eco unit-2

Unit:-2By:-Manoj Kumar Gautam

Theory of DemandIn economics, demand has a specific meaning distinct from its ordinary usage. In common language we treat ‘demand’ and ‘desire’ as synonymously. This is incongruent from its use in economics. In economics, demand refers to effective demand which implies Four things:• Desire for a commodity• Sufficient money to purchase the commodity, rather the ability to pay Willingness to spend money to acquire that commodityAvailability of the commodity

Demand: It is the mother of production.It implies a desire for the commodity backed by the ability & willingness to pay for it. "The demand for a commodity at a given price is the amount of it which will be bought per unit of time at that price”.

Demand Schedule

The law of demand can be illustrated through a demand schedule. A demand schedule is a series of quantities, which consumers would like to buy per unit of time at different prices.

Demand Schedule for Tea

Demand CurveThe law of demand can also be presented through a curve called demand curve.Demand curve is a locus of points showing various alterative price-quantity combinations.

Demand Curve

Law of Demand: “The demand for a commodity increases with a fall in its price and decreases with a rise in its price, other things remaining the same”.

Assumptions to the Law of Demand:

(1) Income level should remain constant, (2) Tastes of the buyer should not change, (3) Prices of other goods should remain

constant, (4) No new substitutes for the commodity, (5) Price rise in future should not be

expected and (6) Advertising expenditure should remain

the same.

Market Demand:The total quantity which all the consumers of a commodity are willing to buy at a given price per time unit, other things remaining the same, is known as market demand for the commodity. In other words, the market demand for a commodity is the sum of individual demands by all the consumers (or buyers) of the commodity, per time unit and at a given price, other factors remaining the same.

Individual demand:The individual demand means the quantity of a product that an individual can buy given its price. It implies that the individual has the ability and willingness to pay.

Factors affecting demand:

Change in people’s income: More the people earn the more they will spend and thus the demand will rise. A fall in income will see a fall in demand.Changes in population: An increase in population will result in a rise in demand and vice versa.Change in fashion and taste: Commodities or which the fashion is out are less in demand as compared to commodities which are in fashion. In the same way, change in taste of people affects the demand of a commodity.Changes in Income Tax: An increase in income tax will see a fall in demand as people will have less money left in their pockets to spend whereas a decrease in income tax will result in increase of demand for products and services because people now have more disposable income.

Change in prices of Substitute goods: Substitute goods or services are those which can replace the want of another good or service. For example margarine is a substitute for butter. Thus a rise in butter prices will see a rise in demand for margarine and vice versa.

Change in price of Complementary goods: Complementary goods or services are demanded along with other goods and services or jointly demanded with other goods or services. Demand for cars is affected the change in price of petrol. Same way, demand for DVD players will rise if the prices of DVDs’ fall.

Advertising: A successful advertising campaign may affect the demand for a product or service.

Climate: Changes in climate affects the demand for certain goods and services.

Interest rates: A fall in Interest rate will see a rise in demand for goods and services.

7 essential exceptions to the Law of Demand The law of demand does not apply in every case

and situation. The circumstances when the law of demand becomes ineffective are known as exceptions of the law. Some of these important exceptions are as under.

1. Giffen goods: It may be any inferior commodity much cheaper than its superior substitute, consumes by poor households.

Some special varieties of inferior goods are termed as Giffen goods. Cheaper varieties of this category like bajra, cheaper vegetable like potato come under this category.

2. Conspicuous Consumption:This exception to the law of demand is

associated with the doctrine propounded by Thorsten Veblen. A few goods like diamonds etc are purchased by the rich and wealthy sections of the society. The prices of these goods are so high that they are beyond the reach of the common man.

3. Conspicuous necessities:Certain things become the necessities of

modern life. So we have to purchase them despite their high price. The demand for T.V. sets, automobiles and refrigerators etc. has not gone down in spite of the increase in their price. These things have become the symbol of status. So they are purchased despite their rising price. These can be termed as “U” sector goods.

4. Ignorance:A consumer’s ignorance is another factor

that at times induces him to purchase more of the commodity at a higher price. This is especially so when the consumer is haunted by the phobia that a high-priced commodity is better in quality than a low-priced one.

5. Emergencies:Emergencies like war etc. negate the

operation of the law of demand. At such times, households behave in an abnormal way. Households Purchase more of the commodities even when their prices are going up.

6. Future changes in prices:Households also act speculators. When

the prices are rising households tend to purchase large quantities of the commodity out of the apprehension that prices may still go up. When prices are expected to fall further, they wait to buy goods in future at still lower prices. So quantity demanded falls when prices are falling.

7. Change in fashion:A change in fashion and tastes affects the

market for a commodity. When a broad toe shoe replaces a narrow toe, no amount of reduction in the price of the later is sufficient to clear the stocks. Broad toe on the other hand, will have more customers even though its price may be going up. The law of demand becomes ineffective.

