Economics - The Law Of Demand - Notes - Economics, Study notes of Economics

Download Economics - The Law Of Demand - Notes - Economics and more Study notes Economics in PDF only on Docsity! 1.3.1 The law of demand The law of demand explains the behaviour of consumers; either a single consumer/household or all the consumers collectively. The law of demand states that other things remaining the same (ceteris paribus), the quantity demanded of a commodity is inversely related to its price. In other words, as price falls, the consumers buy more. Or, the demand for a commodity falls when its price rises. Thus: (1) The concept of demand generally refers to the quantity demanded at a given time, which may be a point of time, a day or a week. (2) The law of demand is based on the assumption that within the given time frame, there would be no change in the quality of the goods in question. To put it differently, among the various determinants of demand, the price of the commodity is only variable. (3) The term ceteris paribus associated with the law of demand implies that taste and preference, income, the prices of related goods and social status, all remains constant over the period in which the impact of price variation on the quantity demanded is being analysed. (4) The law of demand is a partial analysis of the relationship between demand and price, in the sense that it relates to the demand for only one commodity, say X, at a time or over a period of time. 1.3.2 The demand function A demand function shows the relationship between the demand for a good, say X, and the various factors which cause a change in it. The demand function may be expressed as follows:- Dx = f(Px, Py, M, T, W) where, Dx = quantity of commodity X demanded per unit of time, Px = price of X, Py = mean price of all other substitute commodities, M = consumer’s income, T = taste, and W = wealth of the consumer Of the variables mentioned, tastes are difficult to quantify, whereas wealth does not have a direct influence on the demand Dx. Hence, T and W are held constant, and Dx is assumed to be a function of Px, Py and M only. Demand functions are generally homogenous of degree zero. Homogeneity means that changes in all the independent variables, namely, Px, Py and M are uniform. If the degree of a homogenous function is zero, then it would imply that when all prices and income change in the same proportion, Dx would remain unchanged (Barla: 2000). Py and M are generally assumed to be the parameters. For simplicity, the demand for X is assumed to be a function of only Px. The quantity demanded and price has an inverse relationship, except in the case of a Giffen good. The demand curve for a Giffen good is upward sloping, indicating that the price and quantity demanded move in the same direction. Meanwhile, the demand curve for a normal commodity is negatively sloped. The slope of the curve, however, depends upon the price elasticity of demand for the commodity. The demand for a commodity X, depends on its own price Px, the price of other substitute good (Py), consumer’s income, tastes and preference, etc. In reality however, demand depends upon numerous factors. The main determinants of demand are as follows:- a. Price (Px) - As already discussed, the price of a commodity and its demand are inversely related. Hence the negative (inverse) slope of the demand curves. b. Price of other associated good (Py): A change in Py also influences the change in Dx. However, the direction of such change depends upon the nature of relationship between the two goods, namely X and Y: i) X and Y are complementary goods, when both goods satisfy a single want. Eg. ink and pen, milk and sugar, car and petrol, etc. When price of Y rises, the consumer will buy less of Y and also less of X, although the price of X remains unchanged. Thus, Dx and Py , are negatively related. ii) X and Y are substitutes, if the consumer can use more of X at the cost of Y, or vice versa. That is, with a fall in Py, the consumer would buy more of Y because it has become cheaper compared to X. Therefore, the demand for X Y Px2 Px1 0 D D X1 X2 Quantity Demanded Diagram -3: The Demand Curve Diagram - 3 shows that a rise in the price of X from Px1 to Px2 leads to a contraction in the quantity demanded from Ox1 to Ox2 along the demand curve DD. Further, DD indicates that even a small or large change in Px would still support the law of demand. Alfred Marshall assumed that every consumer maximizes total utility only at that level of X where MUx = Px . That is, where Px decreases, the consumer consumes more of X such that MUx equals price level. Therefore, the MU curve and demand curve in the Marshallian analysis are similar. The fall in the quantity demanded due to an increase in Px results from three reasons: i) increase in price affects the utility maximizing quantity of consumption, and to restore the equilibrium, the quantity of X must decrease with an increase in Px. This is because, only with smaller quantity of X, MU will increase and approach close to the higher level of Px; ii) due to substitution and income effects, the consumer will reduce the quantity of X consumed when its price rises, so as to maximize utility; iii) the demand curve is negatively sloping demand due