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FBM 1101 PRINCIPLES OF ECONOMICS

Lecture 3 CONCEPT OF DEMAND

What is demand in economics?

People require goods and services in an economy to satisfy their wants. All goods
and services have wants satisfying capacity which is known as “UTILITY” in economics.
Utility is highly subjective concept; it is different from person to person. Utility (level of
satisfaction) is measured by means of introspection. By demand for goods and services,
economists essentially mean is willingness as well as ability of the consumer in procuring and
consuming the goods and services.

Thus, demand for a commodity or service has two key components (a) desire for a
commodity to satisfy a want of the consumer (b) capability of the consumer to pay for the
good or service. In nutshell therefore we can state that -

When desire is backed by willingness and ability to pay for a good or service then it
becomes Demand for the good or service. Conceptually, demand is nothing but consumer’s
readiness to satisfy desire by paying for goods or services. A desire accompanied by ability
and willingness to pay makes a real or effective demand.

Demand for a good/service is defined as the quantity of a commodity a consumer is


willing & able to purchase at a given price at a given point of time.

Significance of the concept of demand

Demand is one of the most important decision making variables in the present
globalised, liberlised and privatized economy. Under such type of an economy consumers
and producers have wide choice. There is full freedom to both the buyers and sellers in the
market. Therefore demand reflects the size and pattern of the market. The future of a
producer is dependent upon the well analysed consumer’s demand. Even the firm does not
want to make profit as such but want to devote for ‘customer services’ or ‘social
responsibilities’. That is also not possible without evaluating the consumer’s tastes,
preferences, choice etc. All these things are directly built into the economic concept of
demand.

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The survival and the growth of any business enterprise depend upon the proper
analysis of demand for its product in the market. Demand analysis has profound significance
to management for day to day functioning and expansion of the business. Thus the short
term and long term decisions of the management are depend upon the trends in demand
for the product. Any rise or fall in demand for the product has to be to find out reasons and
revised production plans, technology or change in advertisement, packaging, quality etc.

The market system works in an orderly manner because it is governed by certain


Fundamental Laws of Market known as Law of Demand and Supply. The demand and supply
forces determine the price of goods and services in the market. The laws of demand and
supply plays very important role in economic analysis. Thomas Carlyle, the famous 19th
century historian remarked “It is easy to make parrot learned in economics; teach a parrot to
say demand and supply.” The most important function of microeconomics is to explain the
laws of demand and supply, market mechanism and working of the price system.

Individual Demand Schedule

The various quantities of a commodity that a consumer would be willing to purchase


at all possible prices in a given market at a given point in time, other things being equal is
called individual demand.
Individual demand schedule is merely a list of prices together with the quantities that will be
purchased by a consumer.

Individual Demand Schedule can also be defined as a statement showing the varying
quantities of a commodity that would be purchased by consumer at varying prices at a given
time. It represents a functional relationship between price and quantity demanded.

Demand schedule for mango is presented below.

Price per fruit (Rs) Quantity demanded (Nos)


10 2
8 4
6 5

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5 7
4 8
3 10
2 12

At price Rs 10 per mango, consumer is willing to purchase only 2 mangoes. As the


price/ mango start decreasing, consumer is willing to purchase more mangoes.

Market Demand
Market demand is the sum of the demand of all the consumers in a market for a given
commodity at a specific point of time. Assume that in a market there are only three
consumers, viz., A, B and C, with individual demand schedules as presented in the Table
below.

Price / fruit A B C Market demand

10 2 5 0 7

8 4 7 0 12

6 5 9 0 14

5 7 10 0 17

4 8 14 1 23

3 10 16 1 27

2 12 20 2 34

Consumer C is not willing to buy mangoes for any price higher than Rs. 4 per kg. Given the
individual demand schedules, market demand schedule can be worked out at each price
level as indicated in the last column of the table. It is horizontal summation of the demand of
individual consumer at each unit price. The market demand at Rs. 10 per fruit is 7 mangoes
and so on.

