Law Of Demand Elasticity Of Demand

Business Environment Unit 1 HNC Business

INTRODUCTION
It is essential for the business managers to have a clear understanding of the following aspects of the demand for their products : i) What are the sources of demand? ii) What are the determinants of demand? iii) How do the buyers decide the quantity of a product to be purchased? iv) How do the buyers respond to the change in a product prices, their income and prices of the related goods? v) How can the total of market demand for a product for a product be assessed and forecast? These questions are answered by the Theory of Demand

MEANING OF DEMAND
The term demand refers to a desire for a commodity backed by ability and willingness to pay for it. Unless a person has an adequate purchasing power or resources and the preparedness to spend his resources, his desire for a commodity would not be considered as his demand. For example, if a man wants to buy a car but he does not have sufficient money to pay for, his want is not his demand for the car. A want with three attributes - desire to buy, willingness to pay and ability to pay - becomes effective demand.

INDIVIDUAL DEMAND
The individual demand is the demand of one individual or firm. It represents the quantity of a good that a single consumer would buy at a specific price point at a specific point in time.

MARKET DEMAND
Market demand provides the total quantity demanded by all consumers. In other words, it represents the aggregate of all individual demands. Market demand is an important economic marker because it reflects the competitiveness of a marketplace, a consumers willingness to buy certain products and the ability of a company to leverage itself in a competitive landscape. If market demand is low, it signals to a company that they should terminate a product or service, or restructure it so that it is more appealing to consumers.

THE LAW OF DEMAND

The law of demand states that the demand for a commodity increases when its price decreases and it falls when its price rises, other things remaining constant. As the law reveals, there is an inverse relationship between the price and quantity demanded. The law holds under the condition that other things remain constant. Other things include other determinants of demand, viz., consumers income, price of the substitutes and complements, taste and preferences of the consumer, etc. These factors remain constant only in the short run. In the long run they tend to change. The law of demand, therefore, hold only in the short run.

Demand Schedule
The law of demand can be presented through a demand schedule. Demand Schedule is a series of prices placed in descending (or ascending) order and the corresponding quantities which consumers would like to buy per unit of time. Price Quantity The demand schedule presents seven alternative demanded . prices of tea and the corresponding quantities 5 1 (number of cups of tea) demanded per day. At each price, a unique quantity is demanded. As the table 4 2 shows, as price of tea per cup decreases, daily demand 3 3 for tea increases. This Relationship between, quantity demanded of a product and its price is the basis of 2 4 the law of demand 1 5

The Demand Curve

The law of demand can also be presented through a demand curve. A demand curve is a locus of points showing various alternative price quantity combinations. Demand curve shows the quantities of a commodity which a consumer would buy at different prices Each point on the demand curve shows one unique price-quantity combination. The combinations read downward along the demand curve show decreasing price of tea and increasing number of cups of tea demanded. Thus, the demand curve shows a functional relationship between the alternative prices of a commodity and its corresponding quantities which consumer would like to buy during a specific period of time, say day, per week, per month, per season, or per year.

Demand curve
6 5 4 3 2 1 0 1 2 3 4 5 Quantity Demanded

Price

FACTORS BEHIND THE LAW OF DEMAND

The factors that make the law of demand operate are following. Substitution Effect When price of a commodity falls, prices of all other related goods (particularly of substitutes) remaining constant, the goods of latter category become relatively costlier. Or, in other words, the commodity whose price has fallen becomes relatively cheaper. Since consumers substitute cheaper goods for costlier ones, demand for the cheaper commodity increases. The increase in demand on account of this factor is known a substitution effect.

Income Effect As a result of fall in the price of a commodity, the real income of the consumer increases. Consequently, his purchasing power increases since he is required to pay less for the same quantity. The increase in real income encourages the consumer to demand more of goods and services. The increase in demand on account of increase in real income is known as income effect. It should however be noted that the income effect is negative in case of inferior goods.

