Managerial Economics #2 1

Lesson # 2DEMAND

DEMAND

Demand is the effective desire or want for a commodity, which is backed up by the ability (i.e. money or purchasing power) and willingness to pay for it. Demand = Desire + Ability to pay + will to spendThe demand for a product refers to the amount of it which will be bought per unit of time at a particular price.

Consumer DemandTwo levels: Individual Demand

Market Demand

Market Demand is the sum total of all individual demands.

Prices are determined based on Market Demand.

Factors influencing individual demands:

Price of the products.Income of the buyer.Tastes, Habits and Preferences.Relative prices of other goods.Relative prices of substitute and complementary products.Consumer’s expectations about future price of the commodity.Advertisement effect.

Factors influencing Market Demand

Price of the product.Distribution of Income and Wealth.Community’s common habits and scale of preferences.General standards of living and spending habits of the people.Number of buyers in the market and the growth of population.Age structure and sex ratio of the population.Future expecations.Level of taxation and Tax structure.Inventions and Innovations.FashionsClimate and weather conditions.CustomsAdvertisement and Sales propaganda.

Important factors (key variables)affecting demand:

“own price” of the product (P)Price of substitute or (Ps)Price of complimentary product (Pc)Level of disposable income (Yd)(income left with buyers after paying tax)Change in the buyers Taste (T)Advertisement effect (level of ad. Exp) (A)Changes in population (or number of buyers) (N)

Thus, Demand Function, Dx = f(Px, Ps, Pc, Yd, T, A, N, u)Commodity = x Hence, price = Px, Demand = Dx

LAW OF DEMANDCeteris Paribus: (All other things remaining

the same)Other things remaining unchanged, the demand

varies inversely to changes in price. Dx = f(Px). The higher the price of a commodity, the smaller is

the quantity demanded and lower the price, larger the quantity demanded. Other things remaining unchanged, the demand varies inversely to changes in price. Dx = f(Px).

Why does a Demand Curve Slope downward?

The demand varies inversely to changes in price. Dx = f(Px). The demand curve is downward sloping indicating an inverse relationship between price and demand.The price is measured on the Y – axis and Demand on the X- axis. When the price falls, demand increases. The downward slope of demand curve implies that the consumer tends to buy more when the price falls. Thus the demand curve is shown as downward sloping.

What are the assumptions underlying law of demand?

No change in Consumer’s income.No change in consumer’s preferences.No change in the Fashion.No change in the Price of Related Goods.No expectation of Future price changes of shortages.No change in size, age composition, sex ratio of the population.No change in the range of goods available to the consumers.No change in the distribution of income and wealth of the community.No change in government policy.No change in weather conditions.

What are the exceptions to the Law of Demand?

Sometimes it may be observed, that with a fall in price, demand also falls and with a rise in price, demand also rises. This is apparently contrary to the law of demand. The demand curve in such cases will be typically unusual and will be upward sloping.


Giffen Goods: In the case of certain Giffen goods, when price falls, quite often less quantity will be purchased because of the negative income effect and people’s increasing preference for a superior commodity with rise in their real income. E.g. staple foods such as cheap potatoes, cheap bread, pucca rice, vegetable ghee, etc. as against good potatoes, cake, basmati rice and pure ghee.


Articles of Snob appeal (Veblen effect) : Sometimes, certain commodities are demanded just because they happen to be expensive or prestige goods and have a ‘snob appeal’. They satisfy the aristocratic desire to preserve the exclusiveness for unique goods. These goods are purchased by few rich people who use them as status symbol. When prices of articles like diamonds rise, their demand rises. Rolls Royce car is another example.


Speculation: When people are convinced that the price of a particular commodity will rise further, they will not contract their demand; on the contrary they may purchase more for profiteering. In the stock exchange, people tend to buy more and more when prices are rising and unload heavily when prices start falling.


Consumer’s phychological bias or illusion: When the consumer is wrongly biased against

the quality of a commodity with reduction in the price such as in the case of a stock clearance sale and does not buy at reduced prices, thinking that these goods on ‘sale’ are of inferior quality.

Reasons for change (increase or decrease) in

demand:Change in income.Changes in taste, habits and preference.Change in fashions and customsChange in distributioin of wealth.Change in substitutes.Change in demand of position of complementary goods.Change in population.Advertisement and publicity persuasion.Change in the value of money.Change in the level of taxation.Expectation of future changes in price.

Examples of change in Demand

Increase in Advertising

Easy loans for housing

Recession in the Economy

Cut in Incometax Rates

Elasticity of Demand

Elasticity of Demand is the degree of responsiveness of quantity demanded to a change in price.

Any elasticity is simply a ratio between cause and an effect always in percentage terms. The cause goes to the denominator of the ratio, while the effect goes to the numerator of the ratio.

Price Elasticity of Demand

Formula:

ep = Proportionate change in the Quantity demanded

Proportionate change in price

change in the quantity demandedQuantity demanded

= ----------------------------------------------------------------change in price

price

Price Elasticity of DemandLaw of demand tells us that as the price of a

commodity falls, the quantity demanded increases, and vice versa.