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Demand curve

The graphical representation of demand schedule (i.e. quantity and price) is called a
demand curve. Demand curve is obtained by plotting a demand schedule on a graph with
quantity demanded on X axis and price of commodity on Y axis. Demand curve slopes
downward from left to right. It has a negative slope. It shows there is inverse relationship
between price and quantity demanded of a commodity.

The diagrammatic representation of the Demand Curve can be as follows:

Autonomous Demand and Derived Demand

On the basis of dependency of demand of a good on the demand of other goods, we


have two types of demand- autonomous and derived demand.

The goods, whose demand is not linked with the demand of other goods are
supposed to have autonomous demand. Consumer goods are the examples here. The
demand for certain goods is related with the demand for other goods, which is called
derived demand. The demand for fertilizers, pesticides, etc., is a derived demand, for it is
linked with the demand for agricultural products. Thus the goods which are demanded for
their own sake have autonomous demand, while the goods that are required to produce
other goods have derived demand.

KINDS OF DEMAND

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1. Price Demand: It refers to various quantities of a good or service that a consumer would
be willing to purchase at all possible prices in a given market at a given point in time, ceteris
paribus.
2. Income Demand: It refers to various quantities of a good or service that a consumer
would be willing to purchase at different levels of income, ceteris paribus.
Depending on how demand of goods varies in accordance with change in the income of the
consumers, there are three types of goods:
a) Normal goods- Goods for which an increase in income will cause demand to rise and
a decrease in income causes demand to fall. Example- cars, computers, phone etc
b) Inferior Goods- Goods for which an increase in income leads to a decrease in demand
and a decrease in income leads to an increase in demand. For example, necessities
like bread are often inferior goods.
c) Luxury good- A luxury good means an increase in income causes a bigger percentage
increase in demand. For example, HD TV’s would be a luxury good.

3. Cross Demand: It refers to various quantities of a good or service that a consumer would
be willing to purchase not due to changes in the price of the commodity under
consideration, but due to changes in price of related commodities.

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There are two types of related goods- Substitute goods & complementary goods.
Complementary Goods are goods which are used together, e.g. TV and DVD player.
Substitute goods are goods which are alternatives, e.g. Tea & Coffee.

Joint Demand
Certain commodities are to be used together to satisfy a particular want (e.g.) pen
and ink. The demand for such commodities is known as joint demand.

Composite Demand
A commodity can be put to several uses and that commodity may be demanded to
satisfy any one or more of such uses; the demand for such commodities is known as
composite demand (e.g.) Electricity may be demanded for several of the household,
industrial and decorating purposes. Similarly, petrol and coal have composite demand.

LAW OF DEMAND
The law of demand explains the functional relationship between the quantity
demanded of a commodity and its unit price. Law of demand states that other things
remaining constant, if the price of a commodity falls, the quantity demanded of it will rise
and if the price of a commodity rises, its quantity demanded will decline.

Q  1/ P

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Demand varies inversely with the price, other things being equal. The tendency of the
consumer is to buy more quantities of a commodity at a lower price than what he buys at a
higher price.
Law of demand was propounded by Alfred Marshal.

Demand Function

As per the law of demand, demand is function of price provided other things remain
constant

Dx = f (Px)

Where Dx is demand for commodity X, which is dependent variable, and Px is the


price of X, which is independent variable. The demand function if considered as linear or
straight line function can be expressed in the form of following equation:

Dx = a + bPx

Where a and b are constants. 'a' is intercept and 'b' quantifies the relationship
between Dx and Px. The demand - price relationship can be both linear and non-linear.

