The subject matter of economics has been studied under two broad branches:

1. Microeconomics (Price Theory)
2. Macroeconomics (Income Theory)

These two concepts have become of general use in economics. Let us discuss these concepts in detail.

Microeconomics

Adam Smith is considered to be the founder of the field of microeconomics. The term ‘micro’ has been derived from Greek word ‘mikros’ which means ‘small’. Microeconomics deals with analysis of behaviour and economic actions of small and individual units of the economy, like a particular consumer, a firm or a small group of individual units. The concept of microeconomics is very important as it supplies the foundation for most of our understanding of the functioning of an economy.

Microeconomics is that part of economic theory, which studies the behaviour of individual units of an economy. For example, Individual income, individual output, price of a commodity. etc. Its main tools are Demand and Supply.

Macroeconomics

The term ‘macro has been derived from the Greek word ‘makros’ which means ‘large’. So, macroeconomics deals with overall performance of the economy. It is concerned with study of problems of the economy like inflation, unemployment, poverty, etc.

Macroeconomics is that part of economic theory which studies the behaviour of aggregates of the economy as a whole. For example, National income, aggregate output, aggregate consumption, etc. Its main tools are Aggregate Demand and Aggregate Supply.

Micro Vs Macro

• In Microeconomics, the letter T’ stands for Individuals’, i.e. it studies the economic behaviour of individuals.
• In Macroeconomics, the letter ‘A’ stands for ‘Aggregates’, ie. it studies the economy as a whole.

Let us discuss the detailed differences between the two branches of economics.

Difference between Microeconomics and Macroeconomics

Interdependence of Microeconomics and Macroeconomics

Economics is a single subject and the analysis of an economy cannot be split into two watertight compartments. It means, microeconomics and macroeconomics are not independent of each other and there is much common ground between the two. It means, both microeconomics and macroeconomics are interdependent.

Let us elaborate their interdependence with the help of some examples:

Microeconomics depends on Macroeconomics

1. Law of demand came into existence from the analysis of the behaviour of a group (aggregate) of people.
2. Price of a commodity is influenced by the general price level prevailing in the economy.

Macroeconomics depends on Microeconomics

1. National income of a country is nothing but the sum total of incomes of individual units of the country.
2. Aggregate demand depends on demand of individual households of the economy.

Micro-Macro Paradoxes

Paradox is a seemingly absurd or contradictory statement, though, often a true statement. Sometimes, there are paradoxes seen in Micro and Macro activities. It means, an act which is beneficial for an individual, may prove to be harmful for the economy as a whole.

Example: If an individual saves, his family will be benefitted, but if the whole economy starts saving, it will result in contraction of demand, output, employment and income. As a result, the whole economy will suffer.

Which is more Important Microeconomics or Macroeconomics?

Both, microeconomics and macroeconomics have a place of their own and none of them can be dispensed with. Microeconomics concentrates on the working of the individual components and macroeconomics studies the economy in general. While the former is concerned with structures of the aggregates, the latter is concerned with the aggregates themselves. So, both the approaches are supplementary to each other. The superiority of one approach over the other cannot be claimed.

Need for a Separate Theory of Macroeconomics

Microeconomics failed to study the aggregates of the economy as a whole. As a result, there was a need for a separate theory, which could explain the working of the economy. Macroeconomics helps to understand the working of an economic system as well as to explain the various macroeconomic paradoxes.

An indifference curve is a fundamental concept in microeconomics used to analyze consumer preferences. It represents all combinations of two goods that provide a consumer with the same level of satisfaction or utility. The shape, slope, and behavior of indifference curves help economists understand how consumers make choices based on their preferences. Below, the key properties of indifference curves and the possibility of their parallelism are discussed in detail.

1. Downward Sloping Nature

Indifference curves are downward sloping because, to maintain the same level of satisfaction, a consumer must give up some quantity of one good to gain more of another. For instance, if a consumer has two goods, X and Y, an increase in X necessitates a decrease in Y to keep utility constant. This negative slope reflects the trade-off in consumption and is a direct result of the principle of diminishing marginal utility.

2. Convexity to the Origin

Indifference curves are generally convex to the origin, which means they bow inward. This convex shape is explained by the diminishing marginal rate of substitution (MRS), which implies that as a consumer substitutes one good for another, the amount of the good given up decreases progressively. For example, if a consumer substitutes good X for good Y, they are willing to sacrifice less and less of Y for each additional unit of X as X becomes abundant relative to Y.

3. Higher Curves Indicate Higher Utility

An indifference curve that lies farther from the origin represents a higher level of satisfaction than one closer to the origin. This is because a higher curve contains combinations of goods with greater quantities of at least one good, assuming more consumption leads to greater utility (non-satiation principle). Consumers always prefer combinations on higher indifference curves.

