR

In other words, for a business firm, the profit will be maximum, when marginal cost equals
marginal revenue, that is the cost of producing an additional unit becomes equal to the

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revenue earned by selling that additional unit. However, a major drawback of this approach
is that it is applicable only when exact calculation of marginal cost and marginal revenue
is possible and variable cost can be subjected to a unit change.

4.Incremental Principle

A relatively convenient concept, like that of marginal principle which can be used is the
incremental principle. The incremental concept is of great use when bulk production is
involved and total cost and total revenue witness large changes. The increase in revenue
due to a given business decision would be called incremental revenue. On the other hand,
similar increase in cost (due to say expansion in the size of the firm) is called incremental
cost.

The business decision rule in this context is that the given business decision taken is correct
if it leads to a higher incremental revenue as compared to incremental cost. If it is otherwise,
the given business proposition is not accepted. Although marginal analysis is more precise,
the incremental concept finds more practical applicability.

5. Equi-marginal principle

Marginal Utility is the utility derived from the additional unit of a commodity consumed.
The laws of equi-marginal utility states that a consumer will reach the stage of equilibrium
when the marginal utilities of various commodities he consumes are equal. According to
the modern economists, this law has been formulated in form of law of proportional
marginal utility. It states that the consumer will spend his money-income on different goods
in such a way that the marginal utility of each good is proportional to its price, i.e.,

MUx / Px = MUy / Py = MUz / Pz = MUm

Where, MU represents marginal utility and Px , Py , Pz is the prices of goods X,Y, and
Z. and MUm is Marginal utility of money income.

Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the
technique of production which satisfies the following condition:

MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3

Where, MRP is marginal revenue product of inputs 1, 2 and 3 and MC represents

marginal cost of inputs 1,2 and 3.

Thus, a manger can make rational decision by allocating/hiring resources in a manner

which equalizes the ratio of marginal returns and marginal costs of various use of resources
in a specific use.

6. Time Perspective Principle

The time element needs to be given due importance in the process of business decision
making. Every single business decision need be undertaken with a given time perspective.
This means business managers should make decisions by taking into account the time angle
of business propositions well in advance. Relevant past and foreseeable future have to be
given due consideration while taking a business decision. The time difference or duration
between relevant past and foreseeable future refers to the time perspective.

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Relevant past indicates the time period of past experience and trends which are important
for any business decision in the present. Some of the business decisions involve short run
outcome while others may have long run pay-offs. The economic concept of Short-run
refers to a time period in which some factors are fixed while others are variable while the
long run perspective refers to the time period wherein all factors tend to vary. The
production can be increased in the short run by increasing the quantity of variable factors.
A certain business decision may be more profitable in the short-run than in the long-run
and vice-versa. For instance, say, a business firm decides to increase its expenses on
medical facilities along with other facilities to its workers. Such a decision may escalate
costs in the short-run but in the long run it may lead to increasing revenues by way of
enhanced productivity of workers. Therefore, time perspective is of utmost importance in
business decision making.

7. Discounting Principle

According to this principle, if a decision affects costs and revenues in long-run, all those
costs and revenues must be discounted to present values before valid comparison of
alternatives is made. This is essential because a rupee worth of money at a future date is
not worth a rupee today. Money actually has time value. Discounting can be defined as a
process used to transform future dollars into an equivalent number of present dollars. For
instance, $1 invested today at 10% interest is equivalent to $1.10 by the beginning of next
year. Thus, the future value of money invested can be calculated as;

𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 (𝐹𝑉) = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 ∗ (1 + 𝑟)𝑡

Where t is the time between present value and future value and r is the rate of discount.
Therefore, since revenue or returns from all business investments spans over many future
years, considering the changes in the time value of money, their outcomes cannot be
compared in terms of the future values but it must be compared in the present value terms.
It can be calculated by discounting the expected revenue by the required rate of return as
follows;

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝐹 =
(1 + 𝑟)𝑡

8. Scarcity
Scarcity is the situation in which available resources or factors of production are finite,
whereas wants are infinite. There are not enough resources to produce everything that we
need and want. The basic economic problem that arises because people have unlimited
wants but resources are limited. Because of scarcity various economic decisions must be
made to allocate resources efficiently.

9. Production Possibility Curve

A production possibilities curve is a graphical representation of the alternative
combinations of goods and services an economy can produce. Production Possibility Curve
(PPC) indicates different combinations of two commodities that can be produced in an
economy at any point of time with the help of given techniques and resources. Production
Possibility Curve (PPC) is also called Production Possibility Frontier or Transformation
Curve. For an individual consumer, a PPC shows the different combinations of the two

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commodities which a consumer can buy given his income and prices of the two
commodities. However, for the economy as a whole, it depicts the opportunity cost or
alternative cost of producing one good in terms of the amount of the other good sacrificed
subject to the limited availability of resources. This concept is also very important for the
business managers for decision making.

In the diagrams given below, PPC1 PPC2, PPC3 depicts production possibility curve of
three plants in producing commodity 1 and commodity 2. PPC 1 shows that in plant A, in
order to produce one unit more of commodity 2 it has two forego 0.5 units of commodity
1. It means the opportunity cost of producing commodity 2 in plant A is 0.5 units of
commodity 1. In PPC 2, pertaining to plant B, the opportunity cost of producing one unit
of commodity 2 is equal to 1 unit of commodity 1. In plant C, the PPC 3 displays that the
opportunity cost of producing commodity 2 is two units of commodity 1. Overall, it shows
that opportunity cost of producing commodity 2 is highest in plant C and it is lowest in
plant A. Therefore, businessman with these type of plant capacities and initially producing
only commodity 1, if in need of producing commodity 2 will make use of facility in plant
A and if its capacity is fully utilized will make use of plant b in producing commodity 2
and will only lastly rely on plant C.

Combined production possibility curve is presented in PPC 4. It is concave to the origin

indicating increasing opportunity cost as more and more resources are reallocated and
utilized in production of a particular commodity. Point Y indicate the maximum units of
commodity 1 that three plants combined can produce with zero units of commodity 2.
Likewise point X indicates maximum units of commodity 2 that three plants combined can
produce while producing no units of commodity 1. The curve YX depicts the Production
possibility curve faced by the businessman. Any point below this curve indicates
unemployment or not utilizing the full production capacity while point on the PPC curve
indicates full and efficient utilization of resources.

