Why I Am Paying More - IIMA

Dear Reader, Satish Deodhar’s second book in the IIMA Business Books series, published in collaboration with Random House, is informative and stimulating. The book begins with a clear discussion of basic microeconomic concepts, such as utility, cost, supply and demand curve, price determination, producer and customer surplus, and dead weight loss. Satish next moves to a crisp exposition of various forms of market competition—perfect competition, monopoly, monopolistic competition, and oligopoly. He highlights various mechanisms that producers might use to extract consumer surplus and provides a lucid exposition of game theory, made all the clearer with examples such as ‘Phoolan Devi and Veerappan facing prisoners’ dilemma’. The book proceeds to a description of various forms of market failure and the role of regulation in addressing them. The last chapter provides retrospection through the topics covered and ends with an intriguing crossword. At the end of each chapter, references afford interested readers the opportunity to explore topics in further depth, and ready reckoners provide descriptions of key terms. In a deceptively simple manner, the book offers practitioners a thorough and in-depth perspective on a broad swathe of microeconomics topics. Throughout, Satish explains these concepts in a straightforward manner, clarified with the help of simple and intuitive charts and peppered with rich instances from business and daily life. Why I am Paying More is one of a series of books authored by IIMA professors who are not only academically proficient but also have rich experience in consulting and teaching executives. These books are intended to disseminate knowledge in relevant topics in management to practicing executives. Written in conversational style with illustrations from the world of practice, the books are eminently readable and applicable in daily life. I am confident you will enjoy Why I am Paying More, as you will other books in the series. Please do let us know if there are particular topics that you would like covered in the books published in this series. Ashish Nanda Director IIM Ahmedabad

IIM AHMEDABAD

BUSINESS BOOKS

Why I am Paying More Price Theory and Market Structures Made Simple

Also by Satish Y. Deodhar Day to Day Economics

IIM AHMEDABAD

BUSINESS BOOKS

Why I am Paying More Price Theory and Market Structures Made Simple

SATISH Y. DEODHAR

RANDOM HOUSE INDIA

Published by Random House India in 2013 1 Copyright © Satish Y. Deodhar 2013 Random House Publishers India Private Limited Windsor IT Park, 7th Floor, Tower-B, A-1, Sector-125, Noida-201301, UP Random House Group Limited 20 Vauxhall Bridge Road London SW1V 2SA United Kingdom 978 81 8400 405 2 This book is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, resold, hired out, or otherwise circulated without the publisher’s prior consent in any form of binding or cover other than that in which it is published and without a similar condition including this condition being imposed on the subsequent purchaser. Typeset in Sabon by R. Ajith Kumar Printed and bound in India by Replika Press Private Limited

To Deepali, partner-in-life I met a score years ago and to Sylee (17) and Yash (13), the most formidable domestic teen cartel!

CONTENTS

Preface Acknowledgements

xi xiii

0. Introduction

1

1. Utility and Market Demand

9

2. Cost Concepts and Market Supply

21

3. Societal Welfare, Free Enterprise, and Market Price 35 4. Price Ceiling, Price Floor, and the New Support Paradigm

53

5. Perfect Competition

80

6. Monopoly

117

7. Pricing to Extract Consumers’ Surplus

148

8. Monopolistic Competition

178

9. Oligopoly

201

10. Market Failure and the Government

242

11. Retrospection

261

A Note on the Author A Note on the IIMA Business Books

276 279

PREFACE

This book may be considered as a sequel to my first book, Day to Day Economics. When Day to Day Economics was published, I was quite apprehensive about the acceptance of the book by readers. However, there was a pleasant surprise in (book) store! Readers were very kind to me and they turned out to be quite an extrovert lot. They would send sporadic emails or post reviews on blogs and online bookstores expressing their liking for the book. Students and participants from various management programmes at IIMA also complimented me for making economics accessible and relevant. While this was a humbling experience for me, readers discerningly pointed out that the book had focussed mostly on macroeconomic issues. It was suggested that I should also write a similar book on microeconomic issues—issues which would describe why in most cases economists vouch for free enterprise system, how prices are set in different market structures, and what are the circumstances that justify government’s role in free enterprise system. These suggestions sounded almost like the Sanskrit aphorism, Atha to Brahma Jidnyasa—an inquisitiveness to know the ultimate reality! Writing a textbook on

