TOPIC 1: THE THEORY OF DEMAND
Theory of Demand
Meaning of Demand
Define demand
Demand is willingness (desire) and the ability to buy a certain quantity of a commodity at the going price at a specific period of time.
Condition for effective Demand
• Specific period of time
• Given price level
• Community
Demand Schedule and Curves
Draw demand schedule and curves
DEMAND SCHEDULE:
A table that illustrates the alternative quantities of a commodity demanded at different prices. A demand schedule is a simple means of summarizing information about demand price and quantity demanded for a particular good. It is used to highlight the law of demand. It can also be used to derive a demand curve.
A demand schedule is a useful set of information that can summarize several of the more important aspects of demand.
Setting up the Table
The table in this exhibit displays the Shady Valley demand schedule for stuffed Yellow Tarantulas, a cute and cuddly stuffed creature from the Wacky Willy Stuffed Amigos line of collectibles.
This table contains three columns. The first contains reference labels A, B, C, etc. for each price-quantity pair. The second is the demand price, ranging from \$5 to \$50. And the third is the quantity demanded, ranging from 0 to 90 Yellow Tarantulas. This schedule assumes other ceteris paribus factors remain unchanged and that the quantities are those demanded during a one year time period
Demand curve, in economics, a graphic representation of the relationship between product price and the quantity of the product demanded. It is drawn with price on the vertical axis of the graph and quantity demanded on the horizontal axis. With few exceptions, the demand curve is delineated as sloping downward from left to right because price and quantity demanded are inversely related (i.e., the lower the price of a product, the higher the demand or number of sales). This relationship is contingent on certain ceteris paribus (other things equal) conditions remaining constant. Such conditions include the number of consumers in the market, consumer tastes or preferences, prices of substitute goods, consumer price expectations, and personal income. A change in one or more of these conditions causes a change in demand, which is reflected by a shift in the location of the demand curve. A shift to the left indicates a decrease in demand
THE LAW OF DEMAND
The law of demand is amicroeconomic law that states, all other factors being equal, as the price of a good or service increases, consumer demand for the good or service will decrease, and vice versa. The law of demand says that the higher the price, the lower the quantity demanded, because consumers’ opportunity cost to acquire that good or service increases, and they must make more tradeoffs to acquire the more expensive product.
ASSUMPTIONS OF THE LAW OF DEMAND
1. No change in habits, customs and income of consumers: Law of demand tells us that demand goes with a fall in price and goes down with a rise in price. But an increase in price will not bring down the demand if at the same time the income of the buyer has also increased.
2. This law does not apply on necessaries of life: It is assumed that this law is not applicable in the case of necessaries of life. Because, an increase in the price of flour will not bring down its demand. Likewise a fall in its price will not vary much increase the demand for it.
3. Joint demand: Goods which have joint demand also falsify the law. Thus, an increase in the demand of cars will lead to more demand for petrol. Whereas the law of demand states that the demand for petrol should increase on it its price falls.
4. Articles of distinction: Law of demand does not hold goods in case of those goods which confer social distinction. When the price of such goods goes up, their demand shall also increase. For instance, an increase in the price of diamond will raise its demand and a fall in price will lower the demand.
5. Fear of shortage in future: If there is a fear of shortage of a good in future its demand will increase in present as people would start storing. But according to law of demand its demand should go it when its price falls.
6. Change in the price of substitutes: This law does not apply in the case of tea and coffee, because these goods are substitutes of each other. When the price of coffee goes up the demand for tea shall increase although there has been no fall in the price of tea.
7. Fear of a rise in price in future: If consumers think that the price of particular goods will increase in future, they will store it. In other words, the demand of those goods shall increase at the same price. But this law states that demand should go up only if price falls.
8. Ignorance: It is possible that a consumer may not be aware of the previous price of a good. In this case consumer might start purchasing more of a commodity when its price has actually gone up. A new approach called the ordinal utility approach, developed by Edgeworth, Pareto. Slutsky, Johnson, Hicks and Allen are easier and more helpful in solving the problem of consumer’s demand. The ordinal theory not only requires fewer assumptions but possesses greater predictive power than does its cardinal cousin.
The assumption of cardinally measurable utility has been dispensed with not because utility is not cardinally measurable, but simply because such measurement is not at all required for analyzing consumer’s behaviour. The points of distinction between the cardinal and the ordinal measures of utility.
Exception of 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: 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. Sir Robert Giffen or Ireland first observed that people used to spend more their income on inferior goods like potato and less of their income on meat. But potatoes constitute their staple food. When the price of potato increased, after purchasing potato they did not have so many surpluses to buy meat. So the rise in price of potato compelled people to buy more potato and thus raised the demand for potato. This is against the law of demand. This is also known as Giffen paradox.
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. The higher the price of the diamond the higher the prestige value of it. So when price of these goods falls, the consumers think that the prestige value of these goods comes down. So quantity demanded of these goods falls with fall in their price. So the law of demand does not hold good here.
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, famine etc. negate the operation of the law of demand. At such times, households behave in an abnormal way. Households accentuate scarcities and induce further price rises by making increased purchases even at higher prices during such periods. During depression, on the other hand, no fall in price is a sufficient inducement for consumers to demand more.
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 latter 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.
