UNIT II

Demand: Concept & Definition

Demand is an effective desire or want for a commodity/ service, which is backed by the ability to pay and the willingness to pay
Need/ Desire/ Want Ability to pay Willingness to pay

The Law of Demand

Ceteris paribus, the higher the price, the lower the demand and vice versa

Demand Schedule, Demand Curve & Demand Function

The Law of Demand may be exhibited arithmetically in the form of a table showing prices and the corresponding quantities. This table is known as the Demand Schedule

The Demand Schedule when portrayed graphically in the form of a chart is known as a Demand Curve.

 A Demand Function is stated in terms of a mathematical expression bringing out the relationship between the demand for the product and its various determining variables. In composing the demand function for a product, therefore, one should identify and enlist the most important (key) variables that affect its demand.
Symbolically it may be expressed as: Dx = f (Px, Ps, Pc, Yd, T, A, N,u)

Characteristics
Inverse relationship & therefore a negative slope Price is the independent variable and quantity demanded is the dependent variable

1) 2) 3)

Assumptions underlying the Law of Demand:

No change in income No change in consumers preference No change in fashion No change in relative prices No specultive practices No change in weather conditions No change in govt. policies

4)
5) 6) 7)

Determinants (Factors Affecting) of Demand

The law of demand, while explaining the price-demand relationship assumes other factors to be constant. In reality however, these factors such as income, population, tastes, habits, preferences etc., do not remain constant and keep on affecting the demand. As a result the demand changes i.e. rises or falls, without any change in price. Income: The relationship between income and the demand is a direct one. It means the demand changes in the same direction as the income. An increase in income leads to rise in demand and vice versa. Population: The size of population also affects the demand. The relationship is a direct one. The higher the size of population, the higher is the demand and vice versa. Tastes and Habits: The tastes, habits, likes, dislikes, prejudices and preference etc. of the consumer have a profound effect on the demand for a commodity. If a consumers dislikes a commodity, he will not buy it despite a fall in price. On the other hand a very high price also may not stop him from buying a good if he likes it very much.

Determinants (Factors Affecting) of Demand

Other Prices: This is another important determinant of demand for a commodity. The effects depends upon the relationship between the commodities in question. If the price of a complimentary commodity rises, the demand for the commodity in reference falls. E.g. the demand for petrol will decline due to rise in the price of cars and the consequent decline in their demand. Opposite effect will be experienced incase of substitutes. Advertisement: This factor has gained tremendous importance in the modern days. When a product is aggressively advertised through all the possible media, the consumers buy the advertised commodity even at a high price and many times even if they dont need it. Fashions: Hardly anyone has the courage and the desire to go against the prevailing fashions as well as social customs and the traditions. This factor has a great impact on the demand. Imitation: This tendency is commonly experienced everywhere. This is known as the demonstration effects, due to which the low income groups imitate the consumption patterns of the rich ones. This operates even at international levels when the poor countries try to copy the consumption patterns of rich countries.

Movement (extension/contraction) in the Demand Curve

 Movement along the same demand curve is the extension or contraction in the quantity demanded due to changes in the price (as a function of demand) alone Variation is the connotation of the Law of Demand.

Shift (increase/decrease) in the Demand Curve

 Changes in the quantity demanded as a result of the change in the other determinants of demand, causes a shift either upwards (increase) or downwards (decrease) resulting in a new Demand Curve.

Exceptions to the Law Of Demand

Veblen goods, purchased mainly for their snob appeal, e.g.) diamonds, pricey watches, luxury cars, etc. Speculative goods Giffen goods, i.e. those which fall in the category of inferior goods Psychological biases

Individual & Market Demand

The number of units of a commodity that an individual consumer is willing to buy corresponding to each conceivable price for that given commodity, per unit of time, is called Individual Demand . The cumulative quantities of a commodity demanded in aggregate by all the consumers in the market at different prices over a given period of time is the Market Demand.