Preface

microeconomics would not have served the purpose, for the market for textbooks has already become overcrowded. The challenging task was to write a book that will appeal to the intuition of non-economists and non-academicians. Hence this modest effort—a sequel to Day to Day Economics.

xii

ACKNOWLEDGEMENTS

This book being a sequel to my earlier book in the IIMA Business Book Series, I must admit my continuing debt to my family members. As in the past, they endured an inescapable distraction from the comforts of a family of four. I also wish to thank many readers of Day to Day Economics who suggested to me to write a book on economic issues relating to microeconomics. When I was half way through this book, Random House and Penguin came together to form a new entity, Penguin Random House. Of course, while the publication of this book is being concluded under the banner of Random House, I could now cite a live example of business mergers in the chapter on Oligopoly. If Penguin Random House has retained the maiden name of Random House, Radhika and Milee have continued to practice business culture of their sanguine Random House! Thanks to both of them for stoically yielding to somewhat moving deadlines. The book you are about to read was not penned by me alone, for I have been greatly influenced by my economics teachers as also by my colleagues at IIMA. I have been

Acknowledgements

fortunate to assimilate information from diverse sources such as academic journals, textbooks, newspapers, government documents and the internet. Unabashedly, I have relied on all of them to help me connect the dots and further our understanding of pricing and market structures. And, of course, in the absence of the proofreaders, designers, and reviewers from Random House, the book could not have seen the light of the day. I wish to thank them all.

xiv

CHAPTER 0

INTRODUCTION

‘The basic problems of economics are simple; the hard part is to recognize simplicity when you see it. The next hardest part is to present simplicity as common sense rather than ivory tower insensitivity. Theory needs to teach more of both.’

—Harry G. Johnson

Ever since independence, the prime ministers have been addressing the nation from the ramparts of the Red Fort every 15th August. Perhaps with the exception of the euphoria of a few initial years, most people give the speech a miss every year. Closer home, amongst our acquaintances, most of us do encounter a few persons who have a habit of talking quite a lot. Our usual response is to either avoid such persons or reluctantly endure their presence. The purport of this is that such talk gets perceived as being ‘cheap’ because its supply

Why I am Paying More

seems to exceed demand. Of course, there is no rupee price attached to that talk, for it is a non-market activity. However, the intuition we apply in such a deduction is no different than the one usually employed in the marketplace. Consider a somewhat similar situation in the marketplace. A worried client who meets up with his lawyer for consultation behaves differently. The client listens to the lawyer with rapt attention and knows that he has to pay the fees, perhaps handsome amount of rupees per hour. The lawyer’s talk is not free. The lawyer offers a service in the market which may or may not be cheap but there is a positive rupee price attached to it. Like the lawyer’s service, practically zillions of goods and services—from abacus and apples to zucchini and zyloscope—are produced, traded, and consumed in the market. And, each one has a positive price attached to it at any given point in time. What is the process through which this price discovery occurs? Are the prices unilaterally decided by individual firms? Do households have any say in setting the prices? These are some of the questions one would like to get answers to. In fact, come to think of it, it is almost a mystery as to how customers choose from among zillions of products available in the market. Given their preferences for various products, household income, and the prices prevailing in the market, some activity must be taking place in the minds of the customers that guides them to make particular consumption choices. It will be worth fathoming what goes on in the minds of customers. Price determination gets much more interesting depending 2

Introduction

upon different market structures. Why is it that saree emporiums and apparel shops offer heavy discounts on a few occasions during the year? Why is it that airline tickets booked well in advance are always cheaper? Why is it that many amusement parks and fairs in town and cities charge an entry fee at the gate and once again charge separate tickets for different rides inside? And then, of course, there are many prices such as electricity tariffs and minimum wages that are fixed by government intervention. Are such price interventions by government justified and on what grounds? Such and many similar economic issues are quite relevant to customers and producers alike. It is for this reason that one of the most influential economists of the late nineteenth and early twentieth century, Alfred Marshall, described economics as ‘the study of mankind in the ordinary business of life.’ He published his book, Principles of Economics way back in 1890, and it went on to become a standard textbook for generations of economics students. Today, of course, the textbook market is getting increasingly overcrowded for economics in general and for ‘principles of economics’ in particular. As will be discussed in this book later, the market for economics textbooks can be characterized as a monopolistically competitive market! Most economists seem to believe in the doctrine of free enterprise or capitalism. It does not come as a surprise when the best advocates of free enterprise, economists such as Milton Friedman say, ‘Many people want the government to protect the consumer. A much more urgent 3

