## Karnataka 2nd PUC Economics Notes Chapter 3 Demand Analysis

The Concept of Demand:

→ The concept ‘demand’ refers to the quantity of a good or service that a consumer is willing and able to purchase at various prices, during a period of time. It is to be noted that demand in Economics is something more than desjre to purchase though desire is one of the elements of demand. For example, a beggar may desire food, but due to lack of ability to purchase his demand is not effective.

→ So, the concept of demand includes three elements viz., Desire to buy, ability to pay and willingness to pay. Alfred Marshall has developed the theory of demand analysis.

→ According to Alfred Marshall, Demand is “the quantity of a product that a consumer purchases in a market at a particular price and at a particular time.

Determinants of Demand:

There are many factors which influence the demand of consumers: They are:

• Price of the commodity which the consumer is going to buy.
• Price of related products (substitutes).
• Level of income of consumers.
• Tastes and preferences of consumers.
• Demonstration effect – an individual’s demand for a car is influenced by his friend’s or neighbour’s new car.

Demand Function:

→ The Demand Function refers to a functional relationship between quantities demanded and its determinants. It can be expressed as follows:
Qd = f(P, Pr, Y, T, ……..)

→ Where Qd stands for Quantity demanded, ‘f is function, P is Price of commodity, Pr – price of reiated(substitutes, Y is income of consumers, T is tastes and preferences of consumers.

→ As the Price plays a predominant role in determining quantities demanded, we can rewrite the demand equation as follows:
Qd = f (P)

→ where Qd is demand, ‘f’ is function and P is price of the product.

→ The demand function, in the form of equation can be represented as follows:
Qd = a – bp

→ Where Qd is quantity demanded, ‘a’ and ‘b’ are constants. It is linear (i.e., when represented in graph we get a straight line). Here ‘a’ represents maximum limit and ‘-b’ represents slope nf the function. So, the slope of demand is downward. That means there is inverse relationship between price and quantities demanded.

For example, Qd = 40 – 4p
Problem: If Qd = 40 – 4p represents demand for a good in a market and if the price of potato per k.g during different days are Rs.3, Rs.4, Rs.5, Rs.6 and Rs.7, calculate the quantities demanded.
When price is Rs.3
Qd = 40 – 4p
= 40 – 4(3)
= 40 – 12
= 28

When price is Rs.4
Qd = 40 – 4p
= 40 – 4(4)
= 40 – 16
= 24

When price is Rs.5
Qd = 40 – 4p
= 40 – 4(5)
= 40 – 20
= 20

When price is Rs.6
Qd = 40 – 4p.
= 40 – 4(6)
= 40 – 24
= 16

When the price is 7
Qd = 40 – 4p
= 40 – 4(7)
= 40 – 28
= 12

Individual Demand Schedule

 Price- P (in Rs.) Demand (Qd) (in Kgs) 3 28 4 24 5 20 6 16 7 12

The Law of Demand:

→ The law can be explained in the following manner: “Other things being equal, a fall in price leads to expansion in demand and a rise in price leads to contraction in demand”.

→ According to Prof.Samuelson, the law of demand states that ‘People buy more at lower prices and buy less at higher prices, other things remaining the same’.

Individual demand schedule:
→ It is that demand schedule which represents the quantities demanded by an individual consumer at different levels of price.

Individual Demand Schedule

 Price- P (in Rs.) Demand (Qd) (in Kgs) 3 30 4 25 5 20 6 15 7 10

→ In the above individual demand schedule, the consumer is purchasing different quantities at different price levels. At Rs.3 he buys 28 kgs, at Rs.4, 24 kgs are bought arid so on. As the price increases, the quantities demanded falls.

→ Demand Curve: “The graphical presentation of the demand schedule is called demand curve.

→ In the above diagram, price is measured along Y axis and quantities demanded are measured along X axis. The various points on Demand line represent respective quantities demanded. For example, quantity demanded is 20 at the price Rs.5. (Point C). .

→ The demand curve slopes downwards from left to right. It shows that the rate at which demand changes with respect to change in pride. As there is inverse relationship between price and quantities demanded, the Curve is negatively sloped.

