Unit‐1

Theory of demand, Elasticity of demand

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Theory of demand

• Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period

• Demand is different to desire! Effective demand is when a desire to buy a product is backed up by an ability to pay for it

• Latent demand exists when there is willingness to buy among people for a good or service, but where consumers lack the purchasing power to be able to afford the product.

• Derived Demand• The demand for a product X might be connected to the demand for

a related product Y – giving rise to the idea of a derived demand. For example, demand for steel is strongly linked to the demand for new vehicles and other manufactured products, so that when an economy goes into a recession, so we expect the demand for steel to decline likewise.

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Theory of demand

Factors influencing demand

• Price of the good

• Prices of related goods

• Income of the people

• Tastes of consumers

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Theory of demand

The Law of Demand : There is an inverse relationship between the price of a good and demand.

• As prices fall, we see an expansion of demand.

• If price rises, there will be a contraction of demand.

• Ceteris paribus assumption: Many factors affect demand, but in demand curve, economists assume all factors as constant except the price

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Qty

Price Higher prices lead to contraction of demand

Lower price lead toexpansion of demand

Demand curve

Theory of demand

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There are two reasons why more is demanded as price falls:

1. The Income Effect: when the price of a good falls, the consumercan maintain the same consumption for less expenditure resultingin increased income (saving) due to less expenditure. Some of theincrease in income (saving) is used to buy more of this product.

2. The Substitution Effect: When the price of a good falls theproduct becomes cheaper than an alternative item then someconsumers switch their spending from the alternative good orservice to the product thereby increasing the demand.

Ref: Engineering Economics by R Panneerselvam , PHI

Law of demand & supply

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Ref: Engineering Economics by R Panneerselvam , PHI

Price

Demand curve Supply curve

Qty

When price is decreased, the demandincreases and its supply decreases . It is dueto the reason that at lower prices, producersrestrain from releasing more quantities of theproduct in the market.

The point of intersection of the supply curveand demand curve is known as the equilibriumpoint. And the price at that point is called theequilibrium point price.

demand and supply of a product are interdependent and theyare sensitive with respect to the price of that product.

Elasticity of Demand

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elastic of demand =( change in demand/ average demand) / ( change in price/ average price)

Ref: Engineering Economics by R Panneerselvam , PHI

Elastic demand

Price

In elastic demand

Price

Indifference curves

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An indifference curve is a curve showingcombination of two goods that give theconsumer equal satisfaction and utility.

In other words it is loci of combination(bundle) that give equal satisfaction tothe customer

Each point on an indifferencecurve indicates that a consumer isindifferent between the two and all pointsgive him the same utility.

Ref: Engineering Economics by R Panneerselvam , PHI

Qty of of product A

Qty of product B

Indifference curves

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Ex. In a observation over a group it hasbeen observed that following combinationof Apples and bananas provide same utility

Bananas

Apples

CombinationApples Bananas

C1 22 17

C2 14 20

C3 10 26

C4 9 41

C5 7 80

C1

C2 C3

Diminishing marginal utility : The indifference curve is convex due to diminishing marginal utility. When one has a certain no. of bananas –that is all one want to eat in a period. Extra bananas give very little utility, so one may give up a lot of bananas to get something else.

Indifference curves

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Indifference curves have the following properties: 1. An indifference curve slopes down. 2. An indifference curve gets flatter as we move right along the

curve. 3. An individual is better off when he or she’s on an indifference

curve that lies farther up and to the right. •The slope of the indifference curve is known as the marginal rate of substitution(MRS). MRS tells the marginal utility the individual will gain (or lose) from moving up or down on the indifference curve

Indifference curves

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•Marginal utility is simply the benefit the person gains from consuming an additional unit of a good•The MRS is always negative for the same reason that indifference curves are convex

Ex. A hungry person eating a Dosa finds the first one amazing, the second one filling, the third one hard to eat, and the fourth one may be nausea-inducing – Decreasing value or utility or satisfaction

Budget lines

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A budget line shows the combination of goods that can be afforded with your current income An individual doesn't just have one indifference curve – they will have an similar curve at different level of income. and a new income may mean there is no "optimal" point on the original indifference curve.

Banana

Apple

Banana

Apple Income consumption curve

Banana

Apple

Welfare Analysis

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Economic welfare is the total benefit available to society from an economic transaction or situation.Economic welfare is also called community surplus. Welfare isrepresented by the area shown by colors in the diagram, which ismade up of the area for consumer surplus (Green), and the areafor producer surplus (blue).

Qty

Price

Consumer surplus

Producersurplus

S

D

Welfare Analysis Consumer surplus / Producer surplus

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Consumer surplus is derived whenever the price a consumer actually pays is less than they are prepared to pay Producer surplus is the additional benefit to producers, in terms of profit, gained when the price they receive in the market is more than the minimum they would be prepared to supply for.

Qty

Price

Consumer surplus

D

P

Q Qty

Price

Producersurplus

D

P

Q

S

Welfare Analysis Consumer surplus / Producer surplus

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Economic welfare is also called community surplus. Welfare is represented sum of consumer surplus & producers surplusIf we consider govt revenue also, at equilibrium Welfare = CS + PS + GRWhere CS is consumer surplus, PS is producer surplus, Gr is Government revenue

Welfare analysis considers whether economic decisions by individuals,/ organizations/ government increase or decrease economic welfare.• Note that an increase in market price decreases CS & increases PS • So an increase in market price does not necessarily have a negative impact on the economy