Demand and Law of Demand Notes

Chapter 2: Demand and Law of Demand

2.1 Introduction

Core Economic Question: Economics seeks to explain why goods have prices and why some are more expensive than others.
Underlying Factors for Prices
- Goods command prices because they are useful and scarce relative to demand.
- Usefulness: People pay for goods they find useful.
- Scarcity: Goods must be limited in supply to command a price.
Free Goods vs. Economic Goods
- Free Goods: Abundant natural gifts (e.g., air) that don't command a price due to unlimited availability.
- Economic Goods: Scarce items (e.g., clothes, food) that have a price due to their usefulness and limited availability.
Demand and Supply Interaction
- Usefulness manifests as demand from buyers.
- Scarcity manifests as supply from sellers.
- Prices are determined by the interaction of demand and supply in a free economy.
Demand and Supply as Economic Tools: They are central to economic analysis.
Paul Samuelson: Often considered the father of modern economics. Made contributions to welfare economics, public finance, international economics, macroeconomics, and consumer theory.
- Authored "Economics, An Introductory Analysis" (1948), a best-selling textbook that introduced economics to millions.

2.2 Meaning of Demand

Definition of Demand: The quantities of a commodity that consumers are willing and able to purchase at various possible prices during a specific period.
Key Aspects of Demand
- Distinction from Desire: Demand is not the same as desire; it requires both willingness and ability to pay.
- Effective demand: Desire + Willingness to purchase + Ability to purchase.
- Price Relation: Demand is always related to a price. Different quantities are demanded at different prices.
- Time Period: Demand is expressed per unit of time (e.g., per day, week, or year), representing a continuous flow of purchases.

2.2.1 Types of Demand

Demand can be classified by:
- Number of consumers
- Nature of the goods
- Interdependence of demand
- Nature of the use of the product
Five Major Types of Demand
- Individual Demand and Market Demand
- Ex Ante and Ex Post Demand
- Joint Demand
- Derived Demand
- Composite Demand
Individual Demand and Market Demand
- Individual Demand: Demand for a commodity by a single consumer (household demand).
  - Example: Quantity of milk purchased per day by an individual.
- Market Demand: Total quantities of a commodity that all households are willing to buy at various prices during a given period.
  - Aggregate demand: the demand of all people in a particular market or the demand for all goods and services in an entire economy.
  - Example: Total quantity of milk all buyers are willing to buy at a given price per day.
Ex Ante and Ex Post Demand
- Ex Ante Demand: The amount of goods consumers want or are willing to buy during a specific time period (planned or desired demand).
- Ex Post Demand: The amount of goods consumers actually purchase during a specific period (actual demand).
- Discrepancy: Ex post demand may differ from ex ante demand due to availability.
Joint Demand: Demand for two or more goods used together (complementary goods).
- Examples: Cars and petrol, butter and bread, milk and sugar.
- Characteristics: Demand changes simultaneously.
- Price Impact: A rise in the price of one good leads to a fall in the demand for the other.
Derived Demand: Demand for a commodity arising from the demand for another commodity.
- Examples: Demand for steel, bricks, cement derived from the demand for houses.
- Factors of Production: Demand for factors like labor is derived from the demand for goods produced by them.
Composite Demand: Demand for goods with multiple uses.
- Example: Demand for steel in making utensils, bus bodies, room coolers, and cars.
- Price Impact: A change in price leads to a large change in demand across all uses.
- Availability: Increased demand for one use decreases availability for another.

