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# Demand Analysis

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### Demand Analysis

1. 1. Unit 3 Demand Analysis - IIObjectives:After going through this unit, you will be able to explain:Meaning and factors influencing demandLaw of demand, its explanations, applications and exceptionsTypes of changes in demandConcept and types of elasticity of demandMeaning and uses of price, income, and cross elasticity of demandStructure:1.1 Introduction1.2 Demand Concepts1.3 Law of demand1.4 Exceptions to the Law of demand1.5 Factors affecting Demand1.6 Changes in Demand – Expansion/Contraction and Increase/Decrease1.7 Elasticity and Demand1.8 Price elasticity of demand1.9 Factors affecting price elasticity of demand1.10 Types of price elasticity of demand1.11 Business applications of price elasticity of demand1.12 Other types of elasticity of demand1.13 Income elasticity of demand1.14 Factors affecting income elasticity of demand1.15 Cross elasticity of demand1.16 Summary1.17 Key words1.18 Self assessment questions
3. 3. All definitions and perspectives on demand highlight two important characteristics ofeconomic demand, viz, a) Ability to purchase b) Willingness to purchaseDemand or the demand relationship is popularly depicted through the Law of Demandand can be expressed in the form of a demand schedule and a demand curve.1.3 Law of DemandWe have already established that a consumer’s demand cannot be expressed independentof the price of the product. How much of a commodity the consumer will be willing tobuy is dependent on its price. We will add to it now by saying that it is only logical that aconsumer will tend to buy more of a commodity if the price is less, and less of it if theprice is more. This is called the Law of Demand. To put it more formally,The law of demand states that, if all other factors remain equal, the higher the price of agood, the less people will demand that good. In other words, at higher prices, a lowerquantity will be demanded than at lower prices, other things being equal. Alternatively, atlower prices, a higher quantity will be demanded, other things being equal.An elementary way to capture the relationship is in the form of a demand schedule asshown in the following table. The numbers in the table below are what one expects in ademand curve: as price goes up, the amount people are willing to buy decreases. Demand Schedule Price Quantity demanded (in Rs.) (in units) 10 100 20 90
4. 4. 30 80 40 70 50 60 60 50 70 40The same information can also be presented diagrammatically, where it will look like thegraph below.In the above diagram, when price is taken on y-axis, and quantity demanded of acommodity is taken on x-axis, the law of demand expresses the demand relationship interms of a downward sloping demand curve ‘D’. This relationship between price and theamount of a product people want to buy is what economists call the demand curve. Thisrelationship is inverse or indirect because as price gets higher, people want less of aparticular product. This inverse relationship is almost always found in studies ofparticular products, and has a very widespread occurrence.The inverse relationship between quantity demand and price as reflected in the downwardsloping demand curve exists because of the some reasons summarized as follows: a) Substitution Effect b) Real Income Effect c) Multiple uses of a product d) Diminishing Marginal Utility for the product
5. 5. Here is an explanation of each of the above factors causing the demand curve to slopedownwards, a) Substitution effect: Consumers have a tendency to shift to cheaper commodities when the price of a commodity increases. This results in reduction in demand of the expensive commodity causing an inverse relationship between quantity demanded and price. b) Real-income effect: Change in purchasing power occurs when the price of a commodity changes. Purchasing power increase when price of a commodity falls and it declines when the price rises. Consumer’s affordability accordingly changes reflecting this in the downward sloping demand curve. The income and substitution effect are shown in the following diagram, c) Multiple uses of a product: If a product has more than one use, then when the price of the product increases the consumer starts restricting the usage of the product only to important uses. Hence, the quantity demanded lowers as price increases. d) Diminishing Marginal Utility: As a consumer consumes subsequent units of a commodity the utility diminishes. This is the famous Law of diminishing marginal utility, which describes that a consumer equates the price paid for a