Factors which Determine the Strength of Demand (Causes for Demand Changes)
Point the factors which determine the strength of demand (causes for demand changes)
The following are the factors which determine demand for goods:
1. Tastes and Preferences of the Consumers: An important factor which determines demand for a good is the tastes and preferences of the consumers for it. A good for which consumers’ tastes and preferences are greater, its demand would be large and its demand curve will lie at a higher level. People’s tastes and preferences for various goods often change and as a result there is change in demand for them. The changes in demand for various goods occur due to the changes in fashion and also due to the pressure of advertisements by the manufacturers and sellers of different prod­ucts. For example, a few years back when Coca Cola plant was established in New Delhi demand for it was very small. But now people’s taste for Coca Cola has undergone a change and become favour­able to it because of large advertisement and publicity done for it. The result of this is that the demand for Coca-Cola has increased very much. In economics we would say that the demand curve For Coca Cola has shifted upward. On the contrary when any good goes out of fashion or people’s tastes and preferences no longer remain favourable to it the demand for it decreases. In economics we say that the demand curve for these goods will shift downward.
2. Incomes of the People: The demand for goods also depends upon incomes of the people. The greater the incomes of the people the greater will be their demand for goods. In drawing a demand schedule or a demand curve for a good we take incomes of the people as given and constant. When as a result of the rise in incomes of the people, the demand increases, the whole of the demand curve shifts upward and vice versa. The greater income means the greater purchasing power. There­fore, when incomes of the people increase, they can afford to buy more. It is because of this reason that the increase in income has a positive effect on the demand for a good. When the incomes of the people fall they would demand less of the goods and as a result the demand curve will shift below. For instance, during the planning period in India the incomes of the people have greatly increased owing to the large investment expenditure on the development schemes by the Government and the private sector. As a result of this increase in incomes, demand for food-grains has greatly increased which has resulted in rightward shift in the demand curve for them. Likewise, when because of drought in a year the agricultural production greatly falls, incomes of the farmers decline. As a result of the decline in incomes of the farmers, they demand less of cotton cloth and other manufac­tured products.
3. Changes in the Prices of the Related Goods: The demand for a good is also affected by the prices of other goods, especially those which are related to it as substitutes or complements. When we draw a demand schedule or a demand curve for a good we take the prices of the related goods as remaining constant. Therefore, when the prices of the related goods, substitutes or complements, change the whole demand curve would change its position; it will shift upward or downward as the case may be. When price of a substitute for a good falls, the demand for that good will decline and when the price of the substitute rises, the demand for that good will increase. For example, when price of the tea as well as the incomes of the people remains the same but price of the coffee falls, the consumers would demand less of tea than before. Tea and coffee are very close substitutes, therefore when coffee becomes cheaper, the consumers substitute coffee for tea and as a result the demand for tea declines. The goods which are complementary with each other, the change in the price of any of them would affect the demand of the other. For instance, if price of the milk falls, the demand for sugar would also be affected. When people would take more milk or would prepare more khoya, burfi, rasgullas with milk; the demand for sugar will also increase. Likewise, when price of cars falls, the demand for them will increase which in turn will increase the demand for petrol Cars and petrol are complementary with each other.
4. The Number of Consumers in the Market: We have already explained that the market demand for a good is obtained by adding up the individual demands of the present as well as pro­spective consumers or buyers of a good at various possible prices. The greater the number of consumers of a good, the greater the market demand for it. Now, the question arises on what factors the number of consumers of a good depends. If the consumers substitute one good for another, then the number of consumers of that good which has been substituted by the other will decline and for the good which has been used in its place, the number of consumers will increase. Besides, when the seller of a good succeeds in finding out new markets for his good and as a result the market for his good expands the number of consumers of that good will increase. Another Important cause for the increase in the number of consumers is the growth in population. For instance, in India the demand for many essential goods, especially food-grains, has increased because of the increase in the popu­lation of the country and the resultant increase in the number of consumers for them.
5. Changes in Propensity to Consume: People’s propensity to consume also affects the de­mand for them. The income of the people remaining constant, if their propensity to consume rises, then out of the given income they would spend a greater part of it with the result that the demand for goods will increase. On the other hand, if propensity to save of the people increases, that is, if propensity to consume declines, then the consumers would spend a smaller part of their income on goods with the result that the demand for goods will decrease. It is thus clear that with income remaining constant, change in propensity to consume of the people will bring about a change in the demand for goods.
6. Consumers’ Expectations with regard to Future Prices: Another factor which influences the demand for goods is consumers’ expectations with regard to future prices of the goods. If due to some reason, consumers expect that in the near future prices of the goods would rise, then in the present they would demand greater quantities of the goods so that in the future they should not have to pay higher prices. Similarly, when the consumers hope that in the future they will have good income, then in the present they will spend greater part of their incomes with the result that their present demand for goods will increase.
7. Income Distribution: Distribution of income in a society also affects the demand for goods. If distribution of income is more equal, then the propensity to consume of the society as a whole will be relatively high which means greater demand for goods. On the other hand, if distribution of income is more unequal, then propensity to consume of the society will be relatively less, for the propensity to consume of the rich people is less than that of the poor people. Consequently with more unequal distribution of income, the demand for consumer goods will be comparatively less. This is the effect of the income distribution on the propensity to consume and demand for goods. But the change in the distribution of income in the society would affect the demand for various goods differently. If progressive taxes are levied on the rich people and the money so collected is spent on providing employment to the poor people, the distribution of income would become more equal and with this there would be a transfer of purchasing power from the rich to the poor. As a result of this, the demand for those goods will increase which are generally purchased by the poor because the purchasing power of the poor people has increased and, on the other hand, the demand for those goods will decline which are usually consumed by the rich on whom progressive taxes have been levied.
