ECO DIP 3

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UNIT # 3: Law of demand

This law expresses the relationship between quantity of a commoditydemanded and price. The law states that demand varies inversely with price,

not necessarily proportionately.

The law can also be stated as: a rise in the price of a commodity or service is followed by a reduction in demand and a fall in price is followed byan increase in demand, if conditions of demand remain constant.

In Marshall’s words: the greater the amount to be sold, the smaller must be the price at which it is offered in order that it may find purchasers, or inother words the amount demanded increases with a fall in price and diminisheswith a rise in price.

Therefore demand is a function of price.

Limitations of the law

There are certain exceptions to the law of demand i.e. demand does notcontract when price rises and vice versa.

1) Change in taste or fashion: If the fashion is changed, even thecommodity price falls no one will be willing to purchase.

) Change in income: If the consumer!s income is increased, he will bewilling to buy more even the prices are high.

") Change in other prices: The law of demand says that consumer purchase more when the price falls. #onsider the price of tea falls and atthe same time the price of coffee also falls even more heavily. $oconsumers would li%e to go for more coffee rather than tea. &hich is acontradiction to the law of demand

') Discover of s!"stit!tes: $ubstitute goods are those goods, whichsatisfy the same need. If there are substitute goods ( and then demandof commodity ( may rise if the price of commodity is increased.

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Ca!ses of changes in demand

Demand can be afected by the ollowing actors.

1) Changes in tastes, pre erences and ashion.2) Climate or weather change.3) Change in the size and composition o population.

) Changes in money supply.!) Change in the price o a commodity.") Change in the real income.#) Change in the le$el and distribution o income. %&a' rom

rich to poor)() Change in sa$ings. % ore sa$ings less demand)*) Change in asset pre erences. %Consumer pre er cash than

goods)1+) Conditions o trade. % oom and depression o

economy)11) -'pectations or anticipations. %i people are e'pecting

change in income or prices o the commodities, they willwait or the change to occur or ma ing purchases.)

12) /rices o related goods.• 0ubstitute goods. %&ea or cofee)• Complementary goods. % read and am, car and uel)• oint supply. % heat and straw)• Composite supply. %4 uel is cheap, transport is

cheap)13) ar et size1 ) 5d$ertising or mar eting efort

hortcoming of the !tilit anal sis

odern economists are not satis6ed with the utility analysison the grounds o both theory and operational e7ciency.

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8ollowing are the de ects pointed out towards arshallianapproach to the demand theory.

• Unsound Psychology: ar et demand is an ob ecti$e

phenomenon. ut the utility theorist has e'plained it onthe bases o desire, moti$ation etc. &o attribute moti$esto the consumer is unrealistic.

• Cardinal measurements not possible: Cardinalmeasurements means utility can be measured in termso de6nite numbers, which is not possible. e can onlyha$e ordinal measures i.e. we can only compare twosituations to udge satis action le$els.

• Wrong assumption of independent utilities:9tilities are not independent. 9tilities o substitutegoods and complementary goods do afect each other:sdemand.

• Income e ect: hen the prices o commodities godown, real income o a consumer increases. &his efectis totally ignored.

• Substitution e ect: hen income increasesconsumers substitute cheap goods with e'pensi$eone:s. &his efect is also badly ignored.

• Hicks says , ;the distinction between direct andindirect efects o a price change is accordingly le t bythe cardinal theory as an empty bo' which is crying outto be 6lled. <

• Assumption of constant marginal utility of moneyis rong: 0ince the utility is measured in money, andthe measures cannot be change. ut as the consumeris purchasing the marginal utility should increase. &hisefect is totally ignored.

• Applies to one commodity orld: 4n multi productworld the marginal utility o money cannot be constant./roducts with the diferent prices will bring diferentchange in the marginal utility. 4 marginal utility o money will change the law will not hold any more.

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• Assume too much and e!plain too little: &here areso many assumptions but the theory does not e$enanswer some o the undamental =uestions as well.

Shifts in the Demand Curve

• Suppose there is an increase in disposable income which increases

the quantity demanded.• This effect can be shown in Fig, where the price remains constant atOp but the increase in income has shifted the curve from DD to D1D1

• So the quantity demanded at Op rises from q to q1. fall in income or a decline in taste for e!ample would produce the reverse result, i.e. ashift from D1D1 to DD.

