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BCom 1st Year Demand in Business Economics Notes Study Material

BCom 1st Year Demand in Business Economics Notes Study Material

BCom 1st Year Demand in Business Economics Notes Study Material

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BCom 1st Year Demand in Business Economics Notes Study Material
BCom 1st Year Demand in Business Economics Notes Study Material

BCom 1st Year Demand in Business Economics Notes Study Material

Introduction

Economics has a very powerful tool—the theory of supply and demand-for explaining changes in our economic environment. Economists of the eighteenth and nineteenth centuries explained prices, but their efforts were directed mostly into the analysis of supply. Towards the end of the nineteenth century, however, they penetrated deep into the analysis of demand. If anybody is to be credited for this, he is Alfred Marshall (1842-1924). The modern theory of market demand still rests on the structure built by Marshall.

Meaning of Demand

Demand is not the same as desire or need. There are many people who cannot afford a motor-car would have a desire for it. Similarly, there are many children who need milk or more milk but do not get it. Desire or need is not demand unless it is backed up by ability and willingness to pay.

Another point to note is that demand always means demand at a price. It has no importance unless a price is stated or implied. It is also to be noted that demand must mean demand per unit of time, say, per year or per month or per week or per day.

Demand can be defined thus :

“Demand is the relationship between the various possible prices of a product and the amounts of it that consumers are willing and able to buy during some period of time, other things being equal.” -Truett and Truett

(‘Equal’ here means ‘constant.)

Quantity demanded is the amount of a product that consumers wish to purchase at a price per unit of time, say, a week or a month. Two important points need to be noted about this concept. First, quantity demanded is a desired quantity, that is, it is the quantity which the consumers wish to purchase and not necessarily the quantity which they actually purchase.

So a distinction should be made between, the ‘quantity actually purchased and the quantity demanded’. Second, quantity demanded is a flow. Our concern is not with a single isolated purchase but with a continuous flow of purchases.“ Milton Friedman, however, uses the expression “quantity demanded” in the sense of a particular quantity, whereas demand schedule in the sense of a flow. Let us consider the following two statements:

(a) “The price went up and therefore demand went down.”

Here ‘Demand’ is used in the sense of quantity demanded.

(b) “Demand went up and therefore price went up.”

Here ‘Demand’ is used in the sense of demand schedule.

Our analysis of demand, however, uses quantity demanded as a flow and thus it is used in the sense of a demand schedule.

The demand for a commodity or service may be a composite demand that is, demand for a number of different uses. The demand for leather, for instanca is a composite demand for shoes, pocket books, purses, etc.

A product may be jointly demanded with some other products. There is a joint demand for automobiles and tyres, cricket bats and cricket balls, etc.

The demand for a commodity or service may be a derived demand-derived from the demand for some final good. The demand for factors of production or inputs is a derived demand.

Consumer demand is the demand for final products. It is the ultimate source of the derived demand for inputs.

Demand Function

Demand function is an algebraic expression of the relationship between the quantity of a good which a consumer wants to buy and all the quantitative factors which determine this demand. Thus “A demand function is a statement telling how each of a number of relevant variables affects the amount of a product consumers will buy during some time period.” —Truett and Truett

Five main variables influence this quantity. They are:

(i) the price of the product (Pi);

(ii) the prices of other products (Pj…Pn);

(iii) the consumer’s income and wealth (Y);

(iv) various sociological factors (S); and

(v) the consumer’s tastes (T).

The demand function is summarised thus

Qi = f (Pi; Pj, …… Pn;Y; S; T)

where Qi = quantity demanded of good i.

Sociological factors are those such as number of children, place of residence (e.g., big city, small town, village) and the state of weather.

In order to understand the separate influences of each of the above variables, we consider the influence of one variable at a time and assume that all other variables remain unchanged. Economists use the expression ‘ceteris paribus’ for this which means ‘other things being equal’. The type of the demand function that is developed here is one where the quantity of a good demanded is a function of the price of that good only, other things being equal.

