Demand Analysis: Determinants, Function, and Law of Demand

1. DEMAND ANALYSIS Samir K Mahajan, M.Sc, Ph.D.,UGC-NET Assistant Professor (Economics) Department of Mathematics & Humanities Institute of Technology Nirma University Email: samir.mahajan@nirmauni.ac.in https://sites.google.com/a/nirmauni.ac.in/2hm203-_-eebm_even_2014/

2. MEANING OF DEMAND Demand is effective desire which can be fulfilled. Demand must satisfy the following pre-requisites: • Desire for a specific commodity • Ability to pay or sufficient resources to purchase the desired commodity • Willingness to spend on the commodity • Availability of the commodity at particular price, time and place. • All these mentioned requisites must be satisfied simultaneously to satisfy the meaning of demand.

3. DEMAND DETERMINANTS • Demand determinants refer to the factors that affect demand for commodity (a consumer good), such as: • Price of the Commodity • Income of the Consumer • Price of related goods • Taste and presences of consumer • Growth of population • Government policy • Climatic conditions • Income distribution • Expected change in price • Future expectation about income etc.

4. DEMAND DETERMINANTS • Some important determinants of demand are discussed as follows: • Price of the Commodity Normally, quantity demanded of a commodity varies inversely with its price, ceteris paribus ( i.e. other things remaining the same). As price of a commodity rises, quantity demanded of it falls and as price of the commodity falls, quantity demanded of it rises . • Income of the Consumer • Change in income of the consumer also brings about changes in demand for a commodity. • Demand for a normal good varies directly with income of the consumer, other things remaining the same. Normal goods are those goods whose demand increases with increase in income of the consumer and vice versa.  Demand for inferior goods decreases with increases in income of the consumer .

5. DETERMINANTS OF DEMAND(contd) • Price of Related Goods Goods are said to be related when they are either substitute goods or complementary goods. Substitute goods are those goods which compete with each other to satisfy a particular want. E.g. railways and airways, branded mobiles and Chinese mobile. etc . Complementary goods are those goods which are jointly demanded to satisfy a particle want. Examples of complementary goods are car and petrol, etc. In case of substitute goods: Quantity demanded of a commodity varies directly with the price of its substitute. In case of complementary goods: Quantity demanded of a commodity varies inversely with the price of its complementary goods. • Taste And Preferences • Demand for goods is affected by taste and preferences of the consumer which are subjective in nature, and are shaped by individual like and dislikes, faith and belief, fashions, habits, trends etc.

6. DEMAND FUNCTION • Demand functions expresses the functional relationship between demand for a commodity (i.e. a consumer good) and its determinants. It can be written as : • Dx= f (Px , Y, PR ,T, Pe, G, …………..) • Where, • Dxsymbolizes demand for commodity X • Pxsymbolizes price of commodity X • Y symbolizes income of the consumer • PR symbolizes price of related good R • Tsymbolizes taste and presences • Pesymbolizes expected change in price of commodity X • G symbolizes growth of population

7. KINDS OF DEMAND • There are three kinds of demand relations which are usually studied under demand analysis such as: Price Demand, Income Demand and Cross Demand. • Price Demand: Price demand studies how demand for a commodity ( Dx) changes with respect to change in price(Px) , ceteris paribus (other things reaming the same). • Dx= f (Px) • Income Demand: Income Demand examines how demand for commodity ( Dx) changes as a result of change in income of the consumer(Y) , other things remaining the same. • Dx= f (Y)  •  Cross Demand: Cross demand studies how quantity demand of a commodity ( Dx) changes as a result of change in price of its related goods ( PR ), ceteris paribus . Cross demand function can be denoted as follows: • Dx= f ( PR )

8. LAW OF DEMAND The law of demand states that there is inverse relationship between price and quantity demanded of a commodity. In other words, the law of demand states that other things reaming the same, lesser quantity of a commodity will be demanded at higher prices, and more quantity of it will be demanded at lower prices.

