Law of Demand (Part - 2) CA Foundation Notes | EduRev

Business Economics for CA Foundation

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CA Foundation : Law of Demand (Part - 2) CA Foundation Notes | EduRev

The document Law of Demand (Part - 2) CA Foundation Notes | EduRev is a part of the CA Foundation Course Business Economics for CA Foundation.
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Market Demand Schedule 

Market demand is defined as the sum of individual demands for a product at a price per unit of time. In other words, it is the total quantity that all consumers of a commodity are willing to buy per unit of time at a given price, all other things remaining constant. When we add up the various quantities demanded by different consumers in the market, we can obtain the market demand schedule. How the summation is done is illustrated in Table 2. Suppose there are only three individual buyers of the goods in the market namely, P,Q and R. The Table 2 shows their individual demands at various prices. 

Table 2: Market Demand Schedule

Quantity demanded by

PricePQRTotal Market Demand
5
4
3
2
1
10
15
20
35
60
8
12
17
25
35
12
18
23
40
45
30
45
60
100
140

 

When we add the quantities demanded at each price by consumers P, Q and R, we get the total market demand. Thus, when price is ₹ 5 per unit, the market demand for commodity ‘X’ is 30 units (i.e. 10+8+12). When price falls to ₹ 4, the market demand is 45 units. At ₹ 1, 140 units are demanded in the market. The market demand schedule also indicates inverse relationship between price and quantity demanded of ‘X’

Law of Demand (Part - 2) CA Foundation Notes | EduRev

Fig. 2 : Market Demand Curve 

Market Demand Curve: If we plot the market demand schedule on a graph, we get the market demand curve. Figure 2 shows the market demand curve for commodity ‘X’. The market demand curve, like the individual demand curve, slopes downwards to the right because it is nothing but the lateral summation of individual demand curves. Besides, as the price of the good falls, it is very likely that new buyers will enter the market which will further raise the quantity demanded of the good .

Rationale of the Law of Demand 

Normally, the demand curves slope downwards. This means people buy more at lower prices. We shall now try to understand why do demand curves slope downwards? Dierent economists have given different explanations for the operation the of law of demand. These are given below:

(1) Law of diminishing marginal utility: A consumer is in equilibrium (i.e. maximises his satisfaction) when the marginal utility of the commodity and its price equalize. According to Marshall, the consumer has diminishing utility for each additional unit of a commodity and therefore, he will be willing to pay only less for each additional unit. A rational consumer will not pay more for lesser satisfaction. He is induced to buy additional units only when the prices are lower. The operation of diminishing marginal utility and the act of the consumer to equalize the utility of the commodity with its price result in a downward sloping demand curve.
(2) Price effect: The total fall in quantity demanded due to an increase in price is termed as Price effect. The law of demand can be dubbed as “Negative Price Effect” with some exceptions. The price effect manifests itself in the form of income effect and substitution effect

  1. Substitution effect: Hicks and Allen have explained the law in terms of substitution effect and income effect. When the price of a commodity falls, it becomes relatively cheaper than other commodities. Assuming that the prices of all other commodities remain constant, it induces consumers to substitute the commodity whose price has fallen for other commodities which have now become relatively expensive. The result is that the total demand for the commodity whose price has fallen increases. This is called substitution effect.
  2. Income effect: When the price of a commodity falls, the consumer can buy the same quantity of the commodity with lesser money or he can buy more of the same commodity with the same amount of money. In other words, as a result of fall in the price of the commodity, consumer’s real income or purchasing power increases. This increase in the real income induces him to buy more of that commodity. Thus, the demand for that commodity (whose price has fallen) increases. This is called income effect.

(3) Arrival of new consumers: When the price of a commodity falls, more consumers start buying it because some of those who could not afford to buy it earlier may now be able to buy it. This raises the number of consumers of a commodity at a lower price and hence the demand for the commodity in question.
(4) Different uses: Certain commodities have multiple uses. If their prices fall, they will be used for varied purposes and therefore their demand for such commodities will increase. When the price of such commodities are high (or rises) they will be put to limited uses only. Thus, different uses of a commodity make the demand curve slope downwards reacting to changes in price. For example Olive oil can be used for cooking as well as for cosmetic purposes. So if the price of olive oil rises we can limit our usage and thus the demand will fall.