4. Indifference Curves Do Not Intersect

One of the most critical properties is that indifference curves cannot intersect. If two curves were to intersect, it would imply that the same combination of goods offers two different levels of satisfaction, which is logically inconsistent. This principle is rooted in the transitivity of preferences: if a consumer prefers bundle A to B and B to C, they must also prefer A to C.

5. Indifference Curves are Non-Thick

Indifference curves are thin and continuous. A thick curve would imply that multiple points along it represent the same utility level, which contradicts the principle of precise preferences. Continuity ensures there are no sudden jumps or gaps in consumer preferences.

6. Shape Variations Depending on Preferences

While most indifference curves are convex, their shapes can vary based on consumer preferences:

• Perfect Substitutes: Indifference curves are straight lines with a constant slope, indicating a fixed trade-off ratio between two goods.
• Perfect Complements: Indifference curves take an L-shape, representing goods that are consumed in fixed proportions.

Can Indifference Curves Be Parallel?

Indifference curves are not necessarily parallel in most practical scenarios, and their spacing depends on the consumer’s marginal rate of substitution and preferences.

1. Non-Parallel Indifference Curves:

   • The spacing between curves often varies due to the diminishing marginal utility of goods. For example, moving from one curve to a higher curve may require increasing consumption of one good at a changing rate, resulting in non-uniform spacing.
   • The slope of indifference curves can change due to different substitution patterns, leading to variations in their relative positions.

2. Exceptions and Parallelism:

   • In the special case of perfect substitutes, indifference curves are parallel because the trade-off rate (MRS) between two goods is constant. The consumer views the two goods as interchangeable at a fixed ratio, resulting in equidistant and uniformly spaced curves.
   • However, for most real-world preferences, the curves are not parallel, as individual utility functions vary in complexity and shape.

Conclusion

The properties of indifference curves—such as their downward slope, convexity, and inability to intersect—are essential to understanding consumer choice theory. While indifference curves can be parallel in certain theoretical scenarios like perfect substitutes, they are typically not parallel due to the changing marginal rate of substitution and the inherent complexity of human preferences. These properties provide a robust framework for analyzing consumer behavior and the dynamics of choice in economic systems.

Revealed Preference Theory (RPT) is an economic concept that gauges consumer preferences based on the goods they purchase under various price and income scenarios. It was developed to reconcile the utility and demand theories by analyzing customers’ behavior through utility functions.

Revealed preference theory

The belief that customers act rationally roots the foundation of the theory. By holding the price of goods and customers’ income constant, one can determine their purchasing preferences. The theory is best understood through the Weak Axiom of Revealed Preference (WARP), Strong Axiom of Revealed Preference (SARP), and Generalized Axiom of Revealed Preference (GARP).

Revealed preference theory is an economic model to uncover individual preferences based on observed buying patterns.
Revealed preference theory provides a useful tool for analyzing and predicting consumer behavior, particularly regarding how consumers react to price changes and income levels.
It reconciles the utility concept with demand theory by assuming customer choices reflect their preferences. The theory assumes constant prices, incomes, and consistent consumer tastes over time.
Researchers have identified eight main limitations of the theory, including the fact that individual choices may not always reflect true preferences.

Revealed Preference Theory in Economics

Revealed preference theory’s axioms provide a systematic framework for analyzing and evaluating consumer choices, allowing businesses and policymakers to make informed decisions based on consumer behavior patterns. By understanding customers’ preferences, companies can better tailor their products and services to meet their needs, increasing sales and customer satisfaction. It, thus, is essential for understanding consumer preferences by examining their purchasing behavior.

In 1938, economist Paul Anthony Samuelson developed the theory of RPT to quantify the revealed preference theory of consumer behavior. Samuelson illustrated that if a person is given two commodities to choose from (A & B) and two combinations of these commodities (X & Y) with the same quality and price, the person will choose the combination (X) over (Y) because they prefer it.

The price line represents the customer’s real income-price situation, and the consumer may choose any combination on or to the left of the price line, creating a choice triangle from which they can buy any goods. Consumers consider combinations on the price line equally desirable, deem combinations below the price line inferior, and consider those above the price line superior. The difference between the preferred and inferior zones is known as the ignorance zone.

In summary, RPT provides an essential framework for analyzing consumer behavior and understanding their preferences by examining their purchasing decisions at different prices and income levels.

Assumptions

Assumptions of revealed preference theory:

• Consumer tastes remain constant over time.
• The choices a consumer makes reveal their preferences.
• On a price-income line, the consumer selects only one combination.
• Consumers prefer larger sets of goods to smaller ones.
• Consumers have complete and transitive preferences, meaning that if A is preferred over B, and B is preferred over C, then A is preferred over C.
• Consumer behavior exhibits consistency over time.
• Consumers demand more goods as their income increases and less as their income decreases.
• A consumer will purchase more of a product if the price drops significantly.

