Chapter 2 – Theory of Demand and Supply
Demand is a desire which, must be backed by the ability or the capacity to pay for the goods, and the willingness on the part of the consumer to spend for the goods.
Observing the definition you can make out the five elements of Demand-
- Desire (want)
- Purchasing Power
- Willingness to pay
- Certain price and quantity demanded
- Certain period of time
Determinant of Demand
It means factor on which demand for a commodity depends, which are
- The price of the commodity – (Ceteris paribus) other things being equal, demand of a commodity is inversely related to its price.
- The price of the related goods –Here we can study two variants :-
(a) Complementary goods: There is an inverse relation between change in price of one complement and demand of other complementary good. A fall in the price of one will cause the demand of other to rise and vice versa.
(b) Substitutes or Competing goods: There is positive relation between change in price of one substitute and demand of other substitute good i.e. a fall in the price of one leads to a fall in the quantity demanded of its substitute and vice-versa.
- The income of the consumers –
- In case of Normal / Luxury goods demand for goods increase with increase in household’s income and vice versa. So there is positive relation.
- In case of Inferior goods- there is inverse relation.
- In case of Necessaries- the demand for necessaries also increase in the beginning and becomes income inelastic (constant) thereafter.
- The taste and preferences of the consumer – A positive change in the taste and preference shall lead to an inverse in demand and vice-versa.
- Size of the population – Larger the size of population of a country, more will be the demand.
Please note that – ‘Quantity supplied’ and factor price’ do not determine demand.
Law of Demand
“When the price of good increases, its demand decreases and a fall in price will lead to rise in demand-other things remaining constant it is based on following assumptions
- Income of the people remain unchanged
- Taste, preference remain unchanged
- Price of related goods remain unchanged
- No expectation of change in price in future
Market demand curve is horizontal summation of individual demand curves. The law of demand is a qualitative statement because it explains trend but not exactness.
Downward Slope of Demand Curve
Demand curve slopes downward because
- Dimnishing Marginal Utility of a product – Once we have purchased a certain commodity, we will buy additional units in a short span of time or immediately only if the price offered is lesser than the previous price on which we bought the initial units of that commodity.
- Substitution effect: Due to any reason the price of a particular commodity may decrease due to which it will be available at a lower price in comparison to other competitive products. As a result, consumers will buy more of this particular commodity.
- Income effect: Due to decreased price of a particular commodity, a consumer is able to buy more quantity by spending the same amount. This implies that his purchasing power has increased which is also known as real income. This is termed as income effectin economics. Thus price Effect (PE) = Substitution Effect (SE) + Income Effect (IE)
- Number of consumer: When the price of a commodity decreases, more number of consumers starts buying it and this leads to increased demand of that particular commodity.
Exceptions of Downward Slopes Demand Curve
Conspicuous goods: Some consumers measure the utility of a commodity by its price i.e. if the commodity is expensive they think that it has got more utility. This concept of ‘Conspicuous Consumption’ is given by Prof. Thorstein Veblen and it is called Veblen effect or prestigious goods effect.
Giffen goods: ‘Giffen goods’ are those goods, which are considered inferior by consumers. Sir Robert Giffen, found that when price of bread increased, the British workers purchased more bread not less of it. Such goods which exhibit direct price- demand relationship are called Giffen goods. In case of a Giffen good, demand curve will upward sloping to the right.
Conspicuous necessities: The demand for certain goods is effected by the demonstration effect of the consumption pattern of a social group.
Future expectations about prices: when price are rising, households expecting that the prices in the future will be higher, tend to buy larger quantities of commodities.
Irrational and Impulsive purchases: At time consumers tend to make impulsive purchase the law of demand fails.
Demand for Necessaries: In case of necessaries, people have to consume the minimum quantity, whatever is the price. Nareshmalhotra.in
Speculative goods: The law of demand also does not apply in share market because when prices are rising, more will be demanded.
Ignorance effect: a household may demand larger quantity of a commodity even at a higher price because it may be ignorant of the ruling price of the commodity
Extension and Contraction in Demand
Extension of Demand When quantity demanded increases in response to a fall in own price of the commodity. It is also called Expansion of demand.
(In extension of demand the movement of demand curve is from left to right)
Contraction of Demand When quantity demanded decreases in response to a rise in own price of the commodity.