Exceptions to the Law of Demand
According to the law of demand, other things being equal, more of a commodity will be demanded at lower prices than at higher prices,. The law of demand is valid in most cases; however there are certain cases where this law does not hold good. The following are the important exceptions to the law of demand.
(i) Conspicuous goods: Articles of prestige value or snob appeal or articles of conspicuous consumption are demanded only by the rich people and these articles become more attractive if their prices go up. Such articles will not conform to the usual law of demand. This was found out by Veblen in his doctrine of “Conspicuous Consumption” and hence this effect is called Veblen effect or prestige goods effect. Veblen effect takes place as some consumers measure the utility of a commodity by its price i.e., if the commodity is expensive they think that it has got more utility. As such, they buy less of this commodity at low price and more of it at high price. Diamonds are often given as an example of this case. Higher the price of diamonds, higher is the prestige value attached to them and hence higher is the demand for them.
(ii) Giffen goods: Sir Robert Giffen, a Scottish economist and statistician, was surprised to find out that as the price of bread increased, the British workers purchased more bread and not less of it. This was something against the law of demand. Why did this happen? The reason given for this is that when the price of bread went up, it caused such a large decline in the purchasing power of the poor people that they were forced to cut down the consumption of meat and other more expensive foods. Since bread, even when its price was higher than before, was still the cheapest food article, people consumed more of it and not less when its price went up .
Such goods which exhibit direct price-demand relationship are called ‘Giffen goods’. Generally those goods which are inferior, with no close substitutes easily available and which occupy a substantial place in consumer’s budget are called ‘Giffen goods’. All Giffen goods are inferior goods; but all inferior goods are not Giffen goods. Inferior goods ought to have a close substitute. Moreover, the concept of inferior goods is related to the income of the consumer i.e. the quantity demanded of an inferior good falls as income rises, price remaining constant as against the concept of giffen goods which is related to the price of the product itself. Examples of Giffen goods are coarse grains like bajra, low quality rice and wheat etc.
(iii) Conspicuous necessities: The demand for certain goods is affected by the demonstration effect of the consumption pattern of a social group to which an individual belongs. These goods, due to their constant usage, become necessities of life. For example, in spite of the fact that the prices of television sets, refrigerators, coolers, cooking gas etc. have been continuously rising, their demand does not show any tendency to fall.
(iv) Future expectations about prices: It has been observed that when the prices are rising, households expecting that the prices in the future will be still higher, tend to buy larger quantities of such commodities. For example, when there is wide-spread drought, people expect that prices of food grains would rise in future. They demand greater quantities of food grains as their price rise. However, it is to be noted that here it is not the law of demand which is invalidated but there is a change in one of the factors which was held constant while deriving the law of demand, namely change in the price expectations of the people.
(v) The law has been derived assuming consumers to be rational and knowledgeable about marketconditions. However, at times, consumers tend to be irrational and make impulsive purchases without any rational calculations about the price and usefulness of the product and in such contexts the law of demand fails.
(vi) Demand for necessaries: The law of demand does not apply much in the case of necessaries of life. Irrespective of price changes, people have to consume the minimum quantities of necessary commodities.
Similarly, in practice, a household may demand larger quantity of a commodity even at a higher price because it may be ignorant of the ruling price of the commodity. Under such circumstances, the law will not remain valid. For example Food, power, water, gas.
(vii) Speculative goods: In the speculative market, particularly in the market for stocks and shares, more will be demanded when the prices are rising and less will be demanded when prices decline.
The law of demand will also fail if there is any significant change in other factors on which demand of a commodity depends. If there is a change in income of the household, or in prices of the related commodities or in tastes and fashion etc., the inverse demand and price relation may not hold good.