Diagram

Let us look into the diagrammatic representation of revealed preference theory:

The revealed preference theory is a way of understanding people’s preferences based on their observable behavior, such as buying decisions. People often depict the theory graphically using a simple budget constraint diagram.

The diagram consists of two axes: the horizontal axis represents the quantity of one good, and the vertical axis represents the quantity of another good. The budget constraint is a straight line that shows all the combinations of the two goods that can occur with a given income level and the prices of the goods. The slope of the budget constraint represents the relative prices of the two goods.

The area under the budget constraint represents all the available feasible consumption bundles, given the income level and prices of the goods. Any point on the budget constraint represents a particular consumption bundle that exhausts the consumer’s income. The area above the budget constraint represents unaffordable consumption bundles, given the income level and prices of the goods.

Overall, the revealed preference theory graph provides a visual representation of how consumers choose to allocate their limited income among different goods based on their preferences and the prices of the goods.

Limitations

Despite its merits, like being realistic, scientific, consistent, and based on minimal assumptions, the revealed preference theory has faced some criticism. The limitations of RPT theory are the following:

• It does not account for the possibility of indifferences in consumer behavior.
• It fails to distinguish between the income and substitution effect of a price change.
• It only derives the demand curve of an individual and not the market demand curve.
• It considers the consumer behavior of only individuals governed by existing market conditions.
• RPT does not consider that consumers can choose from multiple combinations instead of only one.
• The choice made by the consumer does not necessarily reflect their true preference.
• Game theory becomes invalid under RPT.
• RPT tends to fail in risky or ambiguous situations.

As price of a good X falls, other things remaining the same, consumer would move to a new equilibrium position at a higher indifference curve and would buy more of good X at the lower price unless it is a Giffen good.

Thus, in the Fig. 8.43 the consumer who is initially in equilibrium at Q on indifference curve IC₁ moves to the point R on indifference curve IC₂ when the price of good X falls and the budget line twists from PL₁ to PL₂.

The movement from Q to R represents the price effect. It is now highly important to understand that this price effect is the net result of two distinct forces, namely substitution effect and income effect. In other words, price effect can be split up into two different parts, one being the substitution effect and the other income effect.

There are two approaches for decomposing price effect into its two parts, substitution effect and income effect. They are the Hicksian approach and Slutsky approach.

Further, Hicksian approach uses two methods of splitting the price effect, namely:

1. Compensating variation in income
2. Equivalent variation in income.

Slutsky uses cost-difference method to decompose price effect into its two component parts. How the price effect can be decom­posed into income effect and substitution effect by the Hicksian methods is explained below.

Breaking up Price Effect: Compensating Variation in Income

In the method of breaking up price effect by compensating variation we adjust the income of the consumer so as to offset the change in satisfaction resulting from the change in price o a good and bring the consumer back to his original indifference curve, that is, his initial level of satisfaction which he was obtaining before the change in price occurred. For instance, when the price of a commodity falls and consumer moves to a new equilibrium position at a higher indifference curve his satisfaction increases.

To offset this gain in satisfaction resulting from a fall in price of the good we must take away from the consumer enough income to force him to come back to his original indifference curve. This required reduction in income (say, through levying a lump sum tax) to cancel out the gain in satisfaction or welfare occurred by reduction in price of a good is called compensating variation in income.

This is so called because It compensates (in a negative way) for the gain in satisfaction resulting from a price reduction of the commodity. How the price effect is broken up into substitution effect and income effect through the method of compensating variation in income is illustrated in Fig 8.43.

When price of good X falls and as a result budget line shifts to PL₂, the real income of the consumer rises, i.e., he can buy more of both the goods with his given money income. That is, price reduction enlarges consumer’s opportunity set of the two goods. With the new budget line PL₂ he is in equilibrium at point R on a higher indifference curve IC₂ and thus gains in satisfaction as a result of fall in price of good X.

Now, if his money income is reduced by the compensating variation in income so that he is forced to come back to the original indifference curve IC₁ he would buy more of X since X has now become relatively cheaper than before. In Fig. 8.43 as result of the fall in price of X, price line switches to PL₂. Now, with the reduction in income by compensating variation, budget line shifts to AB which has been drawn parallel to PL₂ so that it just touches the indifference curve IC₁ where he was before the fall in price of X.

Since the price line AB has got the same slope as Pig, it represents the changed relative prices with X being relatively cheaper than before. Now, X being relatively cheaper than before, the consumer in order to maximise his satisfaction in the new price income situation substitutes X for Y.

Thus, when the consumer’s money income is reduced by the compensating variation in income (which is equal to PA in terms of Y or L₂B in terms of X), the consumer moves along the same indifference curve IC₁ and substitutes X for Y. With price line AB, he is in equilibrium at S on indifference curve IC₁ and is buying MK more of X in place of Y. This movement from Q to S on the same indifference curve IC₁ represents the substitution effect since it occurs due to the change in relative prices alone, real income remaining constant.

