Micro Economics - Unit 2 - Demand & Elasticity of Demand PDF

Demand  DEMAND Demand refers to all quantities of a commodity that the consumer is ready to buy at different possible prices of a that commodity. Quantity demanded refers to a specific quantity to be purchased against a specific price of the commodity.  Demand Schedule Accord...

Demand  DEMAND Demand refers to all quantities of a commodity that the consumer is ready to buy at different possible prices of a that commodity. Quantity demanded refers to a specific quantity to be purchased against a specific price of the commodity.  Demand Schedule According to Professor Samuelson the table relating to the price and quantity demanded is called Demand Schedule. It is of two types: A) Individual Demand Schedule B) Market Demand Schedule Individual Demand scedule  market demand schedule Market Demand Schedule shows total demand of all the consumers in the market at different prices of the commodity.  Demand Curves A Demand Curve is a graphical representation of demand schedule expressing the relationship between different quantities demand at different possible prices. It is of two types: A) Individual demand curve B) Market demand curve Individual demand curve Is a curve showing different quantities of a commodity that one particular buyer is ready to buy at different possible prices at a point of time. MARKET DEMAND CURVE De te r of mi De n a n ma ts nd  Demand Function Demand function shows the relationship between the demand for the commodity and its various determinants. It shows how demand for a product is related to the price of the product and various other determinants.  Types of demand function : Individ Market ual Deman Deman d d functio functio n n and  Individual Demand Function  It shows how demand for a commodity by an individual consumer is related to its various determinants.  The expression used is as under :- Dx = f(Px, Pr, Y, T, E)  Dx = f(Px, Pr, Y, T, E) where, Dx – Demand Px – Price of the commodity Pr – Price of related goods Y – Consumer’s income T – Tastes and preferences and E – Consumer’s expectations Determinants of Demand  Price of commodity: Other things being in constant an increase in price results a decrease in demand and vice versa.  Price of related goods: Demand for a commodity is influenced by change in the price of the related goods. Substitute goods and Complementary goods are related goods. Determinants of Demand  Consumer’s income: Change in the consumer’s income results a change in his demand for goods. An increase in salary results an increase in demand for normal goods and vice versa.  Tastes and preferences: The demand for goods & services depends on consumers tastes and preferences. They are influenced by advertisements and include fashion habits, customs etc. Determinants of Demand  Expectations of consumers: A consumer may decide to change his or her present demand for a particular commodity, if he or she expects a change in the availability of the product or its price in the near future Market Demand Function  The expression used for Market Demand is as under :- Mkt. Dx =f(Px, Pr, Y, T, E, N, Yd)  Mkt. Dx =f(Px, Pr, Y, T, E, N, Yd) where, N – Size of the population and Yd – Distribution of income  TYPES OF GOODS  1.Substitute goods  2.Complementary goods  3.Normal Goods  4.Inferior Goods  Normal goods These are those goods incase of which there is positive relationship between income and quantity demanded as income increases quantity demanded also increases.  Inferior goods These are those goods incase of which there is a negative relationship between income and quantity demanded.as income increases quantity demanded decreases.  SUBSTITUTE GOODS These are the goods which can be substituted for each other. Eg;- Tea and coffee,ball pen and ink pen. Incase of such goods INCREASE in the PRICE of one causes INCREASE in the DEMAND of the other good or vise versa.  COMPLEMENTARY GOODS These are good which complete the demand for each other and are demanded together. Example:- car and fuel, pen and ink, screen and projector , electricity and switch, cable and t.v Incase of complementary goods ,a fall in price of one good causes an increase in the demand of the other good or vise versa.  