9. Demand curve Demand curve is the graphical representation of the relationship between demand for a commodity  (Dx) and its price (Px) . Normally, a demand curve slopes downward from left to right indicating the operation of the law of demand. Price D Demand Curve D 0 Quantity demand

10. Exceptional Demand Curves/ Exception to Demand curve or Law of Demand In some rare situations, the law of demand does not hold good. In such situations, the demand curve slopes upward instead of sloping downward suggesting a rise in demand with rising price. Cases in which this tendency is observed are referred to as exceptions to the general law of demand. • Here demand curve DD curve is known as an exceptional demand curve.

11. Exceptional Demand Curvescontd. • Exceptions to law of demand are • Giffen goods, • conspicuous consumption • conspicuous necessities, • expected changes in price, • extraordinary situations like natural disasters, famine, riots etc

12. Exception to Demand curve contd. Giffen goods: In case of certain inferior goods called Giffen goods, when the price falls, quite often less quantity will be purchased than before because of the negative income effect and people’s increasing preference for a superior commodity with the rise in their real income. Few examples of giffen goods are cheap potatoes, coarse cloth, coarse grain, etc. Conspicuous consumption: Some expensive commodities like diamonds, expensive cars, exorbitantly high priced mobile phones etc., are used as status symbols to display one’s wealth or , to distinguish oneself from average people. The more expensive these commodities become, the higher their value as a status symbol and hence, the greater the demand for them. Law of demand does not apply here. Conspicuous necessities: certain things become necessities of modern life. These are purchased even if their prices rise. E.g. TV, refrigerators, mobile phones, automobiles.

13. Exception to Demand curve contd. Expected Changes in Price: Expected or anticipated changes in price of a commodity in future also can affect quantity demanded of it at present. If it is expected that the price of a commodity will rise in future, the demand for it rise and vice versa. Extraordinary situations: War, famines, riots, natural calamities are extra ordinary situations when people’s behavior becomes abnormal. Law demand does not apply in abnormal situations.

14. CHANGES IN QUANTITY DEMANDED/ MOVEMENT ALONG DEMAND CURVE • There are two concepts related to changes in quantity demand such as: • Extension of Demand • Contraction of Demand

15. Changes in Quantity Demandedcontd. EXTENSION OF DEMAND Extension of Demand : Other things remaining the same, when more quantity of a commodity is demanded due to fall in its price, it is called extension of demand. There is a downward movement along the demand curve in case of extension of demand. Price D Extension of demand A P2 B P1 D Q1 Q2 O Quantity Demanded

16. Changes in Quantity Demandedcontd. CONTRACTION OF DEMAND Contraction of Demand : Other things remaining the same, when less quantity of a commodity is demanded due to rise in its price, it is called contraction of demand . There is a upward movement along the demand curve in case of contraction of demand. Price D Contraction of demand A P2 P1 B D Q1 Q2 O Quantity Demanded

17. Changes in Demand/ Shift in Demand Curve/ • There are two concepts related to changes in quantity demand such as: • Increase in Demand • Decrease in Demand • Changes in Demand /Shift in demands are caused by • Changes in income • Changes in price of substitutes • Changes towards the taste and preferences of the commodity • Changes in climate etc.

18. Changes in Demand contd. Increase in Demand When , due to factors other than price, more quantity of a commodity is demanded at same price or same quantity is demanded at higher price, it is called increase in demand. There is a upward /rightward shift in demand. Price more demand at same price Same demand at higher price D/ D P2 P1 D/ D Q1 O O Q1 Q2 Demand

19. Changes in Demand contd. Decrease in Demand When , due to factors other than price, less quantity of a commodity is demanded at same price or same quantity is demanded at lower price, it is called decrease in demand. There is a downward /leftward shift in demand Price Less demand at same price Same demand at lower price D/ D P2 P1 D/ D Q1 O O Q1 Q2 Demand

20. ELASTICITY OF DEMAND Elasticity of demand is the measure of the responsiveness of quantity demanded of a commodity in response to change in a particular demand determinant(say price) while keeping other determinants constant( such as:, income, or price of related good , advertisement, growth of population and so on). Algebraically, it is defined as Where eDis elastic of demand Q is quantity demanded () Z is any demand determinant (initial) dQ is change in quantity demanded dZ is change in demand determinant

