Economics for

Managers

Demand & Supply Analysis

 Agenda

 Demand Analysis

 Elasticity of Demand

 Theory of Consumer
Behavior

 Supply Analysis

20XX SAMPLE FOOTER TEXT 2

Theory of
Consumer
Behaviour
 Human wants

the term ‘want’ refers to a wish,

desire or motive to own or/and use
goods and services that give
satisfaction

Wants may arise due to physical,

psychological or social factors
 Classification of wants

N E C E SS A R I E S C O M F O RT S L U X U RY

 Necessaries are those which  While necessaries make life  Luxuries are those wants
are essential for living and possible comforts make which are superfluous and
sub-divided into necessaries life comfortable and expensive.
for life or existence, satisfying.
 They are not essential for
necessaries for effi ciency
 Comforts are less urgent living. Items such as
and conventional
than necessaries. expensive clothing,
necessaries.
exclusive vintage cars,
 Tasty and wholesome food,
 Necessaries for life are classy furniture and goods
good house, clothes that
things necessary to meet the used for vanity etc. fall
suit different occasions,
minimum physiological needs under this category.
audio-visual and labor
for the maintenance of life
saving equipment's
such as minimum amount of
etc .make life more
Utility
 Economists apply the term utility to "that property in any object, whereby it
tends to produce benefit, advantage, pleasure, good, or happiness”

 Utility is thus the want satisfying power of a commodity.

 The utility of a consumer is a measure of the satisfaction that the consumer

expects to obtain from consumption of goods and services when he spends
money on a stock of commodity which has the capacity to satisfy his want.

 Utility is a subjective and relative entity and varies from person to person. A
commodity has different levels of utility for the same person at different places
or at different points of time
Marginal utility
 The marginal utility theory, formulated by Alfred Marshall, a British economist,
seeks to explain how a consumer chooses to spend his income on different goods
and services so as to maximize his utility.
 According to Marshall, utility is the numerical score in terms of’ utils’
representing the satisfaction that a consumer obtains from the consumption of a
particular good.
 Total utility: Assuming that utility is quantitatively measurable and additive, total utility
may be defined as the sum of utility derived from different units of a commodity
consumed by a consumer.
 Total utility is the sum of marginal utilities derived from the consumption of different
units i.e.
 TU= MU1+MU2+ +Mun
 Marginal utility

The marginal utility of a good or service is the change

in total utility generated by consuming one additional
unit of that good or service. In other words, it is the
utility derived from the marginal or one additional unit
consumed or possessed by the individual.

Marginal utility = the addition made to the

total utility by the addition of consumption of
one more unit of a commodity
MUn = TUn - TUn-1
 Assumptions of Marginal Utility Analysis
 Rationality: A consumer is rational and attempts to attain maximum satisfaction

 Cardinal Measurability of Utility: According to the neoclassical economists, utility is a cardinal

concept i.e., utility is a measurable and quantifiable entity.

 The theory also assumes all the other factors ‘constant’ such as price of the commodity, tastes
and preferences, income, habits, temperament and fashion

 The theory assumes continuity in consumption and that there is no time gap or interval between
consumption of different units.

 The different units of the commodity consumed are assumed to be homogeneous or identical in
nature.

 The different units consumed should consist of standard units. For instance spoonful's of juice or
spoonful's of coffee are too small units

 The assumption of constancy of the marginal utility of money holds that the marginal utility of
money remains constant throughout when the individual is spending money on a good.
Law of Diminishing Marginal Utility

 The law of diminishing marginal utility which states that each successive
unit of a good or service consumed adds less to total utility than the
previous unit, is based on an important fact that while total wants of a
person are virtually unlimited, each single want is satiable i.e., each want
is capable of being satisfied.

 Since each want is satiable, as a consumer consumes more and more

units of a good, the intensity of his want for the good goes on decreasing
and a point is reached where the consumer no longer wants it.

 Thus, the greater the amount of a good a consumer has, the less an
additional unit is worth to him or her.
LDMU
 Marshall, who was the exponent of the marginal utility analysis, stated
the law as follows:

 “The additional benefit which a person derives from a given increase in

the stock of a thing diminishes with every increase in the stock that he
already has.”In other words, ‘as a consumer increases the consumption
of any one commodity keeping constant the consumption of all other
commodities, the marginal utility of the variable commodity must
eventually decline”.
Total and Market Schedule

Quantity of
chocolate bar Total Marginal
consumed per utility utility
day
1 20 20

2 34 14

3 45 11

4 50 5

5 50 0

6 46 -4
 Utility derived
from chocolates
consumed per day
Relationships between total utility and marginal utility

 Total utility rises as long as MU is positive, but at a diminishing rate

because MU is diminishing

 Marginal utility diminishes throughout

 When marginal utility is zero, the total utility is maximum. It is the satiation
point.

 When marginal utility is negative, total utility is diminishing

 MU is the rate of change of total utility or it is the slope of TU curve

 MU can be positive ,zero or negative

Limitations and exceptions of LDMU

 The law of diminishing marginal utility is based on rigorous assumptions such as

cardinal measurability of utility, constancy of marginal utility of money, continuous
consumption, homogeneity of units consumed. The law would operate only when
these unrealistic assumptions are met.

 Utility is not in fact independent. The shape of the utility curve may be affected
by the presence or absence of articles which are substitutes or complements.

 The law is not universal. There are many instances where the marginal utility
does not fall or quite the opposite may increase with increase in consumption or
stock obtained

 prestigious goods , hobbies, creative art, painting, music, poetry etc

 Consumer equilibrium

It states that as the quantity of a good with the consumer

increases, marginal utility of the good decreases.

