MODULE II

1. MODULE II DEMAND ANALYSIS Susan Abraham Assistant Professor Dept of Economics Christian College t

2. Demand • Demand is the desire for a commodity backed by ability and willingness to pay. • It requires: • A desire for the commodity must exist • The ability to pay for the commodity • The willingness to pay money.

3. Law of Demand • Ceteris paribus (other things remaining the same), the quantity of a good or service demanded varies inversely with it price. • inverse relationship between price and quantity demanded • movement is along the same demand curve. • other things which are assumed to be constant are the tastes or preferences of the consumer, the income of the consumer, the prices of related goods, etc. • If these other factors which determine demand also undergo a change, then the inverse price-demand relationship may not hold good

4. Demand Function • Mathematical expression of the price of a commodity and the demand for it. • QD = f (P, Y, PR, ….) • = a - bP

5. Demand Schedule • a table which shows various quantities of a commodity demanded at various prices.

6. Demand Schedule • A demand schedule can be of 2 types: • Individual demand schedule • shows the various quantities of a commodity demanded by a particular individual at different prices. • Market demand schedule(Industry demand Schedule) • shows the total quantity of a commodity demanded at different prices by all the buyers of the commodity in the market.

7. Demand Curve • Graphical representation of a demand schedule.

8. Demand Curve • Demand curve has a negative slope showing negative or inverse relationship between price and quantity demanded. • It may be a straight line (linear) or a curve (non linear) • Demand curves generally slopes downwards to the right.

9. Demand Function • A mathematical expression of the price of a commodity and the quantity demand for it. Demand Schedule • A table which shows various quantities of a commodity demanded at various prices. Demand Curve • A graphical representation of a demand schedule.

10. Market Demand Curve • Horizontal summationof the various quantities demanded by consumers in the market at various prices.

11. Reason for Downward Sloping Demand Curve 1. Diminishing Marginal Utility • A consumer pays for a commodity because it has utility. • He will buy it so long as his marginal utility from its consumption equals its price. PX = MUX • Suppose its price falls , then he needs to purchase more for his marginal utility to equal its price.

12. Reason for Downward Sloping Demand Curve 2. The Price Effect • Price effect comprises of : • Income effect • When price increases, purchasing power of consumer falls, causing him to buy less. • Psychologically, the consumer feels richer. • Substitution effect • When price increases, commodity becomes costlier in comparison with other substitute commodities, causing him to buy less. • Pyschologically the consumer feels poorer, hence he switches to a substitute and so buys less of the original good.

13. Reason for Downward Sloping Demand Curve 3. New Consumers • It is possible that at particular prices, some consumer may not be able to afford a commodity. • When price falls, they purchase more. 4. Different Uses • A commodity can be put to several uses. • Some are more important and some are less important. • When price of a commodity rises, they cut the less important uses and so purchase less. • E.g. Ponni Rice for idalis.

14. Exceptions to the Law of Demand 1. Veblen Goods (Goods having Prestige Value) • Some consumers measure the utility of a commodity entirely by its price • i.e., for them, the greater the price of a commodity, the greater its utility. Such goods are called Veblen Goods. • E.g. diamonds, Rado / Tissot watches, Rolls Royce

15. Exceptions to the Law of Demand 2. Giffen Goods: • A Giffen good is an inferior good with the unique characteristic that a fall in price decreases the quantity of the good demanded.  • When the price of a Giffen good falls, instead of buying more of it, the consumer uses the increase in real income to purchase more of another good. • The demand curve will slope upward to the right and not downward. • This concept was the contribution of Sir Robert Giffen. • Cheap, necessary foods are examples of Giffens goods.

16. D D Price Price A B B A Quantity Quantity Extension & Contraction in Demand

17. Price C A Quantity D1 D Increase & decrease in Demand

18. Changes in Demand & Changes in Quantity Demanded

19. Determinants of Demand 1. Change in Income • Generally, when income increases there is increase in demand. • Normal Goods (Y ↑ → Qd↑ - Positive relation) • Sometimes, when income increases there is a decrease in demand. • Inferior Goods (Y ↑ → Qd↓ - Negative relation)

20. Determinants of Demand 2. Change in Price of Substitutes • When the price of a substitute good increases, the quantity demanded of that substitute good decreases. • People switch to other goods and the demand for those goods increases, even if its price remains the same. • Thus, when price of a substitute good increases, the quantity demanded of own good also increases. • (Ps ↑ → Qd↑- positive relation)

21. Determinants of Demand 3. Change in Price of Compliments • When the price of a complimentary good increases, the quantity demanded of that complimentary good decreases. • The demand for those goods which are used along with the complementary good also decreases, even if its price remains the same. • Thus, when price of a complimentary good increases, the quantity demanded of own good decreases. • E.g. when price of mobiles increase there is decrease in the demand for sim cards • (PC ↑ → Qd↑- negative relation)

22. Determinants of Demand 4. Change in Taste, Preferences and Habits • The demand for a commodity may change due to change in taste, fashion, preferences, etc. of the people in favour of that commodity. • Change in Population • When population increases there is increase in new demand. • If there is decrease in population there is decrease in demand. • (Population ↑ → Qd↑ - Positive relation)

23. Elasticity of demand • Elasticity of demand, refers to the degree of responsiveness of quantity demanded of a goods to a change in its price, income and prices of related goods. • Alfred Marshall introduced the concept of elasticity in economic theory.