EXPANSION AND CONTRACTION OF DEMAND
The demand schedule, demand curve and the law of demand all show that when the price of a commodity falls, its quantity demanded increases, other things being equal. When, as a result of decrease in price, the quantity demanded increases, in Economics, we say that there is an expansion of demand and when, as a result of increase in price, the quantity demanded decreases, we say that there is contraction of demand. For example, suppose the price of apples at any time is ₹ 100/ per kilogram and a consumer buys one kilogram at that price. Now, if other things such as income, prices of other goods and tastes of the consumers remain the same but the price of apples falls to ₹ 80 per kilogram and the consumer now buys two kilograms of apples, we say that there is a change in quantity demanded or there is an expansion of demand. On the contrary, if the price of apples rises to ₹ 150 per kilogram and the consumer then buys only half a kilogram, we say that there is a contraction of demand.
The phenomena of expansion and contraction of demand are shown in Figure 3. The figure shows that when price is OP, the quantity demanded is OM, given other things equal. If, as a result of increase in price (OP”), the quantity demanded falls to OL, we say that there is ‘a fall in quantity demanded’ or ‘contraction of demand’ or ‘an upward movement along the same demand curve’. Similarly, as a result of fall in price to OP’, the quantity demanded rises to ON, we say that there is ‘expansion of demand’ or ‘a rise in quantity demanded’ or ‘a downward movement on the same demand curve.’
Law of Demand (Part - 2) CA Foundation Notes | EduRev
Fig. 3 : Expansion and Contraction of Demand 
INCREASE AND DECREASE IN DEMAND
Till now we have assumed that other determinants of demand remain constant when we are analysing demand for a commodity. It should be noted that expansion and contraction of demand take place as a result of changes in the price while all other determinants of price viz. income, tastes, propensity to consume and price of related goods remain constant. The ‘other factors remaining constant’ means that the position of the demand curve remains the same and the consumer moves downwards or upwards on it. What happens if there is a change in consumers’ tastes and preferences, income, the prices of the related goods or other factors on which demand depends? Let us consider the demand for commodity X:
Table 3 shows the possible effect of an increase in income of the consumer on the quantity demanded of commodity X.  


Table 3 : Two demand schedules for commodity X


Price
(₹)

Quantity of ‘X’ demanded when average household income is ₹ 20,000 per month

Quantity of ‘X’ demanded when average household income is ₹ 25,000 per month

A
B
C
D
E

5
4
3
2
1

10
15
20
35
60

15
20
25
40
60

A1
B1
C1
D1
E1


Law of Demand (Part - 2) CA Foundation Notes | EduRev
Fig. 4: Figure showing two demand curves with different incomes 

These new data are plotted in Figure 4 as demand curve D’D’ along with the original demand curve DD. We say that the demand curve for X has shifted [in this case it has shifted to the right]. The shift from DD to D’D’ indicates an increase in the desire to purchase ‘X’ at each possible price. For example, at the price of ₹ 4 per unit, 15 units are demanded when average household income is ₹ 20,000 per month. When the average household income rises to ₹ 25,000 per month, 20 units of X are demanded at price ₹ 4. A rise in income thus shifts the demand curve to the right, whereas a fall in income will have the opposite effect of shifting the demand curve to the left.

Law of Demand (Part - 2) CA Foundation Notes | EduRev
Fig. 5(a): Rightward shift in the demand curve
Law of Demand (Part - 2) CA Foundation Notes | EduRev
Fig. 5(b): Leftward shift in the demand curve

5(a) A rightward shift in the demand curve (when more is demanded at each price) can be caused by a rise in income, a rise in the price of a substitute, a fall in the price of a complement, a change in tastes in favour of this commodity, an increase in population, and a redistribution of income to groups who favour this commodity.
5(b) A leftward shift in the demand curve (when less is demanded at each price) can be caused by a fall in income, a fall in the price of a substitute, a rise in the price of a complement, a change in tastes against this commodity, a decrease in population, and a redistribution of income away from groups who favour this commodity.

MOVEMENTS ALONG THE DEMAND CURVE VS. SHIFT OF DEMAND CURVE
It is important for the business decision-makers to understand the distinction between a movement along a demand curve and a shift of the whole demand curve.
A movement along the demand curve indicates changes in the quantity demanded because of price changes, other factors remaining constant. A shift of the demand curve indicates that there is a change in demand at each possible price because one or more other factors, such as incomes, tastes or the price of some other goods, have changed.
Thus, when an economist speaks of an increase or a decrease in demand, he refers to a shift of the whole curve because one or more of the factors which were assumed to remain constant earlier have changed. When the economists speak of change in quantity demanded he means movement along the same curve (i.e., expansion or contraction of demand) which has happened due to fall or rise in price of the commodity.
In short ‘change in demand’ represents shift of the demand curve to right or left resulting from changes in factors such as income, tastes, prices of other goods etc. and ‘change in quantity demanded’ represents movement upwards or downwards on the same demand curve resulting from a change in the price of the commodity.
When demand increases due to factors other than price, firms can sell more at the existing prices resulting in increased revenue. The objective of advertisement and all other sales promotion activities by any firm is to shift the demand curve to the right and to reduce the elasticity of demand. (The latter will be discussed in the next section). However, the additional demand is not free of cost as firms have to incur expenditure on advertisement and sales promotion devices.

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