TYPES OF ELASTICITY OF DEMAND PRICE ELASTICITY INCOME ELASTICITY CROSS ELASTICITY ADVERTISEMENT ELASTICITY

PRICE ELASTICITYPrice elasticity measures responsiveness

of potential buyers to changes in price. It is the ratio of percentage change in quantity demanded in response to a percentage change in price.

Price Elasticity = %change in amount demanded ------------------------------------ %change in price

Types of Price Elasticity Of Demand(Degrees of elasticity of Demand)Unitary Elastic Demand(ep=1)-

Rectangular HyperbolaRelatively Elastic Demand(ep>1)-Semi

horizontal shape or flatRelatively inelastic demand(ep<1)- Semi

variablePerfectly Elastic Demand(ep=Infinite)-

HorizontalPerfectly Inelastic Demand(ep=0)- Vertical

INCOME ELASTICITYIncome Elasticity is a measure of

responsiveness of potential buyers to change in income.

Income elasticity of demand measures the relationship between a change in quantity demanded and a change in income. Income elasticity of demand measures the degree responsiveness or reaction of the demand for a good to a change in the income of the consumer.

Income Elasticity = %change in the quantity Demanded -------------------------------------------------

%change in Income

Types of Income elasticity of DemandZero income elasticity(Vertical)Positive income elasticity 1-Unitary income elasticity 2- Less than unity 3- More than unityNegative Income elasticity(Sloped

downward)Infinite income elasticity(Horizontal)

CROSS ELASTICITYHere, a change in the price of one good

causes a change in the demand for another.

Cross elasticity of Demand for X and Y = %change in quantity demanded of commodity X -------------------------------------------------------------

% Proportionate change in the price of commodity Y

Types of cross elasticity of demand

Substitute gooods(Demand curve same as drawn in income elasticity)

Complementary goods(Demand curve same as drawn in price elasticity)

Advertisement Elasticity

Advertisement Elasticity of Demand = %change in the quantity Demanded

------------------------------------------------- %change in Advertisement Expenditure

What are the various methods of measuring Elasticity of Demand? Elasticity of demand is known as price-elasticity of

demand. Because elasticity of demand is the degree of change in amount demanded of a commodity in response to a change in price. Price elasticity of demand can be measured through these popular methods. These methods are:

Total Expenditure method or Total Outlay MethodPercentage method or Arithmetic methodGraphic method or point method.Arc Elasticity Method

1. Percentage method:-According to this method price elasticity is

estimated by dividing the percentage change in amount demanded by the percentage change in price of the commodity. Thus given the percentage change of both amount demanded and price we can derive elasticity of demand. If the percentage charge in amount demanded is greater that the percentage change in price, the coefficient thus derived will be greater than one.

If percentage change in amount demanded is less than percentage change in price, the elasticity is said to be less than one. But if percentage change of both amount demanded and price is same, elasticity of demand is said to be unit.

2. Total expenditure methodTotal expenditure method was formulated

by Alfred Marshall. The elasticity of demand can be measured on the basis of change in total expenditure in response to a change in price.

According to this method-“In order 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”

Contd…..ep=1 when due to rise or fall in price of a

good, the total expenditure remains unchanged.

ep>1 when due to fall in price total expenditure goes up & due to rise in price total expenditure goes down.

ep<1 when due to fall in price total expenditure goes down & due to rise in price total expenditure goes up.

Price of Commodity(Rs)

Qty. Purchased(Kg)

Total Expenditure

Change in Total Expenditure

Elasticity of Demand

241

428

888

Remain Unchanged ep=1

241

4110

8410

TE=Decrease When Price Increased& vice versa

ep>1

241

324

684

TE=Increase when price increases

ep<1

3. Graphic method:Graphic method is otherwise known as

point method or Geometric method. This method was popularized by method. According to this method elasticity of demand is measured on different points on a straight line demand curve. The price elasticity of demand at a point on a straight line is equal to the lower segment of the demand curve divided by upper segment of the demand curve.

Arc Elasticity

The concept of point elasticity is relevant where a change in price and the resulting change in quantity is infinitesimally small. But where the change in price and the consequent change in demand are substantial, the concept of arc elasticity is a more relevant concept.

An arc is a portion or a segment of a demand curve. The question now is to get at the appropriate formula for arc elasticity. The percentage formula, (ΔQ/ΔP) × (P/Q)

Gives different results depending on whether the price is raised or lowered. Now, let us look at the market demand schedule and the market demand curve

IMPORTANCE OF ELASTICITY OF DEMAND1. Useful for Business2. Fixation of Prices3. Helpful to Finance Minister 4. Fixation of Wages5. In the Sphere of International Trade 7. Significant for Government Economic

Policies 8. Determination of Price of Public

Utilities. Distribution of burden of taxes

Estimation of Revenue

Revenue:- In The Words of Dooley “The revenue of a firm is its sale receipt”.