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 Lecture and
Theory of Demand 08
Module 2 Knowledge participative
and Supply Sessions
problem discussion
Demand-law of demand, demand curve, determinants of demand derivation of individual and market
demand schedules, exceptions to Law of demand. Elasticity of demand (Applications) Price Elasticity,
Income Elasticity & Cross Elasticity - Changes in Demand and Changes in Quantity Demanded.
Supply-law of supply, supply curve and determinants of supply - Market Determination of Price and
Quantity. Elasticity of supply (Applications), Equilibrium of demand and supply.

Demand refers to the desire to have a commodity backed by enough money to pay for the
good demanded. Thus, in economics demand refers to that desire which is effectively
supported by an adequate purchasing power. In order to understand the concept of demand
it is essential to distinguish between desire and demand. For instance, if a person wishes to
buy a car but does not have the required money, his wish is a desire. On the other hand, if
he has enough money to buy that; then it becomes effective desire or demand. Moreover,
the demand is not complete unless the consumer has willingness to buy the commodity. If
a person has the desire to buy a product and also has enough money for it, but at a particular
point of time, he may not have willingness to buy the good, maybe due to a sudden change
in his taste or preference or fashion, etc. For example, when a rich person goes to a
showroom to buy an expensive dress but declines to buy, just because he does not find the
colour of his choice. Moreover, demand for a commodity is always expressed in relation to
a particular price and a particular time. Therefore, the demand for a product has the
following five aspects: (i) Desire to buy (ii) Ability to pay (iii) Willingness to spend (iv)
Particular price (v) Particular time period.

Types of Demand

 Direct demand and derived demand: Goods can be demanded for different
purposes, for consumption or for production. On this basis, direct demand refers to
the demand for goods which are meant for final consumption. The demand for all
household goods such as sugar, milk, tea, food items, furniture, medicines,
television, refrigerator, etc., are examples of consumer goods etc. Such
commodities are demanded as they are, that is why their demand is called direct
demand. On the contrary, derived demand refers to the demand for those goods
which are needed as a raw material or as an intermediary good in the production of
any other commodity. Such a good is called a capital good and its demand is called
derived demand. For instance, the demand for steel in the production of steel
utensils is a case of derived demand. Hence, derived demand is the demand for
goods by the producers like the demand for raw materials, intermediate goods,
machine tools and equipment, etc. Similarly, the demand for factors of production
is also an example of derived demand.

 Final demand and intermediate demand: Based on the types of goods - final or
intermediate, the demand may be final demand or intermediate demand. The
demand for goods for final consumption is called final demand while the demand

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 for semi-finished goods and raw materials is intermediate demand. The demand for
final goods is a direct demand. While the demand for semi-finished goods and raw
materials is derived and induced demand as it is dependent on the demand for final
goods.

 Domestic demand and industrial demand: Goods for domestic use have a
domestic demand while goods for industrial use or commercial use have an
industrial demand. Such a distinction between domestic and industrial demand is
very significant in the context of pricing and distribution of a product. For instance,
the price of water, electricity, coal etc. is intentionally kept low in case of domestic
use as compared to their price for industrial use or commercial use.

 Autonomous demand and induced demand: Autonomous demand for a good is

the demand which is completely independent of the use of other product. However,
this is a rare phenomenon in the present world of dependence. On the other hand,
the demand for complementary goods (jointly demanded goods like bread and
butter, pen and ink, tea, sugar milk) is induced demand. In this case the demand for
a product is dependent on the demand of some other product. For instance, the
demand for sugar is induced by the demand for coffee.

 New demand and replacement demand: The demand meant for an addition to
stock is called new demand, for example, demand for new models of a particular
good say computer, mobile, tractor, car or machine is new demand. On the other
hand, replacement demand is the demand for maintaining the old stock of capital or
asset intact like the demand for spare parts of a computer, mobile, tractor, car or
machine is replacement demand. New demand is usually an autonomous demand
while the replacement demand is induced one, as it is usually induced by the various
factors like quantity and quality of existing stock.

 Demand for perishable goods and demand for durable goods: Consumer goods
can be divided into two categories – Perishable and durable. Perishable goods are
also non-durable in nature or single use goods, while durable goods are non-
perishable in nature or repeated use goods. Milk, bread, butter, ice-cream, etc. are
examples of perishable goods, and furniture, computer, mobiles, house, etc. are
durable goods. Perishable goods meet the immediate demand and durable goods
fulfil present as well as future demand. Demand for durable goods is influenced by
the replacement of old products and expansion of stock and hence, changes with
change in business conditions and price expectations.

 Short run demand and long run demand: The demand for a good also depends
on the time for which it is demanded. Short- run demand is immediate demand as it

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 is based on the available taste and technology, products improvement and
promotional measures operating in the short run. Price-income fluctuations play an
important role in case of short run demand. Long run demand, on the other hand, is
more influenced by changes in consumption pattern, urbanization and work culture.
Generally, short run demand is for immediate consumption long-run demand is for
future consumption.

 Individual demand and market demand: The demand of a consumer for a

product over a period of time is called individual demand, whereas the sum total of
demand for a product by all individual consumers in a market is known as market
demand.

 Joint demand and Composite demand: When two or more goods together satisfy
a particular want, the demand for such goods is called joint demand. The demand
for complementary goods is a joint demand, like bread and butter or car and petrol.
On the other hand, when a commodity can be put to several uses its total demand in
all the uses is called composite demand. For instance, milk, electricity, etc. can be
put to multiple uses.

 Company demand and industry demand: Similar to the concept of individual

demand and market demand, is the distinction between company demand and
industry demand. The demand of a company or a single firm involved in the
production of a particular product is company demand. Alternatively, the demand
of an industry (group of firms engaged in the production of the same product) is the
industry demand.

Determinants of Demand

Determinants of Demand Other than price, the quantity demanded for a particular
commodity is influenced by various other factors also. A mathematical function showing
the functional relationship between the demand for a product and various factors
influencing it, is called a demand function. A demand function may be expressed as
follows:

DX = f ( Px, Ps, Pc, Yd, T, A, W, C, E, P, G, U)

where Dx = Demand for commodity X, Px = Price of commodity X, Ps = Price of

substitute of commodity X, Pc = Price of complementary goods of commodity X, Yd =
Disposable income of the consumer, T = Taste and preferences of the consumer, A =
Advertisement of commodity X, W = Wealth of the consumer, C = Climate, E = Price
expectation of the consumer, P = Population, G = Government policies, U = Other
unspecified and unidentified factors.