If the amount of money income which was taken away from him is now given back to him, he would move from S on indifference curve IC₁ to R on a higher indifference curve IC₂. The movement from Son a lower in difference curve to R on a higher in difference curve is the result of income effect. Thus the movement from Q to R due to price effect can be regarded as having been taken place into two steps first from Q to S as a result of substitution effect and second from S to R as a result of income effect. In is thus manifest that price effect is the combined result of a substitution effect and an income effect.

In Fig. 8.43 the various effects on the purchases of good X are:

Price effect = MN

Substitution effect = MK

Income effect = K/V

MN = MK+KN or

Price effect = Substitution effect + Income effect

From the above analysis, it is thus clear that price effect is the sum of income and substitution effects.

Breaking up Price Effect: Equivalent Variation in Income

As mentioned above, price effect can be split up into substitution and income effects” through an alternative method of equivalent variation in income. The reduction in price of a commodity increases consumer’s satisfaction as it enables him to reach a higher indifference curve. Now, the same increase in satisfaction can be achieved through bringing about an increase in his income, prices remaining constant.

The increase in income of the consumer prices of goods remaining the same, so as to enable him to move to a higher subsequent indifference curve at which he in fact reaches with reduction in price of a good is called equivalent variation in income because it represents the variation in income that is equivalent in terms of gain in satisfaction to a reduction in price of the good.

Thus, in this equivalent income-variation method substitution effect is shown along the subsequent indifference curve rather than the original one. How this price effect is decomposed into income and substitution effects through equivalent variation in income is shown in Fig. 8.44.

When price of good X falls, the consumer can purchase more of both the goods, that is, the purchasing power of his given money income rises. It means that after the fall in price of X if the consumer buys the same quantities of goods as before, then some amount of money will be left over. In other words, the fall in price of good X will release some amount of money. Money thus released can be spent on purchasing more of both the goods.

It therefore follows that a change in price of the good produces an income effect. When the power to purchase goods rises due to the income effect of the price change, the consumer has to decide how this increase in his purchasing power is to be spread over the two goods he is buying. How he will spread the released purchasing power over the two goods depends upon the nature of his income consumption curve which in turn is determined by his preferences about the two goods.

From above it follows, that, as a result of the increase in his purchasing power (or real income) due to the fall in price, the consumer will move to a higher indifference curve and will become better off than before. It is as if price had remained the same but his money income was increased. In other words, a fall in price of good X does to the consumer what an equivalent rise in money income would have done to him.

As a result of fall in price of X, the consumer can therefore be imagined as moving up to a higher indifference curve along the income consumption curve as if his money income had been increased, prices of X and Y remaining unchanged. Thus, a given change in price can be thought of as an equivalent to an appropriate change in income.

It will be seen from Fig. 8.44 that with price line PL₁, the consumer is in equilibrium at Q on indifference curve IC₁. Suppose price of good X falls, price of Y and his money income remaining unaltered, so that budget line is now PL₂. With budget line PL₂, he is in equilibrium at R on indifference curve IC₂. Now, a line AB is drawn parallel to PL₁ so that it touches the indifference curve IC₂ at S.

It means that the increase in real income or purchasing power of the consumer as a result of the fall in price of X is equal to PA in terms of Y or L₁B in terms of X Movement of the consumer from Q on indifference curve IC₁ to S on the higher indifference curve IC₂ along the income consumption curve is the result of income effect of the price change. But the consumer will not be finally in equilibrium at S.

This is because now that X is relatively cheaper than Y, he will substitute X, which has become relatively cheaper, for good Y, which has become relatively dearer. It will be gainful for the consumer to do so. Thus the consumer will move along the indifference curve IC₂ from S to R. This movement from S to R has taken place because of the change in relative prices alone and therefore represents substitution effect. Thus the price effect can be broken up into income and substitution effects, showing in this case substitution along the subsequent indifference curve.

In Fig 8.44 the magnitudes of the various effects are:

Price effect = MN

Income effect = MH

Substitution effect = HN

In Fig. 8.44 effect = MMH + HN

Price effect = Income Effect + Substitution Effect

Introduction

According to ‘Law of Demand’, quantity demanded increases with fall in price and decreases with rise in price. The law of demand gives us the direction of change in the quantity demanded as a result of a change in price, but it does not specify the magnitude, amount or the extent by which the quantity demanded changes with a change in its price. In brief, it does not indicate, how much change’ in the quantity demanded due to change in price. Therefore, the concept of ‘Elasticity of Demand’ was developed to measure the magnitude of change in the quantity demanded.

For More Clarity

Suppose, price of computer falls by 20%.

• According to Law of demand, the quantity of computers demanded will increase due to fall in its price. However, it does not indicate, by how much quantity demanded of computers will increase.
• In such cases, the concept of Elasticity of Demand becomes important as it helps in knowing “how much”.

The concept of elasticity was developed by Prof. Marshall in his book ‘Principles of Economics’. Now-a-days, this concept has great importance in economic theory as well as in applied economics.