21. CONCEPTS OF ELASTICITY OF DEMAND • There may be as many as concepts of elasticityof demand as the number of demand determinants. Most important concepts of elasticity of demand are: • Price elasticity of demand (here the demand determinant is price of the commodity) • Income elasticity of demand (here the demand determinant is income of consumer) • Cross elasticity of demand (here the demand determinant is price of related goods)

22. PRICE ELASTICITY OF DEMAND • Price Elasticity of demand is the measure of the responsiveness of quantity demanded of a commodity in response to change in price , ceteris paribus. • Where ePis elastic of demand • Qis quantity demanded (initial) • P is price of the commodity (initial) • dQ is change in quantity demanded • dP change in price ***Price elasticity usually carries a negative sign because of inverse relationship between price and demand. However, it is absolute value of price elasticity of demand that determines the different degrees/kinds of price elasticity of demand.

23. PRICE ELASTICITY OF DEMAND (cntd.) • KINDS OF PRICE ELASTICITY OF DEMAND • Perfectly elastic demand • Elastic Demand /Relatively Elastic Demand • Unit Elastic Demand • Inelastic Demand / Relatively Inelastic Demand : • Perfectly inelastic Demand

24. PRICE ELASTICITY OF DEMAND (cntd.) PERFECTLY ELASTIC DEMAND When quantity demanded of the commodity changes though there is no change in price, it is known as perfect elastic demand. Incase of Perfectly elastic demand, Price Perfectly elastic demand curve P D Q1 Q2 0 Quantity Demand

25. PRICE ELASTICITY OF DEMAND (cntd.) ELASTIC DEMAND When the proportionate change in demand is more than the proportionate changes in price, it is known as relatively elastic demand. E.g. luxury goods Price Incase of elastic demand, Elastic demand curve D P2 P1 D Q1 Q2 0 Quantity demanded

26. PRICE ELASTICITY OF DEMAND (cntd.) UNIT ELASTIC DEMAND When the proportionate change in demand is equal to proportionate changes in price, it is known as unitary elastic demand. Price D Unit elastic demand equal P2 Incase of unit elastic demand, P1 D 0 Q1 Q2 Quantity Demand

27. PRICE ELASTICITY OF DEMAND (cntd.) INELASTIC DEMAND When the proportionate change in demand is less than the proportionate changes in price, it is known as relatively inelastic demand. e.g. necessities, electricity etc. Price D Inelastic demand curve P2 P1 Incase of inelastic demand, D Q1 Q2 Quantity Demanded O

28. PRICE ELASTICITY OF DEMAND (cntd.) PERFECTLY INELASTIC DEMAND When a change in price, howsoever large, change no changes in quality demand, it is known as perfectly inelastic demand. E.g. salts Price D Perfectly inelastic demand curve P2 P1 Incase of perfectly inelastic demand, Q Quantity Demanded 0

29. PRICE ELASTICITY OF DEMAND (cntd.) ALL KINDS OF (Price)DEMAND CUVES BE SHOWN IN ONE DIAGRAM AS FOLLOWs Price 0 Quantity Demanded

30. , Income Elasticity Of Demand • Income Elasticity of demand is the measure of the responsiveness of quantity demanded of a commodity in response to change in income of the consumer, ceteris paribus. • or, • or, Where is income elasticity of demand Q is the quantity demanded (initial) Y is the income of the consumer (initial) dQ is the change in quantity demanded dY is the change in income

31. INCOME ELASTICITY OF DEMAND (cntd.) • KINDS OF INCOME ELASTICITY OF DEMAND • Positive Income elasticity of demand which includes • Unitary Income Elasticity ( ey=1 ) indicates that a proportionate (percentage or relative )change in quantity demanded is equal to proportionate change in money income. • High Income Elasticity (ey > 1 ) indicates that a proportionate change in quantity demanded is more than proportionate change in money income. E.g. luxuries • Income elasticity less than unity / Low Income Elasticity (eY < 1 )indicates that a proportionate change in quantity demanded is less than proportionate relative change in money income. e.g. necessities • Zero Income elasticity /Perfectly Inelastic Income demand (ey = 0 ) indicates a change in income will have no effect on the quantity demandede.g. salts • Negative income elasticity (eY < 0 ) [in case of inferior goods]indicates that less is bought at higher incomes and more is bought at lower incomes.