2.3 Determinants of Demand/Factors Affecting Demand

Definition: Factors influencing households' decisions to purchase a commodity.
Influencing Factors:
- Price of the commodity
- Prices of other commodities
- Consumers' income
- Tastes of consumers
- Advertisement
- Demonstration effect
- Expectations about future prices
- Size of the population
- Wealth
- Distribution of income
- Government policy
Price of the Commodity
- Inverse Relationship: There is typically an inverse relationship between the price of a commodity and the quantity demanded.
- Price Demand: Different quantities of a commodity purchased at different prices.
Income of the Consumer
- Direct Relationship: Generally, there is a direct relationship between income and demand.
- Types of Goods:
  - Normal Goods (NG)
  - Inferior Goods (IG)
  - Inexpensive Necessities of Life (IN)
- Normal Goods: Demand increases with income increase.
  - Examples: Clothes, refrigerators, television sets, cars.
  - Articles of comforts and luxuries fall under this category.
- Inferior Goods: Demand falls with income increase as consumers switch to superior substitutes.
  - Examples: Coarse cereals (maize, jowar), coarse cloth, black and white television.
- Inexpensive Necessities: Demand increases with income up to a certain level, then remains constant.
  - Examples: Salt, matchbox.
- Income Demand: Functional relationship between demand and income level.
Fig. 1 Relation between Income and Demand: Illustrates the relationship between income and demand for normal, inferior, and inexpensive necessities using curves on a graph.
* NG: Positive slope indicating demand increases with income.
* IG: Demand may increase initially but decreases as income increase beyond a certain point.
* IN: Demand increases up to a level, then becomes constant with further income increase.
Consumers' Tastes and Preferences
- Influence: Tastes depend on social customs, habits, fashion, lifestyle, advertisement, and new inventions.
- Dynamic: These can change, leading to shifts in demand (e.g., from old-fashioned to modern goods).
Prices of Related Goods
- Related Goods: Goods where a change in the price of one affects the demand for the other.
  - Substitute or Competitive Goods
  - Complementary Goods
- Substitute Goods: Goods that satisfy the same need (e.g., tea and coffee).
  - Direct Relationship: Demand for a product (tea) varies directly with the price of its substitute (coffee).
- Complementary Goods: Goods used together (e.g., car and petrol).
  - Inverse Relationship: Demand for a good varies inversely with the price of its complement.
Consumers' Expectations
- Future Prices: Expectations of future price increases lead to increased current demand to avoid higher future prices.
- Future Income: Expectations of increased future income lead to increased current demand.
- Scarcity: Expectations of future scarcity increase current demand.
Consumer-Credit Facilities: Availability of credit increases the demand for certain goods (e.g., cars).
Demonstration Effect: The tendency to emulate the consumption style of others increases demand (e.g., luxury cars, expensive mobile sets).
Factors Affecting Market Demand
- The factors that affect individual demand affect market demand as well.
- Additionally, the market demand depends on the number of consumers, the income distribution and the government's policy.
Size and Composition of Population: The larger the population, the larger is likely to be the number of consumers. An increase in the size of population will increase the demand for a commodity by increasing the number of consumers and, vice versa.
Distribution of Income: If it is unequal, there will be more demand for luxury goods. On the other hand, if the income is evenly distributed, there will be less demand for luxury goods and more demand for essential goods
Climatic Factors: For instance, the demand for ice, fans, air conditioners, cold drinks, cotton cloths, etc. increases in summer.
Government Policy: If the government imposes taxes on various commodities in the form of GST, excise duties, etc., the prices of these commodities will increase. As a result, demand for these commodities will fall.

2.3.1 Demand Function

Definition: States the relationship between the demand for a product and its various determinants.
Algebraic Expression: $D = f(P<em>n, P</em>{n-1}, Y, T, E, H, Y', G…)$
- D: Demand for commodity 'n'
- f: Functional relation
- $P_n$ : Price of commodity 'n'
- $P_{n-1}$ : Prices of other commodities
- Y: Income
- T: Taste
- E: Expectations
- H: Size of population
- $Y'$ : Distribution of income
- G: Government's policy
Dependent and Independent Variables: D is the dependent variable, while all factors on the right are independent variables.

2.4 Law of Demand

Central Concept: Relation between demand and price crucial in price theory.
Definition: Shows the functional relationship between the price and quantity demanded of a commodity.

2.4.1 Statement of the Law

Inverse Relationship: Other things remaining equal, the quantity demanded of a commodity increases when its price falls and decreases when its price rises.

2.4.2 Assumptions

Ceteris Paribus: The law assumes that other factors influencing demand remain constant.
Main Assumptions:
1. No change in consumer income.
2. No change in consumer tastes and preferences.
3. Prices of related commodities remain unchanged.
4. The commodity is a normal commodity.
5. Size and age composition of the population do not change.
6. The distribution of income does not change.
7. No expectation of future price changes.