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 Price of the product: It is the single most important determinant of demand of
good. Normally price has a negative effect on demand. Other things remaining the
same, as price increases, the demand for the good tends to fall and vice-versa. This
negative relation between price and demand is known as the law of demand. This
type of demand showing the effect of changes in price of a commodity on its
quantity demanded other things remaining same, indicates the price effect and is
known as price demand.
 Income of the consumer: Disposable income of the consumer an important
variable influencing the demand. As income increases, people have a tendency to
buy more of superior or normal goods and less of inferior goods. A normal good is
a good whose quantity demanded increases with increases in income, like higher
segment cars. An inferior good is a good whose quantity demanded decreases with
increase in income, like inferior quality cereal. The income effect changes the
quantity demanded by allowing consumers to purchase goods which they could not
afford earlier. This type of demand explains the effect of changes in the income of
the consumer on the demand for a commodity, other things remaining same and it
is called income effect.
 Taste and preferences of the consumer: These are important factors which affects
the quantity demanded of a product. The demand for a good will be large if tastes
and preferences are favourable and vice-versa. Many factors play a role in
developing the tastes and preferences like age, gender, professional status, level of
education, social and cultural factors, advertising, to name a few.
 Prices of related goods: Related goods are of two types—substitutes and
complements and their prices affect the quantity demanded of a product. Substitutes
are those goods which can be interchangeably used. For example, tea and coffee are
substitutes. If price of tea increases the consumer can use coffee and vice versa.
Complementary goods are those goods which are demanded together and jointly
satisfy a demand, like bread and butter or car and petrol. In case of substitutes, the
rise in price of one commodity results in an increase in the quantity demanded of
the other. If the price of substitute (say coffee) rises, the demand for tea increases.
However, in case of complementary goods, the change in the price of any of the
two goods surely affects the demand of the other good. For instance, if price of
motor cars rises, there will be a fall in the demand for motor cars. Along with it, the
demand for petrol also falls.
 Consumer’s expectation of future income and prices: The purchases made by a
consumer also depend on future expectations along with present income and prices.
If the price for petrol is expected to rise in the near future, then the demand for
petrol will increase now. If the price for petrol is expected to drop in the near future,
then the demand for petrol will decrease now. Similarly, if a consumer expects a
raise in salary in coming times, he will postpone the demand for some good and buy
it later.

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 Population: Important demographic features of the population like its size, age
distribution, gender ratio, rural urban ratio, etc. have a striking noticeable impact on
the level of demand in the economy.
 Advertisement: Publicity measures have a great influence on demand. Sales
turnover of firms increases due to advertisement which is known as the promotional
effect on demand.
 Climate: The weather and climatic conditions of a region also influence the demand
for different goods. For instance, the demand for coolers and air conditioners
increases in summers, while that of heaters increases in winters.
 Government policy: The government policy on taxes and subsidies of different
commodities also influences the demand of different goods differently. An increase
in tax rates or the imposition of new taxes results in a decrease in the demand and
an increase in subsidies increase the demand.
 There are many other factors also which may not be specified or identified but
influence demand. Hence, a demand function shows the effect of different factors
influencing the level of demand.

Law of Demand
In economics, the law of demand expresses the functional relationship between price
and quantity demanded for a particular commodity. The law states that other things
remaining the same or ceteris paribus, if the price of a commodity falls its quantity
demanded will rise and if price of the good rises quantity demanded will fall. In other
words, there is an inverse relationship between price and quantity demanded.
The law of demand is defined as follows:

“People will buy more at lower prices and buy less at higher prices, ceteris paribus or
other things remaining the same”. --- Samuelson

“Other things being equal, the quantity demanded per unit of time will be greater, the
lower the price and smaller, the higher the price”. ---Bilas

“The amount demanded increases with a fall in price and diminishes with a rise in
price”. ---Marshall

Assumptions of the Law of Demand

The law of demand is based on the following assumptions:
1. The commodity is normal.
2. There is no change in the incomes of consumers.
3. There is no change in the tastes and preferences of consumers.
4. There is no change in the prices of related goods.
5. The goods are perfectly divisible.
6. There are normal conditions in the economy.

These assumptions refer to the ‘other things remaining the same or ceteris paribus’
clause of the statement of the law of demand. In other words, assumptions refer to those
conditions which must be met for the law of demand to be valid.

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Demand Schedule and Demand Curve

A demand schedule is a tabular representation showing the different quantities of a

commodity that would be demanded at different prices. It shows the quantities of a
good that will be purchased at different possible prices. A demand schedule can be
shown as below:

Price of Commodity X Demand for Commodity X (Kg.)

75 22
90 17
105 12
120 8

The demand schedule clearly shows that for a commodity X, as price rises, quantity
demanded falls, other things remaining the same. Such a demand schedule which shows
the quantities of a commodity that would be demanded at different prices for an
individual consumer is called an Individual Demand Schedule. This demand schedule
can be represented in the form of a diagram to get a demand curve as shown as below.
Price of X

Quantity demanded of X

The above figure is a diagrammatic representation of the individual demand schedule

which shows the quantities of a commodity that would be demanded at different prices
for an individual consumer. This curve is called Individual Demand Curve.

Market Demand

When relationship between the quantities of a commodity that would be demanded at

different prices for all the individuals in the market, other things remaining the same, it
is called Market demand. The market demand or aggregate demand for a commodity
refers to the alternative quantities of a commodity that would be demanded at different
prices per time period, by all the individuals in the market. Thus, the market demand
for a commodity depends on all the factors that determine the demand of one individual
and also on the total number of individual buyers of the commodity in the market. A
market demand schedule is a tabular representation showing the different quantities of
a commodity that would be demanded at different prices by all the individual buyers of
the commodity in the market. Similarly, a diagrammatic representation of the market
demand schedule which shows the quantities of a commodity that would be demanded

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 at different prices for all the individual consumers of the commodity in the market, is
called a market demand curve.

Price of Demand for Commodity

Commodity X by Individuals Market demand for commodity X
A B C D E (kg)
75 22 30 17 34 16 119
90 17 24 14 20 15 90
105 12 18 8 19 5 62
120 8 10 6 16 0 40

The market demand schedule clearly shows that for a commodity X, as price rises, the
total quantity demanded in the market or the market demand falls, other things
remaining the same. Such a market demand schedule which shows the quantities of a
commodity that would be demanded at different prices for all the individual consumers
in the market is called an Market Demand Schedule. It is clear that market demand is
the sum of individual demands of A, B, C, D and E, consumers in the market. This
market demand schedule also establishes the negative relation between price and
quantity demanded, other things remaining the same. It can be represented in the form
of a diagram to get a demand curve known as the as shown as below.
Price of X

Total Quantity of X demanded by A, B, C, D, and E

The market demand curve can be obtained by the lateral summation of all individual
demand curves in the market. The market demand schedule and market demand curve
have much significance from practical point of view. First of all market demand
schedule can assist the business managers in deriving the revenue curves of a particular
business firm. Further a market demand schedule can assist the government authorities
in assessing the impact of a particular tax measure on the market demand. Moreover,
the businessmen or the producers, particularly the monopolists, make use of the market
demand schedule in the fixation of the prices of their products. Hence, market demand

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schedule and market demand curve are of great practical importance in assisting the
business managers in the process of business decision making.

