DEMAND ANALYSIS AND THEORY. fei Seesitute goods ssncrease in the price of rice, sises and the demand curve DD, (Fig, 2.7), a fall in price OP, increases the quantity = OX, to OX,. On the otherhand, curve is D,D,, a rise in price ) causes a movement upward e demand curve. As a result, the three approaches in economic the behaviour of a consumer. attempt to explain the 25 0 Quantity of pen (b) Complementary goods Fig. 28; Shits ofthe Demand Cuve negative sloping demand curve, The fistapproach is known as introspective cardinal approach or Marshallian utility approach, after the name of its inventor. A. Marshall—the great neo-classical economist—tefined the utility approach developed by W. S, Jevons, Carl Menger, and L. Walras, independently, Marshall just perfected their analyses. The send approach evolved in the 1930s ‘out of the criticisms levelled against the utility approch. This approach came to Le known as introspective ordinal approach. Sir] R. Hicks and R. G.D.Allen—two great British economists— employed the tool of indifference curve to explain this ordinal approach to consumer behaviour ‘The third appraoch was invented by the US economist P. A. Samuelson in 1938, His approach came to be known as behaviouristic ordinal approach. In this book, we will concetrate on indifference curve analysis only. An alternative approach to Marshall’ utility approach is Hicks-Allen’s indifference analysis. This alternative approach is also known as ‘introspective ordina? approach as contrasted to Marshall's ‘introspective cardinal’ approach. According to Marshall, utility obtained from the consumption of a commodity can be measured in cardinal numbers, just as we can measure the body temperature or the day temperature. ButHicks and Allen argued that utility, being a psycho- logical concept, can never be measured in cardinal numbers, like 1, 2, 3, ete. Utility is intrinsic in character and, hence, not quantifiable. Further, utility varies from person to person. Hence, utility is a relative as well as a subjective concept hardly amenable to measurement. If it can be measured, it can be measured in ordinal numbers, like, I, II, III, etc. Different levels of utility derived from the consumption of commodities can.only be ranked ot ordered. A consumer can only rank or order his preference pattern. He cannot say that commodity A gives utility of 10 while B gives a utility of 13, He can only compare between A and B and say that A is preferable to B or B is preferable to A. But how much utility is obtained from A or from B cannot be quantified by the consumer. Hence, the name ‘ordinal approach’ to demand analysis, 2.4.1, INDIFFERENCE CURVE The indifference curve analysis aims at analysing the choice between different combinations of » two goods, without meduring utility in physical units. The indifference curve analysis argues that utility is not measurable but comparable. If a ‘Consumer is presented with a number of various combinations of two goods (say A, B,C, etc..) he can rank them in a scale of preferences, A is pteferable to B (or in short APB) or BPA. But, he cannot say that from A he gets better utility measured in cardinal numbers. + Assumptions: Before defining indifference curve, we must make the following assumptions: @ completeriess, i) non-satiety, and (ii) consis- tency or transitivity, For simplicity’s sake, let us assume that there are two goods, X and Y, containing various quantities of these two goods, We also assume that preferences are complete. This means that @ consumer can determine which combination of X and Yis preferable or which combinations ‘of X and Y yield the same level of satisfaction. Since the consumer knows the ‘utility value of all possible choices’ economists say that pre- ferences are complete. The assumption of non-satiety states that a consumer always prefers ‘more of a commodity to less’, Let situtation A contain more of good X and good ¥ than the situation B. Obviously, A.would be preferred to situation B since more is preferred to less. The consumer is also expected to behave consistently If a consumer prefers A to B in any situation then he must not choose B over A in other situation. If he chooses, however, B, then his behaviour is said to be contradictory and inconsistent. Further, preferences must be transitive. This means that if a consumer chooses A over B and BoverC, then he chooses A over C. If that were not true, then consumer preferences would not be transitive. Thus, the assumption of consistency is related to the assumption of transitivity 0 Good X Fig. 29: Combinations ofX and ¥ These three assumptions