session-2

Demand Theory

Learning ObjectivesTo understand the meaning of demand and the basic elements of demand

To understand what influences the demand for products.

To understand the difference between changes in quantity demand and change in demand.

To understand the exceptions to the law

of demand.

Demand Demand

The quantity consumers are willing and able to buy at each possible price during a given time period, other things constant

Amounts purchased per period At each possible price

Willing and able Specific period

Determinants of DemandPRICE

Price has a negative effect on demand.If price of the product falls, its quantity demanded will rise and vice versa.

Determinants of Demand INCOME

Goods can be classified into two broad categories: Normal goods: the demand increases when

income increases and decreases when income decreases

Inferior goods: the demand decreases when income increases and increases when income decreases

Determinants of DemandPRICE OF RELATED GOODS

Substitute Goods- A product that can be used in place of another

product- A change in the price of substitute products

affect the demand for the product in the same direction in which the price change.

- E.g: tea vs coffee( Pcoffee↑ Qdd coffee↓ DDtea↑)

Complementary Goods- A product that is used in conjunction with

another product.- The change in the price of a complementary

product affects the demand for the product in the opposite direction to the change price.

- E.g: a disk and computer

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Determinants of DemandTASTE AND PREFERENCES

A good for which consumer’s tastes and preferences are greater, its demand would be large.

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Determinants of DemandEXPECTATIONS(for income,prices,tastes)The higher the expected future price of a product, the higher the current demand for that product and vice versa

POPULATIONA larger population with a high rate of growth creates greater demand for goods and services.

Law of Demand -There is an inverse relationship between price and quantity demanded.

– Quantity demanded rises as price falls, other things remaining constant (ceteris paribus ) – Quantity demanded falls as pricesrise, other things remaining constant(ceteris paribus)

Law of Demand

The law of demand can be explained by theSubstitution Effect and the Income Effect

Observed change in demand via a price change can be decomposed into a Substitution effect(SE) and an Income effect( IE).

SUBSTITUTION EFFECT-When the price of a good falls, its relative price makes consumers more willing to purchase this good

-When the price of a good increases, its relative price makes consumers less willing to purchase this good

-Changes in the relative prices – the price of one good compared to the prices of other goods – causes the substitution effect

- The consumer tries to substitute the commodity(whose price has decreased) for other commodities. As a result ,demand for the commodity rises

INCOME EFFECTMoney income

Number of rupees received per period of timeReal income

Income measured in terms of the goods and services it can buy

When the price of a good decreases, real income increasesWhen the price of a good increases, real income declinesWith fall in the price of the commodity, income remaining the same, purchasing power of the individual rises, inducing the consumer to buy more of that commodity

Demand Function When we express the relation between demand and its determinants mathematically, the relationship is known as demand function

Dx = f(Px, Y, Po, T, Ef, N)Where Dx - Demand for a product x Px - Price of the commodity x Y – Income of the consumer Po – Price of related commodities T – Tastes and preferences Ef - Future Expectation N - Population

Demand Schedule and Demand Curve

The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded.

The demand schedule maps the quantity demanded at each price keeping other determinants to be constant.

The demand curve is a graph of the relationship between the price of a good and the quantity demanded.

The Demand Schedule and Demand Curve for Product A

The market demand D shows the quantity of good A demanded, at various prices, by all consumers.Price and quantity demanded are inversely related.

Demand schedule

D

a

b

c

d

e

Priceper

Unit of A

Quantity Demanded

abcde

Rs1512963

814202632

2620148Quantity Demanded

32 0

9

6

3

12

Pric

e

Rs15

Individual Demand & Market demand

The individual demand is the relationship between the quantity demanded by a single buyer and its prices.

The market demand is the relationship between the total quantity demanded by all consumers in the market and its price

Price of Ice-Cream Cone

Price of Ice-Cream Cone

Price of Ice-Cream Cone

2.00 2.00 2.00

4 3 7

1.00 1.001.00

8 5 13

Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones

seema’s Demand Geeta’s Demand Market Demand+ =

When the price is Rs2.00, seema will demand 4 ice-cream cones.

