Notes on Demand and Elasticity

Introduction

  1. Willing to Purchase at Various Prices during Period of Time
  2. Able to Purchase at Various Prices during Period of Time

Definitions of Demand

• Demand    refers    to    the    Quantities    of Commodity that the Consumers are Able to Buy at each possible Price during a given Period of Time, other things being equal. By : Ferguson

• Demand  is  the  Ability  and  Willingness  to buy Specific Quantity of a Good at Alternative Prices in a given Time Period, Ceteris Paribus. By : B. R. Schiller

Determinants of Demand

  1.  Price of the Commodity
  2.  Price of Related Commodities
  3.  Level of Income of the Household
  4.  Taste & Preferences of Consumers
  5.  Other Factors

• Price of the Commodity

Ceteris   paribus   i.e.   Other   Things Being Equal,

D ∝ 1/P

This  Happens  Because  of  Income  & Substitution Effects

• Price of Related Commodities

Complementary Goods e.g. Pen & Ink

Price of one Good Decrease
Demand of Other Good Decrease


Substituting Goods e.g. Tea & Coffee

Price of one Good Increase 
Demand of Other Good Increase

• Level of Income of the Household

Average Money Income Increase
Quantity Demanded of a Good Increase


Exception: Inferior Goods

Average Money Income Increase
Quantity Demanded of a Good Decrease

• Taste & Preferences of Consumers

• Other Factors

  1. –Size of the Population
  2. –Composition of Population

Law of Demand

Law of demand states that People will Buy more at Lower Prices and Buy less at Higher Prices,   Ceteris   paribus,   or   other   things Remaining the Same. By : Samuelson

The  Law  of  Demand  states  that  Quantity Demanded  Increases  with  a  Fall  in  Price and Diminishes when Price Increases, other things being equal. By : Marshall

Assumption to Law of Demand

• Law of demand holds Good when “Other Things Remain the Same” meaning thereby,   the factors affecting demand ,other then price, are assumed to be constant.

• Demand Function: Dx= f(PX, Pr, Y, T, E)
where,  

Dx = Demand for Commodity
Px = Price of Commodity X
Pr = Price of Other Goods
Y   = Income of the Consumer
T = Tastes
E = ExpGeenceratl Eacotnoimoics:nLawof Dfemtanhd aend  Consumer        

Explanation

• According to Law of Demand, Ceteris Paribus


Quantity Demanded    ∝     1  /  Price


However, this Relation  is  not  Proportional, meaning  thereby  that  it  is  not  necessary that  when  Price  Falls  by  ½,  Demand  for Goods will be Doubled.

This simply indicates the Direction of Change in Demand as change in Price.

Demand Schedule

• Demand    Schedule    is    a    Series    of Quantities which Consumer would like to Buy per unit of Time at Different Prices.

• Two Aspects of Demand Schedule

– Individual Demand Schedule

– Market Demand Schedule

Individual Demand Schedule


• It  is  defined  as  a Table which shows Quantities     of     Given    Commodity   which an Individual  Consumer  will  buy at all  Possible  Prices at a given Time.

Market Demand Schedule

• It is defined as the Quantities of a Given Commodity which all Consumers will buy at all Possible Prices at a given Moment of Time.  In  Market  there  are  many Consumers of a Single Commodity. The Schedule is based on the Assumption that there are in all, 2 Consumers ‘A’ & ‘B’ of Commodity ‘X’. By aggregating their Individual Demand, the Market Demand Schedule is constructed.               

Demand Curve

• A  Demand  Curve  is  a  Locus  of  Points showing various Alternative Price- Quantity Combinations.

• It    shows    the    Inverse    Relationship between Price & Quantity Demanded.

• It Slopes Downwards to the Right.


Individual Demand Curve

Individual Demand Curve
X Axis – Price (Rs.)
Y Axis – Quantity
DD – Demand Curve

The Demand Curve Slopes Downwards from Left to Right, meaning thereby that when   Price   is   High Demand   is   Low   and vice versa.

Market Demand Curve

Market Demand Curve

Why does Demand Curve Slope Downward?

•  Income Effect :

It is the Effect that a Change in a Person’s  Real  Income  caused  by  Change  in  the Price of a Commodity has on the Quantity of that Commodity. In other words, the Increase in Demand on Account of Increase in Real Income is known as Income Effect.

•  Substitution Effect :

It is the Effect that a Change in Relative Prices of Substitute Goods has on the Quantity Demanded.  Substitutes are Goods that can be used in place of each other.

 Different         Uses:        

Demand         for Commodities  with  Alternative  Uses tends  to  Extend  Consequent  upon  the fall in their prices.