EXCEPTIONS TO THE LAW OF DEMAND

The law of demand does not apply to the following cases. Expectations regarding further prices When consumers expect a continuous increase in the price of a durable commodity, they buy more of it despite increase in its price with a view to avoiding the pinch of a much higher price in future. For instance, in pre-budget months, prices generally tend to rise. Yet, people buy more of storable goods in anticipation of further rise in prices due to new levies. Status Goods The law does not apply to the commodities which are used as a status symbol of enhancing social prestige or for displaying wealth and riches, e.g., gold, precious stones, rare paintings, antiques, etc. Rich people buy such goods mainly because their prices are high and buy more of them when their prices move up. Giffen Goods Another exception to the law of demand is the classic case of Giffen goods. A Giffen good may be any inferior commodity much cheaper than its superior substitutes, consumed by the poor households as an essential commodity. If price of such goods increases (price of its substitute remaining constant), its demand increases instead of decreasing because, in case of a Giffen good, income effect of a price rise is greater than its, substitution effect. The reason is, when price of, an inferior good increases, income remaining the same, poor people cut the consumption of the superior substitute so that they may buy more of the inferior good in order to meet their basic need.

SHIFT IN DEMAND CURVE

When demand curve changes its position, the change is known as shift in demand curve. Consider, for instance, the demand curves viz. D1, D2 and D3 in Fig. Let us suppose that demand curve DD is the original demand curve for commodity X. As shown in the figure, at price OP. Consumer buys L units of X, other factors remaining constant. But, if any of the other factor (e.g. consumers in come or price of the substitutes) changes, it will change the consumers ability and willingness to buy commodity X. For example, if consumers disposable income decreases due to increase in income tax, he may be able to buy only L units of X instead of L. The is true for the whole range of prices of X; consumers would be able to buy less at all other prices. This will cause a downward shift in demand curve D to D. Similarly, increase in disposable income of the consumer due to, say, reduction in taxes may cause an upward shift in D to D. Such changes in the location of demand curves are known as shift in demand curve.

Shift In demand Curve

DETERMINANTS OF MARKET DEMAND

Price of the Product The price of product is one of the most important determinants of its demand in the long run, and the only determinant in the short run. The price and quantity demand are inversely related. Price of the Related Goods The demand for a commodity is also affected by the changes in the price of its related goods. Related gods may be substitutes or complementary goods. Substitutes. Two commodities are deemed to be substitutes for each other if change in the price of one affects the demand for the other in the same direction. Tea and coffee, hamburgers and hot-dog, alcohol and drugs are some examples of substitutes in case of consumer goods. By definition, the relation between demand for a product and price of its substitute is of positive nature. A commodity is deemed to be a complement for another when it complements the use of the other or when the use of the two goods goes together so that their demand changes (increases or decreases) simultaneously. For example, petrol is a complement to car and scooters, butter and jam to bread, milk and sugar to tea and coffee, mattress to cot, etc. Two goods are termed as complementary to each other if an increase in the price of one causes a decrease in demand for the other. By definition, there is an inverse relation between the demand for a good and the price of its complement. Consumers Income Income is the basic determinant of quantity of a product demanded since it determines the purchasing power of the consumer. That is why the people with higher current disposable income spend a larger amount on goods and services than those with lower income. Income-demand relationship is of more varied nature than that between demand and its other determinants. Essential consumer goods (ECG). The goods and services of this category are called basic needs and are consumed by all persons of a society, e.g., food grains, salt, vegetable oils, matches, cooking fuel, a minimum clothing and housing. Quantity demanded of this category of goods increases with increase in consumers income but only up to certain limit, even though the total expenditure may increase in accordance with the quality of goods consumed, other factors remaining the same. Inferior goods. In economic sense, a commodity is deemed to be inferior if its demand decreases with the increase in consumers income. The relation between income and demand for an inferior goods is negative in nature Normal goods. Technically, normal are those which are demanded in increasing quantities as consumers income rises. Clothings, household furniture and, automobiles are some of the important examples of this category of goods. The nature of relation between income and demand for such good increases with the increases in income of the consumer, but at different rates at different levels of income. Demand for normal goods increases rapidly with the increase in the consumers income but slows down with further increase in income.