6. 6. commodity with the satisfaction derived from the commodity. This is why if price increases consumer reduces the quantities of the commodity consumed.1.4 Exceptions to the law of demandThe law of Demand may not hold true even under ceteris paribus conditions. Considerthe following situations where law of demand may not hold true. a) War or war like conditions b) Economic Depression c) Speculation d) Natural Calamities e) Giffen’s paradox f) Demonstration effectAll the above situations do not allow an inverse relationship between the demand for aproduct and its price to function even when everything else is kept constant. This isexplained as follows: a) During war or war like conditions there are great possibilities of potential scarcities or doubts of scarcities. Under such a situation people may buy commodities even at higher prices and law of demand may not hold true. b) When there is economic depression the economy is low and everything goes down, which is why even if prices are falling people may not buy more. c) When consumers speculate they anticipate price movements. In a situation when prices are lower, the consumer demand may not rise because they anticipate further lowering of prices and, hence, may postpone purchase. d) Natural calamities may also cause demand to be high at higher prices and low at lower prices because of abnormal economic conditions. e) As Giffen’s paradox states that the consumers attach status to commodities referring them as superior or inferior. For inferior commodities, for instance, demand may not be higher even if prices are falling because the impact of falling prices would enhance consumer affordability and this enhanced affordability
7. 7. could get spent on superior goods rather than inferior goods. So the law of demand may not hold true. f) Every product has a demonstration effect, meaning that consumer purchase pattern is influenced by the purchase patterns in the society in general.1.5 Factors affecting DemandWe already know the dependency of demand on the price of the commodity. There aresome other factors which affect demand. It is imperative for the marketers to know aboutthese factors to understand consumer demand and what could cause it to change. Thisdependency of demand on various factors is described as Demand Function which can beexpressed as,Q = f (Price, Income, Price of related commodities, tastes and preferences)Where Q is the Quantity of goods demanded.The response of demand to each of these factors can be discussed in detail as follows: a) Price: The relationship between price and quantity demanded has been discussed in detail under the Law of Demand. We can recollect that quantity demanded is inversely proportional to a change in price, ceteris paribus (everything remaining constant). This implies an increase in price causes an increase in quantity demanded and vice-versa. b) Income: The relationship between income and price of a commodity is positive. Ceteris paribus, a rise in consumer income will increase his affordability thereby having a positive impact on quantity demanded of a product. c) Tastes and preferences: Consumers tastes and preferences change with time and with trends and fashion, causing demand for goods and services to fluctuate accordingly.
8. 8. d) Prices of related goods: Commodities may be related to each other and the demand for a commodity is influenced by the price of the related commodity in following ways: (i) Substitutes: Substitutes are those commodities which are used in place of each other. Brands in the same product category such as Pepsi and Coke, or some products like tea and coffee can be viewed as substitutes of each other. If commodities are substitutes, a change in the price of one causes a change in demand for the other in the same direction. Suppose commodities A an B are substitutes of each other. The relationship between their price and quantity demanded is exhibited in the following figure: Increase in Increase in quantity Price of A demanded of B Decrease in Decrease in quantity Price of A demanded of B (ii) Complements: Complements are those commodities which have to be consumed simultaneously for greater satisfaction or any satisfaction at all. Ink and pen, Car and petrol are examples of complement goods. When commodities are complements, a change in the price of one good causes a shift in demand for the other in the opposite direction. The relationship between their price and quantity demanded is exhibited in the following figure: Increase in Decrease in quantity Price of A demanded of B Decrease in Increase in quantity Price of A demanded of B
9. 9. The degree to which goods complement each other or can be substituted for each other varies. e) Changes in expectations of future relative prices: People, extensively, anticipate about the future. When they make such anticipations about price movements in the future their current demand for various commodities gets influenced. It is common to see people pre-pone their purchases before the implementation of contentions of the budget in anticipation of a future price increase as a result of changes in taxation policy. f) Population: The size of the market in general influences the demand for a commodity. The larger the size the greater is the demand.1.6 Changes in DemandA marketer is interested in knowing what causes the demand to change in order toanticipate the demand for the product or alter the consumer demand in his favor. We havediscussed in the earlier sections various factors that affect demand for a commodity. Tounderstand the impact of these factors on demand it will be useful to, broadly classify,them into two categories, viz., a) Price factors b) Non Price factorsThis classification is done because of the varying response of the demand to theinfluencing variable – an expansion/contraction or increase/decrease in demand. a) Change in Quantity demanded or expansion or contraction of demand means that a greater or lesser number of units are bought because of a change in price. An expansion in quantity demanded means that a greater number of units are bought because the price has been lowered. We are moving down a particular demand curve. A contraction in quantity demanded means that a lesser number of units are bought because the price has been raised.