Demand Schedule

A demand schedule is a tabular statement of the state of demand for any good in a given market at a given time (say, a week or a month) at each of a series of prices. Since the demand for a thing depends on many factors, a demand schedule is drawn up on the assumption that all other influences, except the price of the good itself, remain unchanged. It thus attempts to isolate the influence exerted by the price of the good upon the quantity demanded. In other words, the quantity of a good demanded is a function of the price of this good alone.

In Table, an imaginary demand schedule is shown. In the table the price of a good X is listed under PX and quantities demanded are listed under QX. It can be seen that more units of X are demanded as the price falls. Thus when the price is Rs.10 per unit, 100 units are bought, say per week.

BCom 1st Year Demand in Business Economics Notes Study Material

Suppose the price falls to Rs.9 per unit, then 120 units will be bought. A further fall in the price to Rs. 8 per unit will lead to 150 units being bought. As the price continues to fall, the units bought go on rising.

Demand Curve

A demand curve is a graphical representation of a demand schedule. So like the demand schedule, a demand curve also relates the price of a commodity to the amount that the consumer wishes to purchase. Such a demand curve is shown in fig. DD is a demand curve. It shows the quantity of the good that the consumer would like to purchase at every possible price. Thus when the price is OP1, quantity demanded is OQ1. A fall in the price to OP2 leads to an increase in the quantity demanded to OQ2.

BCom 1st Year Demand in Business Economics Notes Study Material

A demand curve slopes downward to the right. In other words, it has a negative slope’ which indicates that the quantity demanded increases as the price falls.

Since demand curve is a maximum concept, it can be conceived of as a boundary line. A point on the demand curve represents the maximum quantity that the consumer will take per unit of time at a given price. At this price he would be willing to buy or would be free to buy either the quantity indicated by the curve or any smaller quantity if smaller amount is all he could get.

The demand curve can also be viewed as showing the maximum prices which a consumer will pay for different quantities per unit of time. He will pay no more but can be induced to pay less for the various quantities.

A demand curve serves the purpose of facilitating analysis of the effects of changes in supply. When the time allowed for adjustment in demand is very short, the demand is the least elastic, i.e., it has the lowest elasticity. As the time allowed for adjustment increases, elasticity of the demand curve also increases.

Individual Demand and Market Demand Curve

An individual demand curve relates the price of a commodity to the amount that the consumer wishes to purchase. This curve thus analyses demand from the point of view of one consumer.

When we explain market behaviour, we need to know the total demand of all consumers. A market demand schedule is the horizontal summation of all individual demand schedules. A graphical presentation of the market demand schedule is called the market demand curve.

Thus the horizontal aggregation of the demand curves of all consumers in the market yields the market demand curve. It shows the total amount of the good which all consumers wish to buy at each price.

Market demand curve can be defined thus

“The market demand curve relates the total quantity demanded of a product to its own price, other things being equal.” “The market demand curve shows the aggregate quantity demanded by all consumers together, as a function of price. Geometrically, the market demand curve is obtained by summing the individual demand curves horizontally.”

Bandwagon and Snob Effect on Market Demand Curve

Market demand curve is the summation of the individual demand curves. In this summation it is assumed that each individual demand curve is independent of one another. If it be not so then the market demand curve will be subject to bandwagon or snob effect as the individual demand curves show some inter-dependence.

Bandwagon effect is one whereby as the price of a good falls and demand by some sections or some individuals in the community expands, other individuals or sections imitate the reaction and expand their demand too. It means that the market demand curve is not simply an aggregation of individual demand curves. It expands more than expected because additional consumers “join the bandwagon”. It gives the market demand a gentler slope (it becomes flatter) than would otherwise be the case.