Concept Of Elasticity Of Demand

Demand for a commodity is affected by a number of factors like change in its own price, change in the income of consumer, change in the prices of related goods, etc. Elasticity of demand refers to the percentage change in demand for a commodity with respect to percentage change in any of the factors affecting demand for that commodity. Elasticity of demand can be calculated as:

Elasticity of Demand =  $\frac{Percentage\;Change\;in\;Demand\;for\;X}{Percentage\;Change\;in\;a\;factor\;affecting\;the\;Demand\;for\;X}$

Out of various determinants of demand, there are 3 quantifiable determinants of demand: (1) Price of the given commodity; (2) Price of related goods; (3) Income of the consumer. So, we have 3 dimensions of elasticity of demand:

1. Price elasticity of demand: Price elasticity of demand refers to the percentage change in demand for a commodity with respect to percentage change in the price of the given commodity.
2. Cross elasticity of demand: Cross elasticity of demand refers to the percentage change in demand for a commodity with respect to percentage change in the price of a related good (substitute good or complementary good).
3. Income elasticity of demand: Income elasticity of demand refers to the percentage change in demand for a commodity with respect to percentage change in the income of consumer.

Cross and Income Elasticity of Demand are beyond the scope of Class XII syllabus. So, present chapter deals with ‘Price Elasticity of Demand”.

Price Elasticity Of Demand

Price Elasticity of Demand means the degree of responsiveness of demand for a commodity with reference to change in the price of such commodity.

Some Noteworthy Points about Price Elasticity of Demand

• It establishes a quantitative relationship between quantity demanded of a commodity and its price, while other factors remain constant.
• Higher the numerical value of elasticity, larger is the effect of a price change on the quantity demanded.
• For certain goods, a change in price leads to a greater change in the demand, whereas, in some cases, there is a small change in demand due to change in price. For example, if prices of two commodities ‘x’ and ‘y’ rise by 10% and their demands fall by 20% and 5% respectively, then commodity ‘x’ is said to be more elastic as compared to commodity ‘y’.
• Price is the most important determinant of demand. So, price elasticity of demand is sometimes shortened as ‘Elasticity of Demand’ or ‘Demand Elasticity’ or simply ‘Elasticity’ Unless otherwise stated, whenever these words are used, they mean ‘Price Elasticity of Demand’.

Degrees Of Elasticities Of Demand

1. Perfectly Elastic Demand

Perfectly elastic demand is said to happen when a little change in price leads to an infinite change in quantity demanded. A small rise in price on the part of the seller reduces the demand to zero. In such a case the shape of the demand curve will be horizontal straight line as shown in figure 1.

The figure 1 shows that at the ruling price OP, the demand is infinite. A slight rise in price will contract the demand to zero. A slight fall in price will attract more consumers but the elasticity of demand will remain infinite (e_d=∞). But in real world, the cases of perfectly elastic demand are exceedingly rare and are not of any practical interest.

2. Perfectly Inelastic Demand

Perfectly inelastic demand is opposite to perfectly elastic demand. Under the perfectly inelastic demand, irrespective of any rise or fall in price of a commodity, the quantity demanded remains the same. The elasticity of demand in this case will be equal to zero (e_d = 0).

In diagram 2 DD shows the perfectly inelastic demand. At price OP, the quantity demanded is OQ. Now, the price falls to OP₁, from OP, the demand remains the same. Similarly, if the price rises to OP₂ the demand still remains the same. But just as we do not see the example of perfectly elastic demand in the real world, in the same fashion, it is difficult to come across the cases of perfectly inelastic demand because even the demand for, bare essentials of life does show some degree of responsiveness to change in price.

3. Unitary Elastic Demand

The demand is said to be unitary elastic when a given proportionate change in the price level brings about an equal proportionate change in quantity demanded. The numerical value of unitary elastic demand is exactly one i.e. Marshall calls it unit elastic.

In figure 3, DD demand curve represents unitary elastic demand. This demand curve is called rectangular hyperbola. When price is OP, the quantity demanded is OQ\. Now price falls to OP₁ the quantity demanded increases to OQ2. The area OQ\RP = area OP\SQ₂ in the fig. denotes that in all cases price elasticity of demand is equal to one.

4. Relatively Elastic Demand

Relatively elastic demand refers to a situation in which a small change in price leads to a big change in quantity demanded. In such a case elasticity of demand is said to be more than one (e_d > 1). This has been shown in figure 4.

In fig. 4, DD is the demand curve which indicates that when price is OP the quantity demanded is OQ₁. Now the price falls from OP to OP₁, the quantity demanded increases from OQ₁ to OQ₂ i.e. quantity demanded changes more than change in price.’

5. Relatively Inelastic Demand

Under the relatively inelastic demand, a given percentage change in price produces a relatively less percentage change in quantity demanded. In such a case elasticity of demand is said to be less than one (e_d < 1). It has been shown in figure 5.