(In contraction of demand or movement of demand curve is from right to left)
In both the cases demand will be represented by a movement (moving down and ulp accordingly) along the same demand curve.
Shift in Demand Curve
The demand curve will shift to right in case of increased income (an inferior is exception), when substitute goods price increase, when price of complement goods goes down, population increase and consumers taste change in favour of this product. The opposite changes will shift the demand curve to the left.
Elasticity of Demand
Elasticity of demand is a technical term used by economists to explain the degree of responsiveness in the demand for a good to a change in any of its determinants.
Its divided into 3 Kinds 1. Price Elasticity 2. Income Elasticity 3. Cross Elasticity.
=>Price Elasticity when the percentage change in quantity demanded of a commodity happens due to the percentage change in price of that commodity. It is measured as percentage change in quantity demanded divided by the percentage change in price, other things remaining equal.
Ed = or
Ep = (change in quantity/ change in price ) * (price / quantity)
Where Ep = Price elasticity Q = Quantity
P = Price = Change
Degrees / Types / Coefficient of Price Elasticity of Demand:
- Perfectly elastic demand (Ed = ) : It is a situation in which demand of a commodity continuously change without any change in price. It means demand of commodity is perfectly flexible in case of perfectly elastic demand. In perfectly elastic demand, the demand curve will be horizontal.
- More than unitary elastic demand (Ed>1) :- It refers to a situation by which percentage change in demand of a commodity is higher than percentage change in price of that commodity. It is also called elastic demand. For ex. Change in price is 10% but change in demand is 20%, then 20% / 10% = 2 (E>1) Nareshmalhotra.in
- Unit elastic demand (Ed = 1) : When percentage change in demand of a commodity is equal to percentage change in price, eg. Change in price is 10% but change in demand is 10%, then 10% / 10% = 1 (E = 1)
- Less than unit elastic demand (Ed < 1) : when percentage change in demand of a commodity is less than percentage change in price in price, eg. Change in price is 10% but change in demand is 7% , then 7% / 10% = 70 (E < 1) inelastic demand)
- Perfectly inelastic demand (Ed = 0): When price of commodity does not influence demand of that commodity then that situation is called perfectly inelastic demand. In perfectly inelastic demand curve, the demand curve will be vertical. In other words then if regardless of change in its price, the quantity demanded of good remain unchanged, then the demand curve for the good will be Vertical.
Measurement of Price Elasticity of Demand :
Total outlay method:
Price elasticity can also be measured on the basis of changes in the total outlay (or expenditure) due to the change in the price. Under this method elasticity will be of three types:
(a) E = 1: When as a result of a change in price, the total expenditure remains the same, the commodity is said to have a unitary elastic demand. This curve is also called Rectangular Hyperbole (R.H.).
(b) E > 1: When as a result of a rise in price, the total expenditure on the commodity falls and as a result of a fall in price, the total expenditure rises, the commodity is said to have More than unit elastic demand.
(c) E < 1: when as a result of a rise in price, the total expenditure on the commodity rises and as a result of a fall in price the total expenditure falls, the commodity is said to have Less then unity elastic demand.
Point elasticity method:
This is also known as geometrical method. This method is used when we have to find out elasticity at a point on the demand curve.
EP = Lower segment / upper segment
Arc elasticity method:
When the price change is somewhat larger and we have to measure elasticity over an arc on the demand curve. We use the average of the two prices and quantities.
Factors Affecting / Determinants of Elasticity of Demand
Availability of Substitutes: If commodities have more close substitutes, have more elastic demand. And, if a commodity have less substitutes, have inelastic demand.
Position of a commodity in the consumer’s budget: Generally, greater the proportion of income spent on a commodity, the greater will be its elasticity of demand and vice-versa.
Nature of the commodity: In general, luxury goods are price elastic while necessities are price inelastic.
Number of uses: The more the possible uses of a commodity the greater will be its price elasticity and vice versa.
The Period: So demand will be Elastic in long period. But in the short period, demand will be inelastic.
Consumer habits: If a consumer is habitual consumer of a commodity the demand for the commodity will remain inelastic. Nareshmalhotra.in
Tied demand / Joint demand: The demand for those goods, which are tied / joint to others, is normally inelastic as against those whose demand is independent.
Price range: Goods, which are in very high price range or in very low price range have inelastic demand but those, which are in middle price range have elastic demand. Generally low price good keeps the price elasticity of demand for a good low.