Snob effect is the effect whereby as the price of a good falls and some sections of the community expand their demand for the good, other sections or individuals reduce their demand in order to differentiate themselves from the general trend. It often happens with ostentatious consumption where people tend to do the opposite of the general trend. The effect of this tendency is that the market demand curve may become steeper than would otherwise be predicted from an aggregation of independent individual demand curves.

Law of Demand

The demand curve usually slopes downwards from left to right. This reflects the law of demand which is stated as:

“The lower the price, the greater is the quantity of the good demanded and the higher the price, the lower the quantity of the good demanded, ceteris paribus.”

“The law of demand states that, other things equal, the amount of a product that the consumers are willing and able to purchase during some period of time varies inversely with the price of that product.”

Exceptional Demand Curves

This law is subject to important exceptions. An exceptional demand curve, therefore, is one that slopes upwards from left to right. It means that the demand for a good will be greater at a higher price than at a lower price. The following examples can be cited where exceptional demand curves may occur:

(i) Inferior Goods: Cheap necessary goods are good examples of exceptional demand. It is generally the case that the very poor people are unable to purchase the requisite quantity of foodgrains. Now if their prices rise, they will not purchase less of these articles but, perhaps, the same quantity. Giffen paradox is an example This paradox refers to the observation by Giffen that a rise in the price of bread caused more of it to be bought. Goods which do not obey the law of demand are called Giffen goods.

(ii) Articles of Ostentation: There are some commodities which adne desirable only if they are expensive. Some articles of jwellery, expensive motor cars, furcoats, etc. fall within this category. Higher the prices of these article the greater the quantity of them the rich wish to own. It is so because the high prices give the articles greater exclusiveness in the eyes of purchasers. Som times this is explained as Veblen effect after the name of the America economist. Thorstein Veblen who wrote in 1899 his famous book Theory of Leisure Class’.

Veblen effect is that phenomenon whereby as the price of a good falls some consumers consider this as a reduction in the quality of the good and stop buying it. Consequently, the market demand curve will become steen than would otherwise be predicted. It could even slope upwards in contradiction to the law of demand.

(iii) Price as Indicator of Quality: Where price of the product is taken as an indicator of its quality, e.g., wine, more will be purchased at higher prices.

(iv) Speculation: Where there is a speculative element in the purchase of an article, e.g., stocks and shares, the law of demand will not hold. So if it is believed that the price of a commodity is likely to be higher in the future than at present, then, even though the price has already risen, more of the commodity may be bought at the higher price. This may happen on the outbreak of a war or during an emergency or a crisis.

Basis of the Law of Demand (Or Validity of the Law of Demand)

There are two explanations of the law of demand. In other words, there are two good reasons for expecting the law of demand generally to be valid. One is the law of diminishing marginal utility and the other is the income and substitution effect of a price change.

(i) According to the law of diminishing marginal utility, the successive units of a good yield smaller and smaller amounts of marginal utility. Since the price of a commodity cannot exceed marginal utility but equals it, the consumer will buy additional units of the good only if its price falls. So the demand curve has a negative slope, i.e., it slopes downwards to the right.

(ii) A fall in the price of a commodity makes the consumer both ‘able’ and ‘willing’ to buy more of it.

Suppose there is a consumer with a constant money income of Rs. 160. With this income he can purchase 16 units of X at the price of Rs. 10 per unit. Let us now assume that the price of X falls to Rs. 5 per unit. At the lower price of X, our consumer can buy 16 units of X and free Rs. 80 for buying more 01 – and other commodities. A fall in the price of X increases the real income of be consumer. It is known as the income effect. The income effect is a tendency purchase more as purchasing power increases and less as it falls.

As the price of X falls, the prices of other goods being unchanged, X becomes cheaper and so more attractive to the buyer. So the lower price will induce the consumer to substitute X for some of the now less attractive items of his consumption basket. X may be substituted for other commodities like Y, Z, etc. A lower price increases the relative attractiveness of a product and makes the consumer willing to buy more of it. This is known as the substitution effect. The substitution effect is a tendency to substitute relatively cheaper products for those that are relatively more expensive.