Why does Demand Curve slope downwards?
In order to represent the inverse relationship between price and demand, the demand curve must slope downwards. Apart from this basic reason, there are many other factors which make the demand curve to slope downwards. They are as follows:

1. Operation of the law of Diminishing Marginal Utility:
The law of DMU states that as the consumer acquires larger quantities of any commodity, the additional units of the same product will give him lower utility, and as such he sets a less value for the additional unit. The law of demand states that in order to induce the consumer to buy more, lower price must be offered.

2. Operation of the law of Equi- Marginal Utility:
This law states that utility of the product must be equal to its price in general. As price falls, the equality between the two will be disturbed and in order to re-establish this equality the consumer buys more. Now utility comes to the level of reduced price. Hence, as price falls, a consumer buys more.

3. Income effect:
A change in demand as a result of change in income is called as Income effect. As price falls, the real income of the consumer increases. With this increased real income (gets more purchasing power with more money in his hands), he buys more.

4. Substitution effect:
When the price of one product falls, it become cheaper when compared to other products for which the price remains constant. Hence, a consumer will substitute low priced product to high priced products. The result is that demand for a product rises as price falls.

5. Price Effect:
When the change in quantities demanded is caused by the change in price, . it is called as Price effect. When the price of a product falls, it becomes cheaper and consumer buys more of that and vice versa.

Normal goods and Inferior goods:

Normal goods are those goods for which the demand increases with increase in income of consumers and decrease with decrease in consumers’ income. In case of normal goods, there will be a direct relationship between income of consumers and quantities demanded.

Inferior goods are those goods for which the demand decreases with the rise in income of consumers. If the demand decreases for a product as a result of increase in income of consumers, such products are inferior goods. Here, when the price of goods fall, the consumer’s real income gets increased so that he can go for superior goods with the Same money income. There is inverse relationship between quantities demanded and income of consumer. These goods are also called as Giffen goods.

Substitutes and Complementary goods:

→ The competing goods or substitutes are alternative products which can be used easily in place of another to satisfy a particular need of consumer. For example, coffee and tea, ink pen and ball pen etc,. In case of substitutes, a fall in price of one commodity leads to a fall in the quantity demanded of another commodity. There is direct relationship between price of substitute and quantity demanded of a product.

→ Complementary goods are those goods which are consumed together to satisfy our wants. For example, vehicle and petrol, shoes and socks, bat and ball etc. If the price of petrol increases the demand for vehicle falls and vice versa. There is inverse relationship between price of a product and demand for its complementary product.

Movements along the demand curve – Expansion and contraction of demand:

It shows the movement of quantities demanded due to changes in price level which can be represented on demand curve. When the price becomes less, more quantities are demanded, hence it is called as Expansion of Demand and when the price rises, there will be fall in quantities demanded, it is called Contraction of Demand. When the same is represented on graph, we get movement on the same demand line/curve. Thus any changes in price leads to movements along the demand line as shown below.

In the above diagram, we measure quantities demanded along X-axis and price along Y-axis. When the price rises from OP to OP2 the quantities demanded will be reduced from OM to OM,, it is called contraction of demand and when the price falls from OP to OP1 the quantities demanded gets expanded from OM to OM1, it is called expansion of demand.

Shift in demand curve-Increase and Decrease in Demand:
The increase and decrease in demand are caused by all the determinants of demand except price. When there is a change in consumer’s income, tastes and preferences, price of related goods, there may be increase or decrease in the Demand.

Increase in Demand: When the income of consumer increases, the demand for the product increases and there will be shift in demand line towards right. For normal goods, the demand curve shifts to the right. In the diagram given below, D1 represents shift in demand line towards right indicating increase in demand.

Decrease in Demand: When the price of related goods rise, the demand for the product falls and the demand curve shifts towards left. For example, if there is rise in price of petrol, the demand for vehicle decreases, representing backward shift of demand line In the diagram below, D2 represents shift in demand towards left indicating decrease in demand.

Market Demand: The market demand refers to the aggregate demand function of an entire market. It is said that, the market demand for a product at a particular price is the total demand of all the consumers in the market taken together.

