ICAI Notes- Unit 1: Law of Demand and Elasticity of Demand - 1 | Business Economics for CA Foundation PDF Download

Overview

Consider the following hypothetical situation
Aroma Tea Limited is considering diversifying its business. A meeting of the board of directors is called. While discussing the matter, Rajeev Aggarwal, the CEO of Aroma Tea Limited asks, Sanjeev Bhandari, the marketing head, “What do you think Sanjeev, should we enter into green tea business also? What does the market pulse say? Who all are there in this market? How will the demand for green tea affect the demand for our black tea? Is green tea a luxury good or is it a necessity now? What are the key determinants of the demand for green tea? Will coffee drinkers or soft drinkers shift to green tea? The answers to these questions will help us better understand how to price and position our brand in the market. “Before we rush into this line, I want a report on exactly why you believe green tea will be the star of our company in the coming five years?”

As an entrepreneur of a firm or as a manager of a company, you would often face situations in which you have to answer questions similar to the above. Why do prices change when events such as weather changes, wars, pandemics or new discoveries occur? Why is it that some producers are able to charge higher prices than others? The answers to these and a thousand other questions can be found in the theory of demand and supply. 

The market system is governed by market mechanism. Demand and supply are the forces that make market economies work. These two together determine the price and quantity sold of a commodity or service. While buyers constitute the demand side of the market, sellers make the supply side of that market. Since business firms produce goods and services to be sold in the market, it is important for them to know how much of their products would be wanted by buyers during a given period of time. The buyers include consumers, businesses and even government. The quantity that the buyers buy at a given price determines the size of the market. As we are aware, as far as a firm is concerned, the size of the market is a significant determinant of its prospects. 

When a market is competitive, its behaviour is suitably described by the demand and supply model. We understand that the terms demand and supply refer to the behaviour of buyers and sellers respectively as they interact each other in markets. A thorough understanding of the demand and supply theory is therefore essential for any business firm. We shall study the theory of demand in this Unit.

Meaning of Demand

The term ‘demand’ refers to the quantity of a good or service that buyers are willing and able to purchase at various prices during a given period of time. It is to be noted that demand, in Economics, is something more than the desire to purchase, though desire is one  element of it. For example, people may desire much bigger houses, luxurious cars etc. But there are also constraints that they face such as prices of products and limited means to pay. Thus, wants or desires together with the real world constraints determine what they buy. The effective demand for a thing depends on (i) desire (ii) means to purchase and (iii) willingness to use those means for that purchase. Unless desire is backed by purchasing power or ability to pay and willingness to pay, it does not constitute demand. Effective demand alone would figure in economic analysis and business decisions. 

Two things are to be noted about the quantity demanded.
(i) The quantity demanded is always expressed at a given price. At different prices different quantities of a commodity are generally demanded.
(ii) The quantity demanded is a flow. We are concerned not with a single isolated purchase, but with a continuous flow of purchases and we must therefore express demand as ‘so much per period of time’ i.e., one thousand dozens of oranges per day, seven thousand dozens of oranges per week and so on.
In short “By demand, we mean the various quantities of a given commodity or service which consumers would buy in one market during a given period of time, at various prices, or at various incomes, or at various prices of related goods”

What Determines Demand?

Knowledge of the common determinants of demand for a product or service and the nature of relationship between demand and its determinants are essential for a business firm for estimating the market demand for its products. There are a number of factors which influence the demand for a commodity. All these factors are not equally important. Moreover, some of these factors cannot be easily measured or quantified. The important factors that determine demand are given below. 

(i) Price of the commodity: Obviously, the good’s own price is a key determinant of its demand. Ceteris paribus i.e. other things being equal, the demand for a commodity is inversely related to its price. It implies that a rise in the price of a commodity brings about a fall in the quantity purchased and vice-versa. This happens because of income and substitution effects. 

(ii) Price of related commodities: Related commodities are of two types: (i) complementary goods and (ii) competing goods or substitutes.
Complementary goods and services are those that are bought or consumed together or simultaneously. Examples are: tea and sugar, automobile and petrol and pen and ink.