Causes of the Law of Demand

According to the law of demand there is an inverse relationship between price and
quantity demanded, other things remaining the same. Consequently, the demand curve
slopes downward from left to the right. The demand schedules, both individual and
market, have shown that lower the price of a commodity, the greater is the quantity
demanded of the commodity by the individual or the market. This inverse relationship
between price and quantity is reflected in the negative slope of the demand curve.
Hence, with a few exceptions, the demand curve always slopes downward from left to
the right. It can be attributed to the following reasons:

(a) An important reason is the operation of the law of diminishing marginal utility.
According to the law of diminishing marginal utility, other things remaining the same,
as the consumer goes on buying more and more units of a commodity, the utility derived
from each successive unit goes on diminishing. In equilibrium, there is an equality
between marginal utility and price. This means that the purchase of more units of the
commodity is associated with lower price. Hence, the inverse relationship between
price and quantity demanded is on account of the law of diminishing marginal utility.

(b) Income effect and substitution effect: When the price of a commodity falls, real
income of the people increases. In other words, consumers are now able to buy more
goods and services with the same amount of money they have. Hence, the desire to buy
intensifies and people buy more at lesser price. This is called income effect. When the
price of a commodity decreases, new demand is created for it as many people who could
not earlier afford it, can now buy it. Also, that existing buyers tend to buy more. As a
result, demand curve slopes downward from left to the right. As price of a commodity
decreases, some people will purchase it in preference to other commodities which
means cheaper commodity tends to be substituted for other commodities, which are
relatively costly. This is called substitution effect. Both the income effect and the
substitution effect together increase the capacity of the consumers to buy more quantity
of a commodity, at a lower price.

(c) A commodity can be put to several uses as it becomes cheaper. For example, coal
can be put to many uses. If the price of coal is high, it is possible that it is used only in
the factories. As its price falls, it may be used by railways and power plants. If there is
a further fall in price, the households may also start using it as fuel. Thus, with a fall in
price, the demand for a commodity expands and the demand curve slopes downward
from left to the right.

Exceptions to the Law of Demand

If the assumptions of the law of demand are not met, this law fails to apply. There are
a few exceptions to the law of demand. It means those conditions when the law does
not hold good or the inverse relationship between price and quantity demanded may not
remain valid. In such cases the demand curve does not slope downward from left to the
right. These exceptions are:

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1. The law of demand does not hold in case of certain goods known as Giffen goods.
In case of such goods, quantity of a commodity that would be demanded rises with the
rise in price. These goods were first discussed by Sir Francis Giffen. According to him,
a Giffen good is a strongly inferior good where consumer buys more of an inferior good
when the price of the good rises, which is in direct violation of the Law of Demand.
For example, staple foods like rice. If the price of rice rises then people with less income
will spend less on superior foods and instead buy more rice. This is called Giffen
Paradox.

2. Thorstein Veblen observed that in case of conspicuous consumption, the demand

curve does not slope downwards. Many times people buy certain commodities to show
their higher status in the society, like Rolls Royce cars, diamonds and other precious
stones, etc. Richer people buy more of such goods even at very high price to show off
in the society, violating the law of demand. These goods are called Veblen goods.
3. People may buy more of a commodity even at high prices, out of sheer ignorance.
Hence, the law of demand also not apply to such a commodity also.
4. Speculation, where people make a guesswork or prediction of a future event and act
accordingly, is another exception to the law of demand. If the price of commodity is
rising and consumers expect a further rise in the price, they will tend to buy more of the
commodity in the present even at a higher price.

Hence, Giffen goods and Veblen goods are exceptions to the Law of Demand. They are
extreme cases and show how these goods violate the Law of Demand. The Veblen effect
representing a form of irrational consumption, is an anomaly in the law of demand in
economics. There are two other related effects as given below:
1. The snob effect- It shows that the preference for a good decrease as the number of
people buying it increases. This effect may lead to a demand curve sloping upwards,
violating the law of demand which causes the demand curve to have a negative slope.
The snob effect is a phenomenon indicating a situation where the demand for a certain
good by consumers having a higher income level is inversely related to the demand for
that good by consumers of a lower income level. This situation arises due to the desire
to own unusual and expensive goods, which have a high economic value, but very low
practical value. The snob value of a commodity is reflected in its availability. Lesser is
the quantity available of the commodity, the higher will be its snob value. For examples
goods like rare works of art, designer clothing, etc., have a high snob value.
2. The bandwagon effect - It indicates that the preference for a good increase as the
number of people buying it increases, that is the bandwagon effect reflects the tendency
to follow the actions or beliefs of others. Thus, the bandwagon effect describes the
interactions of demand and preference. It comes into force when people's preference
for a commodity increases when the number of people buying it increases. Such an
interaction disturbs the normal results of the theory of supply and demand, which
assumes that consumers make buying decisions only on the basis of price and their own
personal preference. The bandwagon effect may be so strong that it may make the
demand curve slope upwards, violating the law of demand. The bandwagon effect is
also known as demonstration effect. In this case, the demand for a product appears to
be determined by consumption pattern of trend setters like cricket stars, film stars,
models, etc., and not by the utility derived from it.

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Changes in Demand

In economic analysis, the law of demand explains the changes in demand due to
changes in price. However, sometimes changes in demand are not associated with
changes in price but with certain other non-price factors. Based on the factors causing
the changes in demand – price factors or non-price factors, the changes in demand can
broadly be of two types:
(1) Expansion and Contraction in Demand
(2) Increase and Decrease in Demand

Expansion and Contraction in demand

When the changes in quantity demanded for a commodity take place on account of
changes in its price, these signify either expansion or contraction in demand. Hence,
expansion or contraction in demand relates to the law of demand as in this case, changes
in the quantity demanded take place only in response to the own price of the
commodity. This means all the components of the demand function remain unchanged
except the price the commodity under consideration. If the price of a commodity falls,
other things remaining the same, it leads to larger purchase of this commodity. This is
called expansion in demand. It signifies more demand at a lower price. On the other
hand, if the price of a commodity rises, other things remaining the same, it leads to
smaller purchase of this commodity.