2.4.3 Demand Schedule

Definition: A table showing the relationship between the price of a commodity and the quantity demanded.
Types:
- Individual Demand Schedule
- Market Demand Schedule
Individual Demand Schedule: Shows quantities purchased at different prices by an individual household.
Market Demand Schedule: Shows quantities purchased at different prices by all buyers in the market.
- Equation example: Total Market Demand = (Quantity Demanded by 'A') + (Quantity Demanded by 'B')

2.4.4 Demand Curve and its Derivation

Definition: A graphic presentation of the law of demand.
Conversion: Demand schedule is converted into a demand curve by plotting price-quantity combinations.
Types:
- Individual Demand Curve
- Market Demand Curve
Individual Demand Curve: Shows quantities an individual consumer is willing to buy at different prices.
Market Demand Curve: Represents quantities all consumers are willing to buy at different prices.
- Derivation: Derived by aggregating individual demand curves horizontally.

2.4.5 Reasons for Downward Slope of the Demand Curve

Law of Diminishing Marginal Utility: Additional units of a commodity provide less satisfaction, so consumers buy more only at lower prices.
$Marginal utility of a commodity = Price of the commodity$
Income Effect: A fall in price increases real income, allowing consumers to buy more of the commodity.
Substitution Effect: Consumers substitute relatively cheaper goods for costlier ones when prices change.
$Price Effect = Income Effect + Substitution Effect$
Increase in Number of Consumers: A fall in price attracts new consumers, raising demand.
Several Uses of a Commodity: Goods with multiple uses are demanded more as their prices fall and they become viable for less important uses.

2.4.6 Exceptions to the Law of Demand

Giffen Goods: Inferior goods where demand falls with a fall in price because consumers switch to superior goods.
- Money income vs real income
Articles of Snob Appeal: Goods that serve as status symbols, where higher prices increase prestige and demand.
Expectations About Future Prices: If prices are expected to rise, people buy more even at higher existing prices.
Emergencies: During crises, demand may increase even at high prices due to expected shortages.
Quality-Price Relationship: Consumers may assume high-priced goods are of higher quality.
Change in Fashion: Out-of-fashion goods may not be purchased even at reduced prices.

2.5 Movement Along the Demand Curve and Shift of the Demand Curve

Key Distinction: Economists differentiate between 'change in quantity demanded' and 'change in demand'.

2.5.1 Change in Quantity Demanded- Movement along the Demand Curve

Definition: Change in amount demanded due to a change in the commodity's own price, with other factors constant.
Types:
- Expansion of Demand
- Contraction of Demand
Expansion of Demand: Quantity demanded rises due to a fall in price.
Contraction of Demand: Quantity demanded decreases due to a rise in price.

2.5.2 Change in Demand - Shift in Demand Curve

Definition: Change in amount purchased due to changes in factors other than the commodity's own price.
Types:
- Increase in Demand
- Decrease in Demand
- Shift Factors include Income and Price
Increase in Demand: Consumers buy a larger amount at the same price.
Decrease in Demand: Consumers buy a smaller quantity at the same price.
- Change in demand results in a shift in the entire demand curve.

2.5.3 Distinction between Expansion of Demand and Increase in Demand

Expansion of demand refers to the larger quantity being purchased due to fall in the price of a commodity, while increase in demand refers to more being purchased at the same price.
Expansion of demand is due to fall in a commodity's own price, while increase in demand is due to change in 'other factors' affecting demand.
Expansion of demand simply involves a downward movement along the same demand curve, but increase in demand results in rightward shift of the entire demand curve.

2.5.4 Distinction between Contraction of Demand and Decrease in Demand

Contraction of demand means a fall in the amount purchased due to rise in a commodity's own price; decrease in demand means smaller amount being purchased at the same price.
Contraction of demand is due to a rise in the own price of a commodity; decrease in demand is due to changes in 'other factors' affecting demand.
Contraction of demand simply means upward movement along the same demand curve, but decrease in demand results in the leftward shift of the entire demand curve.