Lecture-3

Demand Analysis
-

Jashim Uddin, ACS

Demand: Demand for a commodity refers to the desire backed by ability to pay
and willingness to buy it. If a person below poverty line wants to buy a car, it is only
a desire but not a demand as he cannot pay for the car. The person desiring is
willing and able to pay for what he desires, the desire is changed into demand.
Demand is always at a price and also the per unit of time (day, week, month & year)
thus the definition of demand is as follows:
By demand we mean the various quantities of a given commodity or service which
consumers would buy in one market in a given period of time at various prices, or at
various incomes, or at various prices of related goods. -Bober
Types of demand:
Three kinds of demand may be distinguished: (a) Price demand, (b) Income demand
& (c) Cross demand
Price demand: Price demand refers to the various quantities of a commodity or
service that a consumer would purchase at a given time in a market at various
hypothetical prices. (income, tastes and prices of interrelated goods remain
unchanged)
Income demand: The income demand refers to the various quantities of goods
and services which would be purchased by the consumers at various levels of
income. (Price, tastes and prices of interrelated goods remain unchanged)

Here, Price demand expresses relationship between price & quantities and the
income demand shows the relationship between income and quantities demanded.
Cross demand: The cross demand means the quantities of a good or service which
will be purchased with reference to change in price not of this good but of other
interrelated goods. These goods are either substitutes or complementary goods. For
instance a change in the price of tea will affect the demand for coffee.
Demand Curve:

Utility analysis of demand:

Theory of demand seeks to establish relationship between the quantity demanded
of a commodity and its price. It also offers an explanation for variations in demand.
There are different approaches known as theory of demand. The oldest approach is
marginal utility analysis which explains consumers demand for a commodity
and derives a law of demand, it shows an inverse relationship between the quantity
demanded and the price of the commodity i.e. if price falls, demand is extended
and vice versa. Modern economist have pointed out several flaws in the utility
1

analysis and offered new theories such as, the indifference curve technique
developed by J.R Hicks and R.G.D. Allen. This has been finally refined in the
Samuelsons Revealed Preference theory and Hicks Logical Weak Ordering
Theory. Now, we shall take up the marginal utility analysis.
Concept of Utility
In the ordinary language, utility means usefulness. In Economics, utility is defined as
the power of a commodity or a service to satisfy a human want. Utility is a subjective or
psychological concept. The same commodity or service gives different utilities to
different people. For a vegetarian, mutton has no utility. Warm clothes have little utility
for the people in hot countries. So utility depends on the consumer and his need for the
commodity.
Total Utility
Total Utility refers to the sum of utilities of all units of a commodity consumed. For
example, if a consumer consumes ten biscuits, then the total utility is the sum of
satisfaction of consuming all the ten biscuits.
Marginal Utility
Marginal Utility is the addition made to the total utility by consuming one more unit of a
commodity. For example, if a consumer consumes 10 biscuits, the marginal utility is the
utility derived from the 10th unit. It is nothing but the total utility of 10 biscuits minus
the total utility of 9 biscuits.
Thus,
MUn = TUn TU n-1
Where
MUn = Marginal Utility of nth commodity, TUn = Total Utility of n units &
TU n-1 = Total Utility of n-1 units.
Relationship between Marginal Utility and Total Utility
(i)
(ii)
(iii)

Marginal Utility
Declines
Reaches zero
Becomes negative

Total Utility
Increases
Reaches maximum
Declines

Basic Assumptions of Marginal Utility Analysis:

(i) Cardinal measurement of utility
It is assumed that utility is quantifiable entity. This means that a person can express the
satisfaction derived from the consumption of a commodity in quantitative terms. For
example, a consumer can say that the first unit of the commodity has utility equal to 10,
the second unit 8 and so on. Utility is usually measured in imaginary units.
(ii) Utilities are independent
Marginal utility analysis assumes that the utilities of different commodities are
independent of one another. That is the satisfaction derived from the consumption of
one good is the function of that good alone and is not affected by the consumption of
another. According to this assumption, the utilities of various goods are additive, i.e.
separate utilities of the various goods can be added to obtain the total sum of the
utilities of all goods consumed.
(iii) Constant marginal utility of money
The important assumption of the marginal utility analysis is that the marginal utility of
money remains constant even though the quantity of money with the consumer is
diminished by the successive purchase made by him. This assumption becomes

necessary because the marginal utility of a commodity is measured in terms of money.