enable us to represent consumer preferences in a graphic form. As a result, we obtain indifference curve. + Meaning: An indifference curve represents various combinations of two goods that yield an equal amount of satisfaction. To show how such a curve can be constructed, we consider Fig. 2.9. In this figure we measure good=". suis and good Y on the ssseng these combiriations. en of rationality states that m pecferred to less. Thus, C is net purchases various and Y shown in Table 2.4. esamelevelof consumption whether he purchases exBorCorD. This table shows of ¥ (or X) are consumed, the use of more of X and less these points we get a curve race curve. Our consumer is es all these points, He cannot Nia 1 23 4 5 & Goodx Fig. 210: lnditference Cue saywhich point is giving him the maximum satisfaction. As he cannot say which combination of the two goods gives him the highest satisfaction he is, therefore, indifferent between different combinations. A set of indifference curves plotted on a graph is called an indifference map. A consumet is indifferent on an indifference curve and not between two indifference curves. Higher indiffe- tence curve represents higher satisfaction and lower indifference curve represents lower satisfaction. Hence, utility or satisfaction is ‘comparable. i ‘The indifference curve that we have drawn is not a straight line. Normally, it slopes downwards from left to the right. Now we present important properties of an indifference curve. 2.4.2. PROPERTIES OF INDIFFERENCE CURVE An indifference curve has three important properties: + Property 1: It slapes downwards rom left to right. In other words, it bas a negative slope. Proof: On an indifference curve, as we move from one point to another point, an increase in the consumption of one good will lead to a decline in the consumption of another good, so that satisfaction remains the same. This implies a negatively sloped indifference curve.) Fig, 211: Unikely shapes Proof of this negatively sloped indifference curve can also be made with the help of the above three figures: In Fig 2.11(@) IC is parallel to the vertical axis, indicating that as a consumer moves from Ato B to C, his consumption of Y rises while that of X remains the same. The consumer is indifferent between having mote or less of good X, Thus, X is a ‘neuter’ good. This means that if we take 1 unit of X away at point A, then we need not compensate the consumer his loss of X with any amount of Y to keep him on the same indifference curve. In Fig 2.11(b),as [Cis parallel to the horizontal axis, consumption of X rises and that of Y remains unchanged. Here Yis a ‘neuter’ good. To have a negatively sloped indifference curve, consumption of one good must rise while that of another must decline, Indifference curve can never be upward rising, as drawn in Fig, 2.11(c). Movement from point ‘A to B to C implies that consumption of both X and Y are rising. Again, this sort of Table 2.5: Diminising MRS Combinations —_X ¥ URS y A 1 6 is 8 2 3 Pat c 3 24 : 1 i D 4 BH Good X ct indiference Curves: indifference curve is ruled out because of th non-satiety assumption: more is preferred t less, Thus, indifference curve must b downwand sloping: + Property 2: An indifference curve is conve to the origin, or concave. from above. Proof: An indifference curve is convex t the origin due to diminishing marginal rate c substitution (MRS) between two goods, MR of X for Y is the rate at which Y must b sacrificed (o get an additional unit of X so as t maintain the same level of satisfaction, As th rate is a diminishing one, an indifference cury is convex to the origin. This we can prove wit the aid of Table 2.5 When our consumer gives up combinatio Ato obtain combination B, he sacrifices 3 uni of Y to getan additional 1 unit of X. Thus, th marginal rate of substitution of X for ¥ is 3: Again, a movement from combination B to suggests that the consumer now gives up 1 un of Y to obtain another unit of X. Heno the MRS becomes 1 : 1. Similarly, this ra declines to 1:4 when a consumer moves fros combination C to D. As MRS is diminishin the indifference curve must be convex to th origin. Diagrammaticaly, convexity of an indifferent curve has been shown in Fig, 2.12. Along t indifference curve, our consumer is indiffere between points D, C and B. As the consumfs willing to substitute X,X, ¥. The marginal rate of DE . CF Tt is obvious that EC > FB’ This means that initially our consumer was willing to give up larger amount of ¥ for an additional unit of X. Ashe possessed larger quantity of Y, marginal significance of ¥ to the consumer is less while