Chapter 2 Demand

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Major Divisions of Economics

Consumption: Optimizing unlimited human wants, limited means with alternative uses and consequent priced goods and services. Production: Meaning creation of values to satisfy consumption and growth needs Exchange: Money is the medium of exchange, Distribution
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Demand
Consumption results in demands of all sorts Demand: meaning: desire backed by willingness and ability to pay for a commodity/service. Px Compliments and substitute goods: Compliments have to be used together: car and petrol Substitutes: When one can replace the other: tea/coffee or wheat and rice
Qx
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Demand schedule and graphs

Individual demand schedule: table Market demand schedule: table Demand curve: linear Effect on demand of changes in its own price results in movement along the demand curve. Effect on demand of changes in other factors results in shifts in demand curve

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The law of demand

States the relationship between price and quantity demanded of the same good. This relationship is mostly inverse. Thus the law of demand states that demand for a good or service is inversely related to its price subject to the condition other things remaining the same These other things are income, prices of other goods, tastes and preferences( Ceteris peribus). Managerial Economics Oxford All rights reserved
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Why is demand curve negatively sloped?

1. when price falls, commodity becomes relatively cheaper than its substitutes: this is called substitution effect 2. When price falls, real income rises, so consumer may buy more of it with the same amount as before: income effect 3. The total effect of a price change equals income plus substitution effects
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Exceptions to the law of demand

1.When prices are expected to rise in future. 2. Absolute necessities: when their price goes up, poor consumers may buy more even at the higher prices. This happens because these necessities even at higher prices remain the cheapest sources of their consumption, rather survival.
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Exceptions to the law

Such goods are known by Giffen Goods. The poor consumers buy more of these by giving up the consumption of superior goods as prices of absolute necessities increase. Sir Robert Giffen (1837-1910) used income and substitution effects to explain this phenomenon.
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Giffen Goods..
1. If the negative income effect works against the substitution effects and outweighs it, we would have a positive relationship between Px and Qx.Income effect is negative when a consumer buys less of a commodity when his real income goes up. 2. If real income falls, he may buy
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Giffen goods
more quantity of the good whose price goes up. Giffen goods are those where the combined effect of substitution and income effects results in a positive relationship between PX and Qx.
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Giffen good

Income effect Price effect + Substitution effect Substitution effect is inversely related to price. Income effect can be inversely related to changes in income Inferior Good Income effect can be positively related to income-Superior good
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Giffen Goods

If income effect of a price increase is inverse and large enough to offset the substitution effect, then it is a Giffen Good The Demand curve for Giffen Good will have a positive slope

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Shifts in demand
When the price of a commodity changes, other things remain constant, the relationship between price and quantity demanded happens on the same demand curve. This gives us extension/contraction of demand. When other things like income change, demand curve shifts up or down and we haveEconomics increase and decrease in demand. All rights reserved Managerial Oxford
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Slope and Elasticity of Demand

Slope can not be standard measure of elasticity as this measure is sensitive to unit of measurement. Proportionate change: proportionate change in quantity demanded to a proportionate change in price/income/other price is the exact measure and independent of units choosen. Managerial Economics Oxford University Press, 2006 All rights reserved

Elasticity
Pe Greater than1 (ignoring sign): Elastic Pe Equal to 1 (ignoring sign) : Unit Elastic Pe Less than 1 ( ignoring sign): Inelastic Price Elasticity and Expenditure: - Pe less than 1 a fall in price lower exp - Pe equal to 1 a fall in price exp. constant - Pe greater than 1 a fall in price higher exp
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Elasticity
Income Elasticity Qx/I * I/Qx Could be negative or positive: Negative for Inferior goods Positive for Superior goods

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Elasticity
Cross Price Elasticity: Qx/Py * Py/Qx Could be negative or positive - Negative for complements - Positive for substitutes

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Point and arc elasticity

Point Elasticity: when price change is very small. Arc Elasticity: when price change is large enough. Price Elasticity measurements: i) Proportionate method: Q/ P x P/Q Examples: if demand function is Q =30 -5P + P2 Marginal function Q/ P = -5+ 2P and average function, or Q/P = (30 -5P + P2)/ P
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Elasticity of demand
Now ed = Q/ P x P/Q, so it equals Marginal function/average function, or Ed= (-5 +2P) x P/( 30 -5P + P2) If P = Rs. 5, ed = (-5 + 10) x 5/( 30 10 + 25) = 50/45 = 1.1, Find ed when P = Rs.3/2, Rs 10
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Demand schedule
Price Rs.
6 5 4 3 2
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Quantity demanded
50 72 112.5 200 450
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Elasticity .
The interesting feature of this type of demand function is that price elasticity of demand is constant and is equal to to the exponent of P. Let P = 3, ed = P/Q> dQ/dP = 3/200X 3600/27 = -2, Let P = 2, ed = 2/450X -3600/8 = -2
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Elasticity
If Q = 20/(P + 1), find elasticity with respect to price. Now dQ/dP = -20( P +1)-2, Ed = P/Q. dQ/dP = P/Q X -20P/ Q( P + 1)2 = -20P/20/(P + 1)( P + 1)2 = -P/( P + 1) If, P = 5, ed = -5/6 = .833
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Income elasticity
Q. If income increases from Rs. 80,000 to Rs. 81000, the quantity demanded of good Q1 increases from 3000 to 3050, find income elasticity of demand. Given a small change in income, we use point elasticity method, therefore Ed (income) = I/Q1XdQ1/dI= (80000/3000) X 50/1000 = 1.33
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Cross price elasticity of demand