When a consumer purchases more of a good, the amount of money with him must
diminish and the marginal utility of money must increase. But this variation in the
marginal utility of money is ignored and it is assumed to remain constant throughout.
(iv) Introspection
This is self observation applied to another person. It is assumed that the mind of men
work identically in similar situations. This is how a system of taxation is built on the
assumption that the same incomes mean the same thing to all persons irrespective of
dissimilar circumstances. That is why according to the law of diminishing marginal
utility, the marginal utility decreases when consumers have more of a good.
Two basic laws governing consumer behavior are: (i) the law of diminishing marginal
utility and (ii) the law of equi-marginal utility.
Law of Diminishing Marginal Utility
The law of diminishing marginal utility explains an ordinary experience of a consumer. If
a consumer takes more and more units of a commodity, the additional utility he derives
from an extra unit of the commodity goes on falling. Thus, according to this law, the
marginal utility decreases with the increase in the consumption of a commodity. When
marginal utility decreases, the total utility increases at a diminishing rate. Gossen,
Bentham, Jevons, Karl Menger contributed initially for the development of these ideas.
But Alfred Marshall perfected these ideas and made it as a law. This Law is also known
as Gossens I Law.
Definition
According to Marshall, The additional benefit which a person derives from a given
increase of his stock of a thing diminishes with every increase in the stock that he
already has.
Assumptions of the Law
1. The units of consumption must be in standard units e.g., a cup of tea, a bottle of cool
drink etc.
2. All the units of the commodity must be identical in all aspects like taste, quality,
colour and size.
3. The law holds good only when the process of consumption continues without any
time gap.
4. The consumers taste, habit or preference must remain the same during the process
of consumption.
5. The income of the consumer remains constant.
6. The prices of the commodity consumed and its substitutes are constant.
7. The consumer is assumed to be a rational consumer, he wants to maximise the total
utility.
8. Utility is measurable.
Explanation
Suppose Mr X is hungry and eats apple one by one. The first apple gives him great
pleasure (higher utility) as he is hungry; when he takes the second apple, the extent of
his hunger will reduce. Therefore he will derive less utility from the second apple. If he
continues to take additional apples, the utility derived from the third apple will be less
than that of the second one. In this way, the additional utility (marginal utility) from the
extra units will go on decreasing. If the consumer continues to take more apples,
marginal utility falls to zero and then becomes negative.
Total and Marginal utility schedule

Table-1
Units
of
appl
e
1
2
3
4
5
6
7

Figure-1
Total
utility

20
35
45
50
50
45
35

Margin
al
utility

20
15
10
5
0
-5
-10

Table 1 gives the utility derived by a person from successive units of consumption of
apples.
From Table-1 and figure-1 it is very clear that the marginal utility (addition made to the
total utility) goes on declining. The consumer derives 20 units of utility from the first
apple he consumes. When he consumes the apples continuously, the marginal utility
falls to 5 units for the fourth apple and becomes zero for the fifth apple. The marginal
utilities are negative for the 6th and 7th apples. Thus when the consumer consumes a
commodity continuously, the marginal utility declines, reaches zero and then becomes
negative. The total utility (sum of utilities of all the units consumed) goes on increasing
and after a certain stage begins to decline. When the marginal utility declines and it is
greater than zero, the total utility increases. For the first four units of apple, the total
utility increases from 20 units to 50 units. When the marginal utility is zero (5th apple),
the total utility is constant (50 units) and reaches the maximum. When the marginal
utility becomes negative (6th and 7th units), the total utility declines from 50 units to 45
and then to 35 units.
Importance of Law of DMU
(i) The Law of Diminishing Marginal Utility (DMU) is the foundation for various other
economic laws. For example, the Law of Demand is the result of the operation of the
Law of Diminishing Marginal Utility. As utility falls, consumer is therefore willing to pay a
lower price only.
(ii) The Law of DMU operates in the case of money also. A rich man already possesses a
lot of money. If more and more money is newly added to his income, marginal utility of
money begins to fall. Alfred Marshall assumed that the marginal utility of money
remains constant
(iii) This law is a handy tool for the Finance Minister for increasing tax rate on the rich.
(iv) Producers are guided by the operation the Law of DMU, unconsciously. They
constantly change the design, the package of their goods so that the goods become
more attractive to the consumers and they appear as new goods. Or else, the
consumers would think that they are using the same commodity, over and over. In such
a situation, the Law of DMU operates in the minds of the consumers. Demand for such
commodities may fall.
Limitations of the Law
The law of diminishing marginal utility as expressed above is based on certain
assumptions:

