Theory of Demand PDF

THEORY OF DEMAND 2 CHAPTER Objectives In the first chapter we learnt that the basic economic problem faced by all societies is that of allocating scarce resources among competing uses in an attempt to satisfy the unlimited demands Before looking in detail at...

THEORY OF DEMAND 2 CHAPTER Objectives In the first chapter we learnt that the basic economic problem faced by all societies is that of allocating scarce resources among competing uses in an attempt to satisfy the unlimited demands Before looking in detail at the working of the price mechanism we first study separately the theory of demand and supply. In this chapter, we are going to concentrate on the theory of demand. Definition of Demand Demand is defined as the ability and willingness to buy a particular commodity or service at a given period of time. Demand for a commodity in economic sense arises when there is a need for the commodity and when the consumers have the money to pay for it Demand Demand curve may be defined as the graphic representation of the individual’s demand schedule The individual demand schedule for commodity X on the other hand shows the alternative quantities of commodity X that the consumer is willing to purchase at various alternative prices for commodity X while keeping other factors constant in a given period of time The quantity of the commodity that an individual is willing to purchase over a specific time period depends on the price of the commodity, his/her money income, prices of other commodities, tastes, advertisement, population, expectation and other relevant variables. By varying the price of the commodity under consideration, while keeping constant everything else (ceteris paribus), we get the individual’s demand schedule for the commodity. Table 2.1: An individual’s demand schedule for commodity X but1 Px (LE) Qdx 6 0 5 1 4 2 3 3 2 4 1 5 0 6  By plotting each pair of values of quantity but1 demanded and their corresponding prices on a graph and joining the resulting points, we Price get the individual’s demand curve for a 6 commodity X depicted in figure 2.1 below. 5 4 3 2 1 quantity 0 1 2 3 4 5 6 Figure 2.1:Individual’s Demand Curve for Commodity X  The Law of Demand but1 The law of demand states that "the lower the price the greater is the quantity demanded at a given point in time", ceteris paribus This inverse relationship between the price and quantity demanded is essentially reflected in the negative slope of demand curve as shown in figure 2.1 With an exception of rare cases (Giffen goods and Veblen goods to be explained in section 2.5), the demand curve always slopes downward from left to the right, implying that as the price of the commodity falls, more of it is purchased The behavioral equation for the law of demand is written as follows: Qd x = f ( Px ). This equation states that, the quantity but1 demanded of commodity X is a function of the price of commodity X, all other things being equal You can see from the equation that, we do not explicitly state all the parameters that are being held constant as shown in the following equation; Qdx = f (Px, Po, Y, T, A, P, E, Z) There are three reasons explaining why the but1 quantity demanded tends to fall as price of the commodity rises. First is the substitution effect. When the price of a particular good rises, usually the consumers tend to substitute this commodity for others whose prices have remained unchanged. Second is the real income effect. When the price of a particular good rises, real income of the consumer falls and less of the goods are purchased. Third reason is because of diminishing marginal utility  Exceptions to the Law of Demand Giffen goods, named after the nineteenth century economist Sir Robert Giffen, are very but1 inferior goods for which quantity demanded increases as price rises, and quantity demanded decreases as price falls. An example of this may be found where consumers are so poor that most of their income is spent on a commodity necessary for subsistence Veblen Goods a good whose quantity demanded rises when its price rises. Veblen goods are sometimes called goods of ostentation, like jewelry and the work of original arts. Veblen goods have been named after the American sociologist, Thorsen Veblen. If goods of this type are sold at a very low price, they will lack snob appeal and consequently they will be in less demand. The more expensive these goods are, the snob appeal rises, and more people will desire them. The quality of the product indicator: Some individuals believe that higher prices are an indicator of quality and well-made products, which leads consumers to purchase them. However, this belief may be wrong in some cases, as merchants may exploit this belief by raising their prices to increase the quantity demanded. In such a case, we face an increasing demand function rather than a decreasing one, as is the general rule. Expectation of Price : Sometimes, a drop in prices occurs, and consumers believe this is a precursor to further decreases, so they refrain from or reduce their purchases until the next drop. Conversely, a price increase may occur, and consumers believe it signals more increases to come, prompting them to buy before the next rise. In this case, there is a direct relationship between demand and price, which is an exception to the general rule. Price but1 D P3 P2 P1 D 0 Q1 Q2 Q3 Quantity Figure 2.2: Demand curve for a Giffen or Veblen goods  Determinants of Demand for a Commodity Other than Own Price but1 Demand for Commodity X and the Price of Commodity Y An increase (decrease) in the price of commodity Y may decrease (increase) the quantity demanded of commodity X. In particular, whenever a fall in price of commodity Y causes a fall in the demand for commodity X, then X and Y are substitutes. Substitutes are goods that compete with each other Complementary goods are jointly consumed e.g. tealeaves and sugar. Under normal circumstances, when the price of a kilogram of sugar falls, more of sugar and tealeaves will be purchased Demand for Commodity and the Consumer’s Income but1 When an individual’s money income rises, while other