that of X is more. But as substitution goes on, ‘marginal significance of Y rises while that of X declines since the consumer gets more of X and less of ¥. That is why willingness to sacrifice Y to get more of X along an indifference curve declines. This means that MRS declines, for which IC is convex to the origin. , It is to be remembered here that the slope of an indifference curve is tht MRS. The slope is -#--8. Thus, the slope is negative. Slope at a point on an indifference curve ean be measured by drawing a tangent to that particulat point. At points D, C and B on an indifference curve, we have drawn three tangents in Fig 2.13(a). As we move downwards, steepness of the tangent declines. Slope of the tangent at D is steeper than the tangent at C or B. This means that the slope or MRS declines So, an indifference curve must be convex to the origin, Or simply, if an indifference curve liesabove a tangent line drawn atany point on the Curve, the curves said to be convex to the origin Fig, 2.13@)), Again, if a straight line connecting any two Points (say AA’ or BB’) on the curve lies above the curve IC (Fig, 2.13(b) the curve is convex to the origin, On the other hand, if the tangents lie above the curve, and a chord ing two points on the curve lies below the curve, the indifference curve becomes concave to the origin. + Property 3: No two indifference curves tan Intersect or touch each other, Proof: If the indifference curves intersect or touch each other, one will encounter an absurd result. In Fig, 2.14, we have drawn two interescting indifference curves that cut each WC=Kand O= B then |A=B ButB>A Good ¥ y % By Me % Good x Fig. 2.14 ntereectng Indiference Curves other at point C. Points C and A lie on IC, and points C and B lie on IC,. As points C and’A lie on IC, the consumer gets the same level of satisfaction. Similarly, the consumer gets the same satisfaction along points C and B on IC,. Thus, along points C and A on IC,, we have OX, + OY, = OX, + OY, Similarly, on points C and B on IC, we have OX, + OY, = OX, + OY, Equating the R.H.S. of the above two equations, we get OX, + OY, = OX, + OY, ee nO and subtracting OY, from both sides, we obtain OX, = OX, But it is clear from the figure that OX, is definitely preferable to OX, So the two curves cannot intersect each other. This property can also be explained in the following way. One of the important assump- tions of indifference curve analysis is theassump- tion of transitivity. This assumption states that if X is preferable to Y and Y is preferable to Z, then X is preferable to Z. Or if X is equivalent to Y and Y is equivalent to Z, then X is equivalent toZ. In Fig. 2.14 we, have two points Cand A on IC, and C and Bon IC, AsC = A, and C= B, then A =B. But the figure shows that B is preferable to A. This happ ens since twoindifference Curves cut each other. Thus, indifference curves must be non-intersecting, 2.4.3. Some UNusuat SHAPES oF INDIFFERNCE CuRVE We have drawn negatively sloped indifference curve for two goods X and ¥. These goods are treated as ‘good! as they ate deemed to be fit for consumption. In other words, when goods are ‘good; indifference curve is negative sloping and convex to the origin. But, sometimes, to a consumer some of the goods may become ‘bad? or unfit for consumption. This means that a Consumer gets less satisfaction by consuming ‘mote of that (‘bad’) commodity. Thus, the ‘good’ becomes a ‘bad’. Ih this case, the consumer will get more satisfaction if he consumes less and less of the ‘bad’ commodity. An example of such ‘bad’ good is pollution. ‘Bad’ good is measured on the horizontal axis, while a ‘good” commodity is measured on the vertical axis in Fig. 2.15(a). Now the indifference curve is upward sloping, A consumer would get higher satisfaction if he consumes less Of the ‘bad’ good. If the consumer consumes mote of a ‘bad’ good then the consumer needs more of the ‘good’ good to stay on the same indifference curve. In Fig, 2.15(b), an indifferenceon ‘offending’ commodity: This is shown in Fig. 2.16 where Of, amount of a commodity, say food, is consumed. At point A, the slope of the indifference curve becomes zero and, hence, MRS is zero, As consumption of food beyond Of, Yields negative utility, the indifference curve becomes positive sloping. In Fig. 2.17, another unusual shaped indiffe- fence curve has been drawn. At point A on this curve marginal utility of X is zero and, at point 5B, marginal utility of Y is zero. Consumption beyond point A implies negative utility for X and consumption beyond point B yields negative utility for Y. Between points