In other words, the marginal utility curve is downward sloping.

A consumer will go on buying a good till the marginal utility of

the good becomes equal to the market price.

In other words, the consumer will be in equilibrium (will be

deriving maximum satisfaction) in respect of the quantity of
one good when marginal utility of that good is equal to its
price.
 Consumer surplus

The concept of consumer surplus was propounded by Alfred

Marshall.

Consumer surplus is a measure of welfare that people gain from

consuming goods and services.

Marshall defined the concept of consumer surplus as the “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
called consumers surplus.”

Thus, consumer surplus = what a consumer is ready to pay -

what he actually pays.
 Marginal Utility
No. of units (worth Rs) Price (`Rs) Consumer
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 –
Change in Consumer Surplus due
to fall in Price

• A fall in price from P to P1 increases consumer surplus

from APE to A P1F.The increase in consumer surplus
has two components.

• The increase in consumer surplus of existing buyers who

were earlier paying price P (the rectangle marked b).

• The consumer surplus now available to the new buyers

who started buying the commodity due to lower prices
(the triangle c)
 Indifference Curve
analysis

An indifference curve is a curve which represents all those

combinations of two goods which give same satisfaction to the
consumer.

Since all the combinations on an indifference curve give equal

satisfaction to the consumer, the consumer is completely
indifferent among them.

In other words, since all the combinations provide the same

level of satisfaction the consumer prefers them equally and
does not mind which combination he gets. An Indifference curve
is also called iso-utility curve or equal utility curve.
 Indifference Schedule

Combinat Food Clothi MRS

ion ng
A 1 12 -

B 2 6 6

C 3 4 2

D 4 3 1
 Indifference Curve
Map

The entire utility function of an individual can be

represented by an indifference curve map which is a
collection of indifference curves in which each curve
corresponds to a different level of satisfaction.

In short, a set of indifference curves is called an

indifference curve map. Each indifference curve is a
set of points and each point shares a common level
of utility with the others
 Indifference Curve Map
We have marked good X on X-axis and good Y on Y-axis.

It should be noted that while the consumer is indifferent

among the combinations lying on the same indifference
curve, he certainly prefers the combinations on the higher
indifference curve to the combinations lying on a lower
indifference curve because a higher indifference curve
signifies a higher level of satisfaction.

Thus, while all combinations of IC1 give him the same

satisfaction, all combinations lying on IC2 give him greater
satisfaction than those lying on IC1
 Marginal Rate of
Substitution

The MRS is the rate at which a consumer is prepared to

exchange goods X and Y, holding the level of satisfaction
constant

The MRS along any segment of an indifference curve

refers to the maximum rate at which a consumer would
willingly exchange units of Y for units of X.

The MRS at any point on the indifference curve is equal

to the the slope of the curve at that point.
 Marginal Rate of Substitution

In the beginning the consumer is consuming 1 unit of food

and 12 units of clothing. Subsequently, he gives up 6 units of
clothing to get an extra unit of food, his level of satisfaction
remaining the same. The MRS here is 6.

Likewise when he moves from B to C and from C to D in his

indifference schedule, the MRS are 2 and 1 respectively.

Thus, we can define MRS of X for Y as the amount of Y whose

loss can just be compensated by a unit gain of X in such a
manner that the level of satisfaction remains the same.
 Properties of Indifference Curve
 Indifference curves slope downward to the right: This property implies that the two commodities
can be substituted for each other and when the amount of one good in the combination is
increased, the amount of the other good is reduced.

 Indifference curves are always convex to the origin :It has been observed that as more and
more of one commodity (X) is substituted for another (Y), the consumer is willing to part
with less and less of the commodity being substituted (i.e. Y). This is called diminishing
marginal rate of substitution. Thus, in our example of food and clothing, as a consumer
has more and more units of food, he is prepared to forego less and less units of clothing.
This happens mainly because the want for a particular good is satiable and as a person has
more and more of a good, his intensity of want for that good goes on diminishing.

 However, there are two extreme situations.

 Perfect substitutes and Perfect Complementaries

 Perfect substitutes

When two goods are perfect substitutes of each

other, the consumer is completely indifferent as
to which to consume and is willing to exchange
one unit of X for one unit of Y. His indifference
curves for these two goods are therefore straight,
parallel lines with a constant slope along the
curve, or the indifference curve has a constant
MRS
 Perfect complements

Goods are perfect complements when a consumer is interested in

consuming these only in fixed proportions. When two goods are
perfect complementary goods (e.g. left shoe and right shoe), the
consumer consumes only bundles like A and B in figure 20(B) in
which both X and Y in equal proportions. With a bundle like A or B,
he will not substitute X for Y because an extra piece of the other
good (here a single shoe) is worthless for him. The reason is that
neither an additional left shoe nor a right shoe without a paired one
of each, adds to his total utility. In such a case, the indifference
curve will consist of two straight lines with a right angle bent which
is convex to the origin, or in other words, it will be L shaped
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
 Indifference curve will not touch either axes :Another
characteristic feature of indifference curve is that it will not
touch the X axis or Y axis. This is born out of our assumption
that the consumer is considering different combination of two
commodities. If an indifference curve touches the Y axis at a
point P as shown in the figure 22, it means that the consumer is
satisfied with OP units of Y commodity and zero units of X
commodity. This is contrary to our assumption that the
consumer wants both commodities although in smaller or larger
quantities.