Determinants of Demand/ Factors affecting demand

i. Price of the commodity- The demand for a product is inversely proportional to its
price. It implies that a rise in price of a commodity brings about a fall in its purchase
and vice versa.
ii. Price of related commodities- When commodities are complements, a rise in the
price of one will cause the demand of the other to fall. When goods are substitutes, a
rise in the price of one commodity will result in a rise in demand for the other
commodity.
iii. Level of income of the households- Other things being equal, the demand for a
commodity depends upon the money income of the household. In most cases, the
larger the average money income of the household, the larger is the quantity
demanded for a particular good.
However, there are certain commodities for which quantities demanded decrease
with an increase in money income. These goods are called inferior goods. Example:

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rice, salt, public transport etc. The commodity for which the demand increases with
an increase in the money income is called superior goods. Example: clothing.
iv. Tastes and preference of consumers- The demand for a commodity also depends
upon tastes and preferences of consumers and changes in them over a period of
time. Goods which are more in fashion command higher demand than goods which
are out of fashion.
v. Other factors

a) Size of population: generally, larger the size of the population of a country or a


region, greater is the demand for commodities in general.
b) Composition of population: If there are more old people in a region, the demand
for spectacles, walking sticks, etc will be high. Similarly, if the population consists
of more children, demand for toys, baby foods, toffees etc will be more.

Movement along the Demand Curve

It refers to change in the quantity demanded due to change in price. It can be either
extension or contraction of demand. Extension of demand means buying more quantity of
commodity at a lower price, while contraction of demand indicates buying less at higher
price.

The terms extension and contraction refer to the movement on the same demand
curve. The downward movement from O to A is extension, while the upward movement
from O to B contraction. Extension and contraction of demand represent the “change in
quantity demanded”. This is purely a price resulted phenomenon of demand changes for a
commodity, while other factors influencing demand are assumed to be at fixed level.

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Shifts in the Demand Curve

It refers to change in demand not due to change in price but due to change in the
values of other variables influencing demand. It can increase or decrease or decrease in
demand. As against extension and contraction of demand, increase and decrease in demand
result in the shifting of the demand curve. Increase in demand means more demand at the
same price or same demand at higher price. On the other hand, decrease in demand means
less demand at the same price or same demand at lower price.

When there is an increase in demand, the demand curve shifts upwards to the right
side of the initial demand curve DD. D1D1 is the new demand curve representing increases in
demand.

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The decrease in demand is indicated by the shift of the demand curve towards left
downwards to the initial demand curve. D2D2 is the demand curve representing decrease in
demand.

Shifters of the demand curve

 Price of the related goods


 Income of the consumers
 Tastes and preference of the consumers
 Population
 Advertisement and Publicity etc

Why does the demand curve slope downward from Left to Right?
The downward sloping nature of demand curve is explained by 3 reasons:

1. Income Effect-
Assuming that money income is fixed, as the price of a good falls, real income - that is,
what consumers can buy with their money income - rises and consumers increase their
demand. Therefore, at a lower price, consumers can buy more from the same money
income, and, ceteris paribus, demand will rise. Conversely, a rise in price will reduce real
income and force consumers to cut back on their demand.
2. Substitution Effect
As the price of one good falls, it becomes relatively less expensive. Therefore,
assuming other alternative products stay at the same price, at lower prices the good
appears cheaper, and consumers will switch from the expensive alternative to the
relatively cheaper one.
3. Law of Diminishing Marginal Utility
Law of Diminishing Marginal Utility states that “As a consumer consumes more and
more units of a specific commodity, the utility from the successive units goes on
diminishing”- Mr. H. Gossen, a German economist

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Later on, Alfred Marshal restated this law as: “The additional benefit which a person
derives from an increase of his stock of a thing diminishes with every increase in the
stock that already has”.

Explanation and Example of Law of Diminishing Marginal Utility:


This law can be explained by taking a very simple example. Suppose, a man is very
thirsty. He goes to the market and buys one glass of sweet water. The glass of water gives
him immense pleasure or we say the first glass of water has great utility for him. If he takes
second glass of water after that, the utility will be less than that of the first one. It is because
the edge of his thirst has been blunted to a great extent. If he drinks third glass of water, the
utility of the third glass will be less than that of second and so on.