It does not tell us by how much the quantity demanded increases, as a result of a certain fall in price or vice versa.

Law of demand tells us only the direction of change in demand but not the rate at which the change takes place.

To know this, we should know the elasticity of demand or Price elasticity of demand.

Price elasticity of demand (Q2 – Q1)

Q1 ep = -------------------------------

P2 – P1 P1Q1 = Original Quantity before price change.Q2 = Quantity demanded at the changed price.P1 = Original price.P2 = Changed price.

Illustration:If Q1 = 2000 Q2 = 2500 P1 = 10 and P2 = 9

(2500 – 2000)2000

ep = ----------------------------------------------------- = -- 2.5

9 – 1010

Price elasticity is negative showing inverse relationship.

Price elasticity of demand(modified Formula)

___ Q2 – Q1)__ Q1 + Q2

2 ep = --------------------------------------

___P2 – P1___ P1+ P2

2Q1 = Original Quantity before price change.Q2 = Quantity demanded at the changed price.P1 = Original price.P2 = Changed price.

Illustration:If Q1 = 2000 Q2 = 2500 P1 = 10 and P2 = 9

_____(2500 – 2000)____2000 + 2500 2

ep = ----------------------------------------------------- = -- 2.11

9 – 10 10 + 9 2

Price elasticity is negative showing inverse relationship.

Modified Formula:While computing elasticity, instead of taking Q1 and P1

in the denominator, we take the average of Q1 + Q2 and P1 + P2. 2

2 The price elasticity ep when worked out using the

modified formula = - 2.11A 1% reduction in price, will result in 2.5% increase in

demand as per the first formula and 2.11% increase as per modified formula.

Modification in formula is done to ensure reversibility and consistency when eleasticity = unity.

This is called Arc Elasticity of DemandAnd is used when the changes in price and quantity

are quite large.

Types of Price Elasticity1. Perfectly elastic2. Perfectly Inelastic3. Unity Elasticity4. Relatively Elastic5. Relatively Inelastic.

Factors determining Price Elasticity of Demand

1. Nature of the commodityExtent of useRange of substitutesIncome levelProportion of income spent on the commodityUrgency of demandDurabilityPurchase frequency

Perfectly inelastic demand

Where no reduction in price is needed to cause an increase in demand.

The firm can sell the quantity in wants to sell at the prevailing price but none at all at even slightly higher price.

The shape of the demand curve is horizontal.

The elasticity is = infinite.

Perfectly inelastic demand

Even a large change in price, does not change the quantity demanded.

Here the shape of the curve is vertical.

Elasticity = 0

Unity elasticityA proportionate change in price results in

exactly the same proportional change in quantity demanded.

Shape of the demand curve is a rectangular hyperbola.

Elasticity = 1

Relatively elastic demand

A reduction in price leads to more than proportionate change in demand.

Shape of the demand curve is flat.

Elasticity > 1

Relatively inelastic demand

A decline in price leads to less than proportionate increase in demand.

Shape of the demand curve is steep.

Elasticity < 1

Change in Demand Vs. Elasticity of Demand

Change in demand occurs whenprice does not change but demand changes due to other factors.

Elasticity of demand refer to that change in demand which occurs due to change in price, other factors remaining the same.

Income Elasticity Income Elasticity may be defined as the degree of responsiveness of quantities demanded to a given change in income.Income Elasticity of Demand is defined as the ratio of the percentage or proportionate quantity demanded to the percentage or proportionate change in income.OR Q2 – Q1 ………… (effect) Q2 + Q1 ey = ---------------------

Y2 – Y1 ………… (cause) Y2 + Y1

Q1 – Original Quantity demanded before Income changeQ2 - Quantity demanded after Income changedY1 - Original IncomeY2 - Changed new income.

IllustrationSuppose a consumer's income is Rs.1000 and he

purchases 10 kgs. of sugar. If income goes up to Rs.1100 he is prepared to buy 12 kgs. Calculate income elasticity of sugar.

Q2-Q1 12 - 10Q2+Q1 12 + 10

ey = ---------- = --------------------Y2-Y1 1100 - 1000 Y2+Y1 1100 + 1000

= 2 -:- 100 = 1 x 21 22 2100 11 1 = 21 = 1.99

11 Demand for sugar is income elastic

Cross Elasticity –Cross elasticity of demand

Cross elasticity of Demand refers to the degree of responsiveness of demand for a commodity to a change in the price of some related commodity.

Cross elasticity of demand is the ratio of proportionate or percentage change in demand of one commodity to proportionate or percentage change in the price of another related commodity.

Cross elasticity of Demand Proportionate or %ge change Qx2 - Qx1ec = in the quantity demanded of X = Qx2 + Qx1

Proportionate or %ge change Px2 – Px1 in the quantity demanded of Y Py2 + Py1 If commodities are inter-related, a change in price of one may cause a change in the price of the other.This is known as Price elasticity of demand.