=>Income Elasticity When the quantity demanded of a commodity changes due to the change in income of the consumers it is related with Income elasticity. So, Income elasticity of demand means the ratio of percentage change in quantity demanded due to percentage change in income of consumers.
Ey = =
Please see: There is no Arc method in Income Elasticity
Types of income elasticity: It may be of three types-
Positive Ey – In case of Normal / Luxury good, there will be positive relation between income and demand
(a) Ey = 1 (equal to one) (% Q = % Y)
(b) Ey > 1 (Greater than one) (%
(c) Ey < 1 (Less than one) – Sometimes it’s found in necessities. (%
Negative Ey (Ey < 0 – Less than zero):- In case of Inferior goods, the income elasticity of demand is negative.
Zero Ey (Ey = 0)- In case of Necessaries goods whether income increases or decreases the quantity remains the same. So zero income elasticity is found here.
=>Cross Elasticity of Demand (Ex):
The cross elasticity of demand is proportional change in quantity of X demanded resulting from given relative change in the price of the related commodity Y.
Ex = or
Ex = ×
x and y may be substitute goods or complementary goods.
- Positive Ex – When substitute goods are taken into account e.g. Tea and Cold Drink (like Pepsi), positive cross elasticity is found here. Positive elasticity has a range between +0 to + . But for goods which are perfect substitutes the cross elasticity will always be infinity.
- Negative Ex – If we observe complementary goods like Tea and Sugar, there exists an inverse reaction between price of sugar and demand of tea, so the nature of cross elasticity found here is opposite or negative which ranges between -0 to –
- Unrelated Goods – In this case the cross elasticity will be zero.
There may be another method in which average of the two prices and quantities are taken:
Arc Method of Ex =
Here do not ignore – or +sign because – indicate negative relation and + indicates positive relation.
Theory of Consumer Behavior
Base of economy is human wants. As need of everything generates due to wants of human which is also known as desire of consumers to satisfy their needs. Wants may classified in
- Necessaries Comforts 3. Luxuries
It was defined by Jeremy Bentham. Wants satisfying power of a good is called utility. It can be measured in cardinal numbers or given ranks. The expected utility often differs from realized utility which may be called real satisfaction. Utility should also be seen differently from benefit or usefulness. Utility is also known as ‘Satiety’.
- Marginal Utility Analysis – Alfred Marshall
Marginal utility is the addition (Marginal satiety) to total utility by the consumption of one additional unit of the commodity.
The sum of the utility (Full Satiety) derived from the consumption of all units of the commodity by a consumer.
Relation between TU and MU – Total utility is the sum of marginal utilities. In the above table MU always declines and when MU decreases TU increase, when MU is zero then TU is maximum. This is called ‘saturation point’ and after that when MU become negative, TU decreases. MU may be positive, zero or negative but TU never negative.
Assumptions of the MU Analysis:-
- The cardinal measurability of utility
- Constancy of the MU of money
- The hypothesis of independent utility
The law of Diminishing Marginal Utility
The marginal utility that any household derives from successive units of a particulars commodity will diminish, when total consumption of the commodity increase. Therefore it is also called the ‘fundamental law of satisfaction’.
Assumptions: This law is based on above four assumptions of the MU analysis and there are also three more assumptions:
- Taste, income of the consumer remains unchanged.
- The units of the commodity are identical in all aspects.
- There is no time-gap between consumption.
- The consumer is rational.
- Cardinal measurement of utility is not possible.
- Law is applicable if there are standard unit – sufficient unit – neither more nor less.
- Law is applicable if there is no time-gap or interval between the consumption.
- Law may not apply to some articles like gold, money, music and hobbies.
Consumer’s Surplus is equal to the difference between amount which is consumer ready to pay
and what actually he pays. It derived from the law of Diminishing Marginal Utility given by Alfred Marshall
‘What a consumer ready to pay’ is taken in terms of ‘MU’ and ‘What he actually pays’ is taken in terms of ‘Price’. So CS = MU – P
- Indifference Curve Analysis – Allen & Hicks
It is said to be ordinal concept in economics. This approach is based on consumer preference. It is believed that human satisfaction is psychological. So it cannot be measured in monetary terms. In this approach consumer’s preference is ranked order-wise. Here it is assumed that consumer is rational and he has monotonic preferences. Nareshmalhotra.in
Indifference curve shows different combination of goods for which consumer is indifferent. In other words all combination gives same satisfaction to consumer. Combination are A, B and C.