Determinants
Price of the commodity Income of the consumer Tastes, habits & preferences Price of substitute goods Price of complimentary goods Consumers expectations Advertisement effect Customs Climate or weather conditions Tax structure Age and gender composition of the population Inventions and Innovations

Elasticity of Demand
The degree of responsiveness of quantity demanded corresponding to a unit change in price

Measurement of Price Elasticity

Ratio method
ed = (%change in Q)/ (%change in P)

Total Revenue (Outlay) method

Price Increases TR/ TO Constant e=1 Type of Elasticity (e)

Decreases Constant Increases Decreases

Decreases Increases
Increases Increases

e>1

Decreases Decreases

e<1

Point elasticity

Assignment on Arc Elasticity

Factors influencing Elasticity of Demand

Nature of commodity Availability of substitutes Number of uses Consumers income Proportion of expenditure Height and Range of price change Time factor in adjustment of consumption pattern

Income Elasticity of Demand

The Income Elasticity of Demand measures the rate of response of quantity demand due to a raise (or lowering) in a consumers income. The formula for the Income Elasticity of Demand is given by : edy= (%change in Q)/ (%change in Y)

Types of Income Elasticities

Income Elasticity of Demand Greater than One: When the percentage change in demand is greater than the percentage change in income, a greater portion of income is being spent on a commodity with an increase in income- income elasticity is said to be greater than one.

Income Elasticity is unitary: When the proportion of income spent on a commodity remains the same or when the percentage change in income is equal to the percentage change in demand, EY = 1 or the income elasticity is unitary.
Income Elasticity Less Than One (EY< 1): This occurs when the percentage change in demand is less than the percentage change in income. Zero Income Elasticity of Demand (EY=o): This is the case when change in income of the consumer does not bring about any change in the demand for a commodity. Negative Income Elasticity of Demand (EY< o): It is well known that income effect for most of the commodities is positive. But in case of inferior goods, the income effect beyond a certain level of income becomes negative. This implies that as the income increases the consumer, instead of buying more of a commodity, buys less and switches on to a superior commodity. The income elasticity of demand in such cases will be negative.

Cross Elasticity
The cross-elasticity is the measure of responsiveness of demand for a commodity to the changes in the price of its substitute and complimentary goods. The formula for measuring cross-elasticity of demand for good x relative to prices of good y is given by: edc = (%change in Q of x)/ (%change in price of y)

In short, cross elasticity will be of three types: 1. 2. 3. Negative cross elasticity Complementary commodities. Positive cross elasticity Substitutes. Zero cross elasticity Unrelated goods.

Importance of Elasticity
The concept of elasticity is of great importance both in economic theory and in practice. Theoretically, its importance lies in the fact that it deeply analyses the price-demand relationship. The law of demand merely explains the qualitative relationship while the concept of elasticity of demand analyses the quantitative price-demand relationship. The Pricing policy of the producer is greatly influenced by the nature of demand for his product. If the demand is inelastic, he will be benefited by charging a high price. If on the other hand, the demand is elastic, low price will be advantageous to the producer. The concept of elasticity helps the monopolist while practicing the price discrimination. The price of joint products can be fixed on the basis of elasticity of demand. In case of such joint products, such as wool and mutton, cotton and cotton seeds, separate costs of production are not known. High price is charged for a product having inelastic demand (say cotton) and low price for its joint product having elastic demand (say cotton seeds).

Importance of Elasticity
The concept of elasticity of demand is helpful to the Government in fixing the prices of public utilities. The Elasticity of demand is important not only in pricing the commodities but also in fixing the price of labour viz., wages. The concept of elasticity of demand is useful to Government in formulation of economic policy in various fields such as taxation, international trade etc. (a) The concept of elasticity of demand guides the finance minister in imposing the commodity taxes. He should tax such commodities which have inelastic demand so that the Government can raise handsome revenue.(b) The concept of elasticity of demand helps the Government in formulating commercial policy. Protection and subsidy is granted to the industries which face an elastic demand. The concept of elasticity of demand is very important in the field international trade. It helps in solving some of the problems of international trade such as gains from trade, balance of payments etc. policy of tariff also depends upon the nature of demand for a commodity. In nutshell, it can be concluded that the concept of elasticity of demand has great significance in economic analysis. Its usefulness in branches of economic such as production, distribution, public finance, international trade etc., has been widely accepted.