FACTORS FOR CHANGE IN DEMAND
1. Tastes and preferences of the consumer: Tastes include fashion, habit, customs etc. A good for which consumers tastes and preferences are greater claim higher demand. Thus the demand curve lies at a higher level. With the change in consumer's taste and preference for particular commodity the demand for that commodity declines. If the taste goes up its amount demanded becomes high even at a high price. Those goods which go out of fashion of people no longer remains attractive to them. So the demand for them decreases.
2. Income of the people: The demand for goods depends upon the income of the people. There is direct relation between income and demand for immodesties. A rise in income gives rise to greater purchasing power. Thus increase in income has a positive effect for a good. With a rise and fall in income the demand curve shifts upward and downward respectively. But in case of giffen goods the income effect is negative.
3. Changes in prices of the related goods: The demand for a commodity is affected by the changes in the prices of other related commodities. The related commodities may be (i) substitute and (ii) complementary. A commodity is said to be substitute only when it yields the same utility and satisfaction in place of other. Complementary goods are jointly demanded. They are consumed untidily for satisfaction. Tea and coffee are substitute’s goods but pen and ink are complementary commodities. When the price of a substitute of a good falls the demand for that good declines and when the price of the substitute rises, the demand for that good increases. In case of complementary goods there is opposite relationship between price of one commodity and the amount demanded for the other. The effect in change in price of related goods on the amount demanded is called as Gross Demand.
4. Future expectation: Present demand for a commodity also depends on the future expectation of the change in price. If people expect that the price of a commodity will rise in future, they will buy more even at a high price so as to escape the further rise in price in future. Similarly any expectation of the fall in price in future will diminute demand for a commodity as people expect further fall in price. Similarly if buyers expect their incomes to rise in future, they may increase the present demand.
5. Population: Rise of population also gives rise to demand for necessaries of life. The composition and size of population affect the demand. With high birth rate demand for milk food, medicines and garments increase. The rise in the proportion of adult, old and woman also shape the nature of demand accordingly.
6. Income distribution: Income distribution in the society affects the demand for goods. If the distribution of income is even then the demand for goods is greater. On the other hand if the distribution of income is unequal, the demand for consumer goods will be comparatively less.
Elasticity of Demand
Define elasticity of demand
The degree to which demand for a good or service varies with its price. Normally, sales increase with drop in prices and decrease with rise in prices. As a general rule, appliances, cars, confectionary and other non-essentials show elasticity of demand whereas most necessities (food, medicine, basic clothing) show inelasticity of demand (do not sell significantly more or less with changes in price).
Price elasticity of demand
Price elasticity of demand (PED) shows the relationship between price and quantity demanded and provides a precise calculation of the effect of a change in price on quantity demanded.
The following equation enablesPED to be calculated.
We can use this equation to calculate the effect of price changes on quantity demanded, and on the revenue received by firms before and after any price change.
Problem: Yesterday, the price of envelopes was \$3 a box, and Julie was willing to buy 10 boxes. Today, the price has gone up to \$3.75 a box, and Julie is now willing to buy 8 boxes. Is Julie's demand for envelopes elastic or inelastic? What is Julie's elasticity of demand?
To find Julie's elasticity of demand, we need to divide the percent change in quantity by the percent change in price. <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
• % Change in Quantity = (8 - 10)/(10) = -0.20 = -20%
• %Change in Price = (3.75 - 3.00)/(3.00) = 0.25 = 25%
• Elasticity = |(-20%)/(25%)| = |-0.8| = 0.8
Her elasticity of demand is the absolute value of -0.8, or 0.8. Julie's elasticity of demand is inelastic, since it is less than 1.
Problem : If Neil's elasticity of demand for hot dogs is constantly 0.9, and he buys 4 hot dogs when the price is \$1.50 per hot dog, how many will he buy when the price is \$1.00 per hot dog?
This time, we are using elasticity to find quantity, instead of the other way around. We will use the same formula, plug in what we know, and solve from there. <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
• Elasticity =
• And, in the case of John, %Change in Quantity = (X – 4)/4
• Therefore :
• Elasticity = 0.9 = |((X – 4)/4)/(% Change in Price)|
• % Change in Price = (1.00 - 1.50)/(1.50) = -33%
• 0.9 = |(X – 4)/4)/(-33%)|
• |((X - 4)/4)| = 0.3
• 0.3 = (X - 4)/4
• X = 5.2 <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
Since Neil probably can't buy fractions of hot dogs, it looks like he will buy 5 hot dogs when the price drops to \$1.00 per hot dog.
Problem : Which of the following goods are likely to have elastic demand, and which are likely to have inelastic demand? <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
• Home heating oil
• Pepsi
• Chocolate
• Water
• Heart medication
• Oriental rugs
1. Elastic demand: Pepsi, chocolate, and Oriental rugs
2. Inelastic demand: Home heating oil, water, and heart medication
Problem: If supply is unit elastic and demand is inelastic, a shift in which curve would affect quantity more? Price more?