Increase and Decrease in Demand

When the changes in quantity demanded for a commodity take place not on account of
changes in its price, but due to other no- price factors, these signify either increase in
demand or decrease in demand. Hence, increase and decrease in demand do not relate
to the law of demand as in this case other components of the demand function change
except the price the commodity under consideration. Only the non-price factors like
income, taste and preferences, price of related goods, climate, population, etc., change
while the price the commodity under consideration remains the same.

Elasticity of demand

Generally speaking, the term elasticity is concerned with the responsiveness of one
variable to changes in another. Specifically, the elasticity of demand indicates the
degree of responsiveness of demand to the changes in its determinants. It shows the
response of the demand of a commodity when there is either increase or decrease in its
price. Business managers of the firms have great advantages by knowing elasticity of
the products of the firm. A greater response in the demand of a commodity indicates
greater elasticity and a smaller response indicates less elasticity. For example, a
business manager will definitely be interested in knowing whether sales will increase
by six percent, twelve percent or maybe more by cutting down price by say, seven
percent. Thus, elasticity of demand of a commodity measures the degree of
responsiveness of demand to a change in price of that commodity.

The concept of elasticity of demand in the economic theory was introduced by Prof.
Alfred Marshall. He defined it as:

Page 20 of 114
“The elasticity (or responsiveness) of demand in a market is great or small according
as the amount demanded increases much or little for a given fall in price and diminishes
much or little for a given rise in price”.

“The elasticity of demand may be defined as the percentage change in the quantity
demand which would result in one percent change in price”.
Boulding

“The elasticity of demand at any price or at any output is equal to the proportional
change of amount demanded in response to a small change in price divided by the
proportional change in price”.
Mrs
Joan Robinson

Thus, elasticity of demand may be defined as the ratio of the percentage change in
quantity demanded to the percentage change in price. Other things remaining the same,
if certain percentage changes in demand of a commodity take place due to certain
percentage change in a price of that commodity, it is known as elasticity of demand.
Boulding has given the following formula to compute the elasticity of demand as
follows:

𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦
=
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑎𝑛𝑦 𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑛𝑡 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦

Theoretically it is possible to discuss the elasticity of demand for all the different factors
affecting demand, represented in the demand function, but in real practice, broadly there
are four main types of elasticity of demand which can be measured and examined.
These four types of elasticity of demand correspond to four specifically important
factors in the demand function: price of the commodity, income of the consumer, the
price of a related product and promotion or advertisement and are referred to as the
price elasticity of demand, income elasticity of demand, cross elasticity of demand and
promotional elasticity of demand respectively.

Types of Elasticity of Demand

Depending on the factors influencing the level of quantity demanded, four main types
of elasticity of demand can be listed. Price elasticity of demand measures the
responsiveness of demand of a commodity to change in the price of that commodity.
Income elasticity of demand measures the responsiveness of demand of a commodity
to change in the income of the consumer. Similarly, cross elasticity of demand captures
the responsiveness of demand of a commodity to change in the price of a related
commodity, and promotional elasticity of demand measures the responsiveness of
demand of a commodity to change in advertisement measured in terms of expenditure
on advertisement.

Price elasticity of demand

Price elasticity of demand is a measure of the responsiveness by which consumers

change their quantity demanded due to a change in price. If demand is more price elastic

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demand, it means that the consumers are more responsive to changes in price. On the
other hand, if demand is less price elastic demand , then the consumers are less
responsive to a price change. The price elasticity of demand is measured as the
percentage change in quantity demanded divided by the percentage change in price.
Demand may be less elastic, more elastic or inelastic. When a small change in price
leads to a great change in demand, demand is said to be elastic. If a two percent cut in
prices of bike results in an increase of twenty percent in sales, then the demand is said
to be highly elastic (as demand has responded greatly). On the other hand, if a great
change in price leads to a small change in demand, the demand is said to be inelastic
demand. Price elasticity of demand is expressed as under:

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦

𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦

Price elasticity of demand is defined as the responsiveness of the quantity demanded of

any good X to a change in its own price, is called the price elasticity of demand.

Degrees of Price elasticity of demand

The price elasticity of demand measures the percentage change in the quantity
demanded of a commodity per unit of time due to a given percentage change in the
price of the commodity. There are five degrees of price elasticity of demand each of
which is discussed as follows;

1. Perfectly Inelastic Demand: Demand for a commodity is said to be perfectly

inelastic, if the quantity demanded of a commodity does not change at all in
response to a given change in price. For example, if a ten percent change in
price results in zero percent change in demand, it is perfectly inelastic demand.
In this case, the demand curve is vertical straight line perpendicular to X-axis
as shown above. When demand for a commodity is perfectly inelastic demand,
the coefficient of price elasticity of demand, e is equal to zero (e=0).
Price of X

Perfectly inelastic Demand curve

Quantity of X demanded

2. Inelastic demand or less than Unit Elastic Demand: Demand for commodity
is said to be inelastic (or less than unit elastic) if the percentage change in
quantity demanded of a commodity is less than the percentage change in price.

Page 22 of 114
 For example, if a ten percent change in price results in six percent change in
demand, it is called inelastic or less elastic demand. In this case, the coefficient
of price elasticity of demand, e is less than one (e<1). This is shown in the figure
given below:

Price of X Inelastic Demand curve

Quantity of X demanded

3. Unitary Elastic Demand: Demand for a commodity is said to be unitary elastic

if the percentage change in quantity demanded is exactly equal to the percentage
change in price. For example, if a ten percent change in price results in ten
percent change in demand, it is called a unitary elastic demand, The demand
curve in in case of unitary elastic demand s shown above is called rectangular
hyperbola. In this case, the coefficient of price elasticity of demand, e is equal
to one (e=1). as shown below.
Price of X

Unitary elastic Demand curve

Quantity of X demanded

4. Elastic demand or More than Unitary Elastic demand: Demand for a

commodity is said to be more than unitary elastic demand if a given change in
price results in a significantly more than proportionate change in demand for
this commodity. For example, if a ten percent change in price results in a
fourteen percent change in demand, it is called more than unitary elastic demand
or elastic demand. In this case, the coefficient of price elasticity of demand, e is
more than one (e>1). This can be shown with the help of the following figure.
Price of X

Elastic Demand curve

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 5. Perfectly Elastic Demand: Demand for a commodity is said to be perfectly
elastic, when a small change the price of the commodity results in an infinitely
large change in its quantity demanded. It is a situation in which demand of a
commodity continuously changes without almost any change in price. For
example, if say half a percent change in price results in an infinite percent
change in demand, it is called perfect elastic demand. In this case, the demand
curve is horizontal straight line parallel to the X-axis and the coefficient of price
elasticity of demand, e is equal to infinity (e=∞).