•  Size of Consumer Group:  

 When the Price of a Commodity falls, then many Consumers, who are unable to buy that Commodity at its Previous Price, Come

Exceptions to Law of Demand


•  Article of Distinction or Veblen Goods: Goods like Jewellery, Diamonds & Gems are considered as Articles of Distinction. These Goods command More Demand when their Prices are High.

Ignorance: Many a time, Consumers out of sheer Ignorance or Poor Judgment consider a Commodity to be of Low Quality if its Price is Low and of High Quality if its Price is High.

•  Giffen Goods : Giffen Goods are those Inferior Goods whose Demand falls even when their Prices Falls. For example, ‘Bajra’. Only those Inferior Goods are called Giffen Goods where Law of Demand Fails.

•  Expectation of Rise or Fall in Price in Future: If Prices are likely to Rise More in the Future then even at the Existing Higher Price people may Demand more Units of the Commodity in the Present and vice versa.

Expansion & Contraction in Demand


Expansion

• Price ↓ (decrease),  QD ↑ (increase)
• Downward Movement  Along the Demand Curve


Contraction

• Price ↑(increase), QD ↓ (Decrease)
• Upward Movement Along the Demand Curve

Expansion and contraction of Demand


Increase & Decrease in Demand

Increase

• Price Same, QD ↑ due to Change in Other Factors
• Rightward Shift

Decrease

• Price Same, QD ↓  due to Change in Other Factors
• Leftward Shift

Increase and Decrease in Demand


Distinction between Extension & Increase in Demand

• Extension  in  Demand means Rise in Demand in Response to fall in the Price of a Commodity, Other things being equal.

• It is expressed  by the Movement from a Higher  Point  to  a Lower Point along the same Demand Curve.

• Increase    in    Demand refers to the Rise in Demand in Response to the Change in the Determinants of Demand other then Price.

• It  is  expressed  by  the Upward Shift of the Entire Demand Curve. 


Distinction between Contraction & Decrease in Demand

• Contraction in Demand means Fall in Demand in Response to a Rise in the Price of a Commodity, Other things being Equal.

• It is expressed  by the Movement from a Lower  Point  to  a Higher   Point   on   the  Same Demand Curve.

• Decrease   in   Demand means Fall in Demand in Response to Change in Determinants of Demand, Other then the Price.

• It  is  expressed  by  a Downward Shift of the Entire Demand Curve.

Elasticity of Demand

• It answers the Question “BY HOW MUCH?”

• Elasticity    of    Demand    is    defined    as    the Responsiveness of the Quantity Demanded of a Good  to  Change  on  one  of  the  Variables  on which Demand Depends.


E =                   (    % Change in Q.D.  )/                               
               % Change in one  of the  Variables on  which Demand depends

 

Types of Elasticity of Demand

  1. Price Elasticity
  2. Income Elasticity
  3. Cross Elasticity


Price Elasticity of Demand

It is Measured as a Percentage Change in Quantity Demanded Divided by the Percentage Change in Price, Other things Remaining Same.
Ep  =                % Change in Q.D./                
                      % Change in Price

Ep =              Change in Quantity ×    Original Price                               
                      Change in Price       x  Original Quantity


Ep =           ∆Q ×  P
                    ∆P    Q

Where,      Ep                         Price Elasticity
∆                           Very Small Change
P                            Price
Q                           Quantity Demanded

Note:  Ep  is  (-)ve  due  to  Inverse  Relationship Between Price & Quantity Demanded.

Degrees of Price Elasticity of Demand

  1. Perfectly Elastic: E = ∞
  2. Perfectly Inelastic: E = 0
  3. Unit Elastic: E = 1
  4. More than Unit Elastic (Elastic): E > 1
  5. Less than Unit Elastic (Inelastic): E < 1

Perfectly Elastic Demand

Perfectly Elastic Demand
•  A Perfectly Elastic Demand is one in which a Little Change in Price will Cause an Infinite Change in Demand.

• A very little Rise in Price causes the Demand to Fall to Zero and a very little Fall in Price causes Demand to Extend to Infinity.

•  Under Perfect Competition, Demand Curve of a Firm is Percfectly Elastic.

Perfectly Inelastic Demand

Perfectly Inelastic Demand

• Perfectly         Inelastic Demand   is   one   in which   a   Change   in Price    Produces    No Change        in        the Quantity Demanded.

• In this case, Elasticity of Demand is Zero. 

Unitary Elastic Demand

 

Unitary elastic Demand


Unitary Elastic Demand is one which a % Change in Price Produces an Equal % Change in Demand.

• This type of Demand Curve       is       called Rectangular Hyperbola. 

Greater than Unitary Elastic

 

Greater than Unitary elastic Demand

• Greater   than   Unitary Elastic  Demand  is  one in     which     a     Given %Change in Price Produces Relatively more %Change in Demand.