The increase in the demand for one causes an increase in the demand for the other. When two commodities are complements, a fall in the price of one (other things being equal) will cause the demand for the other to rise. For example, a fall in the price of petrol-driven cars would lead to a rise in the demand for petrol. Similarly, computers and computer software are complementary goods. A fall in the price of computers will cause a rise in the demand for software. The reverse will be the case when the price of a complement rises. An increase in the price of a complementary good reduces the demand for the good in question. Thus, we find that, there is an inverse relation between the demand for a good and the price of its complement. 

Two commodities are called competing goods or substitutes when they satisfy the same want and can be used with ease in place of one another. For example, tea and coffee, ink pen and ball pen, different brands of toothpaste etc. are substitutes for each other and can be used in place of one another easily. When goods are substitutes, if the price of a product being purchased goes up, buyers may switch to a cheaper substitute. This decreases the demand for the product at a given price, but increases the demand for the substitute. Similarly, a fall in the price of a product (ceteris paribus) leads to a fall in the quantity demanded of its substitutes. For example, if the price of tea falls, people will try to substitute it for coffee and demand more of it and less of coffee i.e. the demand for tea will rise and that of coffee will fall. Therefore, there is direct or positive relation between the demand for a product and the price of its substitutes. 

(iii) Disposable Income of the consumer: The purchasing power of a buyer is determined by the level of his disposable income. Other things being equal, the demand for a commodity depends upon the disposable income of the potential purchasers. In general, increase in disposable income tends to increase the demand for particular types of goods and services at any given price. A decrease in disposable income generally lowers the quantity demanded at all possible prices. 

The nature of relationship between disposable income and quantity demanded depends upon the nature of goods. A basic description of the nature of goods is useful in describing the effect of income on demand.
Normal goods are those that are demanded in increasing quantities as consumers’ income increases. Most goods and services fall under the category of normal goods. Household furniture, clothing, automobiles, consumer durables and semi durables etc. fall in this category. When income is reduced (for example due to recession), demand for normal goods falls.
There are some commodities for which the quantity demanded rises only up to a certain level of income and decreases with an increase in money income beyond this level. These goods are called inferior goods. Essential consumer goods such as food grains, fuel, cooking oil, necessary clothing etc. satisfy the basic necessities of life and are consumed by all individuals in a society. A change in consumers’ income, although will cause an increase in demand for these necessities, but this increase will be less than proportionate to the increase in income. This is because as people become richer, there is a relative decline in the importance of food and other non durable goods in the overall consumption basket and a rise in the importance of durable goods such as a TV, car, house etc. Demand for luxury goods and prestige goods arise beyond a certain level of consumers’ income and keep rising as income increases. Business managers should be fully aware of the nature of goods which they produce (or the nature of need which their products satisfy) and the nature of relationship of quantities demanded with changes in buyers’ incomes. For assessing the current as well as future demand for their products, they should also recognize the movements in the macro economic variables that affect buyers’ incomes. 

(iv) Tastes and preferences of buyers: The demand for a commodity also depends upon the tastes and preferences of buyers and changes in them over a period of time. Goods which are modern or more in fashion command higher demand than goods which are of old design or are out of fashion. Consumers may perceive a product as obsolete and discard it before it is fully utilised and then prefer another good which is currently in fashion. For example, there is greater demand for the latest digital devices and trendy clothing and we find that more and more people are discarding these goods currently in use even though they could have used it for some more years.
External effects on utility such as' demonstration effect',' bandwagon effect’, Veblen effect and ‘snob effect’ do play important roles in determining the demand for a product. Demonstration effect, a term coined by James Duesenberry, refers to the desire of people to emulate the consumption behaviour of others. In other words, people buy or have things because they see that other people are able to have them. For example, an individual’s demand for cell phone may be affected by his seeing a new model of cell phone in his neighbour’s or friend’s house, either because he likes what he sees or because he figures out that if his neighbour or friend can have it, he too can.

Bandwagon effect refers to the extent to which the demand for a commodity is increased due to the fact that others are also consuming the same commodity. It represents the desire of people to purchase a commodity in order to be fashionable or stylish or to conform to the people they wish to be associated with. 

By ‘snob effect’ we refer to the extent to which the demand for a consumers' good is decreased owing to the fact that others are also consuming the same commodity. This represents the desire of people to be exclusive; to be different; to dissociate themselves from the "common herd." For example, when a product becomes common among all, some people decrease or altogether stop its consumption.

