Theory of Demand and Supply

CA Foundation Business Economics Study Material – Law of Demand

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CA Foundation Business Economics Study Material Chapter 2 Theory of Demand and Supply – Law of Demand

The Law of Demand

  • The Law of Demand expresses the nature of functional relationship between the price of a commodity and its quantity demanded.
  • It simply states that demand varies inversely to the changes in price i.e. demand for a commodity expands when price falls and contracts when price rises.
  • “Law of Demand states that people will buy more at lower prices and buy less at higher prices, other things remaining the same.” (Prof. Samuelson)
  • It is assumed that other determinants of demand are constant and ONLY PRICE IS THE VARIABLE AND INFLUENCING FACTOR.
  • Thus, the law of demand is based on the following main assumptions:—
    1. Consumers income remain unchanged.
    2. Tastes and preferences of consumers remain unchanged.
    3. Price of substitute goods and complement goods remain unchanged.
    4. There are no expectations of future changes in the price of the commodity.
    5. There is no change in the fashion of the commodity etc.
  • The law can be explained with the help of a demand schedule and a corresponding demand curve.
  • Demand schedule is a table or a chart which shows the different quantities of commodity demanded at different prices in a given period of time.
  • Demand schedule can be Individual Demand Schedule or Market Demand Schedule.

Individual Demand Schedule is a table showing different quantities of commodity that ONE PARTICULAR CONSUMER is willing to buy at different level of prices, during a given period of time.

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Market Demand Schedule is a table showing different quantities of a commodity that ALL THE CONSUMERS are willing to buy at different prices, during a given period of time.

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(Assumption: There are only 2 buyers in the market)

Both individual and market schedules denotes an INVERSE functional relationship between price and quantity demanded. In other words, when price rises demand tends to fall and vice versa.

A demand curve is a graphical representation of a demand schedule or demand function.

  • A demand curve for any commodity can be drawn by plotting each combination of price and demand on a graph.
  • Price (independent variable) is taken on the Y-axis and quantity demanded (dependent variable) on the X-axis.

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  • Individual Demand Curve as well as Market Demand Curve slope downward from left to right indicating an inverse relationship between own price of the commodity and its quantity demanded.
  • Market Demand Curve is flatter than individual Demand Curve.

Reasons for the law of demand and downward slope of a demand curve are as follows:—

1. The Law of Diminishing Marginal Utility:

  • According to this law, other things being equal as we consume a commodity, the marginal utility derived from its successive units go on falling.
  • Hence, the consumer purchases more units only at a lower price.
  • A consumer goes on purchasing a commodity till the marginal utility of the commodity is greater than its market price and stops when MU = Price ie. when consumer is at equilibrium.
  • When the price of the commodity falls, MU of the commodity becomes greater than price and so consumer start purchasing more till again MU = Price.
  • It therefore, follows that the diminishing marginal utility implies downward sloping demand curve and the law of demand operates.

2. Change in the number of consumers:

  • Many consumers who were unable to buy a commodity at higher price also start buying when the price of the commodity falls.
  • Old customers starts buying more when price falls.

3. Various uses of a commodity:

  • Commodity may have many uses. The number of uses to which the commodity can be put will increase at a lower price and vice versa.

4. Income effect:

  • When price of a commodity falls, the purchasing power (ie. the real income) of the consumer increases.
  • Thus he can purchase the same quantity with lesser money or he can get more quantity for the same money.
  • This is called income effect of the change in price of the commodity.

5. Substitution effect:

  • When price of a commodity falls it becomes relatively cheaper than other commodities.
  • As a result the consumer would like to substitute it for other commodities which have now become more expensive.
    E.g. With the fall in price of tea, coffee’s price remaining the same, tea will be substituted for coffee.
  • This is called substitution effect of the change in price of the commodity.
  • Thus, PRICE EFFECT = INCOME EFFECT + SUBSTITUTION EFFECT as explained by Hicks and Allen.

Exceptions to the Law of Demand

  • Law of Demand expresses the inverse relationship between price and quantity demanded of a commodity. It is generally valid in most of the situations.
  • But, there are some situations under which there may be direct relationship between price and quantity demanded of a commodity.