Prestige and luxury goods. Prestige goods are those which are consumed mostly by rich section of the society, e.g., precious stones, antiques, rare, paintings, luxury cars and such other items of show-off. Demand for such goods arises beyond a certain level of consumers income i.e. consumption enters the area of luxury goods.

Consumers taste and preference Consumers taste and preference play an important role in determining demand for a product, Taste and preference depend, generally, on the changing lifestyle, social customs, religious values attached to a commodity, habit of the people, the general levels of living of the society, and age and sex of the consumers. Change in these factors changes consumers taste and preferences. As a result, consumer reduce or give up the consumption of some goods and add new ones to their consumption pattern. Advertisement Expenditure Advertisement costs are incurred with the objective of promoting sale of the product. Advertisement helps in increasing demand for the product in at least four ways: (a) by informing the potential consumers, about the availability of the product; (b) by showing its superiority to the rival product; (c) By influencing consumers choice against the rival products; and (d) by setting fashions and changing tastes. The impact of such effects shifts the demand upward to the right. IN other words, other factors remaining the same, as expenditure on advertisement increases, volume of sale increases to an extent Consumers Expectations Consumers expectations regarding the future prices, income, and supply position of goods, etc. play important role in determining the demand for goods and services in the short run. If consumers expect a rise in the price of a storable commodity, they would buy more of if at its current price with a view to avoiding the pinch of price-rise in future. ON the contrary, if consumers expect a fall in the price of certain goods, they postpone their purchase of such goods with a view to taking advantage of lower prices in future, mainly in case of nonessential goods. This Behaviour of consumers reduces the current demand for the goods whose prices are expected to decrease in future. Consumer-Credit Facility Availability of credit to the consumers from the sellers, banks, relations and friends or from any other source encourages the consumers to buy more than what they would buy in the absence of credit availability. That is why, the consumers who can borrow more can consume more than those who cannot borrow Credit facility affects mostly the demand for durable goods, particularly those which require bulk payment at the time of purchase Population of the Country The total domestic demand for a product of mass consumption depends also on the size of the population. Given the price, per capita income, taste and preference etc., the larger the population, the larger the demand for a product with an increase (or decrease) in the size of population, employment percentage remaining the same, demand for the product will increase (or decrease).

Distribution of National Income The distribution pattern of the national income is also an important determinant of a product. If national income is evenly distributed, market demand for normal goods will be the largest. If national income is evenly distributed, market demand for normal goods will be the largest. If national income is unevenly distributed, i.e., if majority of population belongs to the lower income groups, market demand for essential goods, including inferior ones, will be the largest whereas the demand for other kinds of goods will be relatively less.

DEMAND FUNCTION
Demand function states the relationship between the demand for a product (the dependent variable) and its determinants (the independent variables). Df={ P,C, N, PO, PC, T, L, I.) Where Df= demand function P= Price C=consumer Preference N=National Income PO=Population PC=Price of related goods T=Technology L=Legislation I=Income

ELASTICITIES OF DEMAND
ELASTICITY CONCEPT
We have earlier discussed the nature of relationship between demand and its determinants. Form a managerial point of view, however, the knowledge of nature of relationship alone is not sufficient. What is more important is the extent of relationship or the degree of responsiveness of demand to the changes in its determinants, it, elasticity of demand. The concepts of demand elasticity's used in business decisions are: Price-elasticity; Cross-elasticity; Income-elasticity;

PRICE ELASTICITY OF DEMAND

Price elasticity of demand is generally defined as the responsiveness or sensitiveness of demand for a commodity to the changes in its price. More precisely, elasticity of demand is the percentage changes in demand as a result of one per cent in the price of the commodity. Percentage change in quantity demanded ep == -----------------------Percentage change in price

Values for price elasticity of demand

If Ped = 0 demand is perfectly inelastic - demand does not change at all when the price changes the demand curve will be vertical. If Ped =INFINITY demand is perfectly elastic - demand change infinitely with a slight change in price the demand curve will be horizontal. If Ped is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the percentage change in price), then demand is inelastic. If Ped = 1 (i.e. the % change in demand is exactly the same as the % change in price), then demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at each price level. If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example if a 10% increase in the price of a good leads to a 30% drop in demand. The price elasticity of demand for this price change is 3

