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Theory of Demand
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Introduction to Demand
Demand is a combination of three factors:
1. Desire to buy
2. Willingness to pay the price3. Ability to pay the price
Absence of any one factor will not create
demand Law of Demand is called as First Law of
Purchase
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The Law of Demand
The price of a good rises and everything elseremains the same, the quantity of the gooddemanded will fall
The words, everything else remains the sameareimportant In the real world many variables change simultaneously
However, in order to understand the economy we mustfirst understand each variable separately
Thus we assume that, everything else remains thesame, in order to understand how demand reacts toprice
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The Demand Schedule
Demand schedule
A list showing the quantity of a good thatconsumers would choose to purchase at different
prices, with all other variables held constant Demand V.S. Quantities demanded
- demand is the entire relationship between price
and quantity represented in demand curve
- quantities demanded are specific amount of goodsbuyers want to buy
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The Demand Curve
The market demand curve (or just demandcurve) shows the relationship between theprice of a good and the quantity demanded ,
holding constant all other variables thatinfluence demand
Each point on the curve shows the total buyerswould choose to buy at a specific price
Law of demand tells us that demand curvesvirtually always slope downward
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Figure 1: The Demand Curve
Number of Bottlesper Month
Price perBottle
A
B
$4.00
2.00
D
40,000 60,000
At $2.00 per bottle,60,000 bottles aredemanded (point B).
When the price is $4.00per bottle, 40,000 bottlesare demanded (point A).
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Why does demand curve slope
downward to right?
Law of diminishing marginal utility
Price effect
Income effect Substitution effect
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Shiftsvs. Movements AlongThe
Demand Curve
Move along the demand curve From a change in the priceof the good we analyze
In Figure 1 A fall in price would cause a movement to the right along the demand
curve (point A to B)
See figure 3(a)
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Figure 3(a): Movements Along and Shifts
of The Demand Curve
Quantity
Price
P2
Q2 Q1 Q3
P1
P3
Price increase moves usleftward alongdemandcurve
Price increase moves usrightward alongdemandcurve
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Shiftsvs. Movements AlongThe
Demand Curve
Shift of demand curve a change in other things than price of the good causes a
shift in the demand curve itself, for example, income
In Figure 2 Demand curve has shifted to the right of the old curve
(from Figure 1) as income has risen
A change in any variable that affects demandexcept forthe goods pricecauses the demand curve to shift
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Figure 2: A Shift of The Demand Curve
B C$2.00
60,000 80,000
D1D2
An increase in incomeshifts the demand curve formaple syrup from D1to D2.
Number of Bottlesper Month
Price perBottle
At each price, more bottlesare demanded after theshift
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Change in Quantity Demandedvs. Change in
Demand
Language is important when discussing demand
Quantity demandedmeans A particular amount that buyers would choose to buy at a specific
price
It is a number represented by a single pointon a demand curve When a change in the price of a good moves us along a demand
curve, it is a change in quantity demand
The term demand means The entire relationship between price and quantity demanded
and represented by the entire demand curve When something other than price changes, causing the entire
demand curve to shift, it is a change in demand
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Income: Factors That Shift The Demand
Curve
An increase in income has effect of shiftingdemand for normal goods to the right
However, a rise in income shifts demand for
inferior goods to the left A rise in income will increase the demand for
a normal good, and decrease the demand foran inferior good
Normal good and inferior good are defined bythe relation between demand and income
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The Impact of a Change in Income
Higher income decreases thedemand for an infer ior good
Higher income increases thedemand for a normal good
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Wealth: Factors That Shift The Demand
Curve
Your wealthat any point in timeis thetotal value of everything you own minus thetotal dollar amount you owe
- Example An increase in wealth will
Increase demand (shift the curve rightward) for a
normal good Decrease demand (shift the curve leftward) for an
inferior good
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The Impact of a Change in the Price
of Related Goods
Price of hamburger rises
Demand for complement good(ketchup) shifts left
Demand for substitute good (chicken)
shifts right
Quantity of hamburger
demanded falls
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Number of buyers
An increase in the number of potential buyers
will increase the demand for the good.
For example, the demand for land increases as
the population increases.
Similarly movie/sports tickets are generally
more expensive in larger cities.
Air tickets in peak season
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Future Prices
An increase in the expected future price of a
good increases current demand.
A decrease in the expected future price of a
good decreases current demand.
For example, when a good is temporarily put
on sale, people stock up on the good.
Prices of financial assets
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Tastes & Quality
Demand curves can shift due to changes in
tastes over time.
For example, demand for Bajaj Chetak
Similarly, demand for Honda Activa
Quality:
Demand curves can shift due to changesquality.
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Small Summary
-- Factors Affecting Demand
Income (depends on goods nature: normal orinferior) [positive and negative respectively]
Wealth (depends on goods nature) [positive and
negative respectively] Prices ofsubstitutes(positively related)
Prices of complements(negatively related)
Population (positively related) Expected price(positively related)
Tastes(positively related)
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Figure 3(b): Movements Along and Shifts
of The Demand Curve
Quantity
Price
D2
D1
Entire demand curve shiftsrightward when:income or wealth price of substitute price of complement population expected price tastes shift toward good
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From Household to Market Demand
Demand for a good or service can be defined
for an individual household, or for a group of
households that make up a market.
Market demandis the sum of all the
quantities of a good or service demanded per
period by all the households buying in the
market for that good or service.
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From Household Demand to Market
Demand
Assuming there are only two households in the
market, market demand is derived as follows:
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Fitting Linear Demand Equation
A mathematical model can be specified as follows: =
where, QD is quantity demanded
a is intercept and
b is slope of the equation
An Econometric model can be specified as follows:
= +
where, is intercept
is slope of the equation and
is the random error term
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Result
QD= 800- 60P
A multivariate specification can be estimated
through Ordinary Least Squares (OLS) method
for forecasting purposes
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Exceptions
Giffen Paradox: Giffen good is one which peopleparadoxically consume more as the price risesand consume less when price falls, violating thelaw of demand.
Example: in 19th century England, price of breadincreased due to nationwide famine but demandsaw an increasing trend.
This was due to the reduced consumption ofother products and diverting the resources tobread.
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Veblen Effect (Conspicuous Consumption):
Goods/services having prestige value or status
symbol, law of demand does not apply.
Speculative Effect: Law of demand does not
apply to speculative market. For e.g. shares,
debentures etc. (i.e. momentum investingbased on algorithm trading, short selling)
Economic Fluctuations: Law of Demand do
not operate during Inflation due to shortageof goods/services or due to increased money
supply
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