Perfectly elastic Demand curve

Price of X

Quantity of X demanded

Measurement of price elasticity of demand

The extent of responsiveness of demand to changes in price can be measured in
different ways. The important methods of measurement of price elasticity of demand
are:
1. Percentage method. 2. Arc method. 3. Point method. 4. Total outlay method. 5.
Revenue method.

1. Percentage method.
Price elasticity of demand can be measured using the percentage method or
proportionate method. According to this method, price elasticity of demand is measured

Page 24 of 114
 as the ratio of the percentage change in quantity demanded to the percentage change in
price as shown below:

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦

𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑒𝑝 =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦
∆𝑞 ∆𝑝
= ÷
𝑞 𝑝

Where ep = price elasticity of demand; Δq = change in the quantity demanded and Δp

= change in price. Also p = price of the commodity and q = quantity demanded. It is
important to note that the price elasticity of demand is always negative because of the
fact that the price and quantity are, in general, inversely related. By convention the
negative sign is dropped.

2. Arc Method
Arc method is another important method to measure the price elasticity of
demand. If there are relatively larger changes in price and demand, the
proportionate method does not give accurate results. In this method, the
averages of original and new prices and quantities are used to measure the price
elasticity of demand. Arc method is so called because in measuring big changes
in demand and price, an arc is formed on the demand curve. Price elasticity of
demand, using arc method can be measured by using the formula shown below:
∆𝑞
𝑞1 +𝑞2 ∆𝑞
2 𝑞1 +𝑞2 ∆𝑞 𝑝1 + 𝑝2
𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑒𝑝 = ∆𝑝 = ∆𝑝 = ∗
𝑝1 +𝑝2
∆𝑝 𝑞1 + 𝑞2
𝑝1 +𝑝2
2
Where, p1= original price; p2 = new price; q1 = original quantity; q2 = new
quantity.

3. Point Method
The point method measures price elasticity of demand at a particular point on
the demand curve. Therefore, it is also known as geometrical method of
measuring price elasticity of demand. Using this method, different types of
elasticity on a demand curve can be measured as follows. D''D is a linear line
demand curve (indicated by a straight line having a constant slope). Price
elasticity of demand at any point on the demand curve is measured using the
following formula.

𝐿𝑜𝑤𝑒𝑟 𝑠𝑒𝑔𝑚𝑒𝑛𝑡 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣𝑒

𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑒𝑝 =
𝑈𝑝𝑝𝑒𝑟 𝑠𝑒𝑔𝑚𝑒𝑛𝑡 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣𝑒

At different points the price elasticity of demand is as shown in the figure given
below. It is obvious that price elasticity of demand falls steadily as we move
from point D'' (e=∞) towards D(e=0), where D''D is the linear line demand
curve. At the mid-point R, where lower segment is equal to the upper segment,
the price elasticity of demand is one (e=1). Between point D'' and the mid-point

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R, the price elasticity of demand is greater than one (e>1). Similarly, between
point R and the point D, the price elasticity of demand is less than one (e<1).

4. Total outlay method.

Total outlay method to measure the price elasticity of demand was primarily
used by Prof. Alfred Marshall. According to this method, elasticity is measured
by comparing the total money spent by the consumer on the goods before and
after the changes in price. Hence, this method of measuring the price elasticity
of demand is also known as the total expenditure method. In this method, the
price elasticity of demand for a commodity is measured with the help of the
total expenditure incurred by a consumer on the purchase of that commodity.
Total outlay or total expenditure can be expressed as;
𝑇𝑜𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 = 𝑃 ∗ 𝑄
If the total expenditure incurred by consumer on a given commodity rises with
an increase in price and falls with a fall in price, it is the case of inelasticity of
demand or less than unitary elastic demand (e < 1).

If the total expenditure incurred by consumer on a given commodity falls with

an increase in price and rises with a fall in price, it is the case of elastic demand
or more than unitary elastic demand (e >1).

When the total expenditure (TQ) on a given commodity remains unchanged

even after a change (rise or fall) in the price of the commodity, then the price
elasticity is said to be unitary elastic.

5. Revenue method
Revenue means the amount that a firm earns by selling its output. What is sold
by a firm reflects the demand by the buyers. Two concepts related to revenue-
average revenue and marginal revenue, are used in this method. Average
revenue is the ratio of the total revenue to the units of output sold. Total revenue
is measured by multiplying price with total units of the product sold. Marginal

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 revenue is the addition made to and total revenue by the sale of an additional
unit of the output.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝐸=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Income elasticity of demand
The demand for a commodity changes not only on account of a change in its price but also due
to a change in the income of the consumer. Income is an important component of the demand
function. Income elasticity of demand indicates the extent by which demand for a commodity
changes due to a given change in the income of the consumer. Thus, income elasticity of
demand measures the level of responsiveness of consumer demand to the changes in income,
other things remaining same.
“The responsiveness of demand to change in income is termed as income elasticity of demand”
… Lipsey.

“Income elasticity of demand means the ratio of the percentage change in the quantity
demanded to the percentage change in income”…
…Watson

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦

𝐼𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 = 𝐸𝑦 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑟
∆𝑄 𝑌
= ∗
∆𝑌 𝑄

Where Q is the quantity demanded and Y is the income of the consumer ∆Q is the change in
the quantity demanded and ∆Y is the change in the income of the consumer. Income elasticity
of demand also has different degrees similar to that of price elasticity of demand.

If the proportionate change in the quantity demanded of a commodity is more than the
proportionate change in the income of the consumer, demand is highly elastic or to be precise,
highly income elastic (e>1).

On the other and, if the proportionate change in the quantity demanded of a commodity is less
than the proportionate change in the income of the consumer, demand is less elastic or less
income elastic (e < 1).

If the proportionate change in the quantity demanded of a commodity is equal to the

proportionate change in the income of the consumer, demand is unitary elastic or unitary
income elastic (e=1).

Two extreme possibilities are e=0, when there is no change in demand at all in response to a
change in income, and e=∞, there is infinite change in demand in response to a given change
in income.