(i) Suitable units: It is assumed that the commodity is taken in suitable units (if you
begin taking water by spoonfuls when thirsty your thirst will be stimulated rather than
the relieved). Unless, therefore, the units are of a suitable size, the law will not hold
good. The initial quantity should be greater than the critical minimum.
(ii) Suitable time: it is further assumed that the commodity is taken within a certain
time, otherwise the law will not apply
(iii) No change in consumers tastes: The character of the consumer does not
change. The consumer must not, for instance, have developed a craving/passion. More
reading lifts a person to a higher plane, and he is able to appreciate and enjoy literature
better than he could before.
(iv) Normal Person: the law of diminishing marginal utility applies to normal person
and not unusual or abnormal persons like misers.
(v) Constant income: it is also essential that the income of the consumer remains the
same. Any change in income will falsify the law.
(vi) Not applicable to money: the law does not apply to money as it is said that more
money he has the more he wants. But explained below, it des apply money too.
Conclusion: the law of diminishing utility, like other economic laws, is merely a
statement of a tendency. It depends upon so many conditions. If the conditions are not
fulfilled, the law does not apply as in the many exceptional cases mentioned above.
The law holds good in all types of satisfaction whether good or bad. We do not assume
rationality on the part of the consumer, nor do we assume that there is a rigidly fixed
order in which wants are arranged by all, although the order will roughly be the same in
the same class of people.
LAW OF EQUI-MARGINAL UTILITY
The idea of equi-marginal principle was first mentioned by H.H. Gossen (1810-1858) of
Germany. Hence it is called Gossens second Law. Alfred Marshall made significant
refinements of this law in his Principles of Economics. The law of equi-marginal utility
explains the behaviour of a consumer when the consumers have more than one
commodity. Wants are unlimited but the income which is available to the consumers to
satisfy all his wants is limited. This law explains how the consumer spends his limited
income on various commodities to get maximum satisfaction. The law of equi-marginal
utility is also known as the law of substitution or the law of maximum satisfaction or the
principle of proportionality between prices and marginal utility.
Definition
In the words of Prof. Marshall, If a person has a thing which can be put to several uses,
he will distribute it among these uses in such a way that it has the same marginal utility
in all.
1.
2.
3.
4.
5.
6.

The
The
The
The
The
The

Assumptions
consumer is rational so he wants to get maximum satisfaction.
utility of each commodity is measurable.
marginal utility of money remains constant.
income of the consumer is given.
prices of the commodities are given.
law is based on the law of diminishing marginal utility.

Explanation of the law

Suppose there are two goods X and Y on which a consumer has to spend a given
income. The consumer being rational, he will try to spend his limited income on goods X
and Y to maximize his total utility or satisfaction. Only at that point the consumer will be
in equilibrium.

According to the law of equi-marginal utility, the consumer will be in equilibrium at the
point where the utility derived from the last Tk. spent on each is equal.
Symbolically the consumer will be in equilibrium when
MUx/ Px = MUy/Py = MUm
Where, MUx = Marginal utility of commodity X, MUy = Marginal utility of commodity Y
Px = Price of commodity X, Py = Price of commodity Y, MUm = Marginal utility of
money.
MUx/ Px and MUy/Py are known as marginal utility of money expenditure.
They explain the marginal utility of one Tk. spent on commodity X and the marginal
utility of one Tk. spent on commodity Y.
The law of equi-marginal utility can also be illustrated with the help of the following
table:
Table- 2
Marginal Utility of goods X and Y
Units
MUx (units)
MUy (units)
1
2
3
4
5
6
7
8

50
45
40
35
30
25
20
15

36
32
28
24
20
16
12
8

Suppose the price of goods X and Y are Tk. 5 and Tk. 4 respectively. The above table
can be reconstructed by dividing the marginal utilities of good X (MUx) by Tk. 5 and
marginal utility of good Y (MUy) by Tk. 4, then we can obtain table -3.
Table- 3
Marginal utility of money expenditure
Units
MUx /px(units)
MUy/Py (units)
1
2
3
4
5
6
7
8