10. 10. b) Increase or decrease in demand means that a greater or lesser number of units are bought without changing price. This means that there is a shift in the demand curve. If it shifts up and to the right, a greater number of units are demanded at any given price. If it shifts down and to the left, a lesser number of units are demanded at any given price. Consider the following figure, Changes in Demand Expansion/Contraction in Increase/decrease in Demand Demand Characteristics: Characteristics: Impact of a change in price Impact of a change in non-price factors Movement along the demand curve Shift of the Demand curve rightwards or leftwards From the above figure, it is clear that demand can change because of price and non-price factors and such demand changes have differing reflections This is shown in the following figures,Price Price Increase Contraction Expansion Decrease Quantity Quantity
11. 11. 1.7 Elasticity and DemandAn understanding of demand enables managers to know more about what, why and howmuch of the consumers purchase of goods and services. In this context knowledge of allthe factors that influence demand also helps, in order to find out the changes in demandand the underlying reasons. Each of these factors has varying impact on the demand for acommodity. Economics provides managers with an important tool called Elasticity whichhighlights the degree of impact that individual influencing factors has on demand.Elasticity, in general, can be understood as a measure of the responsiveness of onevariable to changes in another variable.In the theory of consumer behavior it highlights demand changes in response to variousstimuli. In case of demand we can consider Price, Income, and Prices of related goods asimportant influencing variables. The following section analyses the degree of demand’sresponsiveness to changes in these variables.1.8 Price Elasticity of DemandPrice elasticity of demand measures the response of the quantity demanded to a change inprice. Formally,The price elasticity of demand is the ratio of the proportionate change in quantitydemanded of a commodity with respect to a proportionate change in its price.It is an important concept in understanding consumer demand theory. Price is the singlemost important determining factor of consumer’s demand and price elasticity of demandbrings out the total response of demand to a change in price quantitatively. Priceelasticity of demand can be can be calculated and expressed as,
12. 12. Ep = Proportionate change in quantity demanded Proportionate change in PriceWhere Ep is the coefficient of price elasticity of demandElasticity of demand is often calculated by taking an average the prices and quantitiesgiven by the following formula:Ep = ( Q2 - Q1 ) x P1 ( P2 - P1 ) Q 1Ep = (Q1 + Q2)/2 (P1 + P2)/2Suppose, when commodity A’s price is Rs.10 per unit its quantity demanded is 50 units.When the price changes to Rs.5 its demand increases to 100 units. The price elasticity canbe calculated as follows:In this example, P1= Rs.10, P2= Rs.5, Q1= Rs.50, Q2=Rs.100. We substitute the valuesin equation for calculating the elasticity coefficient.Ep = (100- 50 ) x 10 ( 5 - 10 ) 50Ep = -2It is important to note here that when one calculates price elasticity of demand using thegiven equation the value of coefficient of price elasticity will always have negative value.This is because of the inverse relationship between price and quantity demand of thecommodity. While making a decision regarding the price elasticity the absolute value ofthe coefficient of price elasticity has to be considered. Hence in the above example,ignoring the negative sign the value of coefficient of price elasticity is 2, or,
13. 13. |Ep| = 2For all calculation and decision making purposes a mod value or absolute value of thecoefficient of price elasticity has to be considered.1.9 Factors affecting price elasticity of demandThe degree of demand’s dependency on price is not same for all products. The intensityof relationship between price and quantity demanded of a product or price elasticity ofdemand varies depending on certain factors. They are: a) Existence of substitutes - the closer the substitutes for a particular commodity, the greater will be its price elasticity of demand b) Importance of the commodity in the consumers budget - the greater the percentage of a total budget spent on the commodity, the greater the person’s price elasticity of demand for that commodity c) Time for adjustment in rate of purchase - the longer any price change persists, the greater the price elasticity of demand d) Nature of the commodity - the commodity’s demand is relatively more elastic if it is a necessity as against a luxury good. e) Number of uses of the product - the greater the number of uses a commodity can be put to use the greater is its elasticity. f) Durability - the greater the durability of the product the greater will be its elasticity. g) Addiction - where the products have addictive ability, the elasticity will reduce h) Economic and human constraints - such constraints as posed by availability of resources, government policy, etc. reduce price elasticity of demand.Based on the above factors the response of demand for a commodity to a change in itsprice will be high or low. Further, depending on whether the response is high or low onecan classify various types of price elasticity. This is discussed in the following section:1.10 Types of price elasticity of demand