Perfectly Elastic demand: Quantity demanded will go from 0 to infinity at a particular product price. That is, if the price isnt right, 0 is demanded, as soon as the price is right, infinite amounts will be demanded. Ed = infinity

Elastic Demand demand for a product is elastic if its price elasticity is greater than 1.(resulting percentage change in quantity demanded is greater than the percentage change in price)

Unit Elasticity The elasticity coefficient of demand or supply is equal to 1. (percentage change in quantity is equal to percentage change in price)

Inelastic Demand demand for a product is inelastic if its price elasticity is less than 1. (resulting percentage change in quantity demanded is less than the percentage change in price)

Perfectly Inelastic Demand Quantity demanded does not respond to a change in price. Ed = 0

CROSS-ELASTICITY OF DEMAND
The cross price elasticity of demand (CPE) measures the responsiveness of quantity demanded to changes in the price of a substitute good or a complementary good, holding all else constant. For example, if the price of coke changes, how does this affect the quantity demanded of Pepsi, holding the price of Pepsi constant?

Percentage change in quantity demanded of Product X Epxy == -----------------------Percentage change in price of Product Y Example 1: Consider two goods, good X and good Y. Suppose the price of good X rises from $6 to $7. The increase is the price of good X is demonstrated by a movement along the demand curve for good X. As a result of the increase in the price of good X, the demand for good Y increases. At a given price of good Y, the quantity demanded increases from Qe to Qf. Note: the price of good Y does not change; the price of good X has changed and the consumer responds to this change by buying more of good Y. In my example, the increase in the price of good X causes an increase in the quantity demanded of good Y. there is a positive relationship between the change in the price of X and the change in the quantity demanded of Y. X and Y are substitute goods Example: the cross price elasticity between the price of Coke and the quantity demanded of Pepsi.

Suppose Price of Coke Demand for Pepsi increases (shifts right). At a given price of Pepsi, quantity demanded of Pepsi increases. positive relationship between the price of Coke and the quantity demanded of Pepsi.

Example 2: Consider two goods, good A and good B. Suppose the price of good A rises from $5 to $6. The increase is the price of good A is demonstrated by a movement along the demand curve for good A. As a result of the increase in the price of good A, the demand for good B decreases. At a given price of good Y, the quantity demanded decreases from Qg to Qh. In this example, the increase in the price of good A causes a decrease in the quantity demanded of good B. there is a negative relationship between the change in the price of good A and the change in the quantity demanded of good B. A and B are complementary goods
Example: the cross price elasticity between the price of donuts and the quantity demanded of coffee. Suppose Price of donuts demand for coffee decreases (shifts left). At a given price of coffee, quantity demanded of coffee decreases. negative relationship between the price of donuts and the quantity demanded of coffee. donuts and coffee are complements.

INCOME-ELASTICITY OF DEMAND
The income elasticity of demand (I ) measures the responsiveness of quantity demanded to changes in consumer income Percentage change in quantity demanded I E== -----------------------Percentage change in Income An example will help demonstrate what it is that the income elasticity measures. The graph shows what happens to Janets demand for coffee when her income changes.

At point c, the price of coffee is $3.00, Janets income is $500/week and Janets quantity demanded is 5 cups. When her income rises to $700/week, her demand curve shifts right. She is now willing to buy 8 cups, at the same price. This is given by point w on the new demand curve D1.

In Example 1, Janets quantity demanded increases when her income increases. To Janet coffee is a normal good. The income elasticity coefficient for a normal good is positive.

At point c, the price of coffee is $3.00, income is $500/week and quantity demanded is 5 cups. When income rises to $700/week, quantity demanded has now falls to 3 cups, corresponding to point x on the new demand curve D1. quantity demanded decreases when income increases. Here coffee is an inferior good. The income elasticity coefficient for an inferior good is negative. Zero Income Elasticity: when change in income has no infuence on the demand of the commodity it is known as Zero Income elasticity