Types of Demand
1. 2. 3. 4. 5. 6. 7. 8. 9. Direct & Derived demand Domestic & Industrial Demand for Perishable & Durable goods New & Replacement Intermediary & Final demand Individual & Market demand Company & Industry demand Short Run & Long Run demand Seasonal demand & evergreen demand

Demand Forecasting: Meaning, Importance and Steps

1. 2. 3. 4.

Predicting the future demand/ sales for a firms product/ service. Importance/ scope:
Production planning Sales forecasting Control of business Inventory control Growth & long-term investment programmes Economic planning

5.
6.

Types Of Forecasts
Economic and Non-economic Micro and Macro level Active and Passive Short-run and Long-run

Steps in Demand Forecasting

Specifying the objective Determining the time perspective Making choice of the forecasting method Collection of data Estimation and interpretation of results

Methods: Qualitative methods

Consumer survey methods: Complete enumeration Sample survey End- use method

Opinion Poll method: Expert opinion Delphi method

Market studies & experimentation: Market test Laboratory test

Quantitative methods
Statistical methods: Trend projections Barometric methods Econometric methods

Supply Analysis: Concept

In economics, supply is always understood with relation to price and time period. Thus, the supply of a commodity may be defined as the amount of a commodity which the sellers (or producers) are able and willing o offer for sale at a particular price during a certain period of time. Supply and Stock:
Supply comes out of stock Stock determines the potential supply Stock is the outcome of production

Law of Supply
Other things remaining the same, as the price of a commodity increases, its supply increases, and vice versa.

Supply Schedule, Supply Curve & Supply Function

The Law of Supply may be exhibited arithmetically in the form of a table showing prices and the corresponding quantities. This table is known as the Supply Schedule The Supply Schedule when portrayed graphically in the form of a chart is known as a Supply Curve.

Supply Function
A Supply Function is stated in terms of a mathematical expression bringing out the relationship between the supply of the product and its various determining variables. In composing the supply function for a product, therefore, one should identify and enlist the most important (key) variables that affect its supply. Symbolically it may be expressed as: Sx = f (Px, Ps, Pc, Yd, T, A, N,u)

Determinants of Supply
The cost of the FoP The state of technology The market price of the commodity Prices of substitute products Environmental factors Government policies

Supply Curve

Assumptions
No change in the CoP No change in technology No change in govt. policies No change in No change in transportation costs No change in prices of other goods, etc.

Other concepts related with Supply

Expansion & Contraction in Supply vis--vis Increase & Decrease in Supply Elasticity of supply

Consumer & Producer Surplus

Consumer surplus represents the difference between what a consumer is willing to pay and the actual price paid. If a consumer is willing to pay Rs.500 for a gallon of gasoline, and the actual price is Rs.300, then there is a consumer surplus of Rs.200 with the purchase of that gallon of gasoline. The value to the consumer, or marginal benefit, is Rs.500. Value is calculated by getting the maximum price that consumers are willing to pay Producer surplus is defined as the difference between what a producer actually receives (which will be the market price) for a product and the producer's minimum supply price (marginal cost) for that product. If a producer is willing to provide a unit of a good for Rs.300, and actually gets Rs.400, then the producer would have Rs.100 of producer surplus

Consumer & Producer Surplus

Revenue
The demand curve is a tremendously useful illustration for those who can read it. We have seen that the downward slope tells us that there is an inverse relationship between price and quantity. One can also view the demand curve as separating a region in which sellers can operate from a region forbidden to them. But there is more, especially when one considers what an area on the graph represents.

If people will buy 100 units of a product when its price is $10.00, as the picture below illustrates, total revenue for sellers will be $1000. Simple geometry tells us that the area of the rectangle formed under the demand curve in the picture is found by multiplying the height of the rectangle by its width. Because the height is price and the width is quantity, and since price multiplied by quantity is total revenue, the area is total revenue. The fact that area on supply and demand graphs measures total revenue (or total expenditure by buyers, which is the same thing from another viewpoint) is a key idea used repeatedly in microeconomics.