10
9
8
7
6
5
4
3

9
8
7
6
5
4
3
2

Suppose the marginal utility of money is constant at Re. 1 = 5 units, the consumer will
buy 6 units of commodity x and 5 units of commodity y. His total expenditure will be
(Tk. 5 x 6) + (Tk. 4 x 5 ) = Tk. 50/- on both commodities. At this point of expenditure his
satisfaction is maximised and therefore he will be in equilibrium.
Figure: 2, Consumers Equilibrium

Consumers equilibrium is graphically portrayed in fig. 2. Since marginal utility curves of

goods slope ownward, curves depicting MUx/ Px and MUy/Py will also slope downward.
Taking the income of a consumer as given, let his marginal utility of money be constant
at OM utilities in Fig. 2. MUx/ Px is equal to OM (the marginal utility of money) when OH
amount of good x is purchased; MUy/Py is equal to OM when OK quantity of good Y is
purchased. Thus, when the consumer is buying OH of X and OK of Y, then
MUx/ Px = MUy/Py = MUm
Therefore, the consumer will be in equilibrium when he buys OH of X and OK of Y. No
other allocation of money expenditure will yield greater utility than when he buys OH of
X and OK of Y. Suppose the money income of the consumer falls. Then the new marginal
utility of money will be equal to OM; then the consumer will increase the purchases of
good X and Y to OH and OK respectively.
Limitations of the Law
The law of equi-marginal utility bristles with the following difficulties.
1. Indivisibility of Goods
The theory is weakened by the fact that many commodities like a car, a house etc. are
indivisible. In the case of indivisible goods, the law is not applicable.
2. The Marginal Utility of Money is not constant
The theory is based on the assumption that the marginal utility of money is constant.
But that is not really so.
3. The Measurement of Utility is not possible
Marshall states that the price a consumer is willing to pay for a commodity is equal to
its marginal utility. But modern economists argue that, if two persons are paying an
equal price for given commodity, it does not mean that both are getting the same level
of utility. Thus utility is a subjective concept, which cannot be measured, in quantitative
terms.
4. Utilities are Interdependent
This law assumes that commodities are independent and therefore their marginal
utilities are also independent. But in real life commodities are either substitutes or
complements. Their utilities are therefore interdependent.
5. Indefinite Budget Period
According to Prof. K.E. Boulding, indefinite budget period is another difficulty in the law.
Normally the budget period is assumed to be a year. But there are certain commodities
which are available in several succeeding accounting periods. It is difficult to calculate
marginal utility for such commodities. In conclusion, we may say all prudent and
rational persons are expected to act upon the law consciously or unconsciously.
Importance

According to Marshall, the applications of this principle extend over almost every field
of economic activity.
1. It applies to consumption
Every rational human being wants to get maximum satisfaction with his limited means.
The consumer arranges his expenditure in such a way that, MUx/ Px = MUy/Py = MUz/Pz
so that he will get maximum satisfaction.
2. It applies to production
The aim of the producer is to get maximum output with least-cost, so that his profit will
be maximum. Towards this end, he will substitute one factor for another till MPi / Pi =
MPc / Pc = MPn / Pn
3. Distribution of Earnings between Savings and Consumption
According to Marshall, a prudent person will endeavour to distribute his resources
between his present needs and future needs in such a way that the marginal utility of
the last Tk. put in savings is equal to the marginal utility of the last Tk. spent on
consumption.
4. It applies to distribution
The general theory of distribution involves the principle of substitution. In distribution,
the rewards to the various factors of production, that is their relative shares, are
determined by the principle of equi-marginal utility.
5. It Applies to Public Finance
The principle of Maximum Social Advantage as enunciated by Professors Hicks and
Dalton states that, the revenue should be distributed in such a way that the last unit of
expenditure on various programmes brings equal welfare, so that social welfare is
maximised.
6. Expenditure of Time
Prof. Boulding relates Marshalls law of equi-marginal utility to the expenditures of
limited time, i.e. twenty-four hours. He states that a person should spend his limited
time among alternative uses such as reading; studying and gardening, in such a way
that the marginal utility from all these uses are equal.
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