These are known as exceptions to the law of demand and are as follows:—

1. Giffen Goods:

  • In some cases, demand for a commodity falls when its price fall and vice versa.
  • In case of inferior goods like jawar, bajra, cheap bread, etc. also called “Giffen Goods” (known after its discoverer Sir Robert Giffens) demand is of this nature.
  • When the price of such inferior goods fall, less quantity is purchased due consumer’s increased preference for superior commodity with the rise in their “real income” (Le. purchasing power).
  • Hence, other things being equal, if price of a Giffen good fall its demand also falls.
  • There is positive price effect in this case.

2. Conspicuous goods:

  • Some consumers measure utility of a commodity by its price i.e. if the commodity is expensive they think it has got more utility and vice versa.
  • Therefore, they buy less at lower price and more of it at higher price.
    E.g. Diamonds, fancy cars, dinning at 5 stars, high priced shoes, ties, etc….
  • Higher prices are indicators of higher utilities.
  • A higher price means higher prestige value and higher appeal and vice versa.
  • Thus a fall in their price would lead to fall in their quantities demanded. This is against the law of demand.
  • This was found out by Veblen in his doctrine of “Conspicuous Consumption” and hence this effect is called Vebleri effect or prestige effect.

3. Conspicuous necessities:

  • The demand for some goods is guided by the demonstration effect of the consumption pattern of a social group to which the person belongs.
    E.g. Television sets, refrigerators, music systems, cars, fancy clothes, washing machines etc.
  • Such goods are used just to demonstrate that the person is not inferior to others in group.
  • Hence, inspite of the fact that prices have been continuously rising, their demand does not show tendency to fall.

4. Future changes in prices:

  • When the prices are rising, households tend to purchase larger quantities of the commodity, out of fear that prices may go up further and vice versa.
    E.g. – Shares of a good company, etc.

5. Irrational behaviour of the consumers:

  • At times consumers make IMPULSIVE PURCHASES without any calculation about price and usefulness of the product. In such cases the law of demand fails.

6. Ignorance effect:

  • Many times households may demand larger quantity of a commodity even at a higher price because of ignorance about the ruling price of the commodity in the market.

7. Consumer’s illusion:

  • Many consumers have a wrong illusion that the quality of the commodity also changes with the price change.
  • A consumer may contract his demand with a fall in price and vice versa.

8. Demand for necessaries:

  • The law of demand does not hold true in case of commodities which are necessities of life. Whatever may be the price changes, people have to consume the minimum quantities of necessary commodities. E.g.- rice, wheat, clothes, medicines, etc.

DEMAND CURVE FOR ABOVE EXCEPTIONS IS POSITIVELY SLOPED

Expansion and Contraction of Demand

(changes in quantity demanded. Or movement along a demand curve)

  • The law of demand, the demand schedule and the demand curve all show that
    – when the price of a commodity falls its quantity demanded rises or expansion takes place and
    – when the price of a commodity rises its quantity demanded fall or contraction takes place.
  • Thus, expansion and contraction of demand means changes in quantity demanded due to change in the price of the commodity other determinants like income, tastes, etc. remaining constant or unchanged.
  • When price of a commodity falls, its quantity demanded rises. This is called expansion of demand.
  • When price of a commodity rises, its quantity demanded falls. This is called contraction of demand.
  • As other determinants of price like income, tastes, price of related goods etc. are constant, the position of the demand curve remains the same. The consumer will move upwards or downwards on the same demand curve.

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Figure : Expansion and Contraction of Demand

In the figure

  • At price OP quantity demanded is OQ.
  • With a fall in price to OP1, the quantity demanded rises from OQ toOQ1,. The coordinate point moves down from E to E1This is called ‘expansion of demand’ or ‘a rise in quantity demanded’ or ‘downward movement on the same demand curve’.
  • At price OP quantity demanded is OQ.
  • With a rise in price to P2, the quantity demanded falls from OQ to OQ2. The coordinate point moves up from E to E2. This is called ‘contraction of demand’ or ‘a fall in quantity demanded’ or ‘upward movement on the same demand curve’.
  • Thus, the downward movement on demand curve is known as expansion in demand and an upward movement on demand curve is known as contraction of demand.