The combined influence of the two-income and substitution-effects on demand is shown graphically in fig.

In fig. (A) X-axis measures the quantity of X, while Y-axis measures income. Assume that the initial budget line is ML and initial equilibrium at point A on the budget line. (With the given money income of OM, the consumer purchases OL of X). Now assume that the price of X falls so that with the constant money income of OM, OL1 of X can be purchased.

BCom 1st Year Demand in Business Economics Notes Study Material

The new budget line is ML1 and the new equilibrium is established at the point B. If there be a further fall in the price of X, the budget line shifts to ML2 and another new equilibrium point is C. Joining A, B, C, etc. we get the price-consumption curve (PCC) which helps us to derive the demand curve of X.

In fig. (B), the quantity of X is measured along X-axis, its prices are shown on Y-axis. Prices are calculated from fig. (A) by dividng income OM by the quantity of X purchased. The P1 is derived from OM/OX1, P2 from OM/OX2 and P3 from OM/OX3. From them the demand curve DD is derived. At lower prices, more of X is purchased due both to income effect and substitution effect.

In this fig, the income effect and substitution effect of a price change were shown separately, i.e., how of much of the increased demand was due to income effect and how much due to substitution effect. The difference between Hicksian and Slutsky income effect was also shown. In fig. Ordinary (Marshallian) demand curve, Hicksian demand curve and Slutsky demand curve are shown.

BCom 1st Year Demand in Business Economics Notes Study Material

(i) II is the ordinary or Marshallian demand curve. Here money income and all other prices are the same; only price of X changes. So real income changes.

(ii) II II is the Hicksian demand curve where real income is kept constant by keeping the individual on the same indifference curve.

(iii) III III is Slutsky demand curve where apparent real income is kept constant and the individual is enabled to buy the original bundle.

Changes in Demand

There are two types of changes in demand, as given below:

(i) increase or decrease in demand, and

(ii) extension or contraction of demand.

The first refers to a shift in the demand curve, while the second refers to a movement along a demand curve.

(i) Increase or Decrease in Demand: The demand curve is constructed on the ceteris paribus assumptions, that is, on the assumption of other things remaining the same. If other things change demand will change too even though price of the good concerned does not change. This type of change in demand is shown by the shift in the demand curve. This is shown graphically in fig. The shift in demand curve shows the operation of an important general rule:

“A demand curve shifts to a new position in response to a change in any of the variables that were held constant when the original curve was drawn.” (Lipsey and Chrystal)

In this fig, the original demand curve is DD. At price P1, quantity demanded is OX1.

BCom 1st Year Demand in Business Economics Notes Study Material

A shift in the demand curve from DD to D2D2 indicates an increase in demand. A shift in the demand curve from DD to D1D1 indicates a decrease in demand.

An increase in demand means that more of the commodity is demanded at each price. In fig, it has been shown that at the same price of P1, demand increases from OX1 to OX2. It is the example of an increase in demand shown by the rightward shift in demand curve from DD to D2D2. An increase in demand, that is, a rightward shift in the demand curve may be due to:

(a) a rise in the price of a substitute,

(b) a fall in the price of a complement,

(c) a rise in income,

(d) a redistribution of income in favour of the group having a preference for the commodity, or

(e) a change in tastes that favours the commodity.

A decrease in demand means that less is demanded at each price. It has been shown by a leftward shift in the demand curve from DD to D1D1. As a result of this shift, demand for the commodity decreases from OX1 to OX3 at the same price of P1. This decrease may be due to:

(a) a fall in the price of a substitute,

(b) a rise in the price of a complement,

(c) a fall in income,

(d) a redistribution of income away from the group that favours the commodity, or

(e) a change in tastes that disfavours the commodity.

Lipsey and Chrystal define the increase and decrease in demand thus:

“An increase in demand means that the whole demand curve has shifted to the right; a decrease in demand means that the whole demand curve has shifted to the left.”

