3 demand analysis

DEMAND ANALYSIS

If you can’t pay for a thing, don’t buy it.If you can’t get paid for it, don’t sell it.

Benjamin Franklin

Demand

Human wants are unlimited Can I fulfill all my wants? Demand is defined as that want, need or

desire which is backed by willingness and ability to buy a particular commodity in a given period of time.

Demand is the quantity of commodity which consumers are willing to buy at a given price for particular unit of time.

Types of demand

Categories are based on Nature of commodity demanded

(consumer goods and capital goods) Time unit for which it is demanded

(short-run and long-run) Relation between two goods, Etc.

Direct or Derived

Direct – commodity demanded for it’s own sake, i.e. by final consumer

Called consumer goods E.g. TV, cell phones, computer, furniture… Derived – commodity if demanded for using it

either as a raw material or as an intermediary for value addition

Called capital goods E.g. demand for buildings increase => demand

for construction material also increases

Recurring and Replacement demand

Consumer goods => consumables and durables

Consumable goods have recurring demand, i.e. they are consumed at frequent intervals – e.g. eat snacks 3 or 4 times a day, read newspaper everyday, fill petrol once a week

Goods like TV, car, bikes are examples of durable consumer goods – used for a long period of time – they suffer wear and tear over time or obsolescence of technology – they need replacement

Complementary and Competing Complementary goods – jointly demanded -

demand for one commodity is dependent on demand for another.

E.g. car and petrol, computer and software When more than one good is demanded to satisfy

a want, they are called complementary goods Competing goods – goods which independently

satisfy any particular want – called substitutes E.g. coke and Pepsi, investing in government

bonds or company deposits, etc….

Individual or Market demand Demand of an individual consumer Demand for the product of all firms in an

industry – market / industry demand E.g. X’s demand for Maruti Swift is

individual demand Total sale of Swift in the year, say 2009,

is the annual market demand

Determinants of demand

Price of the good Taste or level of desire for the product by the buyer Income of the buyer Prices of related products:

substitute products (directly competes with the good in the opinion of the buyer)complementary products (used with the good in the opinion of the buyer)

Future expectations:expected income of the buyerexpected price of the good.

For the total market demand (rather than Bob's individual one) the number of buyers in the market is also a determinant of the amount purchased.

Law of Demand

Law of Demand states that ceteris paribus, demand for a product is inversely proportional to its price.

Other things remaining constant, when price of a commodity rises, the demand for that commodity falls, and vice versa.

D = f(Px)

Reasons behind Law of Demand Price effect – goods have multiple uses – a fall in

prices induces a consumer to put it to alternative uses, i.e. they are demanded in larger quantities.2. fall in price induces those consumers to buy who could not afford it earlier.

Substitution effect – when price falls, it is substituted for more expensive goods.

Income effect – when price falls, real income of the consumer increases, money income remaining the same – purchasing power increases – buys more.

Movement along the curve

Movement along the same demand curve is expansion / contraction of demand due to fall / rise in price.

In other words, a movement occurs when a change in quantity demanded is caused only by a change in price, and vice versa.

Shift in demand curve

Imagine price of coffee remaining the same, the demand increases – what’s the reason?

A variable other than price has changed – e.g. income of consumers

Can you show it on the demand curve?

A new demand curve has to be drawn.

Shift of demand curve due to change in factors other than price is called a change in demand

Exceptions

Inferior goods - An inferior good is one the consumption of which falls as incomes rise: it has a negative income elasticity of demand. This contrasts with a normal good, the consumption of which increases as incomes rise.

A rare and extreme type of inferior good, a Giffen good, is subject to such a strong income effect that consumption increases with higher prices.

Giffen goods – goods display a direct relationship with price.

The existence of such goods was postulated by the economist Robert Giffen , who observed that, under some circumstances, the poor consume more bread as its price rises.

Such change reflects two interacting effects of a price rise. First, as the price of a good rises, the consumer's purchasing

power declines; for inferior goods, this income effect is positive—the consumer will tend to consume more of the good because superior alternatives are less affordable.

Second, when the price rises relative to other goods, the substitution effect shifts demand toward relatively cheaper alternatives.

These two forces act in opposite directions, making the change in demand theoretically ambiguous. In most circumstances, the substitution effect would be expected to predominate, so that a price increase results in a reduction in quantity purchased. But in circumstances where one inferior good makes up a very large share of the budget (e.g., bread for the poor), consumption of the good may increase due to a price increase.

Veblen goods Veblen goods – goods have snob value – consumer

measures the satisfaction derived not by their utility value but by social status – e.g. diamonds, works of art.

The Veblen effect is named after the economist Thorstein Veblen, who first pointed out the concepts of conspicuous consumption and status-seeking

Some types of high-status goods, such as high-end wines, designer handbags and luxury cars, are Veblen goods, in that decreasing their prices decreases people's preference for buying them because they are no longer perceived as exclusive or high status products.

Similarly, a price increase may increase that high status and perception of exclusivity, thereby making the good even more preferable.

Elasticity

The degree to which a demand or supply curve reacts to a change in price is the curve's elasticity. Elasticity = (% change in quantity / % change in price)

If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.

Elasticity varies among products because some products may be more essential to the consumer.

Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases.

Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become too high.

Elastic goods

A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied.

Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life.

On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life.

Inelastic goods

Inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price.

Factors Affecting Demand Elasticity

The availability of substitutes - most important factor influencing the elasticity of a good or service. In general, the more substitutes, the more elastic the demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an elastic good because a raise in price will cause a large decrease in demand as consumers start buying more tea instead of coffee.

However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.

Amount of income available to spend on the good - This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that is available to spend on coke, which is $2, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.

Time - The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded.  However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

Income elasticity of demand

The degree to which an increase in income will cause an increase in demand is called income elasticity of demand, which can be expressed in the following equation:

Income Elasticity = (% change in quantity / % change in income)

Cross-price elasticity of demand Cross-price elasticity of demand

measures how the quantity demanded of one good changes as the price of another good changes.

Cross-Price Elasticity = (% change in quantity demanded of good x / % change in price of good y)

Cross elasticity is positive or negative depends on whether the two goods are substitutes or complements