All the five degrees of elasticity of demand have been shown in figure 6. On OX axis, quantity demanded and on OY axis price is given.

It shows:

1. AB — Perfectly Inelastic Demand

2. CD — Perfectly Elastic Demand

3. EG — Less than Unitary Elastic Demand

4. EF — Greater Than Unitary Elastic Demand

5. MN — Unitary Elastic Demand.

Factors Affecting Price Elasticity of Demand

A change in price does not always lead to the same proportionate change in demand. For example, a small change in price of AC may affect its demand to a considerable extent, whereas, large change in price of salt may not affect its demand. So, elasticity of demand is different for different goods.

Various factors which affect the elasticity of demand of a commodity are:

1. Nature of commodity: Elasticity of demand of a commodity is influenced by its nature. A commodity for a person may be a necessity, a comfort or a luxury. When a commodity is a necessity like food grains, vegetables, medicines, etc., its demand is generally inelastic as it is required for human survival and its demand does not fluctuate much with change in price. When a commodity is a comfort like fan, refrigerator, etc., its demand is generally elastic as consumer can postpone its consumption. When a commodity is a luxury like AC, DVD player, etc., its demand is generally more elastic as compared to demand for comforts. The term ‘luxury’ is a relative term as any item (like AC), may be a luxury for a poor person but a necessity for a rich person.
2. Availability of substitutes: Demand for a commodity with large number of substitutes will be more elastic. The reason is that even a small rise in its prices will induce the buyers to go for its substitutes. For example, a rise in the price of Pepsi encourages buyers to buy Coke and vice-versa. Thus, availability of close substitutes makes the demand sensitive to change in the prices. On the other hand, commodities with few or no substitutes like wheat and salt have less price elasticity of demand.
3. Income Level: Elasticity of demand for any commodity is generally less for higher income level groups in comparison to people with low incomes. It happens because rich people are not influenced much by changes in the price of goods. But, poor people are highly affected by increase or decrease in the price of goods. As a result, demand for lower income group is highly elastic.
4. Level of price: Level of price also affects the price elasticity of demand. Costly goods like laptop, AC, etc. have highly elastic demand as their demand is very sensitive to changes in their prices. However, demand for inexpensive goods like needle, match box, etc. is inelastic as change in prices of such goods do not change their demand by a considerable amount.
5. Postponement of Consumption: Commodities like biscuits, soft drinks, etc. whose demand is not urgent, have highly elastic demand as their consumption can be postponed in case of an increase in their prices. However, commodities with urgent demand like life saving drugs, have inelastic demand because of their immediate requirement.
6. Number of Uses: If the commodity under consideration has several uses, then its demand will be elastic. When price of such a commodity increases, then it is generally put to only more urgent uses and, as a result, its demand falls. When the prices fall, then it is used for satisfying even less urgent needs and demand rises. For example, electricity is a multiple-use commodity. Fall in its price will result in substantial increase in its demand, particularly in those uses (like AC, Heat convector, etc.), where it was not employed formerly due to its high price. On the other hand, a commodity with no or few alternative uses has less elastic demand. 7. Share in Total Expenditure: Proportion of consumer’s income that is spent on a particular commodity also influences the elasticity of demand for it. Greater the proportion of income spent on the commodity, more is the elasticity of demand for it and vice-versa. Demand for goods like salt, needle, soap, match box, etc. tends to be inelastic as consumers spend a small proportion of their income on such goods. When prices of such goods change, consumers continue to purchase almost the same quantity of these goods. However, if the proportion of income spent on a commodity is large, then demand for such a commodity will be elastic.
7. Time Period: Price elasticity of demand is always related to a period of time. It can be a day, a week, a month, a year or a period of several years. Elasticity of demand buries directly with the time period. Demand is generally inelastic in the short period. It happens because consumers find it difficult to change their habits, in the short period, in order to respond to a change in the price of the given commodity. However, demand is more elastic in long run as it is comparatively easier to shift to other substitutes, if the price of the given commodity rises.
8. Habits: Commodities, which have become habitual necessities for the consumers, have less elastic demand. It happens because such a commodity becomes a necessity for the consumer and he continues to purchase it even if its price rises. Alcohol, tobacco, cigarettes, etc. are some examples of habit forming commodities.

Finally it can be concluded that elasticity of demand for a commodity is affected by number of factors. However, it is difficult to say, which particular factor or combination of factors determines the elasticity. It all depends upon circumstances of each case.

Introduction, consumer’s surplus was introduced in economics by Alfred Marshall, although the use of the concept goes back at least to the Freanch economist Dupuit writing in the first half of the nineteenth century.