32. INCOME ELASTICITY OF DEMAND (cntd.) ALL KINDS OF INCOME ELASTICITY OF DEMAND SHOWN AS FOLLOWS Income ey = 0 (eY < 1 ) ey=1 (ey > 1 ) (ey< 0) O Quantity Demanded

33. , Cross Elasticity Of Demand • Cross Elasticity of demand is the measure of the responsiveness of quantity demanded of a commodity in response to change in price of its related goods, ceteris paribus. It can be written as: • or, • or, Where • eAB is cross elasticity of demand • QA is the quantity demanded of commodity A (initial) • PB is the Price of the commodity B(initial) • d QA is the change in quantity demanded of commodity A • d PB is the change in price

34. INCOME ELASTICITY OF DEMAND (cntd.) • KINDS OF CROSS ELASTICITY OF DEMAND • Positive Cross elasticity of demand (eAB > 0 ) when the goods A and B are substitutes] e.g. Coca cola and Pepsi, Chinese mobile phones and smart phones. • Negative Cross elasticity of demand (eAB < 0 ) [when the goods A and B are complementary] e.g. vehicle and petrol • Zero Cross elasticity of (eAB = 0 ) [when the goods A and B are independent/unrelated] e.g. gold and rice.

35. INCOME ELASTICITY OF DEMAND (cntd.) ALL KINDS OF CROSS ELASTICITY OF DEMAND SHOWN AS FOLLOWS Price of Related Good eAB = 0 eAB > 0 (eAB <0 ) O Quantity Demanded

36. GEOMETRIC METHOD /POINT METHOD OF MEASURING ELASTICITY OF DEMAND Geometric method attempts to measure numerical elasticity of demand at a particular point on the demand curve. The is method is applied when changes in price and the resultant change in quantity demanded are infinitely small. As per point method, Thus, • Where, • ePis price elasticityof demand • Qis quantity demanded (initial) • P is price of the commodity (initial) • dQ is change in quantity demanded • dP change in price

37. GEOMETRIC OR POINT METHOD contd. Price elasticity of demand at point D at demand curve AB can be written as Price A C P2 dP D P1 E dQ B Q1 O Q2 Demand

38. GEOMETRIC METHOD contd. Different kinds of price edacity of demand is shown in the following through geometric method. d Price e= 8 A e>1 e=1 c e<1 d e=0 B Demand 0

39. ARC METHOD OF MEASURING ELASTICITY OF DEMAND Arc method is applied when changes in price and the resultant change in quantity demanded are somewhat large or we have to measure elasticity over an arch of demand curve. The formula for arc elasticity is as follows: Price Where Q1 is original quantity demanded Q2 is new quantity demanded P1is original price P2 is final price D P2 A B P1 D Q2 Q1 0 Demand

40. UTILITY • Utility is defined as the power of commodity to satisfy a human want. • People know utility of goods by means of introspection and therefore is subjective. • Being subjective, it varies from persons to persons. That is, different persons may derive different amount of utility/satisfaction from the same good. • The desire for a commodity by a person depends upon the utility he expects to obtain from it.

41. UTILITY contd. CARDINAL AND ORDINAL UTILITY • There are two basic approaches to the notion of utility such as: • cardinal approach • ordinal approach • According to the cardinal school of thought, utility can be measured in terms of numerical value 0, 1, 2, 3, 4 etc. Some economists view that utility can be measured in terms of subjective units called ‘utils’ (i.e. 0, 1, 2, 3, 4 …) while others view that utility can be measured in terms of price or monetary units the consumer is willing to pay for the additional unit of the commodity. The concept of cardinal utility has been popularized by economists like Marshall, Jevons, Walrass, etc. • According to the ordinal school of thought, utility is not measurable rather it is an ordinal magnitude which can be ranked and compared as 1st, 2nd, 3rd etc. They view that the consumer does not know in specific units the utility of various commodity in order to make his choice. Rather she/he can rank her/his preferences of for various combinations of two commodities according to the satisfaction derived from each combination of the commodities. The concept of cardinal utility has been popularized by economists like Edgewotrh, Hicks, Allen etc.