Definition of Revenue: By 'revenue' of a firm is meant the total sale proceeds or the total receipts of a firm from the sale of the output. The various kinds of revenue will be discussed here under three heads: (i) Total Revenue, (ii) Marginal Revenue, (iii) Average Revenue. (i) Total Revenue (TR): Definition: By 'total revenue' of a firm is meant the total amount of sale proceeds or the total receipts of the firm. Example: If a firm producing cloth sells one hundred meters of cloth in the market at $4 per meter, the sale proceeds or the receipts of the firm win be $400. This total sale proceed which a firm has received by selling 100 meters of cloth is called its total revenue. The total revenue varies with the sales of a firm. Formula: Total Revenue = Price x Quantity Sold TR = P.q

(ii) Marginal Revenue (MR):

Definition: Marginal revenue is the addition made to the total revenue by a one unit increase in the volume of sales by the firm in the market. It can also called as the net revenue earned by selling on additional unit of output. Example: For example, if a firm sells 100 meters of cloth at $4 per meters, the total revenue of the firm is $400. If it increases the volume of sale from 100 meters to 101 meters, i.e., by one meter, the total revenue of the firm goes up to $404. The addition of $4 which has taken place in the total revenue by a one unit increase in the rate of sales per period of time is known as marginal revenue. MR can be expressed as follows. MR = TR q

(iii) Average Revenue (AR):

Definition: Average revenue is revenue earned per unit of output. Average revenue is obtained by dividing the total revenue by the number of units sold in the market. Example: For example, a firm sells 200 meters of cloth for $600, then the average, revenue will be 600 / 200 = $3 only. Average revenue represents the average sale price per unit of the commodity. Average revenue curve can also be called demand curve. Formula: Average Revenue = Total Revenue Total Output Sold AR = TR q

In the figure below markets demand and supply curves intersect at point K. KL, i.e. $5 is the market price.

In the figure below DD is the demand curve which an individual firm has to face. A firm whether it produces 5 units or 50 units has to sell its product at the prevailing market price, i.e., at $5. If at any time the aggregate demand rises, and the price settles at PR (i.e., $8), then an individual seller can sell its products at $8. He will face the new demand curve D1 D1 as is shown in the figure.
Under perfect competition, the additional output is sold at the price at which, the first unit is sold. The average revenue curve is, therefore, always equal to marginal revenue and so both the curves AR and MR coincide. For instance, when the market prices of a commodity is $5 per unit, the firm sells 10 units. The total revenue of the firm is $50. If it wishes to sell 11 units, an individual firm cannot alter the market price. So it has to sell the additional units also at $5. The total revenue of the firm by selling 11 units will be $5. The addition made to the total revenue by selling one more unit, i.e.. MR is $5. The average revenue is also found by dividing the total revenue by the number of goods sold $( 50 / 10 = 5, 55 / 11 = 5, 60 / 12 = 5). We therefore, find that in perfect competition marginal revenue, average revenue and price are the same. So these curves also coincide as is illustrated in the schedule and diagram.

Exercise
According to a study, people will not buy more than 100 units at a price of $10.00. To sell more, price must drop. Suppose that to sell the 101st unit, the price must drop to $9.95. What will the marginal revenue of the 101st unit be? Or, in other words, by how much will total revenue increase when the 101st unit is sold?

Revenue Curve of an Individual Firm Under Imperfect Competition:

Under imperfect competition, whether it may take the form of monopoly, duopoly or oligopoly, the demand curve facing the firm is negatively inclined or we can say its slopes downward from left to right. This means that a firm can affect the market price and can sell more goods at lower prices and less at a higher price. Under imperfect competition, the behavior of MR curve is that it lies below the AR curve. As production expands, the distance between the two curves increases. The AR line and the price line is the same as is clear from the schedule given below:

 lt is clear from the above figure that average revenue curve and marginal revenue curve both have a negative slope. MR curve lies below the AR curve because the output is sold subsequently at falling prices

Relationship between TR, MR & AR

End of Unit II