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problem is to protect the consumer from the government.’ However, even John Maynard Keynes, the father of modern macroeconomics, who believed in government intervention to promote employment during the times of recession, seemed to be sympathetic to free enterprise and capitalism. He is alleged to have said, ‘Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone.’ If economists swear by free enterprise so much, there must be a way to explain to a layperson as to why this is so. And yet, you bet there are some weak links in the free enterprise system where government intervention is required. The issues raised above form the subject matter of what is called microeconomics. As an informed citizen of the modern world, one must know the basic ideas behind the issues that have been raised above. Of course, it is difficult to explain the laws of nature or their applications, either from physics or economics, purely from the standpoint of a theoretician or purely from the standpoint of a practitioner. Isaac Newton’s challenge to explain laws of motion to a snooker world champion is no harder than the world champion’s challenge to turn Newton into an international snooker player! One has to find a middle ground. There is a vacuum of understanding that needs to be filled with a book that presents principles of microeconomics to laypersons by relating them to their day to day activities, experiences, lifestyles, anecdotes, and their understanding of history, culture, and geography. This book hopes to serve that purpose. 4

Introduction

You will agree with me that we all have been students at some point in time or another. In fact, in today’s modern world we just never seize to be one. The materialistic world around us is such that a student of any discipline, even a casual student of life, cannot become market worthy unless she understands at least a few concepts in economics. This is all the more true for someone who opts for a bachelor’s or a master’s programme in business management and economics. If you want to understand marketing concepts such as price sensitivity or market segmentation, rest assured these concepts are based on the idea of price elasticity of demand which originated in economics literature. You may want to understand finance concepts such as movement of stock prices and rate of returns and they were originally thought through in economics literature. While learning linear programming in the decision science courses, you will come across the term shadow prices. It is based on the economic concept of scarcity of resources and its value. The literature on wage negotiations in human resource management gets related to economic concepts such as efficiency wages and bilateral monopoly. The concept of Prisoners’ Dilemma and its economic extensions are a masterpiece in strategic signalling and communication. And, of course, a student of international business has to have a sound understanding of trade theories propounded by economists. This book cannot touch upon all these claims in detail. However, you will certainly get a hint or a dash of a few in the following pages. 5

Why I am Paying More

With the above objectives in mind, Chapters 1 and 2 cover two fundamental building blocks of economics—market demand curve and the market supply curve, respectively. Chapter 3 integrates the demand and supply tools developed in the earlier chapters to demonstrate how price gets determined in free markets. This chapter also provides the basis for the belief that free enterprise maximizes societal welfare. Quite a few government interventions, price ceilings or price floors in particular, seem to be welfare reducing. Chapter 4 discusses such interventions in comparison to their outcomes in a free enterprise system. Having understood the working of markets in aggregate terms, chapters that follow address the pricing decisions by individual firms in perfectly competitive markets followed by pricing in imperfectly competitive market conditions. Specifically, on a full spectrum of market structures, Chapter 5 deals with one end of the spectrum described as perfect competition and Chapter 6 deals with another end of the spectrum called monopoly. Chapter 7 further devotes to pricing schemes that are possible when firms have a certain degree of monopoly power where markets are segmented. Between perfect competition and monopoly, there are two important market structures—monopolistic competition and oligopoly. These are covered in detail in Chapters 8 and 9, respectively. In Chapter 10, circumstances which necessitate a role for government intervention to take care of various market failures of a free enterprise system are discussed. Finally, the book is concluded in Chapter 11 by taking a 6