(ii) Extension and Contraction of Demand: At any point on the demand curve, a specific quantity is purchased at a specific price. As shown in fig, OX1 quantity of X is bought at the specific price of OP1.

Extension and Contraction of Demand

Now suppose that the price of X falls to OP2. It causes the quantity demanded to increase to OX2. This rise in demand is known as the extension of demand. Lipsey and Chrystal call it an increase (or a rise) in the quantity demanded. Now let us assume that the price of X rises above the initial price of OP1 and is OP3. This causes the demand to fall to OX3. This decline in demand is known as the contraction of demand or a decrease (or a fall) in the quantity demand (according to Lipsey and Chrystal).

“A movement down a demand curve is called an increase (or rise) in the quantity demanded; a movement up the demand curve is called a decrease (or a fall) in the quantity demanded.” (Lipsey and Chrystal)

Determinants of Demand

A determinant of demand is that variable which will cause a demand curve to shift. A list containing all possible determinants of demand will be very long. Using logic and observation, we may list the most generally applicable determinants of demand as given below:

(i) Consumer income

(ii) Prices of related goods and services

(iii) Consumer tastes or fashion

(iv) Number of consumers in the market

(v) Credit terms or loans

(vi) Advertising

(vii) Consumer’s expectations about the future prices

(viii) Accumulated savings or wealth

Changes in Income

It may reasonably be expected that an increase in consumers’ income will cause a rightward shift in the demand curve of a particular good. If it so happens in the case of a product, it is called a ‘normal’ good by the economists. But there re also some goods and services that have opposite relationship to changes in come. They are called “inferior” goods and services.

Consumers buy more of a normal good or service when their income rise and less of it when their incomes fall. In the case of an inferior good or service the opposite occurs.

Changes in Wealth

Wealth of a nation is its accumulated net savings. There are some goods, luxury items, for example, which are particularly sensitive to changes in wealth.

Changes in the Prices of Other Goods

Our willingness to buy a particular item also depends on the prices of related products and for most items alternatives are available. These alternative items may be substitutes or complements. Two goods or services are substitutes if one can be used in place of the other.

Complements are goods that are used with one another. When used together they enhance the satisfaction of the consumer from each. If the price of the substitute changes, the demand for the item will also change. Tea and Coffee are substitutes. If the price of tea changes, the demand for coffee will also change in such a way that a rise in the price of tea will increase the demand for coffee and a fall in its price will lower the demand for coffee.

The demand for a good can also be influenced by a change in the price of its complements. Cassette players and cassettes are complements. A decrease in the price of cassettes is likely to increase the demand for cassette players and an increase in their price is likely to lower the demand for cassette players.

Tastes, Number of Buyers, Credit Terms and Advertising

Consumer’s tastes play an important role in their demand of goods and services. The demand for foreign electronic goods was phenomenal in India before 1990s. But it declined sharply with the opening up of the Indian markets to foreign competition and their manufacture in the country. So when there was a craze for foreign goods, the demand curves for them shifted to the right. When the craze for any commodity dies out, the demand must shift leftward.

An increase in the number of consumers in the market for a good causes the demand for the good to increase without any change in its price. This often happens with new products.

When the terms of credit improve, people’s ability to buy generally goes up. Worsening of credit terms will have the opposite effect. This factor is particularly important in the case of demand for consumer durables like cars, houses, etc.

Advertising is also likely to boost up the demand. It means that larger expenditure on advertisement will increase the demand and lesser spending may lead to reduction in demand. This is likely the case with informative advertising. Competitive advertising may not have these effects.

Expectations About the Future Prices

The demand for an item also depends on buyers’ expectations about the future price of the good. If the buyers expect that the price of the item is likely to increase in future, they are likely to buy more of this item now. particularly so for storable commodities.

“In addition to the influences we’ve just examined, the demand for particular goods can be influenced by weather, demographic trends, government subsidies or taxes, and other factors.”

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