LAW OF DEMAND  Statement  Other things being constant quantity demand in the commodity increases with a fall in its rise and diminishes with an increase in its price. There is an inverse relationship between price and quantity demanded. That is at higher price, less is demand, and at a lower price, more is demand. schedule price quantity demanded 1 40 2 30 3 20 4 10 Assumption  Law of Demand holds good when other things remains constant. The factors [except price of the commodity] influencing demand. These factors constitute Taste and preferences of the consumer remains constant.  Prices of related goods do not change.  Consumers income is constant.  Consumers do not expect any change in the availability of the commodity as change in its price.  Exceptions  Articles of distinction according to prof. Veblan, articles of distinction have more demand e.g. Diamonds , jewellery, carpets ,etc. have more demand because the price are very well high.  Ignorance: out of ignorance the consumers purchase goods at a higher price as they are not aware of the market price. 3. Fashion goods which are in fashion are expensive, people purchase goods which are in fashion in spite of high price, there by going against the law of demand 4.Giffen goods Giffen goods may be defined as those goods whose price effect is positive & income effect is negative. Positive price effect means that demand falls with the fall in rise.  MOVEMENT’S ALONG THE DEMAND CURVE (1)Extension of demand (2)Contraction of demand Extension of demand  It occurs when quantity demanded increases due to a fall in price of the commodity , other factors like taste & preferences , income of the consumer , expectations etc being constant  y.axis D P E Price E1 P 1 D 0 Q Q1 x.Axis Quantity Contraction of demand  It occurs when the quantity demanded decreases due to a fall in price of the commodity , other factors like income of the consumer , expectations etc being constant  y.axis D P E1 1 Price E P D 0 Q1 Q x.axis Quantity SHIFTS IN DEMAND CURVE (1)Increase in demand (2)Decrease in demand Increase in demand  Refers to a situation when quantity demanded of a commodity increases due to favorable changes in other factors like increase in population , favorable change in fashion , taste etc. price of a commodity remaining constant  D D1 Price E E1 P D1 D 0 Q Q1 x.axis Quantity Decrease in demand  Refers to a situation when quantity demanded of a commodity decreases due to unfavorable changes in other factors such as decrease in consumer income , unfavorable changes in taste , fashion etc. Price of the commodity remaining constant  y.axis D D1 Price E E P 1 D D1 0 Q1 Q x.axis quantity Price elasticity of demand  Is defined as measurement of percentage in quantity demanded in response to a given percentage change in price of a commodity  PRICE ELASTICITY OF DEMAND I. 1 Types of Price Elasticity Of Demand II. 2 Percentage Problems Types of elasticity of demand 1. Perfectly Elastic Demand 2. Perfectly Inelastic Demand 3. Unitary Elastic Demand 4. Relatively Elastic Demand 5. Relatively Inelastic Demand Perfectly Elastic Demand  It refers to a situation when demand is infinite at the prevailing price.  Ed = ∞ (infinite) Fig 1 Perfectly Inelastic Demand  When the quantity demanded does not respond to any change in price of a commodity is called perfectly inelastic demand  Ed = 0 Fig 2  Unitary Elastic Demand  It is a situation when the change in price brings about the same change in quantity demanded  10% decrease in price brings about 10% increase in demand.  Hence Ed = 1 Fig 3  Relatively Elastic Demand  The change in price brings about more than proportion change in demand  10% decrease in price brings about 20% increase in income  Ed > 1 Fig 4  Relatively Inelastic Demand  It is when a change in price brings about less than proportional change in demand.  10% decrease in price brings a 5% increase in demand  Ed < 1 Fig 5  Percentage Problems These are the steps to calculate Price Ed  Find original demand and difference in demand.  Use the formula % change in demand = difference in demand X 100 original demand  Find original price and difference in price  Use the formula % change in price = difference in price X 100 original price Ed = % change in demand % change in price Example 1 Price Demand 20 100 30 50 Demand Original demand = 100 New demand = 50 Difference in demand = 100-50 = 50 % change in demand = difference in demand X 100 original demand = 50 X 100 = 50% 100 Price Original price = 20 New price = 30 Difference in price = 30-20 = 10 % change in price = difference in price X 100 original price = 10 X 100 = 50% 20 Ed = % change in demand = 50 % change in price 50 =1 = unitary elastic demand Geometric method of measuring price elasticity of demand In a Geometric Method of measuring price elasticity of demand, one can measure price elasticity of demand at different points on the demand curve. Its also called point method of measuring elasticity of demand. This method is used with reference to a linear demand curve which is a straight line demand curve. Let us now draw a straight line demand curve and learn it in detail  y M A price P B N x 0 quantity demanded This is how a straight line demand curve is drawn.  