Law of Demand and Elasticity of Demand

LEARNING OUTCOMES

  • Explain the meaning of Demand.
  • Describe what Determines Demand.
  • Explain the Law of Demand.
  • Explain the difference between Movement along the Demand Curve and Shift of the Demand Curve.
  • Define and Measure Elasticity.
  • Apply the Concepts of Price, Cross and Income Elasticities.
  • Explain the Determinants of Elasticity.

CHAPTER OVERVIEW

  • Demand
    • Law of Demand
      • Demand Schedule
      • Demand Curve
        • Expansion and Contraction of Demand
        • Increase and Decrease in Demand
    • Determinants
    • Elasticity of Demand
      • Price
      • Income
      • Cross
      • Advertisement
  • Supply
    • Determinants of Supply
    • Law of Supply
      • Supply Schedule
      • Supply Curve
        • Expansion & Contraction of Supply
        • Increase & Decrease in Supply
    • Elasticity of Supply
    • Determinants
  • Theory of Consumer Behaviour
    • Marginal Utility Analysis
    • Indifference Curve Analysis

INTRODUCTION TO DEMAND AND SUPPLY

  • Scenario: Aroma Tea Limited is considering diversifying into the green tea business.
    • CEO Rajeev Aggarwal asks marketing head Sanjeev Bhandari questions about the market pulse, competition, demand effects, luxury vs. necessity, key determinants, and potential consumer shift.
    • The CEO requests a report justifying the green tea venture's potential over the next five years.
  • Relevance: Businesses and managers often face similar questions when assessing market opportunities.
    • Understanding demand and supply answers questions about price changes due to weather, wars, pandemics, or discoveries. It clarifies why some producers can charge higher prices.
  • Market System: Governed by market mechanism; demand and supply determine commodity/service price and quantity.
    • Buyers = demand side; sellers = supply side.
    • Firms need to know how much of their products buyers want.
    • Buyers include consumers, businesses, and government.
    • Quantity buyers buy at a given price determines market size.
    • Market size significantly determines a firm's prospects.
  • Competitive Market: Demand and supply model suitably describes behaviour.
    • Demand and supply refer to buyer and seller behaviour in markets.
    • Understanding demand and supply theory is essential for business firms.
  • Unit Focus: This unit studies the theory of demand; supply theory is discussed in Unit-3.

MEANING OF DEMAND

  • Demand refers to the quantity of a good/service buyers are willing and able to purchase at various prices during a given period.
  • Demand involves more than just the desire to purchase; desire is one element, but real-world constraints like prices and limited means also matter.
  • Effective Demand Depends On:
    • Desire
    • Means to purchase
    • Willingness to use means for purchase
  • Desire must be backed by purchasing power and willingness to pay to constitute demand.
  • Effective demand is key for economic analysis and business decisions.
    • The quantity demanded is always expressed at a given price; different prices yield different quantities demanded.
    • Quantity demanded is a flow, related to a continuous stream of purchases over a time period (e.g., per day, per week).
  • Definition: Demand refers to the various quantities of a given commodity/service consumers would buy in a specific market during a given period, at various prices, incomes, or prices of related goods.

WHAT DETERMINES DEMAND?

  • Understanding common determinants of demand and their relationships is crucial for estimating market demand.
  • Numerous factors influence demand, with varying importance and measurability.
  • Important Factors Determining Demand:
    • (i) Price of the Commodity:
      • A key determinant.
      • Ceteris paribus (other things being equal), demand is inversely related to price.
      • Price increase leads to a fall in quantity purchased, and vice versa, due to income and substitution effects.
    • (ii) Price of Related Commodities:
      • Two types: complementary goods and competing goods (substitutes).
      • Complementary Goods:
        • Bought/consumed together (e.g., tea and sugar, automobile and petrol, pen and ink).
        • Increase in demand for one causes an increase in demand for the other.
        • Fall in price of one (other things equal) causes demand for the other to rise (e.g., cheaper petrol cars increase petrol demand).
        • There is an inverse relation between the demand for a good and the price of its complement.
      • Competing Goods/Substitutes:
        • Satisfy the same want and can be used in place of each other (e.g., tea and coffee, ink pen and ball pen, different brands of toothpaste).
        • If the price of a product rises, buyers may switch to a cheaper substitute, decreasing demand for the original product but increasing demand for the substitute.
        • Fall in price of a product (ceteris paribus) leads to a fall in the quantity demanded of its substitutes.
        • There is a direct or positive relation between the demand for a product and the price of its substitutes.
    • (iii) Disposable Income of the Consumer:
      • Purchasing power is determined by disposable income.
      • Ceteris paribus, demand depends on disposable income.
      • Increase in disposable income tends to increase demand, while a decrease lowers quantity demanded.
      • The relationship between disposable income and quantity demanded depends on the nature of goods.
        • Normal Goods:
          • Demand increases as income increases (e.g., household furniture, clothing, automobiles).
          • Demand falls when income is reduced (e.g., recession).
        • Inferior Goods:
          • Quantity demanded rises only up to a certain income level, then decreases with further income increases.
        • Essential Consumer Goods:
          • Satisfy basic necessities (e.g., food grains, fuel, cooking oil).
          • Change in income causes a less than proportionate increase in demand, because the relative importance of non-durable goods declines as people become richer.
        • Luxury Goods:
          • Demand arises beyond a certain income level and keeps rising as income increases.
      • Business managers should be aware of the nature of goods they produce and how quantities demanded relate to changes in buyers' incomes.
      • They should recognize the movements in macroeconomic variables that affect buyers’ incomes to assess current and future demand.
    • (iv) Tastes and Preferences of Buyers:
      • Demand depends on tastes and preferences, which change over time.
      • Modern or fashionable goods have higher demand than old or unfashionable ones.
      • Consumers may discard a product before it is fully utilized in favor of a more fashionable one.
      • External effects on utility such as ‘demonstration effect,’ ‘bandwagon effect’, Veblen effect, and ‘snob effect’ play important roles.
        • Demonstration effect:
          • Coined by James Duesenberry; refers to the desire to emulate others' consumption behaviour.
          • People buy things because they see others have them (e.g., an individual’s demand for cell phone may be affected by seeing a new model in a friend’s house).
        • Bandwagon effect:
          • Extent to which demand increases because others are consuming the same commodity.
          • Represents the desire to be fashionable, stylish, or conform to people they wish to associate with.
        • Snob effect:
          • Extent to which demand decreases because others are consuming the same commodity.
          • Represents the desire to be exclusive and different from the