Class 7-Theory of Demand

8/13/2019 Class 7-Theory of Demand

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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

Class 7-Theory of Demand

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