A and B, marginal utilities for both X and ¥ are positive. ™ 2.5, BUDGET LINE OR PRICE LINE OR CONSUMPTION- POSSIBILITY LINE Range of preferences of an individual for two ‘goods is represented by indifference curves Thus, Psychic element is involved in an indifference curve, But it does not tell anything about the Purchasable combinations of two goods from the limited money income. Such purchase plan is determined by money income, prices of the goods that a consumer buys, tastes and Preferences, etc. A consumer always tries to mamimise satisfaction from the consumption of commodities. But in this pursuit, he is hampered by his limited income, ie. his budget. How does consumer dis ibute his fixed income in the purchase of two goods X and Y whose prices are fixed can be known from the budget line or the consumption-possiily line, Assume that a consumer has a fixed money income, M, to purchase two goods, X and Y, whose prices are P,, and P,, respectively. It is also assumed that the prices of X and Y are also fixed. Thus, the total expenditure on X and Y can be zeptesented by the following equation: M2X.P.+Y.P, ww-(2:1) This non-equality equation suggests that money income may equal or exceed total expenditure. However, we will consider the equality form of equation (2.1) ie, M=X.P.+¥.P, + (22) This is the equation of a steaight line. If the consumer spends his entire income on good X then the budget equation becomes M=X.P, +0 BY Or if the entire income is spent on Y, the budget line equation becomes M=O+Y.P: G4) From equation (2.2), solving for X, we obtain M-Y.P, ial a . @5) wy Py Cee - (25a) Here, p shows the amount of X that a consumer can purchase, if no Y'is bought. This is indicated by the distance OB in Fig 2.18, Thus, Fplivwhetnentisnaetenney equation ee Banke! ee the slope of the budget Similasly, solving for ¥, one obtains yesh 26) ¥ o y=M_ Ry PR Py . Co Here = is the vertical intercept of the equation (262).Itshows the maximum purchasable amount of Y, if no X is bought at all. This is represented by the distance OA. ~Biistheslope of the budget line, . Thus, the two points A and B are the two extreme points in Fig 2.18. Now if these two points are joined together we obtain the budget line AB which shows different purchasable combinations of ‘two goods X and Y if thefeasible or attainable m Point C or any other point on = (em, point E). Though point E is ot feasible or attainable since Budget Line due to a change in Income = Odamoune sf ¥ _/ oM/P, “mere Omr, OA. ot Bee PE ee OBi tiie Thus, the budget line is defined as the purchasable combinations of two goods if the entire money income is spent. The slope of this straight line boundary is given by the negative of the price ratio, It is to be noted here that as long as prices of two goods are fixed and independent of the quantities purchased, the budget line is necessarily linear. 2.5.1. SHirrinG or THE BuGeT Line— Errects or CHANGES IN INCOME AND PRICE The position and slope of the budget line depends on money income and prices of two goods that a consumer can purchase. In other words, if there is a change in money income or a change in the price of a good there will be a shift in the budget line. Letus consider an increase in money income from M to 2M, while P, and Py remain fixed. Thus the budget line equation changes to 2M=X,Py +¥,P, ‘Obviously, both the horizontal and vertical intercepts will change from OB to OB, and Fig, 219(b): Shits in Budget Line de to a Change in pcefrom OA to OA,. Thus, the new budget line becomes A,B, [Fig.2.19(a)]- So, when-money income increases, budget line shifts parallely from AB to A,B,. Since Py and Py do not change, the slope of the budget line does not change. Or as there is a parallel shifting of the budget line following a changein money income, the slope of the budget line remains unchanged. Now, suppose Py, declines to Px, , while money income and price of good Y remain fixed. This means that horizontal intercept of Fig 2.19(b) changes from OB to OB, while vertical intercept remains anchored at OA. Thus, when price of X falls, the budget line shifts from AB to AB, As a result the slope of the budget line A | P, P, changes’ from (R)o(#). Since P< a(R) -(#) In other words, the Py Py slope of the new budget line AB, is less steep than the slope of the original budget line AB. If ptice of ¥ changes, holding P,, and M constant, only the vertical intercept of the budget line would change. And the slope of the budget line would also change. Further, assume that the prices of both the goods change proportionately, money income remains constant. This is equivalent to an increase in money income. In such a situation, budget line would shift parallel and the slope would remain unchanged. 