14. 14. Depending on the degree of demand’s dependency on price and value of coefficient of price elasticity of demand there can be five cases of price elasticity of demand. They are: a) Relatively Elastic Demand: Proportionate change in demand is more than the proportionate change in price. b) Relatively Inelastic Demand: Proportionate change in demand is less than the proportionate change in price. P P c) Perfectly Elastic Demand: Change in demand is infinitely possible even when there may not be any change in price. 1 2 . d) Perfectly Inelastic Demand: Change in demand is not possible even when any changes in price. e) Unitary Elasticity: A change in demand is exactly proportionate to a change in price. The various cases of price elasticity of demand are summarized in the following table: S.No. Q Price elasticity of demand Numerical Q Shape of the demand 0 0 value curve 1. Relatively Elastic Demand Ep>1 Downward sloping 3 demand curve which isP P 4 relatively flatter 2. Relatively Inelastic Demand Ep<1 Downward sloping demand curve which is relatively steeper 3. Perfectly Elastic Demand Ep=∝ Perfectly horizontal demand curve 4. Perfectly Inelastic Demand Ep=0 Perfectly vertical demand Q curve Q0 0 5. Unitary Elasticity Ep=1 Rectangular hyperbole P The above elasticity can be shown through diagrams as follows: 5 Q 0
15. 15. The different price elasticity of demand can also be depicted in same figure as follows,
16. 16. Price D1 D4 D3 D2 QuantityIn the above figure,D1 - Perfectly inelastic demand curveD2 - Perfectly elastic demand curveD3 - Relatively elastic demand curveD4 - Relatively inelastic demand curveThe above demand curves show that as the slope of the demand curve increases priceelasticity of demand also increases. In other words, the flatter the demand curve thegreater is the price elasticity and the steeper the demand curve the lesser is the elasticity.1.11 Business applications of price elasticity of demandThe concept of elasticity is very widely used by business and government. Some specificsituations where the concept is of particular importance are discussed below: a) Pricing policy: The seller can have a high price policy for commodities which have relatively inelastic demand and a low price policy for commodities which have relatively elastic demand.
17. 17. b) Joint demand: Commodities can have joint demand whereby the source of the products is the same. For example fruit juice and jam, or meat and wool. In such cases the prices of the products can be fixed so that a higher price can be charged for the product whose demand is relatively inelastic and lower price for the product whose demand is relatively elastic. c) Taxation Policy: While deciding on the taxation policy for various commodities, particularly the indirect taxes like sales tax, octroi, etc, government makes use of the concept of price elasticity of demand in order to know who will bear the burden of the tax between the buyer and the seller. If the demand for the commodity is relatively elastic the seller may have to bear he burden of the tax, while if the demand is relatively inelastic there are greater chances that the buyer has to bear the burden of the tax. For example the government may decide to have minimum taxation on essential commodities for the common good for their demand is highly price inelastic. On the other hand, government may levy heavy taxation on commodities having addictive value so as to discourage their consumption for their demand is again relatively inelastic. d) Public Utility: Government renders those services under public utility whose demand is highly inelastic such as sewage, garbage disposal etc. If these services were not under public utility there would be great chances of user exploitation. e) International Trade: A country benefits from international trade if its imports are price elastic while its exports are price elastic. If this happens the country operates in buyers market when importing and in a sellers market when exporting. The gulf countries enjoy this advantage when exporting petroleum.1.12 Other types of ElasticityApart from price there are certain other factors that affect demand which marketers takesignificant cognizance of. We have already established the relationship between demandand several non-price factors. The concept of elasticity can be further used to arrive at thedegree of demand’s dependency on each of these factors.The following section analyzes two elasticity concepts,
18. 18. a) Income Elasticity of demand b) Cross elasticity of demand1.13 Income Elasticity of demandIncome elasticity of demand measures the relationship between changes in quantitydemanded as a result of a change in consumer income. The coefficient of incomeelasticity of demand can be, formally, defined as is:Percentage change in quantity demanded of good X divided by the percentagechange in real consumers’ incomeIncome elasticity of demand can be calculated using the following equation,Ey = Proportionate change in quantity demanded Proportionate change in IncomeWhere Ey is the coefficient of income elasticity of demandBased on the value of the coefficient of income elasticity of demand one can concludeabout the nature of the commodity. This can be drawn out from the response of demandfor a commodity to a change in income. For instance, the demand for necessities willincrease with income, but at a slower rate. This is because consumers, instead of buyingmore of only the necessity, will want to use their increased income to buy more of aluxury. During a period of increasing income, demand for luxury products tends toincrease at a higher rate than the demand for necessities.Here is a classification of various types of goods based on their income elasticity ofdemand.