42. TOTAL UTILITY AND MARGINAL UTILITY Total Utility Total psychological satisfaction obtained by a consumer from consuming a given amount of a particular commodity is called total utility. Marginal Utility Marginal Utility is the extra utility derived by a consumer from the consumption of an additional unit of a particular commodity.

43. RELATIONSHIP BETWEEN TU AND MU TU MU

44. RELATIONSHIP BETWEEN TU AND MU. • Total utility (TU) is the sum total of marginal utilities . • TU=∑MU • Marginal utility (MU) is the rate of change in total utility with respect to a unit change in quantity of the commodity consumed. • MU=dU/dQ • dU symbolizes change in total utility • dQ symbolizes change in quantity of commodity consumed • When the MU decreases, TU increases at decreasing rate. • When MU becomes zero, TU is maximum. It is a saturation point. • When MU becomes negative, TU declines

45. LAWS OF CARDINAL UTILITY ANALYSIS • Laws of Diminishing Marginal Utility • Law of Equi-Marginal Utility

46. LAW OF DIMINISHING MARGINAL UTILITY It is a psychological fact that when a person consumes more and more units of a commodity during a particular time, the extra utility he derives from the successive units of the commodity will diminish. The Law of Diminishing Marginal Utility states thatthe additional satisfaction derived from the additional units of a commodity goes on diminishing. The law highlights that while total wants of a man is unlimited, each single want is satiable. As a consumer more and more units of a commodity, intensity for the commodity goes on falling , and a point is reached where he does not want more of it. He is completely satisfied with the commodity which is reflected by zero marginal utility. The law of diminishing marginal utility also serve the basis for law of law of demand or downward sloping demand curve.

47. A consumer is in equilibrium when he maximises his utility or satisfaction by spending his given money income on different goods. • Consumer’s Equilibrium in Case of Single Good • Let us take a simple model of single commodity X. • The consumer either spends his money income on the good or retains his money income. • In such situation, the consumer will be in equilibrium when MUX= PX • Where, MUX is marginal utility of commodity X • PX is price of the commodity X. • If MUX > PX , the consumer can increase his well-being by purchasing more units of the commodity X. • If MUX < PX , the consumer can increase his total cost satisfaction by cutting down the quantity of commodity X and keeping more of his income unspent. • Thus, he maximises his satisfaction when MUX = PX CONSUMER’S EQUILIBRIUM

48. CONSUMER’S EQUILIBRIUM contd. Consumer’s Equilibrium In case of More Than One Good and Law of Equi-Marginal Utility The law of equi-marginal utility states that a consumer distributes his limited income among various commodities in such a way that marginal utility of money expenditure on each good is equal. This is the condition of consumer’s equilibrium in case of more than one commodity. Marginal utility of money expenditure on a good is the ratio of marginal utility of the commodity to price of it.

49. CONSUMER’S EQUILIBRIUM contd. Consumer’s Equilibrium In case of More Than One Good and Law of Equi-Marginal Utility Thus if there are more than one commodity, the condition for equilibrium is the equality of the ratios of marginal utilities’ of the individual commodities to the respective prices. Subject to constraint imposed by money income (Y) Y =P1Q1 + P2Q2 + P3Q3 +……. Where, MU1 , MU2 , MU3 …….. are marginal utilities of commodity 1, 2, 3,……. P1 , P2 , P3, ……. are prices of commodity 1, 2, 3,………………. Q1 , Q2 , Q3 are quantities of commodity 1, 2, 3, ………………. is marginal utility of money expenditure

50. SUPPLY Supply indicates quantities of a commodity of a offered for sale at each possible price at a given time period, other things constant Determinants of Supply • Price of the product • State of technology • Prices of relevant resources • Prices of alternative goods • Producer expectations • Number of producers/sellers in the market