Market Demand Schedule: The Market Demand Schedule includes the demand schedules of individual consumers. For example, the following market demand schedule is derived from two individuals, viz., A and B

Market demand curve: It is derived from individual demand curves just by adding individual demand curves horizontally. It is also called as horizontal summation to obtain Market demand curve.

Elasticity of Demand

Meaning & Definition:
→ Elasticity of demand is generally defined as the responsiveness or sensitiveness of demand to a given change in the price of commodity.

→ It refers to the capacity of demand either to stretch or shrink to a given change in price.

Concepts of Elasticity of Demand:
I. Price Elasticity of Demand
II. Income Elasticity of Demand
III. Cross Elasticity of Demand.

I. Price Elasticity of demand:
→ In the words of Prof. Stonier & Hague, “Price elasticity of demand is a technical term used by economists to describe the degree of responsiveness of the demand for a good to a change in its price.

→ It is measured by using the following formula.

→ Here, ∆q stands for change in quantity, ∆p for change in price, ‘p’ is the initial price and ‘q’ is initial quantity.

Problem: If the price of Potato rises from Rs.20 to Rs.30 per kg and its quantity demand decreases from 10 to 5 kgs, calculate the PED.
Solution:
∆q = 5 – 10 = -5; ∆p = 30 – 20 = 10; then PED is ,
PED = $$\frac{\Delta q}{\Delta p} \times \frac{p}{q}$$
PED = $$\frac{-5}{10} \times \frac{20}{10}$$ = -0.5 × 2 = -1
⇒ Price Elasticity = – 1.

Classification of Price Elasticity of Demand:

On the basis of the degree of price elasticity for different goods, we classify PED as follows:

1. Perfectly Elastic Demand:
In this case, a very small change in price leads to an infinite change in demand. The demand curve is a horizontal curve and parallel to x axis. The numerical co-efficient of price elasticit of demand is unlimited or infinity. Ped = ∞

2. Perfectly Inelastic Demand:
In this case, whatever may be the change in price, quantity demanded will remain perfectly constant. The demand curve is a vertical straight line and parallel to Y axis. Quantity demanded would be 10 units, irrespective of price changes from Rs. 10.00 to Rs.2.00. Hence, the numerical co-efficient of perfectly inelastic demand is zero. Ped = 0

3. Relatively Elastic Demand :-More elastic demand.
In this case, a slight change in price jeads to more than proportionate change in demand. One can notice here that a change in demand is more than that of change in price. Hence, the elasticity is greater than one. For e.g., price falls by 3% and demand rises by 9%. Hence, the numerical co-efficient of demand is greater than one.

Here the percentage change in quantities demanded is greater than percentage change in price i.e., ∆q > ∆p or M M1 > P P1.

4. Relative Inelastic Demand:-Less Elastic Demand.
In this case, a large change in price, say 8% fall in price, leads to less than proportionate change in demand; say 4% rise in demand. One can notice here that change in demand is less than that of change in price. This can be represented by a steeper demand curve. Hence, elasticity is less than one. (PED<1)

Here the percentage change in quantities demanded will be less than percentage change in price, i.e., ∆q < ∆p or M M1 < P P1.

5. Unitary or Equal Quantity, Elastic Demand:
In this case, proportionate change in price leads to Equal proportionate change in demand. For e.g., 5% fall in price leads to exactly 5% increase in demand: Hence, elasticity is equal to unity. It is possible to come across unitary elastic demand but it is a rare phenomenon.

Here, the percentage change in quantities demanded will be equal to the percentage change in price, i.e., ∆q – ∆p or M M1 = P P1.

Out of five different degrees the first two are theoretical and the last one is a rare possibility. Hence, in all our general discussions, we make reference only to the two terms- relatively elastic demand and relatively inelastic demand.

Determinants of Price Elasticity of Demand:

1. Nature of the Commodity:
→ In case of comforts and luxuries, demand tends to be elastic because people buy those more only when their prices are low. For e.g. TV sets.

→ In case of necessaries, demand is inelastic because whatever may be the price people have to buy and use them. For e.g. Rice.