A firm’s revenue is the amount it receives by selling goods or services in a given period.

Total Revenue:- it may be defined as the amount of money that the firm receives from the sale of total output

TR=Summation of MR or TR=P*Q

Contd…..Marginal Revenue:- Change in total

revenue on account of the sale of one more unit of commodity

MR=TRn-TRn-1

Average Revenue:-It is the ratio of total revenue to the quantity sold of the product.

AR=TR/Q=P*Q/Q=P

Demand Forecasting

It is the predictions about future demand of the product. It is an estimation of future demand based on an analysis of past statistical data & various effective determinants.

Characteristics of Demand forecasting

It can be for a particular product or for the whole product line.

It can be monetary terms or physical terms or both

It is for a definite periodIt is foundation of business planningIt is an estimate of future salesIt is made on the basis of past data and

present conditions prevailing in the market.

Characteristics of good demand forecastingAccuracySimplicity & ease of comprehensionEconomyReliabilityFlexibilityPracticability

Demand Forecasts

The three principles of all forecasting techniques:

Forecasting is always wrongEvery forecast should include an estimate of errorThe longer the forecast horizon the worst is the

forecast Aggregate forecasts are more accurate

Selecting a forecasting technique

What is the purpose of the forecast?How is it to be used?What are the dynamics of the system for

which forecast will be made?How important is the past in estimating

the forecast?

Methods of Forecasting Demand

1.Quantitative methods: numerical and statistical methods for forecasting demand - more objective.

2.Qualitative Methods: subjective, base on judgements of managers - subjective and depends on managers judgement.

Combination of two might be used.


Quantitative methods: Trend analysis Simple and multiple regression Percentage of sales method

Qualitative Methods:1- Survey of buyers intention: marketer ask buyers about how

many units that they would like to purchase from ABC company’s products for coming period of time.

Well defined buyers Limited in number

Advantage: Simple and Easy Disadvantage: buyers might change their opinions, there is no enforcement

on buyers to buy that much, buyers might over or under estimate.


2- Test Marketing: this research method is heavily preferred when company offers a new product to the market (innovation).

Before offering product to the market, marketers need to get some real feedback from market.

Marketer: choose a specific region or a store to test the product in real market conditions.

Advantage: provide real feedbacks about customers reactions and make estimates upon that.

Disadvantage: no control over who will purchase our new product. Rivals might get aware of it and company loose all of its competitive

advantage.


3- Sales force composite:

Marketers have sales managers or representatives at different sales territories (districts/region) and marketers believe that sales managers know their territory better than anybody else.

Marketers ask respective sales manager to forecast expected sales in their own territories. The total of all these estimates basically gives company’s sales/demand forecast for next period.


Advantage: simple Disadvantage:

forecasting requires especial education and training, most managers have lack of education on this issue

sometimes managers 1- Over estimate: More than sales potential

Over production (extra cost) Additional cost for keeping stock.

2- Under estimate: Less than sales potential

Demand do not match Shift to competitors and decrease in sales and decrease

in profitability.


4- Executive method (jury of executive method): Company forms a committee to make forecast from members from different departments (marketing, accounting, R&D, production)

Make their own forecast and send to committee at a written form Committee members came together and discuss forecasts and agree

one of the estimates or come up with a new estimate for whole company.

Advantage: easy and simple to use. Disadvantage:

estimates are for whole markets and difficult to separate them to specific market or product line;

Reliability and accuracy of estimate depend on how to up-to-date; Members can easily influence each other (objectivity is in question).


5- Delphi method: Very similar to jury of executives method but this time members are both

inside and outside the company Members do not know each other and never come together. A moderator

from company organize all the contacts Moderator prepare data and send it to members to make their own estimate Members send their estimate to moderator as a written form and moderator

makes analysis on estimates and form a new data set and conditions and send back to members for further estimate

This will continue until all members agree on same forecast. (it is suitable for long-term forecasts).

Advantage: No group pressure, more objective Disadvantage: Takes long time.

Utility Analysisutility means satisfaction which a consumer derive from commodities and services by purchasing different units of money.Utility refers to want satisfying power of a commodity. it may or may not be useful .It is a subjective concept, it is quite difficult to measure it directly.It can be estimated indirectly by the price one is willing to pay for a specific good.

Utility Analysis

Cardinal Utility

(Marshall)

Ordinal Utility

(J.R. Hicks )

Contd…..

Cardinal Utility:- This concept of utility suggests measurement of utility in cardinal or definite numbers like 1,2 3,4

Ordinal Utility:- This concept of utility suggests comparision of utility derived from the consumption of two goods or two sets of goods. Expression of utility in terms of numbers is ruled out.