Shifting the demand curve would affect quantity more, and shifting the supply curve would affect price more.
Problem: Katherine advertises to sell cookies for \$4 a dozen. She sells 50 dozen, and decides that she can charge more. She raises the price to \$6 a dozen and sells 40 dozen. What is the elasticity of demand? Assuming that the elasticity of demand is constant, how many would she sell if the price were \$10 a box?
To find the elasticity of demand, we need to divide the percent change in quantity by the percent change in price. <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
• % Change in Quantity = (40 - 50)/(50) = -0.20 = -20%
• % Change in Price = (6.00 - 4.00)/(4.00) = 0.50 = 50%
• Elasticity = |(-20%)/(50%)| = |-0.4| = 0.4 <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
The elasticity of demand is 0.4 (elastic). <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
To find the quantity when the price is \$10 a box, we use the same formula: <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
• Elasticity = 0.4 = |(% Change in Quantity)/(% Change in Price)|
• % Change in Price = (10.00 - 4.00)/(4.00) = 1.5 = 150% <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
Remember that before taking the absolute value, elasticity was -0.4, so use -0.4 to calculate the changes in quantity, or you will end up with a big increase in consumption, instead of a decrease! <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
• -0.4 = |(% Change in Quantity)/(150%)|
• |(%Change in Quantity)| = -60% =
• -0.6 -0.6 = (X - 50)/50
• X = 20 <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
The new demand at \$10 a dozen will be 20 dozen cookies.
For example, if the price of a daily newspaper increases from £1.00 to £1.20p, and the daily sales fall from 500,000 to 250,000, the PED will be:
• - 50%/ + 20%
• = (-) 2.5
The negative sign indicates that P and Q are inversely related, which we would expect for most price/demand relationships. This is significant because the newspaper supplier can calculate or estimate how revenue will be affected by the change in price. In this case, revenue at £1.00 is £500,000 (£1 x 500,000) but falls to £300,000 after the price rise (£1.20 x 250,000).
The range of responses
The degree of response of quantity demanded to a change in price can vary considerably. The key benchmark for measuring elasticity is whether the co-efficient is greater or less than proportionate. If quantity demanded changes proportionately, then the value of PED is 1, which is called ‘unit elasticity’.
PED can also be:
• Less than one, which means PED is inelastic.
• Greater than one, which is elastic.
• Zero (0), which is perfectly inelastic.
• Infinite (∞), which is perfectly elastic.
PED along a linear demand curve
PED on a linear demand curve will fall continuously as the curve slopes downwards, moving from left to right. PED = 1 at the midpoint of a linear demand curve.
Five cases of Elasticity of Demand:
1. Perfectly elastic demand
2. Perfectly inelastic demand
3. Relatively elastic demand
4. Relatively inelastic demand
5. Unitary elastic demand
• Perfectly elastic demand: The demand is said to be perfectly .elastic when a very insignificant change in price leads to an infinite change in quantity demanded. A very small fall in price causes demand to rise infinitely. Likewise a very insignificant rise in price reduces the demand to zero. This case is theoretical which is never found in real life.
• Perfectly inelastic demand: The demand is said to be perfectly inelastic when a change in price produces no change in the quantity demanded of a commodity. In such a case quantity demanded remains constant regardless of change in price. The amount demanded is totally unresponsive of change in price. The elasticity of demand is said to be zero.
• Relatively more elastic demand: The demand is relatively more elastic when a small change in price causes a greater change in quantity demanded. In such a case a proportionate change in price of a commodity causes more than proportionate change in quantity demanded. If price changes by 10% the quantity demanded of the commodity change by more than 10% i.e. 25%. The demand curve in such a situation is relatively flatter.
• Relatively inelastic demand: It is a situation where a greater change in price leads to smaller change in quantity demanded. The demand is said to be relatively inelastic when a proportionate change in price is greater than the proportionate change in quantity demanded. For example If price falls by 20% quantity demanded rises by less than 20% i.e 15%.
• Unitary elastic demand: The demand is said to be unit when a change in price produces exactly the same percentage change in the quantity demanded of a commodity. In such a situation the percentage change in both the price and quantity demanded is the same. For example if the price falls by 25% the quantity demanded rises by the same 25%. It takes the shape of a rectangular hyperbola. Numerically elasticity of demand is said to be equal to 1.(ed = 1).
There is a precise mathematical connection between PED and a firm’s revenue.
There are three ‘types’ of revenue:
1. Total revenue (TR), which is found by multiplying price by quantity sold (P x Q).
2. <!--[endif]-->Average revenue (AR), which is found by dividing total revenue by quantity sold (TR/Q). Consider these figures and calculate Total, Marginal and Average Revenue.
3. <!--[endif]-->Marginal revenue (MR), which is defined as the revenue from selling one extra unit. This is calculated by finding the change in TR from selling one more unit.
 PRICE (£) Qd TR MR AR 10 1 - - - 9 2 - - - 8 3 - - - 7 4 - - - 6 5 - - -- 5 6 - - - 4 7 - - - 3 8 - - - 2 9 - - -- 1 10 - - -
Study the patterns of numbers and see if you can analyse the relationships between the three measures of revenue – then answer the following:
1. How are price and average revenue connected?
2. What happens to total revenue as output increases?
3. What is the connection between total revenue and marginal revenue?
4. How are marginal revenue and average revenue connected?
Observations
When TR is at a maximum, MR = zero, and PED = 1.