to the rise in consumption as a result of a fall in price, or conversely, due to fall in consumption when price increases. When there are two goods namely X and Y, then the ratio of their marginal utilities must be equal to the ratio of their respective prices. This is known as the law of equi-marginal utility maximization. The consumer is in equilibrium when the ratio of marginal utility and prices for all the goods is equal, i.e., MUx MUy MUx Px = or = Px Py MUy Py The consumer maximizes utility by buying certain combination of X and Y. If Px increases and the consumer consumes the same quantity of X, thus holding the level of marginal utility of X at the original level, then equilibrium will be disturbed, i.e. MUx MUy < Px Py Thus, if in spite of a rise in the price of X, the quantity demanded is held constant, the marginal utility of Y will change due to a decrease in its quantity because the consumer now spends more on X. Then, the consumer no longer maximizes utility. For maximization of utility, the consumer has to reduce the quantity of X in response to the increase in Px. Thus, when price increases, a consumer can maximize utility only by reducing the quantity demanded. Conversely, the quantity demanded has to increase when the price of X falls. In the process, the equilibrium is restored at a new equilibrium at a new combination of X and Y. 1.3.4 Demand schedule A demand schedule shows the list of prices and the corresponding quantities of a commodity. While preparing the demand schedule, it is assumed that the marginal utility of money is constant and that the quantity demanded depends only on price. 1.3.5 Elasticity of demand In economics, the term elasticity measures a proportionate (percentage) change in one variable to a proportionate (percentage) change in another variable. In other words, it measures the responsiveness of the dependent variable to a given change in one of the independent variables, other variables remaining constant. Elasticity of demand is the responsiveness of the quantity demanded to a given change in the price of a commodity, the prices of other commodities and consumer’s income remaining the same. The elasticity (e) of X with respect to Y may be written as: - Exy = or, Exy = percentage change in X percentage change in Y ∆X/X ∆Y/Y Given the demand function: - Dx = f (Px, Py, M) expressed as: - EXy, PY = percentage change in DX percentage change in PY ∆DX PY or, Exy = . ∆PY DX For substitute commodities, the cross elasticity of demand is positive. This implies that when the price of Colgate falls, the demand for Peposdent will fall, as the two commodities are substitutes. When two commodities are complements, the cross elasticity of demand will be negative. This indicates that when the price of coffee falls, the quantity demanded of sugar will go up as the two goods are complementary. Thus, while the signs of cross elasticity show whether two commodities are substitutes or complements, their magnitude indicate the degree of their relationship. The greater the cross elasticity, the more closely related the two goods are. If the two goods have no relationship, the cross elasticity between them will be zero. The concept of cross elasticity of demand is useful in measuring the interdependence of demand for a commodity and the prices of its related commodities. Its knowledge thus helps a firm to estimate the likely effects sales of pricing decisions of its competitors on its own sales. c ) Income Elasticity of Demand Income elasticity of demand (eD X, I) measures the responsiveness of demand for a commodity, say X (DX) to a change in consumers’ income (I). It can be computed from the following formula: percentage change in DX EXI = = percentage change in I ∆DX/DX ∆ I/I ∆DX I or EXI = . ∆ I DX For superior goods income elasticity is positive, whereas for inferior good it is negative. Positive income elasticity can assume three forms: greater than unity (one) elasticity, unity elasticity and less than unity elasticity. When a change in income results in a direct and more than proportionate change in the quantity demanded, the income elasticity is said to be positive and more than unity. Luxury goods are its example. When a change in income leads to a direct and proportionate change in the quantity demanded, then it is known as positive and unit income elasticity. Its examples include semi-luxury and comfort goods. When an increase in income results in a less than proportionate increase in quantity demanded, then the elasticity is positive and less than unity. Necessary goods fall under this category. The income elasticity is negative when an increase in income leads to a decrease in quantity demanded. Inferior quality goods came under this category. Knowledge of income elasticities of demand for various commodities is useful in determining the effects of changes in business activity on various industries. d) Promotional elasticity of demand: It measures the expansion of demand through advertisement and other promotional strategies. It is also known as advertisement elasticity of demand. It may be expressed as: - percentage change in DX E X A = percentage change in A DX A or, E XA = ° A DX where, A = expenditure on advertisement and other promotional strategies.