Two Nobel Prize winners in economics disagree fundamen­tally about the utility of the concept; John Hicks saw great use for the concept as a cornerstone of welfare economics, whereas Paul Samuelson believes that we can talk of discard the concept without loss. There is also the question of whether we can talk of consumer’s surplus or only of consumer’s surplus—whether we can use the concept for a whole group of consumers of a product or only for an individual household.

The doctrine of consumer’s surplus is a deduction from the law of diminishing marginal utility. The price that we pay for a thing measures only the marginal utility, but not the total utility. Only on the marginal unit, which a man is just induced to buy, the price is exactly equal to the satisfaction that he expects to get from that unit. But, on other units that he buys, he enjoys some extra amount of satisfaction.

He would be willing to pay higher prices for these units than what he actually pays for them. The difference between the amount of satisfaction which a consumer obtains from purchasing things over that which he actually pays for them is the economic measure of consumer’s surplus.

It represents the excess of satisfac­tion that he secures, the excess being equal to the difference between the utility of the goods acquired and that of the money sacrificed. Had he been deprived of the commodity, he would then have been forced to spend the money on the purchase of other commodities from which he does not derive the same amount of satisfaction, but less.

Alfred Marshall has introduced the term ‘consumer’s surplus’ in eco­nomic theory to show that, in various situations consumer receives more from a commodity than he pays for it.

Marshall explained consumer’s surplus thus:

“The price which a person pays for a thing can never exceed and seldom comes up to that which he would be willing to pay rather than go without it – so that the satisfaction which he gets from its purchase generally exceeds that which he gives up in paying away its price: and he thus derives from the purchase a surplus of satisfaction”.

The excess of the price which he would be willing to pay rather than go without the thing, over that which he actually does pay, is the economic measure of this surplus satisfaction. In short, the benefit which a person derives from purchasing, at a low price, thing for which he would rather pay a high price, than go without it may be called his consumer’s surplus.

At times, we find that a consumer’s willingness to pay for a commodity may be greater than the price he actually pays for it. The price that he is ready to pay for a commodity is his individual demand price and the price he actually pays for it is the market price. According to Paul Samuelson, consumer’s surplus is nothing but the excess of the individual demand price over the market price of a commodity (or, the positive difference between the potential price and the actual price of a commodity).

Example:

In order to give definiteness to our idea, let us take the example of shoes. Suppose, from the first pair of shoes a man expects to get satisfaction worth at least Rs. 500, from the second he expects additional satisfaction worth Rs. 400, from the third he expects additional satisfaction worth Rs. 300. Suppose, he is just induced to buy three pairs and no more.

Since in a market there cannot be more than one price, the price that he pays for each pair is measured by that of the marginal pair, i.e., by Rs. 300. He will pay (Rs. 300 x 3) or Rs. 900 in all for the three pairs. But, by hypothesis, he is enjoying from the three pairs an amount of satisfaction worth (Rs. 500 + Rs. 400 + Rs. 300) = Rs. 1200.

Hence, he enjoys a surplus of satisfaction from his purchase worth (Rs. 1200 – Rs. 900) = Rs. 300. Consumer’s surplus is then measured by the difference between the total utility and the total expendi­ture made by the consumer on a commodity (shoes). It is the difference between individual demand price and market price.

Hence, the consumer’s surplus may be shown in another way:

Consumer’s Surplus = Total Utility – (Total units purchased x marginal utility or price). In short, consumer’s surplus is the positive difference between the total utility from a commodity and the total payments made for it.

The concept of consumer’s surplus can also be illustrated with the help of Fig. 3:

In Fig. 3, the quality of a particular commodity is measure on the horizontal axis and its marginal utility or production on the vertical axis. Here DD’ is the demand price for it. If a consumer buys all the units (OR) at RS price per unit, he gets a total satisfaction equal to the area DORS. But, he spends only ORST amount of money, so his surplus satisfaction is DTS (i.e., the shaded area). If the price falls to R’ S’, he would buy OR’ and his surplus would increase to DTS’.

So, consumer’s surplus is measured by the area under the demand curve but above the market price. A difficulty is that as the price falls the demand where, the real income of the consumer increases. To get a more accurate measure of the benefit of the surplus; therefore, an adjustment must be made to offset the effect of the difference in real income at the higher price (RS) and the lower price (R’S’).

Difficulties of Measurement

Consumer’s surplus is measured by the area under an individual’s demand curve between two prices. It is a monetary measure, although originally represented in terms of surplus utility by Marshall. It is a measure of the benefit to the consumer, net of the sacrifice he has to make from being able to buy a commodity at a particular price. However, Marshall’s doctrine of consumer’s surplus is subject to a number of criticisms, mainly due to various difficulties associated with this measurement.

The main criticisms of the doctrine are the following:

Constant Marginal Utility of Money

Marshall’s doctrine of con­sumer’s surplus is based on the assumption of constant marginal utility of money. Hicks considers this to be the greatest difficulty in accepting the concept of consumer’s surplus. As he put it, “A stronger incentive will be required to induce a person to pay a given price for anything if he is poor than if he is rich. A pound is the measure of the less pleasure, or satisfaction, of any kind, to a rich man than to a poor one.”