• In this case Elasticity of Demand is Greater than Unitary. 


Less than Unitary Elastic Demand

Less than Unitary elastic Demand

 • Less      than      Unitary Elastic  Demand  is  one in which a given % Change in Price Produces Relatively Less % Change in Demand

• In  this  case,  Elasticity of Demand is Less then Unitary.

Point Elasticity of Demand

• Refers to Measuring the Elasticity at a Particular Point on Demand Curve.

• Makes Use of Derivative Changes Rather than Finite Changes in Price & Quantity.

• Defined As: dq/dp   ×   p/q
Where, dp/dq
is the derivative of Quantity w.r.t. Price at a point on Demand Curve.

Point Elasticity =(  Upper Segment)/(Lower Segment) = PM/PN

Point Elasticity of Demand

• As  we  Move  from  N to M, Elasticity Goes on Increasing. At Mid Point, Ep = 1, at N Ep = 0 & at M Ep = ∞

Arc Elasticity of Demand

• When  Elasticity  is  to  be found  between  2  Points, we use Arc Elasticity.            

Arc Elastic Demand

Elasticity = (q1   − q 2) /(q1   + q2) × (p1    + p2 )/(p1 − p2)

Where,
p1 = Original Price
q1 = Original Quantity
p2   = New Price
q2 = New Quantity

Total Expenditure (Outlay) Method

• This  Method  was  evolved  by  Dr.  Alfred Marshall.

• According to this Method, To Measure the Elasticity  of  Demand  it  is  Essential  to Know How Much & In What Direction the Total Expenditure has Changed as a Result of Change in the Price of a Good.

Elasticity of Demand Price Total Expenditure
Greater than Unity Ep>1 Increase
Decrease
Decrease
Increase
Unity  Ep=1 Same
Same

Unchanged
Unchanged

Less than Unity  Ep<1 Increase
Decrease
Increase
Decrease

Total Outlay method

 

Determinants of Price Elasticity of Demand

  1. • Availability of Substitutes
  2. • Position   of   Commodity   in   Consumer’s Budget
  3. • Nature of Need that a Commodity Satisfies
  4. • Number of Uses to which a Commodity is Put
  5. • Period
  6. • Consumer Habits

 

Income Elasticity of Demand


• Income Elasticity of Demand is the Degree of Responsiveness of Quantity Demanded of a Good to a Small Change in the Income of Consumer.

Ey =  % Change in Quantity Demanded
                    % Change in Income


Degrees of Income Elasticity of Demand

  1. Positive Income Elasticity of Demand
    1. Unitary Income Elasticity of Demand
    2.  Less than Unitary Income Elasticity of Demand
    3.  More than Unitary Income Elasticity of Demand
  2.  Negative Income Elasticity of Demand
  3.  Zero Income Elasticity of Demand


Positive Income Elasticity of Demand

Positive Income Elasticity
• Income    Elasticity    of Demand for a Good is Positive,   When   with  an    Increase    in    the Income of a Consumer, his   Demand   for   the Good    Increases    and Vice Versa.

• It is Positive in case of Normal Goods.                            

 

Negative Income Elasticity of Demand

Negative Income Elasticity
• Income    Elasticity    of Demand is Negative when Increase in the Income of the Consumer is Accompanied by Fall in Demand of a Good

• It is Negative in case of Inferior Goods which are  known  as  Giffen Goods.

 

Zero Income Elasticity of Demand

Zero Income Elasticity
• Income   Elasticity   of Demand is  Zero, When Change in the Income of Consumer evokes No Change in his Demand.

• Demand   for Necessaries like oil, salt, etc., have Zero Income   Elasticity   of Demand

 

Cross Elasticity of Demand

•  Cross Elasticity of Demand is a Change in the Demand of One  Good  in  Response  to  a  Change  in  the  Price  of Another Good.


Ec  = (∆Q x / ∆Py ) ×  (Py /  Qx)


Where,          Ec = Cross Elasticity
Qx = Original Q.D. of X
∆Qx = Change in Q.D. of X
Py = Original Price of Y
∆Py = Change in Price of Y

Positive Cross Elasticity of Demand

Positive Cross Elasticity

• It is positive in case of Substitute Goods.

• For example, Rise in the Price of Coffee will lead to Increase in Demand for Tea.

• The    Curve    slopes Upward from Left to Right.

Negative Cross Elasticity of Demand

Negative Cross Elasticity

• It is Negative in Case of Complementary Goods.

• For example, Rise in Price of Bread will bring Down the Demand for Butter.

• The    Curve    slopes Downwards from Left to Right.

Zero Cross Elasticity of Demand

• Cross Elasticity of Demand is Zero when Two Goods are Not Related to each other.

• For example, Rise in the Price of Wheat will have No Effect on the Demand for Shoes.


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