Introduction

retrospective view of what has been presented in the earlier chapters. By the end of the book, I hope to have achieved in part, what economist Harry Johnson had opined and which I have quoted at the beginning of this chapter. To this end, I have appended a crossword puzzle to the last chapter. The crossword puzzle may serve two purposes—it can be viewed as an unobtrusive self-accreditation by the reader and a litmus test of whether or not I have succeeded, at least partially, in addressing the concern Harry Johnson had expressed in 1974 in the foremost journal in economics—American Economic Review. REFERENCES: Johnson, H., (1974), ‘The State of Theory’, American Economic Review, Vol. 64, No. 2, Papers and Proceedings of the Eightysixth Annual Meeting of the American Economic Association, May, pp. 323–324 Marshall, A., (1890), Principles of Economics, London: McMillan and Company Ltd., republished in 1920, 8th edition

7

READY RECKONER

Microeconomics: Study of economic behaviour of agents such as households and firms and determination of prices and outputs in product and input markets. Macroeconomics: Study of behaviour of aggregate variables in an economy such as national income, unemployment, interest rates, and inflation. Free Enterprise: An economic system with (mostly) private ownership of factors of production and their rewards, where economic activities are governed by market forces of demand and supply. It is synonymous with the term Capitalism. Capitalism: See Free Enterprise.

CHAPTER 1

UTILITY AND MARKET DEMAND

‘What makes my approach special is that I do different things. I do jazz, blues, country music and so forth. I do them all, like a good utility man.’

—Ray Charles

THE MARGINAL UTILITY I bet you have attended quite a few parties and some were more memorable than others. Usually one enjoys going to parties because it feels good. This ‘feel good’ objective has been defined in many different ways. One could call it satisfaction, welfare, benefit, or as economists would put it, utility. It would be safe to assume that one would like to maximize his or her utility while attending the party. How does one maximize this utility? Well, resembling a piece of furniture at the party does not help. Assuming that one is in the company of interesting people, one’s utility would depend

Why I am Paying More

on a few important features at the party—conversation, cuisine, cocktail, and cavort. If you have only a few hours at your disposal, a choice has to be made as to how much time you can spend on each of these features or activities. Of course, it would all depend on an individual’s preference. Some may want to spend substantive time conversing with others, some may spend a good amount of time savouring food, some others may prefer to hang around the bar, and still some others would prefer to do a lot more of dancing and cavort. Whatever the individual choices, it must be true that the final minute spent on each of the activities must be giving same additional utility (called marginal utility) to the party goer. For, if that was not so, total utility could have been maximized by switching a minute from one activity to the other. If the marginal utility derived from spending an additional minute on conversation was always higher than the marginal utility derived from spending an additional minute on other activities, then one would only talk at the parties. Similarly, if the marginal utility of an additional minute spent at the bar was always higher than an additional minute spent elsewhere, one would only have cocktails and nothing else! The fact that most choose to engage in quite a few activities shows that marginal utility of engaging in any one activity must be declining as one does more of that activity. If this was not so, there would have been specialization in the choice of activity. One would either only talk or hog or cavort or drink to no end, depending upon which activity gave higher 10

Utility and Market Demand

marginal utility per unit of time spent. For an alcoholic, it must be true, therefore, that the marginal utility of drinking is either very high, does not decline with every glass, or worse, increases with every gulp. Therefore, alcoholics maximize their utility by specializing in consumption—that of liquor alone! Thankfully, these are aberrations and not the norm in human behaviour. Of course, no one really sits down and calculates the marginal utilities of different activities. Perhaps it simply goes against the spirit of spontaneity that human beings demonstrate. However, choices of utility maximizing levels of each activity must be compared implicitly in one’s mind. Workings of a mind may be a black box but the mind must be making implicit calculations taking into account the fact that there is limited time available to spare, there are a few activities available at the party that one can engage in, and that each of the activity is characterized by diminishing marginal utility. Perhaps this same idea is revealed by Ray Charles’s quote mentioned at the beginning. His satisfaction levels as a musician are highest when he engages in different kinds of music styles. The amount of time he spends on each type would be decided implicitly in his mind where marginal utility derived per unit of time from each style of music becomes equal. This is possible when marginal utility of engaging in each music style declines as he engages more and more in each of the styles. For, if this was not so, he would maximize satisfaction by specializing in only one form of music which gave him highest marginal utility per unit of time. 11