Law of Diminishing marginal Utility (DMU)Dr. Marshall states this, law as follow: The additional benefit which a person derives from a given increase of his stock of anything diminishes with the growth of the stock that he has another words the law of DMU simply states that other things being equal, the marginal utility derived from successive units of a given commodity goes on decreasing. Hence the more we have of a thing; the less we want of it, because every successive unit gives less and less satisfaction.

The law is explained with the help of following example

Units of commodity

No. Of mangoes

Total Utility (TU)

Marginal Utility (MU)

1 8 82 14 63 16 24 16 05 14 -2

It will be better to know some terms for understanding the law and they are.

Initial Utility: It is the utility of the initial or the first unit. In the table initial utility is 8

Total Utility: In column 3 of the table, it gives the total utility at each step. For example if you consume one mango total utility is 8, if you consume two mangoes, the total utility is 14.

Zero Utility: When the consumption of a unit of a commodity makes no addition to the total utility, then it is the point of zero utility. In our table, the TU after the 3rd unit is consumed is 16 and the 4th also it is 16. Thus, the 4th mango results in no increase. Thus is the point of zero utility. It is seen that the total utility is maximum when the MU is zero.

Marginal Utility: The addition to the total utility by the consumption of the last unit considered just worthwhile. The can be worked out by using following formula.

Negative Utility: It the consumption of a unit of a commodity is carried to excess, then instead of giving any satisfaction, it may cause dissatisfaction. The utility in such cases is negative. In the table given above the marginal utility of the 5th unit is negative.

Assumptions: The assumptions of the law of DMU are:

All the units of the given commodity are homogenous i.e. identical in size shape, quality, quantity etc.

The units of consumption are of reasonable size. The consumption is normal.

The consumption is continuous. There is no unduly long time interval between the consumption of the successive units.

The law assumes that only one type of commodity is used for consumption at a time.

Though it is psychological concept, the law assumes that the utility can be measured cardinally i.e. it can be expressed numerically.

The consumer is rational human being and he aims at maximum of satisfaction.

Exceptions: The exceptions to the law of DMU are as follows:

Hobbies: In case of certain hobbies like stamp collection or old coins, every addition unit gives more pleasure. MU goes on increasing with the acquisition of every unit.

Drunkards: It is believes that every does of liquor Increases the utility of a drunkard.

Reading: reading of more books gives more knowledge and in turn greater satisfactions.

INDIFFERENCE CURVE ANALYSISThis approach to consumer behavior is

based on consumer preferences.

It believes that human satisfaction being a psychological phenomenon cannot be measured quantitatively in monetary terms as was attempted in Marshall's utility analysis.

In this approach it is felt that it is much easier and scientifically more sound to order preferences than to measure them in terms of money.

The consumer preference approach, is, therefore an ordinal concept based on ordering of preferences compared with Marshall's approach of cardinality.

What are Indifference Curves?

Ordinal analysis of demand (here we will discuss the one given by Hicks and Allen) is based on indifference curves. An indifference curve is a curve which represents all those combinations of goods which give same satisfaction to the consumer.

Assumptions Underlying Indifference Curve Approach

1 The consumer is rational and possesses full information about all the relevant aspects of economic environment in which he lives.

2. The consumer is capable of ranking all conceivable combinations of goods according to the satisfaction they yield. Thus if he is given various combinations say A, B, C, D, E he can rank them as first preference, second preference and so on.

3. If a consumer happens to prefer A to B, he can not tell quantitatively how much he prefers A to B.4. If the consumer prefers combination A to B, and B to C, then he must prefer combination A to C. In other words, he has consistent consumption pattern behavior.5. If combination A has more commodities than combination B, then A must be preferred to B.

Table Indifference Schedule

A Consumer's Indifference Curve

Properties of Indifference Curves:

(i) Indifference curves slope downward to the right

(ii) Indifference curves are always convex to the origin

Count……. (iii) Indifference curves can never intersect each other

Count……

(iv) A higher indifference curve represents a higher level of satisfaction than the lower indifference curve:

Budget line : A higher indifference curve shows a higher level of satisfaction than alower one. Therefore, a consumer in his attempt to maximize satisfaction will try to reachthe highest possible indifference curve.

Consumer’s Equilibrium: Having explained indifference curves and budget line, we are in a position to explain how a consumer reaches equilibrium position. A consumer is in equilibrium when he is deriving maximum possible satisfaction from the goods and is in no position to rearrange his purchases of goods.

We assume that :(i) The consumer has a given indifference map which shows his scale of preferences for various combinations of two goods X and Y.(ii) He has a fixed money income which he has to spend wholly on goods X and Y.(iii) Prices of goods X and Y are given and are fixed for him.

eco unit-2

Documents