1. Price and AR are identical, because AR = TR/Q, which is P x Q/Q, and cancel out the Qs to get P.
2. A curve plotting AR (=P) against Q is also a firm’s demand curve.
3. TR increases, reaches a peak and decreases.
Why does a firm want to know PED?
There are several reasons why firms gather information about the PED of its products. A firm will know much more about its internal operations and product costs than it will about its external environment. Therefore, gathering data on how consumers respond to changes in price can help reduce risk and uncertainly. More specifically, knowledge of PED can help the firm forecast its sales and set its price.
• Sales forecasting; The firm can forecast the impact of a change in price on its sales volume, and sales revenue (total revenue, TR). For example, if PED for a product is (-) 2, a 10% reduction in price (say, from £10 to £9) will lead to a 20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from £10,000 to £10,800.
• Pricing policy; Knowing PED helps the firm decide whether to raise or lower price, or whether to price discriminate. Price discrimination is a policy of charging consumers different prices for the same product. If demand is elastic, revenue is gained by reducing price, but if demand is inelastic, revenue is gained by raising price.
• Non-pricing policy; When PED is highly elastic, the firm can use advertising and other promotional techniques to reduce elasticity.
Determinants of PED
There are several reasons why consumers may respond elastically or inelastically to a price change, including:
• The number and ‘closeness’ of substitutes. A unique and desirable product is likely to exhibit an inelastic demand with respect to price.
• The degree of necessity of the good. A necessity like bread will be demanded in elastically with respect to price.
• Whether the good is habit forming. Consumers are also relatively insensitive to changes in the price of habitually demanded products.
• The proportion of consumer income which is spent on the good The PED for a daily newspaper is likely to be much lower than that for a new car!
• Whether consumers are loyal to the brand Brand. loyalty reduces sensitivity to price changes and reduces PED.
• Life cycle of product PED will vary according to where the product is in its life cycle. When new products are launched, there are often very few competitors and PED is relatively inelastic. As other firms launch similar products, the wider choice increases PED. Finally, as a product begins to decline in its lifecycle, consumers can become very responsive to price, hence discounting is extremely common.
Firms may use persuasive advertising by to win new customers and retain the loyalty of existing ones.
Advertisers use a range of media, including television, press, and electronic media. Advertising will shift demand to the right, and make demand less elastic.
There are three extreme cases of PED.
1. Perfectly elastic, where only one price can be charged.
2. Perfectly inelastic, where only one quantity will be purchased.
3. Unit elasticity, where all the possible price and quantity combinations are of the same value. The resultant curve is called a rectangular hyperbola.
Factors that Determine Degree of Elasticity (Changes) of Demand
Identify the factors that determine degree of elasticity (changes) of demand
Various factors which affect the elasticity of demand of a commodity are:
1. Nature of commodity: Elasticity of demand of a commodity is influenced by its nature. A commodity for a person may be a necessity, a comfort or a luxury. i. When a commodity is a necessity like food grains, vegetables, medicines, etc., its demand is generally inelastic as it is required for human survival and its demand does not fluctuate much with change in price. ii. When a commodity is a comfort like fan, refrigerator, etc., its demand is generally elastic as consumer can postpone its consumption. iii. When a commodity is a luxury like AC, DVD player, etc., its demand is generally more elastic as compared to demand for comforts. iv. The term ‘luxury’ is a relative term as any item (like AC), may be a luxury for a poor person but a necessity for a rich person.
2. Availability of substitutes: Demand for a commodity with large number of substitutes will be more elastic. The reason is that even a small rise in its prices will induce the buyers to go for its substitutes. For example, a rise in the price of Pepsi encourages buyers to buy Coke and vice-versa. Thus, availability of close substitutes makes the demand sensitive to change in the prices. On the other hand, commodities with few or no substitutes like wheat and salt have less price elasticity of demand.
3. Income Level: Elasticity of demand for any commodity is generally less for higher income level groups in comparison to people with low incomes. It happens because rich people are not influenced much by changes in the price of goods. But, poor people are highly affected by increase or decrease in the price of goods. As a result, demand for lower income group is highly elastic.
4. Level of price: Level of price also affects the price elasticity of demand. Costly goods like laptop, Plasma TV, etc. have highly elastic demand as their demand is very sensitive to changes in their prices. However, demand for inexpensive goods like needle, match box, etc. is inelastic as change in prices of such goods do not change their demand by a considerable amount.
5. Postponement of Consumption: Commodities like biscuits, soft drinks, etc. whose demand is not urgent, have highly elastic demand as their consumption can be postponed in case of an increase in their prices. However, commodities with urgent demand like life saving drugs, have inelastic demand because of their immediate requirement.
6. Number of Uses: If the commodity under consideration has several uses, then its demand will be elastic. When price of such a commodity increases, then it is generally put to only more urgent uses and, as a result, its demand falls. When the prices fall, then it is used for satisfying even less urgent needs and demand rises. For example, electricity is a multiple-use commodity. Fall in its price will result in substantial increase in its demand, particularly in those uses (like AC, Heat convector, etc.), where it was not employed formerly due to its high price. On the other hand, a commodity with no or few alternative uses has less elastic demand.