19. 19. Classification of goods based on income elasticity of demand Normal goods Inferior goods Ey is positive Ey is negative Necessities Luxuries 0<Ey<1 Ey>1 a) Normal Goods: Normal goods have a positive income elasticity of demand so that as income rise more is demanded at each price level. We make a distinction between normal necessities and normal luxuries. (i) Necessities have an income elasticity of demand of between 0 and +1. For such goods demand of the commodity rises with income, but less than proportionately. (ii) Luxuries on the other hand are said to have an income elasticity of demand greater than +1 i.e., demand rises more than proportionate to a change in income. b) Inferior Goods: Inferior goods have a negative income elasticity of demand i.e., demand falls as income rises.Consider the following table which cites examples of various types of goods based ontheir income elasticity. Luxury Goods Necessities Inferior goods International Air travel Fresh vegetables Bus travel Fine vines Expenditure on Utilities Salt Antique furniture Shampoo/toothpaste/detergent Tinned meat1.14 Factors affecting income elasticity of demand
20. 20. Within a given market, the income elasticity of demand for various products can vary.Consider the following factors: a) Perception of a product: Perception of a product must differ from consumer to consumer. What to some people is a necessity might be a luxury to others. b) Income and spending decisions: For many products, the final income elasticity of demand might be close to zero, in other words there is a very weak link at best between fluctuations in income and spending decisions. In this case the “real income effect” arising from a fall in prices is likely to be relatively small. Most of the impact on demand following a change in price will be due to changes in the relative prices of substitute goods and services. Consider the following diagram, c) Time: The above diagram also shows that the income elasticity of demand for a product will also change over time – the vast majority of products have a finite life-cycle. Consumer perceptions of the value and desirability of a good or service will be influenced not just by their own experiences of consuming it but also the appearance of new products onto the market. One can take the example of the income elasticity of demand for flat-screen color televisions as the market for
21. 21. plasma screens develops and the income elasticity of demand for TV services provided through satellite dishes set against the growing availability and falling cost (in nominal and real terms) of integrated digital televisions.1.15. Cross Elasticity of demandCommodities may be related to each other. They can be substitutes or complements. Suchrelationships imply that changes or price movements of one commodity invites responsein quantity demanded of the related commodity. The concept of cross elasticity ofdemand can be used to establish this relation between commodities that of substitutes andcomplements. It can be defined as,Cross price elasticity (Ec) measures the degree of responsiveness of demand forcommodity X following a change in the price of another commodity Y.It can be calculated as,Ec = Proportionate change in quantity demanded Proportionate change in price of related goodsWhere Ec is the coefficient of cross elasticity of demand.We have already discussed the concept of substitutes and complements earlier, with crossprice elasticity we make an important distinction between substitute products andcomplementary goods and services as shown in the following table:Nature of the commodity Coefficient of cross elasticity of demandSubstitutes PositiveComplements NegativeAs shown in the above table if coefficient of cross elasticity of demand is positive thecommodities are substitutes and if coefficient of cross elasticity of demand is negative
22. 22. then commodities are complements to each other. Unrelated products have a zero crosselasticityBesides the higher is the co-efficient of cross-price elasticity of demand, the stronger therelationship between two products. For example with two close substitutes, the cross-price elasticity coefficient will be strongly positive. Likewise when there is a strongcomplementary relationship between two products, the cross-price elasticity coefficientwill be highly negative. Consider the following diagram,1.16 SummaryThis unit discusses a very important economic tool for managers that are demand.Various concepts and issues related to demand are explained to enable skills to betterunderstand consumer demand and what motivates it. The concept of elasticity furtherclarifies demand and its degree of dependency on price, income, and related