Units Total Utility Marginal Utility Total utility - Total satisfaction obtained
from the consumption of all possible units of
1st glass 20 20 a commodity.

Marginal utility - Additional utility derived


2nd glass 32 12 from the consumption of one more unit of
the given commodity. MU can be calculated
3rd glass 40 8 as: MUn = TUn – TUn-1

Where: MUn = Marginal utility from nth unit;


4th glass 42 2
TUn = Total utility from n units; TUn-1 = Total
utility from n – 1 units; n = Number of units
5th glass 42 0 of consumption

6th glass 39 -3

The utility goes on diminishing with the consumption of every successive glass water
till it drops down to zero. This is the point of satiety. It is the position of consumer’s
equilibrium or maximum satisfaction. If the consumer is forced further to take a glass of
water, it leads to disutility causing total utility to decline. The marginal utility will become
negative. A rational consumer will stop taking water at the point at which marginal utility
becomes negative even if the good is free. In short, the more we have of a thing, ceteris
paribus, the less we want still more of that, or to be more precise.

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The law of demand is based on the law of Diminishing Marginal Utility. According to
this law, when a consumer buys more units of a commodity, the marginal utility of that
commodity continues to decline. Therefore, the consumer will buy more units of that
commodity only when its price falls. When less units are available, utility will be high and the
consumer will be prepared to pay more for the commodity. This proves that the demand will
be more at a lower price and it will be less at a higher price. That is why the demand curve is
downward sloping.

Exceptions to the law of Demand


Following are the exceptional cases, where, the law of demand does not hold good.
1. Giffen Goods (Inferior Goods): This phenomenon which is explained below was given
by Sir Robert Giffen. It was named after him as Giffen paradox. This phenomenon
says that rise in price is followed by an extension of demand, while a fall in price is
followed by a reduction in demand for the good.
Robert Giffen of Scotland observed in the 19th century (1840s) that poor people
spent the major portion of their income on a staple item, viz., potato. If the price of
this good rises they will become so poor that they were found to spend less on other
items and buy more potatoes in order to get a minimum diet and keep themselves
alive. Upward-sloping demand curve, which is contrary to the fundamental law of
demand, came to be known as Giffen Paradox.
2. Goods having Prestige value: A few goods like diamonds etc are purchased by the
rich and wealthy sections of society. The prices of these goods are so high that they
are beyond the reach of the common man. The higher the price of the diamond, the
higher its prestige value. So when price of these goods falls, the consumers think that
the prestige value of these goods comes down. So quantity demanded of these
goods falls with fall in their price. So the law of demand does not hold good here.
This is known as ‘snob appeal’/ Veblen effect, which induces people to purchase
items of conspicuous consumption.
Such a commodity is also known as Veblen good (named after the economist
Thorstein Veblen) whose demand rises (falls) when its price rises (falls).
3. Price expectation: When the consumer expects that the price of the commodity is
going to fall in the near future, they do not buy more even if the price is lower.

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On the other hand, when they expect further rise in price of the commodity,
they will buy more even if the price is higher.
4. Fear of Shortage: When people feel that a commodity is going to be scarce in the
near future, they buy more of it even if there is a current rise in price.
5. Basic necessities of life: In case of basic necessities of life such as salt, rice, medicine,
etc. the law of demand is not applicable as the demand for such necessary goods
does not change with the rise or fall in price.

ELASTICITY OF DEMAND

The law of demand says that demand varies inversely with the price, other things
being equal. From the law of demand, we know the direction in which quantity and price are
moving. What is not known is the extent by which quantity demanded is responsive to
changes in price.
Alfred Marshall developed the concept of elasticity of demand which measures the
responsiveness of quantity demanded to changes in price. Elasticity of demand indicates the
degree of relation between quantities demanded changes because of change in price. In fact
elasticity of demand is the rate at which quantity demanded changes because of change in
price.
To be more precise, elasticity of demand is defined as “the relative change in the
quantity demanded to the relative change in the price”. Shows how much & as to what
extent the quantity demanded will change in response to change in factors affecting
demand.