7. Share in Total Expenditure: Proportion of consumer’s income that is spent on a particular commodity also influences the elasticity of demand for it. Greater the proportion of income spent on the commodity, more is the elasticity of demand for it and vice-versa. Demand for goods like salt, needle, soap, match box, etc. tends to be inelastic as consumers spend a small proportion of their income on such goods. When prices of such goods change, consumers continue to purchase almost the same quantity of these goods. However, if the proportion of income spent on a commodity is large, then demand for such a commodity will be elastic. 8. Time Period: Price elasticity of demand is always related to a period of time. It can be a day, a week, a month, a year or a period of several years. Elasticity of demand varies directly with the time period. Demand is generally inelastic in the short period. It happens because consumers find it difficult to change their habits, in the short period, in order to respond to a change in the price of the given commodity. However, demand is more elastic in long rim as it is comparatively easier to shift to other substitutes, if the price of the given commodity rises. 9. Habits: Commodities, which have become habitual necessities for the consumers, have less elastic demand. It happens because such a commodity becomes a necessity for the consumer and he continues to purchase it even if its price rises. Alcohol, tobacco, cigarettes, etc. are some examples of habit forming commodities. Finally it can be concluded that elasticity of demand for a commodity is affected by number of factors. However, it is difficult to say, which particular factor or combination of factors determines the elasticity. It all depends upon circumstances of each case.
Exercise 1
QUIZ
• State the law of law of demand and its assumption.
• Explain the factor that influencing the demand of a commodity.

TOPIC 2: THE THEORY OF SUPPLY

Theory of Supply
The Meaning of Supply
Explain the meaning of supply
What Is Supply?
In economics, we have two forces: the producer, who makes things, and the consumer, who buys them. Supply is the producer's willingness and ability to supply a given good at various price points, holding all else constant. An increase in price will increase producer's revenues, so they'll be willing to supply more; a decrease in price will reduce revenues, and so producers will supply less.
The Law of Supply:
The law of supply states that, ceteribus paribus (Latin for 'assuming all else is held constant'), the quantity supplied for a good rises as the price rises. In other words, the quantity demanded and price is positively related. Supply curves are drawn as 'upward sloping' due to this positive relationship between price and quantity supplied. Note: There are theoretical instances where the law of supply might not hold, though these are rarely, if ever, seen in the real world. Supply’s counterpart is demand; it measures how many consumers will want to buy a product at various price points.
FACTORS INFLUENCING SUPPLY
1. Price of the given Commodity: The most important factor determining the supply of a commodity is its price. As a general rule, price of a commodity and its supply are directly related. It means, as price increases, the quantity supplied of the given commodity also rises and vice-versa. It happens because at higher prices, there are greater chances of making profit. It induces the firm to offer more for sale in the market. Supply (S) is a function of price (P) and can be expressed as: S = f (P). The direct relationship between price and supply, known as ‘Law of Supply’. The following determinants are termed as ‘other factors’ or factors other than price’.
2. Prices of Other Goods: As resources have alternative uses, the quantity supplied of a commodity depends not only on its price, but also on the prices of other commodities. Increase in the prices of other goods makes them more profitable in comparison to the given commodity. As a result, the firm shifts its limited resources from production of the given commodity to production of other goods. For example, increase in the price of other good (say, wheat) will induce the farmer to use land for cultivation of wheat in place of the given commodity (say, rice).
3. Prices of Factors of Production (inputs): When the amount payable to factors of production and cost of inputs increases, the cost of production also increases. This decreases the profitability. As a result, seller reduces the supply of the commodity. On the other hand, decrease in prices of factors of production or inputs, increases the supply due to fall in cost of production and subsequent rise in profit margin. To make ice-cream, firms need various inputs like cream, sugar, machine, labour, etc. When price of one or more of these inputs rises, producing ice-creams will become less profitable and firms supply fewer ice-creams.
4. State of Technology: Technological changes influence the supply of a commodity. Advanced and improved technology reduces the cost of production, which raises the profit margin. It induces the seller to increase the supply. However, technological degradation or complex and out-dated technology will increase the cost of production and it will lead to decrease in supply.
5. Government Policy (Taxation Policy): Increase in taxes raises the cost of production and, thus, reduces the supply, due to lower profit margin. On the other hand, tax concessions and subsidies increase the supply as they make it more profitable for the firms to supply goods. 6.
6. Goals / Objectives of the firm: Generally, supply of a commodity increases only at higher prices as it fulfills the objective of profit maximization. However, with change in trend, some firms are willing to supply more even at those prices, which do not maximise their profits. The objective of such firms is to capture extensive markets and to enhance their status and prestige.
Supply Schedule and Curves
Draw supply schedule and curves
Supply Schedules:
A supply schedule is a table which lists the possible prices for a good and service and the associated quantity supplied. The supply schedule for oranges could look (in part) as follows: <!-- [if !supportLineBreakNewLine]--> <!--[endif]-->
• 75 cents - 470 oranges a week
• 70 cents - 400 oranges a week
• 65 cents - 320 oranges a week
• 60 cents - 200 oranges a week
The Supply Curve
The supply curve shows the quantity supplied of a given product at varying price points, holding all else constant. Here's a graph of the supply curve.