Why I am Paying More

Let us broaden this concept to product choices one makes in the marketplace. Disposable income of a household is generally less than the sum total of the salaries of the earning members of a household, as they pay income tax. Out of the disposable income, it is fair to assume that the household saves some amount and the rest of the net income is available for spending on products (both goods and services). In the marketplace, from the morning alarm clock to the zero-watt night lamp—from A to Z—there are innumerable products a household consumes every month. How does the household decide what to buy and how much to consume of each of the products? A household would like to maximize its satisfaction or utility given the constraint that net income per month is limited and that products available in the marketplace have positive prices. Of course, if net income was not a constraint and/or unlimited quantity of products were available for free, then there would be no economic choice to be made. Life would have been uninteresting then. Fortunately that is not the case and households have to make choices. Sure, like the party goers and Ray Charles, this will depend on the individual preferences of the household. However, it also depends upon the all-important concept of diminishing marginal utility. Given that the net income available to spend on products is limited, products are positively priced, and marginal utility declines as a household consumes more and more of a product, household utility is maximized when marginal utility per rupee spent on different products is equal. For the ease of exposition, consider that there are only two 12

Utility and Market Demand

goods in the marketplace, A and Z. The utility maximizing consumption levels of A and Z will be determined by an implicit black-box calculation in one’s mind given by the equation: MU(A) MU(Z) = PA PZ where MU(A) and MU(Z) represent the marginal utilities of products A and Z and PA and PZ are their market prices. What this equation tells us is that when utility is maximized, a rupee spent on both products gives same level of marginal utility. For, if it were not so, household could have increased total utility by spending more on a product that gave higher marginal utility per rupee and spending less on the other product that gave lower marginal utility per rupee. The adjustment will continue until the equality is re-established.

The Water Diamond Paradox The term Utility, for the satisfaction one receives on consumption of a product was introduced by Jeremy Bentham in the late eighteenth century in England. Around the same time, Adam Smith, considered the Father of Modern Economics, made a mention in his treatise, The Wealth of Nations (1776), regarding value-in-use and valuein-exchange for a given product. He gave the famous example of the Water Diamond Paradox. Diamonds have a high price, i.e., high value-in-exchange but they are unnecessary for life, i.e., low

13

Why I am Paying More

value-in-use. And, conversely, water has a low price, i.e., low valuein-exchange but it is necessary for life, i.e., high value-in-use. The economics profession had to wait till 1862 to explain this paradox. That year, W.S. Jevons read a paper to the British Association of the Advancement of Science introducing the concept of marginal utility. He explained that it is not the total utility but the additional utility derived from the consumption of the last unit (marginal utility) that matters. Essentially, it is the marginal utility that the household relates to product price, or what Adam Smith called, value-in-exchange. Therefore, for someone who purchases both diamonds and water, the following must be true: MU(D) PD

=

MU(W) PW

where MU(D) and MU(W) represent the marginal utilities of diamond and water and PD and PW are the market prices of diamond and water. While the total utility derived from the stock of water could be quite high compared to that from diamond, it is also true that relative to diamonds water is abundantly available. Therefore, given that the marginal utilities decline with additional units of consumption, both the marginal utility and price of water are low compared to the marginal utility and price of diamonds. However, when total utility derived by consuming both products is maximized, the ratio of the marginal utility to price should be same for both. Moreover, there is also merit in the argument that one cannot really make interpersonal comparisons of preferences and utility. That diamonds are unnecessary for life is a very subjective

14

Utility and Market Demand

assessment. After all, a beggar may not get two square meals a day but he could still smoke! Perhaps by now you would be wondering—just as weight is measured in, say kilogrammes, can utility also be measured in, say utils? Of course, the answer is a clear ‘no’. From the latter half of the nineteenth century onwards, Wilfredo Pareto and other economists argued that it is sufficient to rank utilities as higher or lower to make choices in the marketplace and one does not need to measure them cardinally. An elaborate explanation on this topic is beyond the scope of this book. However, interested readers can always refer to a standard principles textbook on microeconomics (Mankiw, 2012).