Usually with an increase in income of the consumer, the quantity demanded also increases, that
is, income elasticity of demand is positive. But in certain cases the income elasticity of demand
is negative. Goods whose income elasticity of demand is positive (greater than zero) are
normal goods while the goods that have a negative (less than zero) income elasticity of demand
are known as inferior goods. A good having zero income elasticity of demand is called a
neutral goods.

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Cross elasticity of demand

The demand for a commodity change also due to a change in the prices of related goods like
substitutes or complements. The demand of tea is affected by the price of its substitute coffee
and also the demand of car is affected by the price of its complement petrol. The cross elasticity
of demand indicates the extent by which demand for a commodity change due to a given change
in the price of its related good. Hence, the cross elasticity of demand measures the correlation
between a commodity and its substitutes or complements. Or, the responsiveness of quantity
demanded to a change in the prices of related commodities – substitutes or complements, is
called cross elasticity of demand.

The responsiveness of demand to a change in the prices of other commodities is called cross
elasticity of demand. Lipsey

The cross elasticity of demand is the proportionate change in the quantity of X demanded
resulting from a given relative change in the price of the related good Y. --- Ferguson

𝐶𝑟𝑜𝑠𝑠 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝐸𝑐

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑖𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑋
=
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌
Where QX is the quantity demanded of commodity X and PY is the price of the related
commodity Y. ∆QX is the change in the quantity demanded of X and ∆PY is the change in the
price of the related commodity Y.

Positive cross elasticity of demand: If a certain percentage increase in the price of X causes
an increase in the quantity demanded of related good Y, the cross elasticity of demand is said
to be positive (e>0). Thus, in case of positive cross elasticity of demand, the demand of Y
moves in the same direction as the price of X. Such goods are known as substitutes, those
goods which can be interchangeably used. Suppose the price of coffee rises by 5 percent and it
causes the demand of tea to rise by 3 percent, the cross elasticity of demand is positive.
Negative cross elasticity of demand: If a certain percentage increase in the price of X causes
a decrease in the quantity demanded of related good Y, the cross elasticity of demand is said
to be negative. Such goods are known as complementary goods.

Zero cross elasticity of demand: If a certain percentage increase in the price of X causes no
change in the quantity demanded of related good Y, the cross elasticity of demand is said to be
zero (e=0). Thus, in case of zero cross elasticity of demand, the demand of Y does not change
at all as the price of X changes. Such goods are not related to each other.

The knowledge of cross elasticity of demand of their products is important for the business
firms in order to assess the pricing and marketing strategies of their competitors. Using the
concept of cross elasticity of demand, the business managers can estimate the impact of their
price changes in relation to substitutes or complements.

Promotional or advertisement elasticity of demand

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Advertisements and sales promotion activities are vital for any competitive business firm.
Expenditure on publicity or advertisement brings about different degrees of changes in the sales
of different products. The optimum level of expenditure on advertisement can be determined
using the concept of advertisement elasticity. The advertisement elasticity may be defined as
the degree of responsiveness of sales of a firm to the changes in expenditure on advertisement.
𝐴𝑑𝑣𝑒𝑟𝑡𝑖𝑠𝑒𝑚𝑒𝑛𝑡 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝐸𝑎
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑋 ∆𝑆 𝐴
= = ∗
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑎𝑑𝑣𝑒𝑟𝑡𝑖𝑠𝑒𝑚𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝑋 ∆𝐴 𝑆
where S shows the sales, ΔS indicates the change in sales, A is the initial advertisement cost,
and ΔA represents the increase in advertisement expenditure. The coefficient of advertisement
elasticity lies between zero and infinity (0 ≤ eA ≤ ∞). Normally the advertisement elasticity is
positive as an increase in advertisement expenditure leads to an increase in sales. However,
other factors influencing the advertisement elasticity include the level of total sales (as total
sales increase, the advertisement elasticity decreases); advertisement by rival firms; change in
price and consumer income.

Factors determining elasticity of demand

Nature of commodity: The commodities can be broadly classified as necessaries, comforts

and luxuries. The demand for necessaries like wheat, salt, etc. is inelastic meaning very little
or no change in the quantity demanded due to a given change in price. As regards comforts,
the demand changes in almost the same proportion as the price, that is demand is unitary elastic.
In case of luxuries like gold, diamonds, luxury cars, etc. a small change in price causes
relatively much larger change in the quantity demanded and elasticity of demand is more than
unity.
Existence of substitutes: If a commodity has different substitutes, a slight increase in its price
causes a substantial degree of substitution of other commodities in its place, and the demand
will be more elastic. However, the demand will be inelastic in case of commodities having no
substitutes.
Goods with several uses: If a commodity can be put to many different uses, its demand will
be highly elastic. For instance, in a household, milk can be used for various purposes such as
for making curd, cake, sweets, buttermilk, etc. With a fall in price, demand increases but a little
rise in its price causes the demand to fall greatly.
Possibility of postponement of use: If it is possible to postpone the consumption of a
commodity (like new clothes, new sofa, mobile, computer, etc.) then its demand will be elastic
and if the demand is urgent and cannot be postponed at all (like, electricity) the demand will
be inelastic.
Level of income – At very high and very low levels of income, the overall demand for
commodities tends to be relatively less elastic. On the other hand, in the middle-income range,
the demand is relatively more elastic.
Proportion of income spent: The elasticity of demand is also influenced by the percentage of
income spent on a given commodity. If the percentage is very low, like salt, pen, pencil, etc.,
then the demand will be inelastic.
Influence of habit, fashion and customs- Those commodities whose consumption is
influenced by conventions, customs or habit, will have an inelastic demand. For example
demand for cigarettes and liquor or some latest brand of clothing. In this case people do not
compromise with price and do not cut demand even if the price is high.
Complementary goods- Those goods which are jointly demanded, such as petrol, ink, etc.
have less elastic demand as their demand depends not only on their respective prices but also
on the demand of other products.

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Durability of the commodity- If the commodity is a durable one like a house, the demand is
generally inelastic because consumer buys a house only after a very long period. On the other
hand, in case of perishable commodities, like milk, vegetables, the demand is relatively elastic.

Importance of determining elasticity of demand

The concept of elasticity of demand is of much significance in various situations both from
theoretical and practical viewpoints. The role of elasticity of demand is discussed below:
Importance in taxation policies- The concept of elasticity of demand also proves helpful to
the finance minister in the formulation of taxation policies. He considers the nature of a
commodity and its elasticity of demand before levying a tax on it. If taxes are levied on goods
with more elastic demand, rise in price after tax imposition will cause a large contraction in
demand and tax revenues may fall, and vice-versa.
Price fixation under monopoly: The monopolist has to consider the elasticity of demand for
his product while fixing its price. In case his product has a less elastic demand, he fixes a higher
price and tries to appropriate a larger revenue even if he is selling a limited quantity.