Increase and Decrease in demand (changes in demand OR shift in demand curve)

  • When there is change in demand due to change in factors other than price of the commodity, it is called increase or decrease in demand.
  • It is the result of change in consumer’s income, tastes and preferences, changes in population, changes in the distribution of income, etc.
  • Thus, price remaining the same when demand rises due to change in factors other than price, it is called increase in demand. Here, more quantity is purchased at same price or same quantity is purchased at higher price.
  • Likewise price remaining the same when demand falls due to change in factors other than price, it is called decrease in demand. Here, less quantity is purchased at same price or same quantity is purchased at lower price.
  • In above cases demand curve shifts from its original position to rightward when demand increases and to leftward when demand decreases. Thus, change in demand curve as a result of increase or decrease in demand, is technically called shift in demand curve.

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Figure : Increase and Decrease in Demand

In the figure

  • Original demand curve is DD. At OP price OQ quantity is being demanded.
  • As the demand changes, the demand curve shifts either to the right (D1D1) or to the left (D2D2)
  • At D1D1, OQ1, quantity is being demanded at the price OP. This shows increase in demand (rightward shifts in demand curve) due to factor other than price.
  • At D2D2, QO2 quantity is being demanded at the price OP. This shows decrease in demand (leftward shift in demand curve) due to a factor other than price.
  • When demand of a commodity INCREASES due to factors other than price, firms can sell a larger quantity at the prevailing price and earn higher revenue.
  • The aim of a advertisement and sales promotion activities is to shift the demand curve to the right and to reduce the elasticity of demand.

 

CA Foundation Business Economics Study Material – Introduction to Demand

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CA Foundation Business Economics Study Material Chapter 2 Theory of Demand and Supply – Introduction to Demand

Meaning of Demand

  • In ordinary speech, the term demand is many times confused with ‘desire’ or ‘want’.
  • Desire is only a wish to have any thing.
  • In economics demand means more than mere desire.
  • Demand in economics means an effective desire for a commodity ie. desire backed by the ‘ability to pay’ and ‘willingness to pay’ for it.
  • Thus, demand refers to the quantity of a good or service that consumers are willing and able to purchase at different prices during a period of time.
  • Thus, defined, the term demand shows the following features:
    1. Demand is always with reference to a PRICE.
    2. Demand is to be referred to IN A GIVEN PERIOD OF TIME.
    3. Consumer must have the necessary purchasing power to back his desire for the commodity.
    4. Consumer must also be ready to exchange his money for the commodity he desires.
  • E.g. Mr. A’s demand for sugar at Rs. 15 per kg. is 4 kgs. per week.

Determinants of Demand

For estimating market demand for its products, a firm must have knowledge about—
(a) the determinants of demand for its product, and
(b) the nature of relationship between demand and is determinants.

The various factors on which the demand for a product/commodity depends are as follows:—

Price of the commodity:

  1. Other things being equal, the demand for a commodity is inversely related with its price.
  2. It means that a rise in price of a commodity brings about fall in its demand and vice versa.
  3. This happens because of income and substitution effects.

Price of the related commodities:

  1. The demand for a commodity also depends on the prices of related commodities.
  2. Related commodities are of two types namely—
    • Substitutes or competitive goods, &
    • Complementary goods.
  3. Substitute goods are those goods which can be used with equal ease in place of one another.
  4. E.g. Essar Speed Card and Airtel Magic Card; Coke and Pepsi; ball pen and ink pen; tea and coffee; etc.
  5. Demand for a particular commodity is affected if the price of its substitute falls or rises.
  6. E.g. If the price of Airtel Magic card falls, its demand will increase and demand for Essar Speed Card would fall and vice versa.
  7. Thus, there is a POSITIVE RELATIONSHIP between price of a commodity and demand for its substitutes.
  8. Complementary good are those goods whose utility depends upon the availability of both the goods as both are to be used together.
  9. E.g. a ball pen and refill; car and petrol; a hand set and phone connection; a tonga and horse, etc.
  10. The demand for complementary goods have an INVERSE RELATIONSHIP with the price of related goods.
  11. E.g. If the price of Scooters falls, its demand will increase leading to increase in demand for petrol.