23. 23. commodities. The applications of elasticity in day to day and strategic business decisionsmake it very vital for managers to be equipped with the knowledge of the concept.1.17 Key words a) Demand: Willingness and ability of people to purchase goods or services in the market for a given price. b) Law of demand: If all other factors remain equal, the higher the price of a good, the less people will demand that good. c) Substitution effect: Consumers have a tendency to shift to cheaper commodities when the price of a commodity increases. d) Real-income effect: Change in purchasing power occurs when the price of a commodity changes. e) Substitutes: Substitutes are those commodities which are used in place of each other. f) Complements: Complements are those commodities which have to be consumed simultaneously for greater satisfaction or any satisfaction at all. g) Expansion or contraction of demand: Greater or lesser number of units of a product is bought because of a change in price. h) Increase or decrease in demand: Greater or lesser number of units of a product is bought because of changes in factors other than the price. i) Elasticity: A measure of the degree of responsiveness of one variable to changes in another variable. j) Price elasticity of demand: Degree of responsiveness of quantity demanded of a commodity to a change in its price. k) Income elasticity of demand: Degree of responsiveness of quantity demanded of a commodity to a change in consumer’s income. l) Normal Goods: Goods having a positive income elasticity of demand. m) Inferior Goods: Goods having a negative income elasticity of demand. n) Cross elasticity of demand: Degree of responsiveness of quantity demanded of a commodity to a change in price of related goods.
24. 24. 1.18 Self assessment questions 1. Explain the concept of economic demand. What factors determine consumer’s demand? 2. Discuss in detail the law of demand and its exceptions 3. Distinguish between: a) Substitution effect and real-income effect b) Substitutes and complements 4. What is price elasticity of demand? What factors determine the value of coefficient of price elasticity? 5. Consider the following table and answer the questions that follow: Commodity P1 Q1 P2 Q2 X 50 25 60 20 Y 10 10 5 200 0 Z 20 80 25 60 For each of the above the above commodities X, Y, and Z, a) Calculate the price elasticity of demand b) Show that the commodities follow the law of demand c) Suggest an appropriate price policy 6. Write short notes on: a) Cross elasticity of demand b) Superior and inferior goods 7. The law of demand states that, if all other factors remain equal, the higher the price of a good, a) Higher is the demand b) Lesser is the demand c) Demand is the same d) Can’t say
25. 25. 8. Consumers have a tendency to shift to cheaper commodities when the price of a commodity increases. a) Mostly true b) Never true c) Can’t say d) None of the above9. When consumers speculate they anticipate a) Price movements b) Elasticity movements c) Both a and b d) Neither a nor b10. Giffen’s paradox states that the consumers attach status to commodities referring them as a) Superior or inferior b) Substitutes or Complements c) Necessities or luxuries d) None of the above11. Demonstration effect means that consumer purchase pattern is influenced by the purchase patterns in the society in general. a) True b) False c) They are not related d) Can’t say12. Fill in the blanks: a) Consumer’s tastes and preferences change with time and with trends and fashion, causing demand for goods and services to ________________ accordingly. b) The size of the market ________________ the demand for a commodity.
26. 26. c) Expansion or contraction of demand means that a greater or lesser number of units are bought because of a change in________________ .d) Elasticity highlights the degree of impact that individual influencing factors has on ________________.e) The price elasticity of demand is the ratio of the proportionate change in ________________ of a commodity with respect to a proportionate change in its________________.f) The commodity’s demand is relatively more elastic if it is a ________________ as against a luxury good.g) The greater the number of uses a commodity can be put to use the ________________ is its elasticity.h) Commodities can have joint demand whereby the ________________ of the products is the same.i) Income elasticity of demand measures the relationship between changes in quantity demanded as a result of a change in ________________.j) Cross price elasticity measures the degree of responsiveness of ________________ for commodity X following a change in the________________ of another commodity Y.