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"#AS$ICI$% &' (")A*(

• >aw o demand shows an in$erse relationship betweendemand and price, i.e. i price increases, demand increasesand $ice $ersa.

• Change in demand, due to the price change is nown as-lasticity o Demand.

• 4t is the rate at which the =uantity demanded $aries with a

change in price.• 4t is the degree o relationship between demand and price.

"#AS$IC A*( I*"#AS$IC (")A*(:

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• 5 change in demand is ne$er proportional to the change inprice.

• 4 a small change in price leads to a great change indemand, then demand is elastic or sensiti$e or responsi$e.

• 4 a big change in price lead to a small change in demand,then it is inelastic or non?responsi$e demand.

• 8or e'ample, @eduction in price o gold A -lastic demand@eduction in price o salt A 4nelastic demand

• Demand is elastic, when price decreases. &otal re$enueincreases. %/rice B uantity)

• Demand is inelastic, when price decreases. &otal re$enuedecreases. %/rice B uantity)

• arshall says< &he elasticity or responsi$eness o demand in

a mar et is great or small according to the amountdemanded increases much or little or a gi$en all in priceand diminishes much or little or a gi$en rise in price<.-lasticity is a matter o degree only.

CAS"S &' "#AS$ICI$%:

&here are 6$e cases o elasticity.

+, I*'I*I$" "#AS$ICI$% &- P"-'"C$ "#AS$ICI$%:• 5 $ery small reduction in price brings unlimited e'tension

o demand.

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., P"-'"C$#% I*"#AS$IC &- /"-& "#AS$ICI$%

• 5ny amount o reduction in price brings no change in theamount o demand.

0, -"#A$I1"#% "#AS$IC: %>ess elastic demand or commonlyinelastic)

• /rice all is more than increased demand.

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• 5rea o the rectangle denotes the total re$enue recei$ed bythe seller.E /F A be ore price change

E :/:F: A a ter price change

2, -"#A$I1"#% I*"#AS$IC:

/rice all is less than amount demanded.

E /F A area be ore price change, E :/:F: A area a ter pricechange

i.e. E /F G E :/:F:, &here ore, demand is elastic.

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3, U*I$ "#AS$ICI$%:

oth areas are same i.e. E /F H E :/:F:.

&he price change brings the e'act increase in =uantity. 0o,total re$enue be ore and a ter changing price becomes e=ual.8or e'ample,

1+ B !+ H !++ %/B )

! B 1++ H !++ %price changed)

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$%P"S &' "#AS$ICI$%:

&here are three types o elasticity

+, P-IC" "#AS$ICI$%:

H I Change in =uantity demanded

I Change in price

'AC$&-" ("$"-)I*I*4 P-IC" "#AS$ICI$% &' (")A*(:

-lasticity is relati$e. 8or one person or at one place, demandmaybe elastic and or another person and place, demand

maybe inelastic.

8ollowing actors determine the price elasticity o demand.

i, *"C"SSA-I"S A*( C&*1"*$I&*A# *"C"SSA-I"S:

• asic necessities o li e, we buy 6'ed =uantity,whate$er is the price. -.g. wheat, rice, consumer goodsetc.

• 4n poor countries demand or these goods is alsoelastic.

• E$erall demand or wheat maybe inelastic but in aspeci6c mar et it could be elastic. 4.e. a small rice inprice, company may lose the entire mar et.

• Demand or lu'uries is elastic. ut or rich peoplemaybe it is inelastic.

• >u'urious goods are con$entional necessaries or richpeople.

• 5 high priced lu'ury or a poor man is a low pricednecessary or the rich.

• 5 commodity maybe lu'ury in one country and maybenecessary in another. -.g. 5JC in 95- and /a istan.

• >u'uries o yesterday ha$e become necessaries o today.