Explaination: y M In the diagram, price is represented on the y axis and quantity demanded is A represented on the x axis. MN is the straight line demand curve, P is the specific point on P price the demand curve which divides the curve into two segments PM and PN. B N x 0 quantity demanded  y M ► Ed = ∞ up A ► Ed = > 1 pe rs eg m en price t P ► Ed = 1 “midpoint” low B ► Ed = < 1 er se gm en t N ► Ed = 0 x 0 quantity demanded These are some extra details of a straight line demand curve  Explaination: y M ► Ed = ∞ Elasticity of demand at point P is estimated as the ratio between the upper segment up A ► Ed = > 1and lower segment. pe rs Ed at point P = eg m en price t P ► Ed = 1 “midpoint” low B ► Ed = < 1 er se gm en t N ► Ed = 0 x 0 quantity demanded  Explaination: The following diagram also shows details of Ed at different points of linear demand y M ► Ed = ∞ curve. Following situations are evidents from the diagram At point P Ed = 1 (unitary) At point A Ed > 1 ( relatively elastic) up A ► Ed = > 1 At point M Ed = ∞ (perfectly elastic) pe rs At point B Ed < 1 (relatively inelastic) eg m At point N Ed = 0 (perfectly inelastic) en price t P ► Ed = 1 “midpoint” low B ► Ed = < 1 er se gm en t N ► Ed = 0 x 0 quantity demanded  Some of the important determinants of price elasticity of demand are as follows: Nature of commodity Availability of substitutes Diversity of uses Postponement of use Income level of the buyer Habbit of consumers  A) Nature of commodity : Necessities like salt, oil, text book, vegetables etc. have less than unitary Ed (relatively inelastic demand) whereas luxuries or comforts like air conditioners, furniture, cars have more than unitary Ed (relatively elastic demand) B) Availability of substitutes : Demand for goods which have close substitutes is relatively more elastic because when price of such good increases the consumer has the option of shifting to its substitutes. Goods without close substitutes have less elastic demand. C) Diversity of uses : Commodities that can be put to variety of uses have elastic demand. For instance electricity has multiple uses. It is used for lighting, room heating, air conditioners, cooking etc. if the price of electricity increases its use may be restricted only to important purposes like lighting. Other uses may be abandoned. On the other hand commodity such as paper has only few uses, its demand is likely to be less elastic.  D) Postponement of use : Demand will be elastic for goods, the consumption of which can be postponed, demand for residential houses may be taken as an e.g.. People often differ their demand for residential houses when interest rates on loans are high.  E) Income level of the buyer : Ed for a good also depends on the income level of its buyers. If the buyer of the good has a high income level he will not be bothered by a rise in its price. Accordingly Ed is expected to be low. On the other if income level of the buyer is low, Ed is expected to be high. F) Habbit of consumers : Goods to which consumers become accustomed or habitual will have inelastic demand ; like cigarettes and Tobacco, its because of this factor that the demand for cigarette and liquor does not reduce even when this goods are highly taxed. Relationship between price elasticity and total expenditure Prof. Alfred Marshall works out a relationship between price elasticity of demand and total expenditure. He estimates the degree of price elasticity of demand depending on the change in total expenditure. Following a change in own price of a commodity. He observes three different situations as under.; A) If rise or fall in the old price of a commodity causes no change in total expenditure on the commodity the Ed is unitary. B) If a fall in old price of a commodity causes arise in total expenditure and arise in price causes of fall in total expenditure on the commodity then Ed is > unitary (Ed>1) C) If a fall in old price of a commodity causes a fall in