24. Price Elasticity • Price Elasticity of Demand is the degree of responsiveness of quantity demanded to changes in price. ep= % change in quantity demanded % change in price

26. Degrees of Price Elasticity of Demand

27. Elastic Demand d 20 → η > 1  10 d  d Unit Elastic Demand 20 → η= 1 13 90  10  d d 15 45 30 Inelastic Demand  →η< 1 10  d 28 30

28. . Perfectly Inelastic Demand d 20 → η= 0 Perfectly Elastic Demand 10 → η= ∞ 10 d 15 15 ∞

29. Degrees of Price Elasticity of Demand Perfectly Elastic Demand → η= ∞ → η> 1 Elastic Demand → η = 1 Unit Elastic Demand → η< 1 Inelastic Demand → η = 0 Perfectly Inelastic Demand

30. Elasticity along a Linear Demand Curve η = ∞ Perfectly Elastic Price η > 1 Elastic η = 1 Unit Elastic η < 1 Inelastic η = 0 Perfectly Inelastic Qty Demanded

31. Factors Affecting Price Elasticity 1.  Nature of Commodity: • Necessity • comfort • 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 elasticas compared to demand for comforts. 

32. Factors Affecting Price Elasticity 2.  Availability of Substitutes: • perfect or close substitutes - Elastic • Substitutes - More Elastic • E.g. a rise in the price of Pepsi encourages buyers to buy Coke and vice-versa. • Few or no substitutes - Inelastic

33. Factors Affecting Price Elasticity • Income Level: • Higher income groups - inelastic • Lower income group - highly elastic 4. Level of Price: • Average prices of commodity high – Elastic demand • Average prices of commodity low– Inelastic demand • E.g. Needle, match box, etc. is inelastic demand.

34. Factors Affecting Price Elasticity • Share in Total Expenditure: • Greater the proportion of income spent on a commodity, greater the elasticity of demand for it and vice-versa. • Demand for necessities, goods like salt, needle, soap, match box, etc. tends to be inelastic as consumers spend a small proportion of their income on such goods. • If the proportion of income spent on a commodity is large, then demand for such a commodity will be elastic.

35. Factors Affecting Price Elasticity 6. Number of Uses: • If the commodity under consideration has several uses, then its demand will be inelastic. • When price of such a commodity increases, then it is generally put to only more urgent uses and, as a result, its demand falls. • E.g. 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.

36. Factors Affecting Price Elasticity 6. Postponement of Consumption: • Commodities like biscuits, soft drinks, etc. whose demand is not urgent, have highly elastic demand • Commodities with urgent demand like life saving drugs, have inelastic demand because of their immediate requirement.

37. Factors Affecting Price Elasticity • 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. • Demand is generally inelastic in the short period. • Demand is more elastic in long run

38. Factors Affecting Price Elasticity 8. Habits: • Commodities, which have become habitual necessities for the consumers, have less elastic (inelastic) demand. • Alcohol, tobacco, cigarettes, etc. 9. Recurring Demand: • Commodities characterized by recurring demand will be more elastic

39. Methods of Measurement 1. Percentage Method • This method measures the percentage responsiveness of quantity demanded to changes in price off the commodity.

40. 1. Percentage Method

41. 2. The Point Method: • Elasticity is measured at a point on the demand curve.

42. 3. The Arc Method • Elasticity is measured over a range of prices (between two points on the same demand curve) • The formula for price elasticity of demand at the mid-point of the arc on the demand curve is

43. 4. Expenditure or Total Outlay Method • Total outlay is price multiplied by the quantity of a good purchased: Total Outlay = P x QD. According to this method:

44. Uses of the Concept of Elasticity of Demand • In the determination of monopoly price: • In the determination of prices of public utilities: • In the determination of prices of joint products: • In the determination of wages: • In the determination of Government Policies • While Granting Protection to industries • While Deciding about Public Utilities • In Fixing Minimum Prices for Farm Products • Importance to the Finance Minister: • Importance in the Problems of International Trade

45. Income elasticity of demand measures the degree of responsiveness of quantity demanded of a good to changes in the consumer’s income. ηi = % change in quantity demanded % change in income Income Elasticity of Demand

46. 0 1 ∞ -1 Income Elasticity of Demand η > 1 Luxury Good POSITIVE Positive - Normal Good η < 1 Necessary Good Negative - Inferior Good NEGATIVE

47. Income Elasticity of Demand • If income elasticity is positive (ηi >1) the good is a normal good (because a change in income and a change in demand move in the same direction). • If income elasticity is positive but less than 1 (ηi <1) the good is a necessary good. • If income elasticity is positive but greater than 1 (ηi >1) the good is a luxury good • If income elasticity is negative(ηi <0), (the good is an inferior good because a change in income and a change in demand move in opposite directions).

48. 0 1 -1 Cross Elasticity of Demand Positive – Substitute Good η > 1 + η < 1 Negative – Complimentary Good -

49. Cross Elasticity of Demand • Cross Elasticity of Demand is a measure of the degree of responsiveness of quantity demanded of commodity X to changes in the price of commodity Y.

50. Inferior GoodGiffen Good • When Y ↑, QD ↓ • When P ↑, QD ↓ • Positive Price Effect • Positive income effect > Negative substitution effect. • The demand curve for Giffen goods is upward sloping • When Y ↑, QD ↓ • When P ↑, QD ↑ • Negative Price Effect • Positive income effect < Negative substitution effect. • The demand curve for inferior goods is downward sloping.