When the price is Rs 2.00, geeta will demand 3 ice-cream cones.

The market demand at Rs 2.00 will be 7 ice-cream cones.

When the price is Rs1.00, Seema will demand 8 ice-cream cones.

When the price is Rs1.00, Geeta will demand 5 ice-cream cones.

The market demand at Rs1.00, will be 13 ice-cream cones.

The market demand curve is the horizontal sum of the individual demand curves!

Changes in Quantity Demand and Changes in Demand

Changes in quantity demanded result in movement along the demand curve due to a change in price while other factors remain constant. (upward/downward movement)

Change in demand is the shift of the demand curve due to a change in other factors while price remains constant. (leftward/ rightward shift)

Movements Along and Shifts of The Demand Curve

Quantity

Price

P2

Q2 Q1 Q3

P1

P3

Price increase moves us leftward along demand curve

Price decrease moves us rightward along demand curve

Changes /Shifts of the Demand Curve

1. Money income of consumers

2. Prices of other goods

3. Consumer expectations

4. The number or composition of consumers in the market

5. Consumer tastes

Shifts in The Demand CurvePrice

Quantity

Increasein demand

Decreasein demand

Demand curve, D3

Demandcurve, D1

Demandcurve, D2

0

Changes in Consumer Income Increase in consumer income

Willing and able to buy more at each price Increase in demand Demand curve shifts rightward

Normal good Demand increases as income increases

Inferior good Demand increases as income increases

Changes in the Prices of Other Goods

Substitutes An increase in the price of one good

Increases the demand for the other Rightward shift

Complements – used in combination An increase in the price of one

Decreases the demand for the other Leftward shift

Changes in Consumer Expectations

Income expectations Future income increase

Increase the current demand Price expectations

Future price increases Increase current demand

Number or Composition of Consumers

Increase in number of consumers Increases demand Right shift

Composition of the population Shift the demand

Changes in Consumer Tastes Tastes

Likes and dislikes Assumed given and relatively stable

Change in tastes Shift the demand

Shifts in Demand Curve

Quantity

Price

D2

D1

Entire demand curve shifts rightward when:• income ↑• price of substitute ↑• price of complement ↓• population ↑• expected price ↑• tastes shift toward good

Shifts in Demand Curve

Quantity

Price

D1

D2

Entire demand curve shifts leftward when:• income or wealth ↓• price of substitute ↓• price of complement ↑• population ↓• expected price ↓• tastes shift toward good

Exceptions to the Law of Demand

GIFFEN GOODS

•This fact was analysed by Sir Robert Giffen, so it is also called Giffen Paradox.•Giffen goods are those goods whose price effect is positive and income effect is negative.•In case of giffen goods, Price effect is positive i.e demand rise with the rise in price & falls with the fall in price.•In case of giffen goods, Income effect is negative, demand falls with rise in Income & vice versa.

All giffen goods are inferior goods but all inferior goods are not giffen goods.

Exceptions to the Law of Demand

SNOB APPEAL/VEBLEN EFFECT

People tend to purchase products which have snob appeal such as expensive cars, jewellery etc. When the price of such products rises then demand also rises and if for some reason the price falls then demand also falls as the product losses its novelty.

Exceptions to the Law of Demand

FUTURE EXPECTATION OF PRICESWhen the prices are rising and it is expected that they will continue to rise infuture, consumer buy more to keep a stock.Eg:During Famine or a Flood

GOODS WITH NO SUBSTITUTEFor the goods which have no substitute, people have no option but to buy them, whatever be the price.Eg: Indian Railways

Class Task-1 What effect will each of the following have on the

current demand for small automobiles?a) Small automobiles become more fashionable.b) The price of large automobiles rises(with the price

of small autos remaining the same).c) Income declines and small autos are an inferior

good.d) Consumers anticipate that the price of small autos

will greatly come down in future.e) The price of petrol substantially drops.

Class task-2• How will each of the following affect the position of

the demand curve for DVD players?a) An increase in the price of film DVDs.b) A decrease in the price of DVD players.c) An increase in per capita income.d) A decrease in the price of cinema tickets.