Highly priced goods are consumed by status seeking rich people to satisfy their need for conspicuous consumption. This is called ‘Veblen effect’ (named after the American economist Thorstein Veblen). For example, expensive cars and jewels. The distinction between the snob effect and the Veblen effect is that the former is a function of the consumption of others and the latter is a function of price. We conclude that people have tastes and preferences and these do change - sometimes, due to external and sometimes due to internal causes - and influence demand. 

Knowledge regarding tastes and preferences is extremely valuable for the manufacturers and marketers as it would help them appropriately design new models of products and services and plan production to suit the changing tastes and needs of the customers.

(v) Consumers’ Expectations: Consumers’ expectations regarding future prices, income, supply conditions etc. influence current demand. If the consumers expect increase in future prices, increase in income and shortages in supply, more quantities will be demanded. If they expect a fall in price or fall in income they will postpone their purchases of nonessential commodities and therefore, the current demand for them will fall. Levels of consumer and business confidence about their future economic situations also affect spending and demand. 

Other factors: Apart from the above factors, the demand for a commodity depends upon the following factors: 

• Size of population: Generally, larger the size of population of a country or a region, larger would be the number of buyers and the quantity demanded in the market would be higher at every price. The opposite is the case when population is less. 
• Age Distribution of population: If a larger proportion of people belong to older age groups relative to younger age groups, there will be increased demand for geriatric care services, spectacles, walking sticks, etc. and less demand for children’s books. Similarly, if the population consists of more of children, demand for toys, baby foods, toffees, etc. will be more. Likewise, if there is migration from rural areas to urban areas, there will be decrease in demand for goods and services in rural areas. 
• The level of National Income and its Distribution: The level of national income is a crucial determinant of market demand. Higher the national income, higher will be the demand for all normal goods and services. The wealth of a country may be unevenly distributed so that there are a few very rich people while the majority is very poor. Under such conditions, the propensity to consume of the country will be relatively less, because the propensity to consume of the rich people is less than that of the poor people. Consequently, the demand for consumer goods will be comparatively less. If the distribution of income is more equal, then the propensity to consume of the country as a whole will be relatively high indicating higher demand for goods. 
• Consumer-credit facility and interest rates: Availability of credit facilities induces people to purchase more than what their current incomes permit them. Credit facilities mostly determine the demand for investment and for durable goods which are expensive and require bulk payments at the time of purchase. Low rates of interest encourage people to borrow and therefore demand will be more. 
• Government policies and regulations: The governments influence demand through its taxation, purchases, expenditure, and subsidy policies. While taxes increase prices and decrease the quantity demanded, subsidies decrease the prices and increase the quantity demanded. For example taxes on luxurious goods and subsidies for solar panels. Similarly total bans, restrictions and higher taxes may be used by government to restrict the demand for socially undesirable goods and services. Government’s policy on international trade also will affect the domestic demand for goods and services.
  Apart from above, factors such as weather conditions, business conditions, stage of business cycle, wealth, levels of education, marital status, socioeconomic class, group membership, habits of the consumer, social customs and conventions, salesmanship and advertisements also play important roles in influencing demand.

The Demand Function

As we know, a function is a symbolic statement of a relationship between the dependent and the independent variables. The demand function states in equation form, the relationship between the demand for a product (the dependent variable) and its determinants (the independent or explanatory variables). Any other factors that are not explicitly listed in the demand function are assumed to be irrelevant or held constant. A simple demand function may be expressed as follows:
Q_x = f (P_X, Y, P_r,)
Where Qx is the quantity demanded of product X
P_X is the price of the commodity
Y is the money income of the consumer, and
P_r is the price of related goods
The demand function stated as above does not indicate the exact quantitative relationship between Q_x and P_X, M and P_r,. For this, we need to write the demand function in a particular form with specified values of the explanatory variables appearing on the right-hand side. For example; we may write Q_x = 45 + 2y + 1 Pr, – 2 P. In this unit, we will be studying demand as a function of only price, keeping everything else constant.