Price discrimination: A monopolist sometimes follows the policy of price discrimination by

charging different prices for the same product in different markets. The basis of price
discrimination is difference of elasticity of demand in different markets. He charges a higher
price in the market where the demand is less elastic and vice-versa.
Price determination in case of joint products: There are many products which are produced
jointly like rice and bran, wheat and straw, sugar and alcohol, etc. The cost of production in
such cases cannot be ascertained separately. In such a situation, the price of the major product
is determined at a higher level if elasticity of demand is low and vice-versa; while the price of
the by-product is fixed keeping in mind the total costs and a reasonable amount of profit.
Wage determination: If the demand for labour for a particular industry is relatively less
elastic, the employer will have to give in to the demand of trade unions to get their wages
raised. The same applies to other factors of production also with a relatively inelastic demand.
Determination of terms of trade- Terms of trade between two countries can be calculated by
taking into account the mutual elasticities of demand for the products of each other.
Determination of the Rate of Exchange- The rate of exchange between the currencies of
different countries is determined by the elasticities of demand for the currencies of one another.
Hence, this concept is very important in the field of international trade.

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Supply

Supply of a commodity refers to the various quantities of the commodity which a seller is
willing and able to supply at different prices in a given market at a point of time, other things
remaining the same. Supply is what the seller is able and willing to offer for sale. The Quantity
supplied is the amount of a particular commodity that a firm is willing and able to offer for sale
at a particular price during a given time period.

Supply Schedule: is a table shows different quantities of commodity the producer or supplier
is willing to offer at different prices.

Law of Supply: is the relationship between price of the commodity and quantity of that
commodity supplied at a point of time. Other things remain same, quantity supplied by the
producer will increase with an increase in the price of the commodity.

Supply Curve: A graphical representation of how much of a commodity that a firm sells at
different prices. The supply curve is upward sloping from left to right. Therefore, the price
elasticity of supply will be positive.

Determinants Of Supply:
1. The cost of factors of production: Cost depends on the price of factors. Increase in factor
cost increases the cost of production, and reduces supply.
2. The state of technology: Use of advanced technology increases productivity of the
organization and increases its supply.
3. External factors: External factors like weather influence the supply. If there is a flood, this
reduces supply of various agricultural products.
4. Tax and subsidy: Increase in government subsidies results in more production and higher
supply.
5. Transport: Better transport facilities will increase the supply.
6. Price: If the prices are high, the sellers are willing to supply more goods to increase their
profit.

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7. Price of other goods: The price of other goods is more than that of the commodity X then
the supply of X will be increased.

Elasticity of Supply: Elasticity of supply of a commodity is defined as the responsiveness of

a quantity supplied to a unit change in price of that commodity.

𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑆𝑢𝑝𝑝𝑙𝑦 = 𝐸𝑠
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑋
=
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑎𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑋
∆𝑄𝑠 𝑃
= ∗
∆𝑃 𝑄𝑠

Types of Supply Elasticity

Price elasticity of supply: Price elasticity of supply measures the responsiveness of changes
in quantity supplied to a change in price.
 Perfectly inelastic: If there is no response in supply to a change in price. (Es = 0)
 Inelastic supply: The proportionate change in supply is less than the change in price (Es
=0-1)
 Unitary elastic: The percentage change in quantity supplied equals the change in price
(Es=1)
 Elastic: The change in quantity supplied is more than the change in price (Ex= 1- ∞)
 Perfectly elastic: Suppliers are willing to supply any amount at a given price (Es=∞)

The major determinants of elasticity of supply are availability of substitutes in the market and
the time period, Shorter the period higher will be the elasticity.

Factors Influencing Elasticity of Supply

1. Nature of the commodity: If the commodity is perishable in nature then the
elasticity of supply will be less. Durable goods have high elasticity of supply.
2. Time period: If the operational time period is short then supply is inelastic. When
the production process period is longer the elasticity of supply will be relatively elastic.
3. Scale of production: Small scale producer’s supply is inelastic in nature compared
to the large producers.
4. Size of the firm and number of products: If the firm is a large-scale industry and
has more variety of products then it can easily transfer the resources. Therefore, supply
of such products is highly elastic.
5. Natural factors: Natural calamities can affect the production of agricultural products
so they are relatively inelastic.
6. Nature of production: If the commodities need more workmanship, or for artistic
goods the elasticity of supply will be high.

Equilibrium Price and Equilibrium Quantity

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An equilibrium is a state where there is no tendency to change. The equilibrium of a market is
determined by the market forces of demand and supply. If consumers demand more of a good
than what firms supply at a particular price, the quantity demanded will exceed the quantity
supplied. The resultant shortage will push up the price. This is because when firms do not
produce enough to sell, they can raise the price without losing sales. Therefore, they will do so
to increase their profits. A rise in the price of the good will incentivise
Supply curve firms to increase the
production due to the higher profitability and consumers to decrease the consumption due to
the higher relative price and the lower real income. Therefore, the quantity supplied will rise
and the quantity demanded will fall. The price will continue rising until the quantity demanded
Price of X

is equal to the quantity supplied, at which point the shortage is eliminated

Equilibrium andquantity
price and an equilibrium
is established

Demand curve

Quantity of X demanded and supplied

In the above diagram, given the demand (D) and the supply (S), the equilibrium price and
quantity is determined at the point where demand and supply curve intersect. At a price below
equilibrium price, the quantity demanded (QD) is greater than the quantity supplied (QS) and
this results in a shortage (QD – QS). As the price rises, the quantity demanded falls and the
quantity supplied rises and this process continues until the price rises to equilibrium
price where the quantity demanded and the quantity supplied are equal at equilibrium.
Similarly, if firms supply more of a good than what consumers demand at a particular price,
the quantity supplied will exceed the quantity demanded. The resultant surplus will push down
the price. This is because when firms cannot sell all the output that they produce, their stocks
will build up. Therefore, they will lower the price to reduce their stocks. A fall in the price of
the good will incentivise firms to decrease the production due to the lower profitability and
consumers to increase the consumption due to the lower relative price and the higher real
income. Therefore, the quantity supplied will fall and the quantity demanded will rise. The
price will continue falling until the quantity demanded is equal to the quantity supplied, at
which point the surplus is eliminated and an equilibrium is established.

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