3 Finally, if both money income and prices of two goods X and Y change in the same propor- tion and in the same direction, budget line would remain unchanged. =2.6. CONSUMER EQUILIBRIUM— MAXIMISING SATISFACTION By equilibrium of a consumer we mean maximisation of satisfaction. The basic goal of a consumer is the maximisation of satisfaction from the consumption of the two goods. Such maximisation goal can be represented by indifference map and budget line. ‘An indifference map represents the ranking of choices of two goods. An indifference curve shows the willingness to purchase different combinations of ‘two goods which yield equal satisfaction. The budget line shows the purrhasable combinations of two goods that a consumer can buy from his fixed money income. Let us assume that a consumer, with his limited income, purchases two goods X and Y whose prices are fixed. The purchasable combinations are represented by the budgetline - AB of Fig, 2.20. In this figure, we have drawn three indifference curves IC,, IC, and IC, to represent rank or ordering of all combinations of X and Y that a consumers is willing to buy. To explain equilibrium, we bring together the indifference map and the budget line. A consumer would reach equilibrium if the following assumptions hold: + money income of the consutner does not change; «» prices of the two goods remain unchanged; «+ tastes and preferences of the consumer also remain fixed; ; + goods and preferences of the consumer also remain fixed; + the consumer is consistent in his choice, and + the consumer is rational. With these assumptions in mind, a consumer would reach equilibrium when the budget line becomes tangential to the highest as well as attainable indifference curve. This condition holds at point E on IC, Though IC,—a higher order indifference curve—is desirable to consumer, it is not attainable because the fixed income will not pexinit him to climb on to IC,, IC, is within the feasible area but this lower order indifference curve cuts the budget line at two points, C and D. Ths, points Cand D (.e.,non- tangency points) on IC, are not equilibrium points since a consumer moves to a lower= carve and, thus, detives lower level When the consumer stays at aims at moving towards point higher satisfaction and when stays on point D on IC,, he tries és point E on IC, so that higher & derived. Thus, point E is the cist. Corres-ponding to this point, purchases OX, of X and OY, of ES optimum satisfaction. Eessative explanation may also be of- - sumer would reach equilibrium Sf difference curve analysis, when = conditions are fulfilled simul- ef the budget line must be equal to of the indifference curve, This a is known as the necessary ‘Mathematically, this is called - condition for equilibrium, islope of the budget line is the ‘of the price ratio (ie, Pp )and of the indifference curve is the rate of substitution between X ‘Ge, MRS,,) and its sloy Symbolically this con difference curve must be convex ‘exigin at the point of equilibrium, ‘condition is known as sufficient 8 or mathematically, second- condition. : E the necessary condition as well as are being fulfilled (called a’). Thus, point E is the point where he gets maximum Butat points C and D, though the condition is satisfied, first-order nothold hence these are inferior C, the slopes of budget line and sSarve are unequal. In fact, at point ok. Now the consumer can ,y > Goood ¥ 9 % $ Fig. 2.20: Consumer Equilibrium increase his satisfaction, without spending more, by purchasing mote of X and less of Y. Doing this, the consumer, along the budget line, moves to point E which lies on a higher indifference curve—indicating a higher level of satisfaction, The opposite is true at point D where E> MRS qq. So the consume, inorder 15 get higher satisfaction, will go on purchasing more of ¥ and less of X, of course, without incurring any additional expenditure. Anyway, the optimum point is reached at the tangency point where MRS = 2 Thus the festoeder condition for equilibrium is satisfied at point E. Further, at point E, the second-order condition is also satisfied. Point Eis thus, called ‘interior solution’ where the consumer buys both the goods. (Good K 1. A demand function is estimated to be = —30P + 0.05M + 2P, + 4A where P is the own price, M the money income, P, the prices of related goods and Ais the advertisement expenditure. (@) Assuming M = Rs, 5,000, P. = 25, and A = Rs. 30, draw the graph for the demand function.