THE DEMAND CURVE The concept of diminishing marginal utility is important to understand the choices consumers make in marketplace. As explained in the box above, it demystifies the famous Water Diamond Paradox of the marketplace. More importantly, the concept gives an intuitive explanation to the inverse relation between the price of a product and its quantity demanded. Surely, at some point in time or another you must have formed an early opinion about economics—that it is concerned with demand and supply? True, it is. And this is when the demand curve comes into the picture. Let us continue to assume that there are only two products, apple (A) and zucchini (Z) in the marketplace. Let the prices of apple and zucchini be PA = Rs 50/kg and PZ = Rs 25/kg 15

Why I am Paying More

over a period of one month and the marginal utilities of the last kilogrammes of apple and zucchini purchased by a representative household during that month be 300 and 150 respectively. Given this information, the representative household must have maximized its utility over the period since: MU(A) 300 MU(Z) 150 = = 6 = = PA 50 PZ 25 where the number 6 represents marginal utility per rupee spent on each of the two products. Now suppose that the price of apple goes up to say Rs 75/kg in the following month. This would mean that MU(A)/PA = 300/75 = 4, which is less than 6. A rupee spent on zucchini continues to give a marginal utility of 6 per rupee and a rupee spent on apple now gives only 4. Therefore, total utility can be maximized by reducing consumption of apples and increasing consumption of zucchini. The adjustment will continue until a rupee spent gives same level of marginal utility for both. Because both products are subject to diminishing marginal utility, increase in consumption of zucchini will lead to fall in its marginal utility and vice versa for apples. The following could be a possible outcome: MU(A) 375 MU(Z) 125 = = 5 = = PA 75 PZ 25 To cut the long story short, for a given level of net income, as price of apple goes up, consumption of apple goes down. 16

Utility and Market Demand

And we now know how—as price of apple goes up, the per rupee marginal utility of apple goes down and hence the household switches to more consumption of zucchini and less of apple to make maximum use of its limited income. This relation between price and quantity demanded of a product is summarized by the Law of Demand—ceteris paribus, i.e., other things remaining the same, as the price of a product goes up the quantity demanded falls. There is an inverse relation between the two. This is depicted for a representative household in Fig. 1 below where rupee price per kilogramme of apple is measured on the vertical axis and quantity on the horizontal axis. In Fig. 1 (a), the line segment ‘dd’ shows the downward sloping individual household demand curve for apple. As the price of apple goes up from Rs 50/kg to Rs 75/kg the quantity demanded falls, say from qA50 to qA75. The quantity qA could be measured in, say kilogrammes. Of course, we only considered a representative household. Preferences vary among different households and their individual demand curves will be different. Some will be willing to pay much higher prices and some others will buy too many apples at very low prices compared to many others. However, all such demand curves will be downward sloping. If we were to add such individual demand curves for all households, we get an aggregate demand curve for apples. In fact, as price goes down, not only would existing customers buy more apples but more customers would enter the market to buy apples. A representative market demand curve is depicted in Fig. 1(b) by the line segment ‘DD’ which shows 17

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the total quantity of apples demanded (QA) in the market at each price level. We deliberately denote the quantity of apples for market demand as QA implying that QA quantity is much larger than the quantity qA demanded by an individual household. The quantity QA could be measured say in quintals or tonnes. For simplicity of exposition we have assumed the demand curves to be straight lines. They need not be. Fig. 1: Household and Market Demand for Apples (a) Household Demand Curve

(b) Market Demand Curve PA

D

PA d

Rs 75 Rs 50 d 0

qA75

qA50

D qA

0

QA

So far we have constructed the story of the process of utility maximization by customers and its manifestation in the marketplace through the household demand curve and the market demand curve. However, demand is only one side of the market economy. The supply story forms the other side. In the next chapter, we move to building the foundation of that story. 18

Utility and Market Demand

REFERENCES: Jevons, W.S., (1871), The Theory of Political Economy, London: Macmillan and Co, http://www.econlib.org/library/YPDBooks/ Jevons/jvnPE0.html, Accessed on 31 March, 2013 Mankiw, N.G., (2012), Principles of Microeconomics, 6th edition, Delhi: Cengage Learning Smith, A., (1776), An Inquiry into the Nature and Causes of the Wealth of Nations, Oxford World’s Classics, New York: Oxford University Press, Reissued in 2008

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READY RECKONER

Demand Curve: A downward sloping graphical representation of the law of demand. Marginal Utility: Additional utility derived by consuming one more (or the last) unit of a product. Law of Demand: Ceteris paribus, i.e., other things (like income) remaining the same, quantity demanded of a product increases as its price goes down. Total Utility: Satisfaction derived by consuming a certain number of units of a product.