You'll notice that the x-axis is labelled 'Q', and the y-axis is labelled 'P.' Those stand for quantity and price. Just like we saw earlier, when the price of a good goes up, the supply does as well. Each producer has his or her own supply curve for a given product, which can vary from one producer to another. The exact curve depends on production costs and other variables.
Let's look at an example. Imagine two wineries in the Paso Robles region: Paso Winery and Robles Winery. Paso Winery may be willing to supply 20 bottles of their wine if the market price were \$10 per bottle but willing to supply 100 bottles if the price were \$50 per bottle. Robles Winery may only be willing to supply 5 bottles if the price were \$20 each and 50 bottles at a price of \$50 each.
The summation of the two individual supply curves creates a market supply curve, with red wine ranging from \$10 a bottle up to \$50 a bottle. The two individual supply curves differ because the wineries are willing and able to supply red wine at different prices. This may be due to varying input costs. Those are the costs associated with producing the wine, such as the variety of grape being used, labour costs, or technique of fermenting the grapes.
The Causes of Supply Changes
Mention the causes of supply changes
Changes in Supply in Market: Causes and Effects (With Example)
A change in supply occurs when the conditions facing suppliers alter. In such a situation, a different quantity will be offered for sale at each price. For instance, a good period of weather may increase the rice crop in a country. This will make it possible for rice farmers to supply more. Table 1 shows the original supply schedule in the previous season and the supply schedule in the current season.
Shifts in the Supply Curve:
While a change in the price of the product itself causes a movement along the supply curve, a change in supply conditions causes the supply curve to shift. An increase in supply is illustrated by a shift to the right as shown in Fig. 1. At each and every price, more is supplied.
In contrast, a decrease in supply results in a movement of the supply curve to the life, as shown in Fig. 2. Now whatever the price, less will be supplied.
Causes of Changes in Supply:
Among the factors that can cause a change in supply are changes in the costs of production, improvements in technology, taxes, subsidies, weather conditions, health of livestock and crops. It is also affected by the price of other products. Disasters, wars, discoveries of new sources and depletion also contribute to this change of commodities.
Changes in the costs of production:
If it costs more to produce a product, suppliers will want a higher price for it. For example, if it costs \$200 to produce four units, firms would supply four units at a price of \$50 per unit. If costs rise to \$280, they would be prepared to sell only four units, at a price of \$70 each.
The two basic reasons for a change in costs of production are:
1. A change in the price of any of the factors of production
2. A change in their productivity.
If, for example, the price of raw materials used increases, it will be more expensive to produce a product. One cost which changes frequently is the cost of transporting goods. This is because the price of oil used in petrol, is itself very volatile.
A rise in the productivity of a factor of production will reduce unit cost. For example, if a worker who is paid \$200 a week produces 100 units, the labour cost per unit is \$2. If her or his productivity rises to 200, the labour cost per unit would fall to \$1.
An increase in the wages paid to workers by it would raise the costs of production and therefore cause a decrease in supply. It is interesting to note, however, that if it is accompanied by an equal rise in productivity, then unit costs and supply will remain unchanged.
Improvements in technology:
This influence is closely related to the previous one, since improvements in technology raise the productivity of capital, reduce costs of production and result in an increase in supply. It has become much cheaper to produce a range of products due to the availability of more efficient capital goods and methods of production.
For instance, whilst world demand for personal computers has increased in recent years, the supply has increased even more as it has become easier and cheaper to produce them. Fig. 3 shows these changes and the resulting fall in price.
Taxes:
Taxes on firms, including corporation tax and indirect taxes such as VAT and excise duty, are effectively a cost that firms have to pay. They are likely to try to recoup at least some of this extra cost by raising the price paid by the consumers.
Nevertheless, the firms themselves are largely responsible for passing on the tax revenue to the government. A rise in the rate of an existing tax or the imposition of a new tax will make it more expensive to supply a product and hence will reduce supply. In contrast, a cut in a tax or its removal will increase supply.
Subsidies:
A subsidy given to the producers provides a financial incentive for them to supply more. Besides being paid by the consumer, they are now being paid by the government also. As a result, the granting of a subsidy will cause an increase in supply whilst the removal of a subsidy will cause a decrease in supply.
Most countries, throughout the world, subsidies some agricultural products. A number of them also give subsidies to new and important industries. Less frequently, a government may also give a subsidy to consumers, to encourage them to buy a particular product. For example, grants may be given to households to enable them to buy houses. In this case, of course, it is demand and not supplies conditions which change.
Weather conditions and health of livestock and crops:
Changes in weather conditions affect particular agricultural products. A period of good weather around harvest time is likely to increase the supply of a number of crops. Very dry, very wet or very windy weather, however, is likely to damage a range of crops and thereby reduce their supply.
The amount of agricultural products produced and available for supply is also influenced by the health of livestock and crops. The outbreak of a disease, such as foot and mouth in cattle or blight in crops, will reduce supply.
Prices of other products:
Firms often produce a range of products. If one product becomes more popular, its price will rise and supply will extend. In order to produce more of this product, the firm may divert the resources from the production of other products.