When a consumer buys more of a particular thing, his stock of money falls and the marginal utility of money to him will increase. Such a reduction in the marginal utility of money will automatically involve the revaluation of the utilities from the earlier units of the commodity!

It is true that Marshall’s assumption of constant marginal utility of money becomes valid when a consumer spends a very small proportion of his income for a commodity. But, this assumption is not always realistic, for a consumer is often required to spend a large portion of his income for a commodity (e.g., expenditure on foodstuff by a poor household).

Lack of Precise Measurement

The accurate measurement of con­sumer’s surplus is not possible as we have no knowledge of the potential prices that a consumer is willing to pay for the earlier units of the commodity purchased. In fact, the individual demand prices for the earlier units of the commodity are merely hypothetical and imaginary. For this reason, Prof. Nicholson remarks that the concept of consumer’s surplus is purely hypo­thetical and more a figment than a fact.

Difficulties in Measuring Consumer’s Surplus

Further difficulties arise when we try to increase of consumer’s surpluses of a group or of a community by means of adding up the consumer’s surplus of different individuals. Such difficulties arise because the individual demand price for a thing varies from person to person owing to differences in their incomes, tastes, preferences, etc.

Unlimited Consumer’s Surplus in the Case of Necessities

It is also pointed out that the consumer’s surplus cannot be measured in the case of necessaries and of conventional necessaries of life as their utility (or the individual demand prices for these goods) is infinite or indefinite to a consumer. It is very often found that a consumer is sometimes willing to pay anything under his possession for these goods when he is in urgent need of them, and this makes the individual demand prices for these goods to be infinite. Examples of such goods are textbooks or life-saving drugs.

Conspicuous Consumption Goods

Tausig has pointed out that the concept of consumer’s surplus cannot be applied in the case of articles of conspicuous consumption (e.g., for coats of diamonds). The term was used by Thorstesin Veblem (1857-1929) to identify that ostentatious personal expenditure which satisfies no physical need but rather a psychological need for the esteem of others.

Goods may be purchased not for their practical use but as ‘status symbols’ and to ‘keep up with the Joneses’. These goods have a high prestige value to their users, but their utility falls when their prices fall. In such cases, a fall in the prices causes a fall in consumer’s surplus — a result which becomes inconsistent with the definition of con­sumer’s surplus.

Impossibility of Meaning Cardinal Utility

Furthermore, Marshall’s analysis of consumer’s surplus is based on an important premise that the utility of a thing can be measured and numbered. But, most of the modern writers have shown that utility, being a psychological concept, cannot be cardinally (objectively) measured and quantified.

Difficulties in the Case of Complements and Substitutes

Again, consumer’s surplus cannot be measured in the case of complementary goods (e.g., tea and coffee, etc.) Because, in such cases the utility of a thing depends not only on its total stock but also on the supply of other related goods. Marshall has tried to overcome this difficulty by suggesting that we should treat the related goods as one commodity and group them under one common demand schedule. But, actually, it is not possible to do so.

Purely Hypothetical and Unreal Concept

Prof. Nicholson has ex­pressed serious doubts about the utility of the whole doctrine. He asked, “Of what avail is it to say that the utility of an income of (say) £ 100 a year is worth (say) £ 1000 a year?” According to him, the doctrine is thus purely hypothetical and unreal.

But, Marshall points out that the question raised by Nicholson would have some relevance if we compare the living conditions in Central Africa with those in London. There are many things, many amenities of life which are available in London, but not in Central Africa. The living conditions at those two places may be measured by the statement that £ 100 in London yields the same benefits to the consumer as £ 1000 in Central Africa.

Useless Theoretical Toy

Prof. Little has characterised the concept of consumer’s surplus as “a totally useless theoretical toy” as it cannot provide us any practical objective criterion for measuring economic welfare.

Historical and Doctrinal Interest

Samuelson has not attached much importance to the doctrine of consumer’s surplus in the study of economics. He remarks, “The subject (the concept of consumer’s surplus) is of historical and doctrinal interest, with a limited amount of appeal as a mathematical puzzle”.

Hicks’s Concept of consumer’s surplus:

Owing to various difficulties in measuring consumer’s surplus as explained by Marshall, J.R. Hicks has formulated the concept of consumer’s surplus in a different way. In his opinion, “the best way of looking at consumer surplus is to regard it as a means of expressing, in terms of money income, the gain which accrues to the consumer as a result of a fall in price”.

Thus, when a thing (say, sugar or edible oil) becomes cheaper as a result of a fall in its price, a consumer gets the same amount at a lower price. Because of such a gain in money income, he may buy more of that thing or he may buy another thing; in any case he is now better off than before. To Hicks such a gain in money income as a result of a fall in the price of a thing is consumer’s surplus.