determinants of demand are held constant, the consumer’s demand for that commodity will increase. This increase is reflected in the shift of demand curve to the right. However, for the case of inferior goods, the resultant effect of increased money income would be to reduce the demand for that good. On the other hand, if the demand for the commodity remains unchanged after a certain period of time following a rise in consumer’s income, we usually say that commodity is a necessity. e.g. salt. Demand for a Commodity and the Consumer’s Taste but1 When the consumer’s taste changes in favor of a particular commodity, usually there is a corresponding change in the quantity demanded. For instance, when a particular commodity comes into fashion, usually there is a tendency to buy more of the commodity. This tendency is reflected in the outward shift to the right of the demand curve. On the contrary, if a particular commodity is no longer fashionable to the consumer, the demand curve shifts downward to the left. Demand for a Commodity and the Size of the but1 Population The larger the population of consumers the larger is the demand since in general the larger population will purchase more goods and services than a smaller population. Demand for housing is greater in populous cities compared with low populated cities  but1 Demand for a Commodity and Advertisement. Lack of information concerning the price and availability of a particular commodity is one of the factors, which may prevent the commodity from reaching those consumers who would benefit from it. Advertising is thus meant to provide information to consumers to buy a particular brand name rather than rivals. In this way, the demand for a particular product may be purchased in large quantities as a result of rigorous advertisement. Expectation and Demand for a Commodity but1 Demand for a particular good may rise in the face of mounting uncertainties with regard to the possible rise in the price of a particular good in the future. This is particularly so during the inflationary period when prices are persistently and abruptly rising. In such a situation, consumers may buy a plethora of goods as a hedge against price rise. Another case is when the consumer speculates future price rise following an increase in tax, increase in the cost of production, or sometimes declined production as a result of natural and man made catastrophes. Other Related Factors and the Demand for a but1 Commodity. Other factors such as religious beliefs, taboos, social and cultural differences may have an impact on demand for a commodity. In purely Muslim communities for examples, it is strictly forbidden to eat pork. In such communities, pork is not a commodity to be sold Change in Demand versus Movement along the but1 Demand Curve Change in demand refers to shift in demand curve whereas change in quantity demanded refers to the movement along the same demand curve. Change in demand is caused by change in any of the factors other than own price changes. Figure 2.3 shows a shift in demand curve.  Price but1 D D* P* D D* 0 X1 X2 Quantity Figure 2.3: Change in Demand The demand curve shifting to the right indicates an increase in demand  6 5 A but1 4 B 3 C 2 D 1 E 0 1 2 3 4 5 6 Quantity Figure 2.4: Change in Quantity Demanded Figure 2.4 shows that when the price of commodity X changes from LE 5/= to LE 2/=, the quantity demanded of commodity X changes from 1 unit to 4 units per unit of time. The demand curve does not shift. The change in quantity demanded is seen as movement along the same demand curve from point A to D  but1 The Market Demand for a Commodity The market demand for a commodity gives the alternative amounts of the commodity demanded per time periods at various alternative prices, by all the individuals in the market. The market demand for a commodity thus depends on all the factors that determine the individual’s demand and in addition on the number of buyers of the commodity in the market. Geometrically, the market demand curve for a commodity is obtained by the horizontal summation of all individuals' demand curves for a commodity. THE END Income along the demand curve. a) increases B) decreases but1 C) is held constant D) either increases or decreases Which of the following will NOT cause a shift in the demand curve for DVDs? A) a change in income B) a change in wealth C) a change in the price of prerecorded VHS tapes D) a change in the price of DVDs The law of-------- implies that as prices fall,------. A) demand; demand increases B) demand; demand falls C) demand; quantity demanded increases D) supply; supply According to the law of demand there is negative relationship between and. A) price; demand B) quantity; income C) price; income D) price; quantity If the demand for mac and cheese decreases as income increases, but1 mac and cheese is a(n) A) complementary good. B) normal good. C) inferior good. D) substitute good If the demand for green tea increases as income increases, green tea is a(n) A) complementary good. B) substitute good. C) normal good. D) inferior good Suppose the demand for lawnmowers goes down when the price of gasoline goes up. We can say that these two goods are A) complements. B) substitutes. C) unrelated goods. D) perfect substitutes During an economic upturn when consumer income rises, the demand for caviar increases and the demand for hummus decreases. This implies that caviar A) and hummus are complements. B) is a normal good and hummus is an inferior good. C) is an inferior good and hummus is a normal good. D) is an economic bad and hummus is an economic good An increase in demand for laptop computers would likely be caused by A) an increase in the price of a substitute good. but1 B) an increase in the price of laptop computers. C) an increase in the price of a complementary good. D) a decrease in the price of laptop The quantity demanded of Coca Cola has increased. The best explanation for this is that A) the price of Pepsi has decreased. B) Coca Cola has instituted a new, successful advertising campaign. C) the price of Coca Cola has decreased. D) Coca Cola consumers had an increase in income