Marginal rate of substitution in the rate at which the consumer is prepared to exchange goods X and Y.
=Imperfect substitute MRSxy declines
=Perfect substitutes MRSxy straight line
=Perfect complementary MRSxy zero
Properties of Indifference Curve
- It is convex to its origin and slopes downward.
- Two indifference curve never intersect each other.
- Indifference curve will not touch X axis or Y axis.
- Higher IC curve represents higher satisfaction.
Budget Line or Price Line
Budget Line or Price Line shows the combination of good1 and good1 on which consumer spends his whole income either on good1 or on good2 or on both.
- As seen in the figure, the segment joining X axis and Y axis is called budget line. If consumer spends all his money on books he will buy 20 books and alternatively he will be able to buy 40 movies if he spends entire money on it.
- Any point beyond the budget line is not affordable as it is out of consumer’s reach.
- Any point inside the budget line shows under-spending by consumer.
Consumer’s Equilibrium with IC analysis
It refers to the optimum choice of the consumer. In terms of indifference curve analysis, the consumer achieves his optimum choice when he strikes a balance between what he wishes to buy and what he buys. Equilibrium is struck at Q. IK is the price line.
At Equilibrium Point Q, MRSxy (Marginal rate of substitution)
MRSxy = Px / Py
Theory of Supply and Elastics of Supply
- The term supply refers the amount of goods or services which producers are willing and able to offer to the market at various prices during a period of time.
Determinants of Supply
- Price of goods – When price increase then supply increase and when price decreases then supply decreases.
- Price of related goods – If prices of related commodities (substitutes or complements) rise, they will become relatively more attractive to produce and the supply of that commodity rises.
- Price of factor of production(e.g., Land, rent, wage rate etc.) – A rise in prices of factors of production of a commodity will make the production of that commodity less profitable, so supply will decrease.
- Technology( e.g. new machinery) – Technology advances reduce the cost of production and results in more and more supply of the commodity.
- Government policy( e.g., free tax for certain periods) – If Govt. policies are favourable then supply will increase and if Govt. policies are unfavourable then supply will fall.
- Future Expectations – If there is future expectation about rise in price then supplier will not increase the supply at present and if there is future expectation about fall in price then supplier will increase his supply.
- Other factors – Natural factor, market structure goal of the firm.
- Law of Supply
If the price of a good increases the supply by producers for that goods will also increase in the market and other things remaining constant.
Movement of Supply Curve
It is described as increase or decrease in quantity supplied caused by change in own price of the commodity.
Shifts in the Supply Curve
It is described as the increase or decrease in supply when price of Y the commodity remains constant and other factors change.
- Elasticity of Supply
It is defined as the degree of responsiveness of the quantity supplied of a commodity to a change in its price.
Other methods of measurement of elasticity of elasticity of supply: Other methods are-
(1) Point elasticity:- Point elasticity measures elasticity at a point on the supply curve. The elasticity at a point on the supply curve can be measured with the help of following formula.
Es = Where is the differentiation of the supply function with respect to Price.
(2) Arc elasticity: In measurement of arc elasticity, we use the average of the two price (original and subsequent) and average of the two quantity (original and subsequent).
Arc Elasticity =
Types of Elasticity of Supply-
- Perfectly elastic supply (Es = ):- It is situation in which supply of a commodity continuously change without any change in price. In perfectly elastic supply curve, the supply curve will be horizontal parallel to quantity axis.
- More than unitary elastic supply (Es>1):- It refers to a situation by which percentage of change in supply of a commodity is higher than percentage change in price of that commodity. For ex. Change in price is 10% but change in supply is 20%, then 20% / 10% = 2 (E=2).
- Unit elastic supply (Es = 1):- When percentage change in supply of a commodity is equal to percentage change in price. For ex. Change in price is 10% but change in supply is also 10%, then 10% / 10% = 1 (E = 1) Nareshmalhotra.in
- Less than unit elastic supply (Es < 1):– When percentage change in supply of a commodity is less than percentage change in price. For ex. Change in price is 10% but change in supply is 8%, then 8% / 10% = 0.8 (E<1) (Inelastic supply).
- Perfectly inelastic supply (Es = 0):– When price of commodity does not influence supply of that commodity that situation is called perfectly inelastic supply.