2. Existence of Substitutes:
→ If a product has substitutes, demand tends to become elastic because people compare the prices of substitute goods and cheaper products are purchased. For eg. Blades, Soaps.

→ If a product has no substitutes, demand becomes inelastic because in that case whatever may be the price, people have to buy them. For e.g. Onion.

3. Durability of the commodity:
→ If a product is perishable or non durable, demand tends to be inelastic because people buy them again and again.

→ If a product is durable, demand tends to be elastic because people buy them occasionally.

4. Number of uses of a commodity:
→ If a product has multiple uses, demand tends to become elastic because, with a fall in price, the same product can be used for many purposes. For e.g. Electricity, coal etc.

→ If a product has only one use, the demand becomes inelastic because people have to buy them for a specific single purpose whatever may be the price. For e.g. All eatables, seeds, fertilizers, pesticides etc.

5. Possibility of postponing the use of a product:
→ If there is a possibility to postpone the use of particular product, demand tends to become elastic. For eg. Buying a scooter, motorcycle, TV sets etc.’people generally buy these articles when they are cheaper.

→ If it is not possible to postpone, demand tends to become inelastic. In this case, whatever may be the price, people have to buy them. For e.g. Medicine.

6. Level of income of people:
→ Generally speaking, demand will be elastic in case of the poor people because even a small change in price will affect the demand for various products.

→ On the other hand, demand will be inelastic in case of rich people because they are ready to spend any amount on buying a product.

7. Habits:
→ If people are not habituated for the use of certain products, then demand tends to be elastic. If products are cheaper, they buy more and if they become costly, they may buy less or may not buy them at all.

→ When people are habituated for the use of a commodity, they do not care for price changes over a certain range. For eg. Cigarettes, liquor etc. In that case, demand tends to become inelastic.

8. Complementary goods:
→ Goods which are jointly demanded are inelastic in nature. For e.g., pen and ink, vehicles petrol etc. This is because, if people buy one product, they have to buy the supplementary products also without which they cannot make use of the first item.

→ Demand tends to be elastic in case of independent products. For eg., biscuits, chocolates, ice-creams etc. In this case, consumption or use of a product is not linked to any other products. Hence, they may or may not buy a product.

II. Income Elasticity of demand:
→ Income elasticity of demand may be defined as the ratio or proportionate change in the quantity demanded of a commodity to a given proportionate change in the income. In short, it indicates the extent to which demand changes with a variation in the consumers income.

→ The following formula helps to measure YED.

→ Here, ∆q stands for change in quantity, ∆y is change in Income of consumer, ‘y’ is the initial income and ‘q’ the initial quantity.

Problem: Calculate the income elasticity of demand when income of consumer increases from Rs.20,000 to Rs.24,000 and his demand for vegetables rise from 10 to 20 kgs.
Solution:
∆q = 20 – 10 = 10; ∆y = 24,000 – 20,000 = 4000;

So, Income Elasticity of Demand is greater than one.

III. Cross Elasticity of Demand:
→ It may be defined as the proportionate change in the quantity demanded of a particular commodity in response to a change in the price of another related commodity. In the words of Prof. Watson “Cross elasticity of demand is the rate of change in quantity associated with a change in the price of related goods”. Generally it arises in case of substitutes and complements.

→ The formula for calculating cross elasticity of demand is as follows:

→ Where Ced is Cross Elasticity of Demand, ∆qA – change in quantity demanded of product A, ∆pB change in price of product B, pB – Original or initial price of B, and qA orginal or initial quantity of A.

Problem: When the price of coffee in a college canteen rises from Rs.10 to Rs.15, the demand for Tea increases from 80 to 120 cups per day (Price of tea remains at 10) Calculate Cross Elasticity of Demand (Ced).
Solution:
∆qA = 120 – 80 = 40; ∆pB = 15 – 5 = 5; pB = 10; qA = 80
Therefore Ced = $$\frac{\Delta q^{A}}{\Delta p^{B}} \times \frac{p^{B}}{q^{A}}$$
= $$\frac{40}{5} \times \frac{10}{80}$$ = 1
Therefore, the Cross Elasticity of demand is equal to one (Ced = 1).