Types of Elasticity of Demand


There are three types of elasticities of demand

1) Price Elasticity of Demand (P)


It is a measure of change in quantity of a commodity demanded in response to
change in the price of that commodity.

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅


P = 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒄𝒐𝒎𝒎𝒐𝒅𝒊𝒕𝒚

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Elasticity along a linear demand curve

2) Income Elasticity of Demand (I)


It measures the responsiveness of demand due to changes in the income of the
income of the consumers in terms of percentage, when other factors influencing
demand viz., price of the commodity, price of substitutes, tastes, preferences, etc., are
kept at constant level.

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅


I = 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒊𝒏𝒄𝒐𝒎𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒄𝒐𝒏𝒔𝒖𝒎𝒆𝒓

Engel Curve

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Engel Curves, named after 19th Century German statistician Ernst Engel, illustrate the
relationship between consumer demand and household income.
Engel curves for normal goods slope upwards – the flatter the slope the more
luxurious the good, and the greater the income elasticity. In contrast, Engel curves for
inferior goods have a negative slope.

Normal goods have a positive income elasticity of demand so as consumers' income


rises more is demanded at each price i.e. there is an outward shift of the demand curve (I >
0). Inferior goods have a negative income elasticity of demand meaning that demand falls
as income rises (I < 0). In case of luxury goods, I > 1, increase in income causes a bigger
percentage increase in demand.

3) Cross elasticity of demand


Demand for one good (X) is also influenced by the price of other related good (Y).
These may be substitutes or complements. It is the ratio of percentage change in quantity
demanded of commodity (X) and percentage change in price of related commodity (Y).

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅 𝒐𝒇 𝒄𝒐𝒎𝒎𝒐𝒅𝒊𝒕𝒚 (𝑿)


CP = 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒓𝒆𝒍𝒂𝒕𝒆𝒅 𝒄𝒐𝒎𝒎𝒐𝒅𝒊𝒕𝒚 (𝒀)

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In case of substitutes, (Tea and Coffee) the cross elasticity of demand is positive and
large. In case of complementary goods (Tea and Sugar) the rise in price of one commodity
brings about the fall in the demand of the other (Eg. Car and Petrol) and hence it is negative.

DEGREES OF ELASTICITY OF DEMAND


Based on the magnitudes of elasticity of demand, it can be categorized into five
degrees as given below.

1) Perfectly Elastic Demand (Ep = )


A slightest change in price of a commodity leads to an infinite change in quantity
demanded. The demand in such a situation is said to be perfectly elastic. The demand is
hypersensitive and the elasticity of demand is infinite. Here the demand curve will be a
horizontal line parallel to X-axis. It is mostly a theoretical concept.

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2) Perfectly inelastic demand (EP = 0)


It is the situation in which change in price of a commodity leaves the demand unaffected.
The price of the commodity may increase or decrease, but the quantity demanded remains
the same. The demand here is insensitive. Elasticity of demand is zero. The demand curve is
vertical to X axis. The case of perfectly inelastic demand is also a theoretical concept.

3) Relatively Elastic demand (EP > 1)


Demand is said to be elastic when percentage change in quantity demanded is larger
than the percentage change in price. A lesser proportionate change in the price of a
commodity is followed by a larger proportionate change in the quantity demanded.
Elasticity of demand is greater than unity.

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4) Relatively Inelastic demand (EP < 1)


It means that large proportionate change in the price of a commodity is followed by a
smaller proportionate change in the quantity demanded. Elasticity of demand is less than
unity.

5) Unitary elastic demand (EP = 1)


When a given proportionate change in price results in the same proportionate
change in the quantity demanded of commodity, the demand is said to be unitary elastic.
Elasticity of demand is one.

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