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ii, P-&P&-$I&* &' $&$A# "5P"*(I$U-":( consumer good *e.g. soap) absorb a small proportion of total

expenditure. $o the demand will be inelastic.

iii, 4&&(S HA1I*4 S"1"-A# US"S:• $uch goods demand is always elastic. +.g. wheat, if it is very cheap it

can be used for cattle feed. If expensive.• ence the demand will be elastic. (nother e.g. coal, used for coo%ing,

heating and industrial purposes. If it becomes expensive, it will be used

to satisfy the most urgent wants. ence the demand will remain elastic.i6, C&)P#")"*$A-% 4&&(S:• If the price of the oil become higher and the cars become cheap. $till the

demand will not increase, i.e. demand is less elastic.6, (U-A7#" 4&&(S:

• -uring war people postponed their purchases e.g. building a house, buying furniture or having a number of warm suits.

• 0o demand or such products is elastic, because wepurchase these goods when they are cheap.

6i, #"1"#S &' P-IC"S:• ( very expensive or very cheap good, demand will be inelastic. or e.g.

actual price / 0, selling / 0, reduced price /20, still people will not purchase.

• 5lso, $ery low price, people ha$e already purchased a lot.0o, demand will be inelastic.

6ii, #"1"# &' I*C&)":• 3oor people are more sensitive to price change, whereas a rich man do

not bother much of price change and %eep on purchasing at every price.• &here ore, demand or the poor is more elastic than on

the part o the rich.

6iii, )A-8"$ I)P"-'"C$I&*S:• 3eople are ignorant about price fall. $o, demand will be inelastic.

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$% INC&M' 'L( TICIT):

• 4esponsiveness of potential buyers to change in income• It shows how the demand changes when the income of the purchaser

changes, the price of the commodity remaining the same.

Income elasticity: 3roportionate change in the quantity purchased 3roportionate change in income

3rice is constant.• It is 5ero income elasticity of demand when change in income ma%es no

change in purchases.• It is negative when increase in income brings less purchase for consumer.• It is positive when income increases and consumer purchases also increases.

3%C*& 'L( TICIT):

• #hange in the demand of one good causes a change in the demand of another good.

#ross elasticity of demand for 6 and 7 3roportionate change in purchase of commodity 6

3roportionate change in price of commodity 7

• #ross elasticity arises in the case of inter8related goods. or e.g. substitutesand complementary goods.

• If 6 and 7 are complementary: then, if price of 6 increases, demand of 7decreases. 9r .if price of 6 decreases, demand of 7 increases.

• #ross elasticity of complementary goods is positive. If 6 and 7 are substitutes: then, reduction in the price of 6, decrease

the demand for 7. (nd. Increase in the price of 6, increase the demand for 7.• #ross elasticity of substitute goods is negative.

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(++LIC(TI&N &, 'L( TICIT) &, D'M(ND:

-%T(.(TI&N:• overnment put taxes on commodities with inelastic demand, i.e. price will

be increased and demand will remain same *consumer goods).• ut on humanitarian grounds, such taxes are generally avoided.

$% M&N&+&L) +*IC':

• If demand is inelastic, monopolist will charge high price and sell a smallquantity.

• If demand is elastic, monopolist will lower the price, stimulate the demandand thus will maximi5e the net revenue.

3% /&INT +*&DUCT 0 C&M+L'M'NT(*) 1&&D :

• $eparate costs are not applicable. 3roducers are mostly guided by demandand its nature. or example transportation, they charge what people can pay.

2% INC*'( IN1 *'TU*N :

• &hen an industry is sub;ect to increasing returns, manufacturer lowers the price to develop the mar%et and to ta%e advantage of +conomies of $cale.

% &UT+UT 4INDI5IDU(L (ND M(*6'T D'M(ND7:

• The individual demand is inelastic.• Individuals are not ready to buy the second copy of the newspaper or

maga5ine, whatever is the reduction in price.• <ar%et demand is elastic. ecause reducing the newspaper or maga5ine

price will result in increased mar%et sale as a whole.

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• +lasticity of demand effects industrial output.

8% 9(1' :• If demand for a specific s%illed labor is relatively inelastic, it is easy to raise

wages, but not otherwise.

% +overt in plent :

• (n increased crop is useless if the demand of the crop is inelastic *notdemanded). It becomes worst if the product is perishable.

• or durable products the demand is less inelastic. In years of bad harvest, therise in price would sufficiently compensate the reduced output.

;% 'ffect on the econom :

• #onsumer demand sets the guidelines. It affects the total demand of goodsand services in an economy.

• 3roducers demand different factors of production.