The prices of these other products have not changed but the firm will now supply less at each and every price. For example, if a farmer keeps cattle and sheep, a rise in the price and profitability of lamb is likely to result in the farmer keeping fewer cows and a corresponding decrease in the supply of beef.
Besides the products being supplied in a competitive environment, they can also be jointly supplied. This means that one product is automatically made when another product is produced i.e. one product is a by-product of the other one. For example, when more beef is produced, more hides will be available to be turned into leather.
In the case of products which are jointly supplied, a rise in the price of one product will cause an extension in supply of the other product. Firms make more of one product because its price has risen. The supply of the other product will increase automatically. More is produced, not because it has risen in price but because the price of a related product has risen.
Disasters and wars:
Natural disasters, such as hurricanes, floods and wars, can result in a significant decrease in supply. The Tsunami, for instance, that hit Sri Lanka and other South Asian countries in December 2004 destroyed hotels, damaged beaches and killed the staff working in hotels. As a result, the supply of hotel accommodation decreased.
Discoveries and depletions of commodities:
The supply of some commodities, such as coal, gold and oil, is affected by discoveries of new sources. For instance, the discovery of new oilfields will increase the supply of oil. In contrast, if coal mines are expended, the supply of coal will be reduced in the future.
The Effect of Changes in Supply:
Changes in supply cause a change in price and a movement along the demand curve. Initially, an increase in supply will cause a surplus. This surplus will drive down the price and result in an extension in demand, as shown in Fig. 4.
A decrease in supply will have the opposite effect. It will cause a rise in price, which in turn causes a contraction in demand, as shown in Fig. 5
Elasticity of Supply
Calculate elasticity of supply
Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price. It is necessary for a firm to know how quickly, and effectively, it can respond to changing market conditions, especially to price changes. The following equation can be used to calculate PES
Elasticity of Supply = (% change in quantity supplied) / (% change in price).
While the coefficient for PES is positive in value, it may range from 0, perfectly inelastic, to infinite, perfectly elastic.
Consider the following example:
Let's look at an example. Assume when pizza prices rise 40%, the quantity of pizzas supplied rises by 26%. Using the formula above, we can calculate the elasticity of supply.
Elasticity of Supply = (26%) / (40%) = 0.65.
Example 1
Example
Calculate the price elasticity of supply using the mid-point formula when the price changes from \$5 to \$6 and the quantity supplied changes from 20 units per supplier per week to 30 units per supplier per week.
Solution
• Percentage change in quantity supplied = (30 − 20) ÷ {(30 + 20) ÷ 2} = 40%
• Percentage change in price = (\$6 − \$5) ÷ {(\$6 + \$5) ÷ 2} ≈ 18%
• Price elasticity of supply ≈ 40% ÷ 18% = 2.22
A firm’s market price increases from £1 to £1.10, and its supply increases from 10m to 12.5m. PES is:
+25 +10 = (+) 2.5
The positive sign reflects the fact that higher prices will act an incentive to supply more. Because the coefficient is greater than one, PES is elastic and the firm is responsive to changes in price. This will give it a competitive advantage over its rivals.
Extreme cases
There are three extreme cases of PES.
1. Perfectly elastic, where supply is infinite at any one price.
2. <!--[endif]-->Perfectly inelastic, where only one quantity can be supplied.
3. <!--[endif]-->Unit elasticity, which graphically is shown as a linear supply curve coming from the origin.
Determinants of PES
How firms respond to changes in market conditions, especially price, is an important consideration for the firm itself, and to an understanding of how markets work.
The key considerations are:
1. Are resource inputs readily available?
2. <!--[endif]-->Are factors mobile - are workers prepared to move to where they are needed?
3. <!--[endif]-->Can finished products be easily stored, and are there existing stocks?
4. <!--[endif]-->Is production running at full capacity?
5. <!--[endif]-->How long and complex is the production cycle or production process?
What is the most desirable PES for a firm?
It is desirable for a firm to be highly responsive to changes in price and other market conditions. This is because a high PES makes the firm more competitive than its rivals and it allows the firm to generate more revenue and profits.
Improving PES
Because a high PES is desirable, it may be necessary for firms to undertake actions that improve their speed of response to changes in market conditions. Examples of these actions include:
• 6. Creating spare capacity
• <!--[endif]-->7. Using the latest technology
• 8. Keeping sufficient stocks
• 9. Developing better storage systems
• 10. Prolonging the shelf life of products
• <!--[endif]-->11. Developing better distribution systems
• <!--[endif]-->12. Providing training for workers
• <!--[endif]-->13. Having flexible workers who can do a range of jobs
• <!--[endif]-->14. Locating production near to the market
• <!--[endif]-->15. Allowing inward migration of labour if there is a labour shortage.
Exercise 1
QUIZ
• Explain the factor influence change in supply of commodity
• State the law of supply
COMMERCE O'LEVEL ALL TOPICS
FORM ONE TOPICS
FORM TWO TOPIC 1-2.
FORM TWO TOPIC 3-4.
FORM TWO TOPIC 5-6.
FORM THREE TOPIC 1-2.
FORM THREE STUDY NOTES TOPIC 3-5
STUDY NOTES FORM THREE TOPIC 6-8.
FORM FOUR STUDY NOTES, TOPIC 1-2.
FORM FOUR STUDY NOTES, TOPIC 3-4.