Law of Demand,Demand Elasticty

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The Law of Demand states that the demand for a commodity increases when its price decreases and falls when its price rises, other things remaining constant.

It states the nature of relationship between the quantity demanded of a product and the price of the product.

Demand Function = Qx = f(Px).

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A demand curve is a locus of point showing various alternative price-quantity combinations. ORThe demand curve for any good shows the quantity demanded at each price, holding constant all other determinants of demand.

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The DEPENDENT variable is the quantity

demanded.The INDEPENDENT variable is the good’s own price.

1) Substitution Effect : When the price of a commodity falls, prices of its substitution remaining constant, then the substitute become relatively costlier i.e. the commodity whose price has fallen becomes relatively costlier. The increase in demand on account of this factor is known as substitution effect.

Demand

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2) Income Effect : When the price of a commodity falls, other things remaining the same, then the real income of the consumer increases. The increase in demand on account of an increase in real income is known as the income effect.

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(a) Expectations regarding further prices: When consumer expect a continuous increase in the price of durable commodity ,they buy more of it despite the increase in its price with a view to avoiding the pinch of a much higher price in future.

(b) Status Goods: The law of does not apply to the commodities which are used as a status symbol for enhancing social prestige or for displaying wealth and riches. For e.g. gold.

(c) Giffen Goods: If the price of giffen goods increases, (price of its substitute remaining constant), its demand increases instead of decreasing because ,in case of these goods, income effect of price rise is greater than the substitution effect.

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Shift in the Demand Curve

A change in any variable other than price that influences quantity demanded produces a shift in the demand curve or a change in demand.

Factors that shift the demand curve include:

• Change in consumer income

• Consumer preferences

• Prices of related goods

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Shift in the Demand Curve

This demand curve has shifted to the right. Quantity demanded is now higher at any given price.

Demand is a function of own-price, income, prices of other goods, and tastes.

The demand curve shows demand as a function of a good's own price, all else constant.

Changes in own-price show up as movements along a demand curve.

Changes in income, prices of substitutes and complements, and tastes show up as shifts in the demand curve.

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The degree of responsiveness of demand to the change in its determinants, is called elasticity of demand.It is the measurement of the percentage change in one variable that results from a 1% change in another variable.

Price elasticity

Cross-elasticity

Income elasticity

Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

Percentage Change in Quantity

Ep = Percentage Change in Price

Change in Quantity Quantity Ep =

Change in Price Price

Ep = (24/40) ÷ (5/30) = 3.6

P

Q

D

ab

30

25

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A price elasticity of 3.6 means that for each one percent change in price the quantity demanded will change by 3.6 percent.

Perfectly InelasticQuantity demanded does not respond to price changes.

Perfectly ElasticQuantity demanded changes infinitely with any change in price.

Unit ElasticQuantity demanded changes by the same percentage as the price.

Elasticity is less than 1Quantity demanded changes less as compared to the change in price.

Elasticity is grater than 1Quantity demanded changes more as compared to the change in price.

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Arc elasticity Point Elasticity

The measure of elasticity of demand between any two finite points on a demand curve is known as arc elasticity.

2/)(2/)( 21

12

21

12

PP

PP

QQ

QQEp

Price

Quantity

20

10

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Point Elasticity on a linear demand curve

Point Elasticity on a non-linear demand curve

Point elasticity is the elasticity of demand at a finite point on a demand curve, e.g., at a point A or B on the linear demand curve in contrast to the arc elasticity between points A and B.

Ep = AN AM

Ep = Lower segment Upper segment

Price

Quantity

Price

A

M

Lower Segment

O

Quantity DemandedN

B

D

D

R

ep =Upper Segment

Draw a tangent AB on the demand curve at point R

Slope of AB = OB/OA

Ep = (OB/OA)* (RN/RM)

As triangle AOB, AMR and NRB are similar (OB/OA)= (NB/RN)

Ep = (NB/RN)*(RN/RM) = NB/RM

Again NB/RM = RB/AREp = RB/AR

Ep = Lower Segment Upper Segment

1. Availability of Substitutes: The higher the degree of closeness of the substitutes, the greater the elasticity of demand for the commodity.

2 .Nature of Commodity: Luxury and necessities. Demand for luxury goods is more elastic than the demand for necessities

3. Weightage in the Total Consumption: If proportion of income spent on a commodity is large, its demand will be more elastic.

4.Time Factor in adjustment of Consumption Pattern: The longer the time available, the greater the price-elasticity.

5. Range of Commodity Use: The wider the range of the uses of a product, the higher the elasticity of demand for the decrease in price.

Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income.

It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Income elasticity of demand =

Percentage change in quantity demanded

Percentage change in income

Goods consumers regard as necessities tend to be income inelastic

• Examples include food, fuel, clothing, utilities, and medical services.

Goods consumers regard as luxuries tend to be income elastic.

• Examples include sports cars, furs, and expensive food.

The cross-elasticity is the measure of responsiveness of demand for a commodity to the changes in the price of its substitutes and complementary goods.

The formula for measuring cross-elasticity of demand for tea (et,c) and the same for coffee (ec,t) is given below:

et,c = Percentage change in demand for tea (Qt) Percentage change in price of coffee (Pc)

= Pc . ∆Qt

Qt ∆ Pc

ec,t = Pt . ∆Qc

Qc ∆Pt

A measure of utility, or satisfaction derived from the consumption of goods and services, that can be measured using an absolute scale. Cardinal utility exists if the utility derived from consumption is measurable in the same way that other physical characteristics--height and weight--are measured using a scale that is comparable between people.

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A method of analyzing utility, or satisfaction derived from the consumption of goods and services, based on a relative ranking of the goods and services consumed. With ordinal utility, goods are only ranked only in terms of more or less preferred, there is no attempt to determine how much more one good is preferred to another.

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A consumer may not be able to tell that an ice-cream give 5 utils and chocolate gives 10 utils.But he or she can always tell whether chocolate gives more utility or less utility than ice-cream.

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1. Rationality: It is assumed that the consumer is a rational being in the sense that he satisfies his wants in the order of their preference. That is, he or she buys that commodity which yields the highest utility.

2. Limited money income: Consumer has a limited income to spend on the goods. Limitedness of income, along with utility maximization objectives makes choice between goods inevitable.

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3. Maximization of satisfaction: Every rational consumer intends to maximize his/her satisfaction from his/her given money income.

4.Utility is cardinally measurable: The cardinalists have assumed that utility is cardinally measurable and that utility of one unit of a commodity equals the money which consumer is prepared to pay it or 1 util=1 unit of money.

5.Diminishing marginal utility: Following law of diminishing marginal utility, it is assumed that the utility gained from the successive units of a commodity consumed decreases as a consumer larger quantity of a commodity.

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6.Constant marginal utility of money: The cardinal utility approach assumes that the marginal utility of money remains constant whatever the level of a consumer’s income.

7.Utility is additive : Cardinalists assumed not only that utility is cardinally measurable but also that utility derived from various goods and services consumed by a consumer can be added together to obtain the total utility.