The price of desktop computers declines from Rs.50,000 to rs.25,000, sale of printers goes up from 50 to 150 per month: Ed (cross price) = dQx/dPy x Py/Qx, Since the the change is large, we use arc elasticity measure, so Qx = (50 + 150)/2 = 100, Py = (50000 + 25000)/2 = 37500, dQx = 100, and dPy = 25000, Ed = 100/25000(37500/100) = - 1.5
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Elasticity
If price elasticity of petrol is 0.5, how much of price increase would be required to reduce consumption by 10%? Ed = (dQ/Q)/ dP/P= 0.5 Now dQ/Q = 10% = 0.1, so dP/P = .1/.5= .2 or 20%

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Elasticity of demand
Elasticity of demand can also be expressed as: ed = Marginal quantity demanded divided by Average quantity demanded= Q/ P divided by Q/P,

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Determinants of price elasticity

Availability of substitutes: Cases of close substitutes like cold drinks and no substitutes like salt Number of uses for a commodity: greater uses leads to greater elasticity like for electricity, when restricted uses like for wheat demand is relatively inelastic Relative importance of a commodity in total expenditure of a consumer: Salt/ match box cases vs cloth/ readymade garments. Consider the impact of doubling of their prices on total demand of consumer
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Determinants of elasticity continued

Nature of the need being satisfied by a commodity, like necessities, comforts, luxuries Time allowed for adjustment to price change, the longer the time period greater the elasticity and vice versa * Habits tend to make demand inelastic * Joint demand like for machine oil and machines makes demand relatively inelastic
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Determinants of elasticity continued

Nature of the need being satisfied by a commodity, like necessities, comforts, luxuries Time allowed for adjustment to price change, the longer the time period greater the elasticity and vice versa * Habits tend to make demand inelastic * Joint demand like for machine oil and machines makes demand relatively inelastic
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Distinctive types of elasticity

Industry elasticity: Refers to the change in total industry sales with a change in the general level of prices for the industry as a whole. The industry demand has elasticity with respect to competition from other industries.

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Distinctive types of ela

Market share elasticity: Relates the change in companys share of industry-wide sales to the price differential between the companys price and industrywise price level. Expectations elasticity: Refers to responsiveness of sales to buyers
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Distinctive types.
guesses about the values of demand determinants, such as the future price of a commodity or of its substitutes, future incomes of buyers, prospects of easy availability or otherwise in the future, or future promotional outlays.
Interest rate elasticity and demand for consumers durables: In USA elasticity of interest rates to housing demand is estimates at .15 which means a ten per cent increase in interest rates would result in 1.5% change in housing demand.
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Engles Law of Consumption

Dr. Engle was a German statistician. He made a study of family budgets around the middle of the nineteenth century He arrived at the following major conclusions: i) As income increases the percentage expenditure on food decreases and vice versa ii) The percentage expenditure on clothing, etc. remains more or less constant at all levels of income
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Engles
iii) The percentage expenditure on fuel, light, rent, etc. also remains practically the same at all levels of income. iv) However, the percentage expenditure on what may be called comforts and luxuries of life increases with increase in income and vice versa.
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Propensity to consume and save concepts

These are macro-economic concepts. The propensity to consume refers to the proportion of income consumed Average propensity to consume refers to economy as a whole, say like C/I Marginal propensity to consume refers to the proportion of change in consumption to proportion of change in income, say, C/ I income to
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Propensity to save and consume..

The propensity to save is reverse of propensity to consume. The concepts, especially marginal propensity to consume and save, exercise considerable influence on the growth performance of an economy

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Propensity continued
A higher marginal propensity to consume leads to faster economic growth through its multiplier effects, unless there exist bottlenecks on the supply side like in the developing world The propensity to consume declines as incomes keep on increasing
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Hyperbolic demand functions

Q = ap-n or Q = a/Pn where a and n are constants, Suppose a = 1800 and n = 2, demand funct Q = 1800/P2 = 1800x p-2 , the resulting demand
schedule at different prices can be as follows:

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