Income of the consumers

  1. Other things being equal, generally the quantity demanded of a commodity bear a DIRECT RELATIONSHIP to the income of the consumer ie. with an increase in income, the demand for a commodity rises.
  2. However, this may not always hold true. It depends upon the class to which commodity belongs ie. necessaries or comforts and luxuries or inferior goods:
    • Necessaries (E.g. Food, clothing and shelter). Initially, with an increase in the in-come, the demand for necessaries also rises upto some limit. Beyond that limit, an increase in income will leave the demand unaffected.
    • Comforts and Luxurious (E.g. Car; Air-Conditioners; etc.) Quantity demanded of these group of commodities have a DIRECT RELATIONSHIP with the income of the consumers. As the income increases, the demand for comforts and luxuries also increases.
    • Inferior goods (E.g. Coarse grain; rough cloth; skimmed milk; etc.). Inferior goods are those goods for which superior substitutes are available Quantity demanded of this group of commodities Have an INVERSE RELATIONSHIP with the income of the consumer. E.g. A consumer starts consuming full cream milk (normal good) in place of toned milk (inferior good) with an increase in income.

Therefore, it is essential that business managers must know—

  • the nature of good they produce,
  • the nature of relationship between the quantities demanded and changes in consumer’s income, and
  • the factors that could bring about changes in the incomes of the consumers.

Tastes and Preferences of the consumers

  • Tastes and preferences of consumers generally change over time due to fashion, advertisements, habits, age, family composition, etc. Demand for a commodity bears a direct relationship to those determinants.
  • Modern goods or fashionable goods have more demand than the goods which are of old design and out of fashion.
    E.g. People are discarding Bajaj Scooter for say Activa Scooter.
  • The demand of certain goods is determined by ‘bandwagon effect’ or ‘demonstration effect’. It means a buyer wants to have a good because others have it. It means that an individual consumer’s demand is conditioned by the consumption of others.
  • Taste and preferences may also undergo a change when consumer discover that consumption of a good increases his PRESTIGE. E.g. Diamonds, fancy cars, etc.
  • A good loses its prestige when it becomes a commonly used good. This is called ‘snob effect’.
  • Status seeking rich people buy highly priced goods only. This form of ‘conspicuous consumption’ or ‘ostentatius consumption’ is called ‘VEBLEN EFFECT’ (named after American economist THORSTEIN VEBLEN)
  • Tastes and preferences of people change either due to external causes or internal causes.
  • Therefore, knowledge about tastes and preferences is important in production planning, designing new products and services to suit the changing tastes and preferences of the consumers.

Other Factors. Other things being equal demand for a commodity is also determined by the following factors:—

  1. Size and composition of Population:
    • Generally, larger the size of population of a country, more will be the demand of the commodities.
    • The composition of the population also determines the demand for various commodities.
      E.g. If the number of teenagers is large, the demand for trendy clothes, shoes, movies, etc. will be high.
  2. The level of National Income and its Distribution:
    • National Income is an important determinant of market demand. Higher the national income, higher will be the demand for normal goods and services.
    • If the income in a country is unevenly distributed, the demand for consumer goods will be less.
    • If the income is evenly distributed, there is higher demand for consumer goods.
  3. Sociological factors:
    • The household’s demand for goods also depends upon sociological factors like class, family background, education, marital status, age, locality, etc.
  4. Weather conditions:
    • Changes in weather conditions also influence household’s demand.
      E.g. – Extraordinary hot summer push up the demand for ice-creams, cold drinks, coolers etc.
  5. Advertisement:
    • A clever and continuous campaign and advertisement create a new type of demand.
      E.g. Toilet products like soaps, tooth pastes, creams etc.
  6. Government Policy:
    • The government’s taxation policy also affects the demand for commodities.
    • High tax on a commodity will lead to fall in the demand of the commodity.
  7. Expectation about future prices:
    • If consumers expect rise in the price of a commodity in near future, the current demand for the commodity will increase and vice versa,
  8. Trade Conditions:
    • If the country is passing through boom conditions, demand for most goods is more.
    • But during depression condition, the level of demand falls.
  9. Consumer-credit facility and interest rates:
    • If ample credit facilities with low rates of interest is available, there will be more demand specially of consumer durable goods like scooters, LCD /LED televisions, refrigerators, home theatre, etc.

Demand Function

Mathematical/symbolic statement of functional relationship between the demand for a product (the dependent variable) its determinants (the independent variables) is called demand function

Dx = f (Px, M, Ps ; Pc, T, A)

Where—
Dx= quantity demanded of product
Px = the price of the product
M = money income of the consumer
Ps = the price of its substitute
Pc = the price of its complementary goods
T = consumer’s tastes and preferences
A = advertising effect measured through the level of advertisement expenditure.