Py2 – Py1Py2 + Py1

PxEpy = --------------------Px2 – Px1Px2 + Px1

AdvertisingAdvertising consists of those activities by which visual or oral messages are

addressed to selected respondents for the purpose of informing and influencing them to buy products or services or to act or be inclined favourably towards ideas, persons, trade marks, institutions or associations featured.Two important functions of advertising are

(a)To shift the demand curve to the right(b)To reduce the elasticity of demand.(c) However, advertising has a cost payable to the media.1. A certain amount of sales is possible without advertising.2. Other things being equal, there is a direct relationship between extent of

advertisement and volume of sales.3. Upto a point an increase in advertisement will lead to more than

proportionate increase in sales.Beyond this point, an increase will lead to leass than proportionate increase in sales till the saturation point, when no further increase in sales is possible.

Promotional or Advertising Elasticity of Demand

Advertising elasticity of demand is the degree of responsiveness of demand to changes in advertising expenditure.

Q2-Q1 QQ2+Q1 Q Q A

eA = ------------------------------- = -------------------------- = ------- x -----

A2-A1 A A Q A2+A1 A

Q = Quantity of sales A = Advertisement expenditure.

Illustration:At initial advertisement expenditure of Rs.50,000 the demandFor the firm’s product is 80,000 units. When the advertisementBudget is increased to Rs.60,000 the sales volume increasedto 90,000 units. What is the advertising elasticity?

A1 = Rs. 50000 A2 = Rs.60000 A = Rs.10000Q1 = 80000 units Q2 = 90000 units Q = 10000 units

eA = Q x A = 10000 x 50000 = 0.625

A Q 10000 80000Note: When price-quantity changes are very small, pointElasticity is used. When there is substantial change, arc elasticity is used.

If Arc elasticity is found for the above example,eAarc = Q x A1 + A2 = 10000 x 50000 + 60000 = 0.647 A Q1 + Q2 10000 80000 + 90000

Point Elasticity of DemandPoint Elasticity of Demand at any point on the Linear Demand Curve is measured as under :

Lower segment of the Demand Curveep = --------------------------------------------------

Upper Segment of the Demand Curve

e p = 1 Unitary elasticity

ep < 1 Inelastic range

ep > 1 Elastic rangeep = Infiniteelasticity

Uses of Elasticity of Demand for Managerial Decision Making

For taking decisions on a pricing policy, the businessman has to know the likely effects of price changes on the demand for his product in the market. He can calculate if the demand will increase by lowering of the price and to what extent, and whether it will result in substantial increase in revenue and profits. Some businessmen do not pay any attention to the aspect of elasticity of demand, and suffer heavy losses by wrong decisions. In scientific management decision making, on has to have as precise an idea as possible of the degree of elasticity of demand.By knowing the type of elasticity, it is possible to fix the precise price of the product in a very profitable way. Unitary elastic demand will not bring in more revenue. Demand elasticity being more than unity, a price cut would lead to increase in revenue.If the product has inelastic demand, raising price will fetch better revenue and profits. A monopolist can have a rational price discrimination policy. E.g., BSES, BWSSB.In items which are highly responsive to change in income, such as TV sets, when per capita income rises, larger number of TV sets are sold even at slightly higher prices.Cross elasticity helps businessmen to mould their business policies. Demand for oil increases when ghee price rises. Sugar prices has a relationship to changes in price of gur. Rise in umbrella prices may push demand for raincoats. So businessmen can fix their prices appropriately in such cases.

Factors influencingelasticity of demand

1. Nature of the commodity.2. Availability of Substitutes3. Number of Uses4. Consumer’s Income.5. Height of Price and Range of Price Change.6. Proportion of Expenditure.7. Durability of the Commodity.8. Habit.9. Complementary Goods.10.Time.11.Recurrence of Demand.12.Possibility of Postponement.


1. Nature of Commodity: Luxury and comfort goods are price elastic while necessaries are price inelastic.

2. Availability of substitutes: Where there are close substitutes in the same price range, demand will be elastic. E.g., beverages, coffee-tea. Where there are no effective substitutes, demand is inelastic. E.g.salt.

3. Number of uses: Demand for a multi-use commodity in those uses where marginal utility is high, will be inelastic, while in those uses where marginal utility is low, the demand will be elastic.


4. Consumer’s Income: Larger the income, demand is relatively inelastic. Low income tends to make the demand for some

goods relatively elastic.

5. Height of price and range of price: If the change in price in highly priced commodities is substantial, the demand

will be elastic.

6. Proportion of Expenditure: The demand for Items which are a small percentage of the family budget is relatively inelastic.


7. Durability of the commodity: In the case of durable goods the demand is relatively inelastic.

8. Habit: Demand of habituated products is inelastic. e.g., cigarettes.

9. Complementary goods: Goods which are jointly demanded have less elasticity. E.g., ink, petrol.


10. Time : Demand in the short period is generally inelastic and become elastic in the long period.

11. Recurrence of Demand: If the demand is recurring, it will be elastic. (FMCG).

12. Possibility of postponement: Consumption goods which cannot be postponed, the demand is inelastic. Demand is elastic if it is postponable.

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Managerial Economics #2 1