The Law of Demand

Most of us have an implicit understanding of the law of demand. The law of demand is one of the most important laws of economic theory. The law states the nature of relationship between the quantity demanded of a product and its price. Prof. Alfred Marshall defined the Law thus: “The greater the amount to be sold, the smaller must be the price at which it is offered in order that it may find purchasers or in other words the amount demanded increases with a fall in price and diminishes with a rise in price”. 

The law of demand states that other things being equal, when the price of a good rises , the quantity demanded of the good will fall. Thus, there is an inverse relationship between price and quantity demanded, ceteris paribus. The ‘other things’ which are assumed to be equal or constant are the prices of related commodities, income of consumers, tastes and preferences of consumers, and all factors other than price which influence demand. If these factors which determine demand also undergo a change, then the inverse price-demand relationship may not hold good. For example, if incomes of consumers increase, then an increase in the price of a commodity, may not result in a decrease in the quantity demanded of it. Thus, the constancy of these ‘other factors’ is an important assumption of the law of demand. 

The quantity demanded is the amount of a good or service that consumers are willing to buy at a given price, holding constant all the other factors that influence purchases. The quantity demanded of a good or service can exceed the quantity actually sold. The Law of Demand may be illustrated with the help of a demand schedule and a demand curve. 

The Demand Schedule 

A demand schedule is a table showing the quantities of a good that buyers would choose to purchase at different prices, per unit of time, with all other variables held constant. To illustrate the relation between the quantity of a commodity demanded and its price, we may take a hypothetical data for prices and quantities of ice-cream. A demand schedule is drawn upon the assumption that all the other influences remain unchanged. It thus attempts to isolate the influence exerted by the price of the good upon the amount sold.

Table 1 shows how many cups of ice-cream this particular buyer buys each week at different prices of ice-cream, holding constant everything else that influences how much of ice-cream this particular consumer wants to buy. If ice-cream is free (price =0), she consumes 12cups of ice-cream per week. As the price rises, she buys fewer and fewer cups of ice-cream. When the price reaches ₹60 per cup, she does not buy ice-cream at all. The above table depicts an inverse relationship between price and quantity of ice-cream demanded. We may note that that the demand schedule obeys the law of demand: As the price of ice-cream increases, ceteris paribus, the quantity demanded falls. 

The Demand Curve 

A demand curve is a graphical presentation of the demand schedule. By convention, the vertical axis of the graph measures the price per unit of the good. The horizontal axis measures the quantity of the good, which is usually expressed in some physical measure per time period. By plotting each pair of values as a point on a graph and joining the resulting points, we get the individual’s demand curve for a commodity. It shows the relationship between the quantities of a good that buyers are willing to buy and the price of the good. We can now plot the data from Table 1 on a graph. 

In Fig. 1, we have shown such a graph and plotted the seven points corresponding to each price-quantity combination shown in Table 1. The demand curve hits the vertical axis at price ₹60 indicating that no quantity is demanded when the price is ₹ 60 (or higher). The demand curve hits the horizontal quantity axis at 12, the amount ice-cream that the consumer wants if the price is zero. Point A shows the same information as the first row of Table 1, and Point G shows the same information as does the last row of the table.

We now draw a smooth curve through these points. The curve is called the demand curve for ice-cream and shows the quantity of ice-cream that the consumer would like to buy at each price. The negative or downward slope indicates that the quantity demanded increases as the price falls. Consumers are usually ready to buy more if the price is lower. Briefly put, more of a good will be purchased at lower prices. Thus, the downward sloping demand curve is in accordance with the law of demand which, as stated above, describes an inverse price-demand relationship. 

The slope of a demand curve is - ∆P/∆Q (i.e the change along the vertical axis divided by the change along the horizontal axis). The negative sign of this slope is consistent with the law of demand.
The demand curve for a good does not have to be linear or a straight line; it can be curvilinear- meaning its slope may vary along the curve. If the change in quantity demanded does not follow a constant proportion, then the demand curve will be non linear. However, linear demand curves provide a convenient tool for analysis. 