<% 'conomic policies:

• overnment formulates economic policies on the basis of elasticity of demand.

• overnment can produce goods with inelastic demand and where amonopoly element is present.

-=% International trade:

• +lasticity helps in international trade also.

--% *ate of foreign e>change:

• &hile fixing foreign exchange rates, government considers elasticity of imports and exports.

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THE CLASSIFICATION OF GOODS AND SERVICES

Normal Goods• The vast ma"ority of goods and services in the world are normal

goods.• The demand curve slopes downwards from left to right. For e!amplelu!ury goods

Inferior Goods• The demand curve for an inferior good also slopes downwards from

left to right.• #t has a negative income elasticity of demand. s incomes increase

the demand curves shifts inwards to the left, indicating that less isdemanded at each price and vice a versa.

Giffen Goods• $iffen goods %named after Sir &obert $iffen' are a special case of

inferior goods.• #n practice $iffen goods are rare. (!amples are the types of food

items that form an important part of the daily diet for e!ample,bananas or rice, are the main daily foods for many of the world)s mostimpoverished people.

• The demand curve for $iffen goods slopes upwards from left to right,unli*e the demand curve for normal goods.

• The negative real income effect associated with the rise in priceoutweighs the desire to buy less because of the higher price.

• Strictly the term +$iffen+ applies only when the +inferior+ income effectcreated by a change in price is more powerful than the normal pricesubstitution effect which leads people to switch their e!penditure infavour of goods as they become relatively cheaper.

Luxury G ds• u!ury goods are usually high-priced goods, often with a well-*nown

brand name.• #n contrast to $iffen goods, the income elasticity for lu!ury goods is

positive, as it is for normal goods.Bads• + ads+ are simply those things that we would rather not have but

which may e!ist, and be consumed in the sense that people have nochoice but e!perience them.

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• For e!amples atmospheric pollution, water pollution, noise and crime.

Substitutes

• n increase in the price of one product will lead to an increase in thedemand for the other and vice a versa.

• For e!ample, a decrease in the price of digital cameras will lead to adecrease in the demand for traditional film-based cameras.

C m!"ements

• n increase in the price of one will lead to a decrease in the demand

for the other.• For e!ample, a large increase in the price of cars will lead to a

decrease in the demand for petrol.

REVEN#E AND REVEN#E CHANGE

Total Revenue• #n general revenue refers to the money received from the sales of a

product. For this reason, the term +sales revenue+ is often used.

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•

#f all belts can be sold at /0 each, total revenue continues to increaseat a constant rate. Suppose # find that total revenue rises if # reducethe prices as follow

• This effect can be shown in the form of a simple graph

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Avera$e Revenue

• 2e are going to use the term +average+ in its most common sensethe average revenue is the total revenue divided by the quantity of goods sold.

• #f all goods are sold at the same price in the given time period 3 as,say, with our leather belts 3 then the average revenue is the same asthe price. The average revenue curve for the belts is shown in Figure .

Avera$e revenue %urve f r &e"ts

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'ar$ina" Revenue

• The change in total revenue brought about by a small or unit changein the quantity flow of sales is *nown as the marginal revenue.

• 4arginal revenue is not always the same as the price or averagerevenue. % (!ample of the leather belts'

Num&er f TV setss "d !er (ee)

*ri%e !er set£

T ta" revenue£

'ar$ina" revenue£

+ ,-- ,--

. /0/ ++/- //-

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1 //- +,/- /--

2 /./ .+-- 2/-

/ /-- ./-- 2--

, 20/ .3/- 1/-

0 2/- 1+/- 1--

3 2./ 12-- ./-

4 2-- 1,-- .--

+- 10/ 10/- +/-

++ 1/- 13/- +--

+. 1./ 14-- /-

+1 1-- 14-- -

+2 .0/ 13/- 5/-

Chan$e in mar$ina" revenue (hen !ri%e is redu%ed

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• lthough Figure does not continue the average curve until it meetsthe quantity a!is, we can deduce where it would meet if continued inthe same straight line. #t would meet the quantity a!is at 50 T6 sets 3twice the marginal revenue quantity when marginal revenue equals7ero, thus indicating that this supplier would be able to dispose of only 50 sets, even if he did not charge any price at all %i.e. give themaway'.

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ECO DIP 3