Market Demand Schedule 

The market demand for a commodity gives the alternative amounts of the commodity demanded per time period, at various alternative prices, by all the buyers in the market. In other words, it is the total quantity that all the buyers of a commodity are willing to buy per unit of time at a given price, other things remaining constant. The market demand for a commodity thus depends on all the factors that determine the individual’s demand and, in addition, on the number of buyers of the commodity in the market.
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 two individual buyers of good X in the market namely, A and B. The Table 2 shows their individual demand at various prices.

When we add the quantities demanded at each price by consumers A and B, we get the total market demand. Thus, when good X is free or price is zero per unit, the market demand for commodity ‘X’ is 5 units (i.e.3+2). When price rises to ₹ 10, the market demand is 3 units. At a price of ₹ 20, only one unit is demanded in the market. At price ₹ 30, both A and B do not buy good X and therefore, market demand is zero. The market demand schedule also indicates inverse relationship between price and quantity demanded of ‘X’.

The Market Demand Curve

The market demand curve for good X represents the quantities of good X demanded by all buyers in the market for good X. The market demand curve is obtained by horizontal summation of all individual demand curves.

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 two consumers A and B have different individual demand curves corresponding to their different preferences for good X. The two individual demand curves are shown in Figure 2 along with the market demand curve for good X. When there are more than two consumers in the market for some good, the same principle continues to apply and the market demand curve would be the horizontal summation of all the market participants' individual demand curves. 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. 

In addition to the demand schedule and the demand curve, the buyers' demand for a good can also be expressed algebraically, using a demand equation. The demand equation relates the price of the good, denoted by P, to the quantity of the good demanded, denoted by Q. The straight-line demand curve where we hold everything else constant is described by a linear demand function. We can write a demand function as follows: Q = a - bP
Where ‘a’ is the vertical intercept and ‘b’ is the slope.
For example: For a demand function Q = 100 ‐2P

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? Put in other words, why do people buy more at lower prices? Different economists have given different explanations for the operation of the law of demand. These are given below: 

1. Price Effect of a fall in price: The price effect which indicates the way the consumer's purchases of good X change, when its price changes, is the sum of its two components namely: substitution effect and income effect. 
   • Substitution effect: Hicks and Allen have explained the law in terms of substitution effect and income effect. The substitution effect describes the change in demand for a product when its relative price changes. When the price of a commodity falls, the price ratio between items change and 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. When the price falls, the substitution effect is always positive; i.e it will always cause more to be demanded. The substitution effect will be stronger when:
     (a) the goods are closer substitutes
     (b) there is lower cost of switching to the substitute good
     (c) there is lower inconvenience while switching to the substitute good 
   • Income effect: The increase in demand on account of an increase in real income is known as 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. A part or whole of the resulting increase in real income can now be used to buy more of the commodity in question, given that the good is normal. Therefore, the demand for that commodity (whose price has fallen) increases. However, there is one exception. In the case of inferior goods, the income effect works in the opposite direction to the substitution effect. In the case of inferior goods, the expansion in demand due to a price fall will take place only if the substitution effect outweighs the income effect. 
2. Utility maximising behaviour of Consumers: 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. 
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 increases. 
4. Different uses: Many commodities have multiple uses. When the price of such commodities are high (or rises) they will be put to limited uses only. If the prices of such commodities fall, they will be put to more number of uses and therefore their demand will increase. Thus, the increase in the number of uses consequent to a fall in price make the buyer demand more of such commodities making the demand curve slope downwards. For example: Electricity

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 used by the rich people as status symbol for enhancing their social prestige or /and for displaying wealth. These articles will not conform to the usual law of demand as they become more attractive only if their prices are high or keep going up. 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. 

(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 available and which occupy a substantial place in consumers’ budget are called ‘Giffen goods’. All Giffen goods are inferior goods; but all inferior goods are not Giffen goods. 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, air-conditioners 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 even 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 even as their price rises. On the contrary, if prices are falling and people anticipate further fall, rather than buying more, they postpone their purchases. However, it is to be noted that here it is not the law of demand which is invalidated. 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) Incomplete information and irrational behaviour: The law has been derived assuming consumers to be rational and knowledgeable about market-conditions. However, at times, consumers have incomplete information and therefore make inconsistent decisions regarding purchases. 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. Sometimes, 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. 

(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 the prices of related commodities or in tastes and fashion etc., the inverse demand and price relation may not hold good.