Theory of Demand and Supply - Part 1

Table of Content: 

1. Theory of Demand and Supply -CA Foundation
2. WHAT DETERMINES DEMAND? 
3. THE DEMAND FUNCTION
4. Exceptions to the Law of Demand
5. EXPANSION AND CONTRACTION OF DEMAND
6. ELASTICITY OF DEMAND 
7. ADVERTISEMENT ELASTICITY

WHAT DETERMINES DEMAND? 

(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.

(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.

(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.

(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.

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: 

                   Qx= f (PX, Y, Pr,)
Where Qx is the quantity demanded of product X 
 PX is the price of the commodity
 Y is the money income of the consumer, and 
 Pr is the price of related goods 

The demand function stated as above does not indicate the exact quantitative relationship between Qx and PX, M and Pr,. 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 Qx=45 + 2y + 1 Pr, – 2 P. In this unit, we will be studying demand as a function of only price, keeping everything else constant.

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

(ii) Giffen goods

(iii) Conspicuous necessities

(iv) Future expectations about prices

(v) Incomplete information and irrational behaviour

(vi) Demand for necessaries

(vii) Speculative goods

EXPANSION AND CONTRACTION OF DEMAND

The demand schedule, demand curve and the law of demand all show that when the price of a commodity falls, its quantity demanded increases, other things being equal. When, as a result of decrease in price, the quantity demanded increases, in Economics, we say that there is an expansion of demand and when, as a result of increase in price, the quantity demanded decreases, we say that there is a contraction of demand. For example, suppose the price of apples is ` 100/ per kilogram and a consumer buys one kilogram at that price. Now, if other things such as income, prices of other goods and tastes of the consumers remain the same but the price of apples falls to ` 80 per kilogram and the consumer now buys two kilograms of apples, we say that there is a change in quantity demanded or there is an expansion of demand. On the contrary, if the price of apples rises to ` 150 per kilogram and the consumer then buys only half a kilogram, we say that there is a contraction of demand.

The phenomena of expansion and contraction of demand are shown in Figure 3. The figure shows that when price is OP, the quantity demanded is OM, given other things equal. When as a result of increase in price (O PII), the quantity demanded falls to OL, we say that there is ‘a fall in quantity demanded’ or ‘contraction of demand’ or ‘an upward movement along the same demand curve’. Similarly, as a result of fall in price to OPI, the quantity demanded rises to ON, we say that there is an ‘expansion of demand’ or ‘a rise in quantity demanded’ or ‘a downward movement on the same demand curve.’ 

ELASTICITY OF DEMAND 

Till now we were concerned with the direction of the changes in prices and quantities demanded. From the point of view of a business firm, it is more important to know the extent of the relationship or the degree of responsiveness of demand to changes in its determinants. 

Often, we would want to know how sensitive is the demand for a product to its price; for example, if price increases by 5 percent, how much will the quantities demanded change? Also, how much change in demand will be there if the average income rises by 5 percent? What effect will an advertising campaign have on sales? Economists use a number ofdifferent types of elasticity to answer questions like these so as to make demand predictions and to recommend changes in strategies. 

Elasticity of demand is defined as the degree of responsiveness of the quantity demanded of a good to changes in one of the variables on which demand depends. More precisely, elasticity of demand is the percentage change in quantity demanded divided by the percentage change in one of the variables on which demand depends. 

Price Elasticity of Demand

Perhaps, the most important measure of elasticity of demand is the price elasticity of demand which measures the sensitivity of quantity demanded to ‘own price’ or the price of the good itself. The concept of price elasticity of demand is important for a firm for two reasons. 

 Knowledge of the nature and degree of price elasticity allows firms to predict the impact of price changes on its sales.
 Price elasticity guides the firm’s profit-maximizing pricing decisions.

Price elasticity of demand expresses the degree of responsiveness of quantity demanded of a good to a change in its price, given the consumer’s income, his tastes and prices of all other goods. In other words, it is measured as the percentage change in quantity demanded divided by the percentage change in price, other things remaining equal. The price elasticity of demand (also referred to as PED) tells us the percentage change in quantity demanded for each one percent (1%) change in price. That is, 

The percentage change in a variable is just the absolute change in the variable divided by the original level of the variable. 

Total Revenue 

Total revenue (TR) = Price × Quantity sold 

Except in the rare case of a good with perfectly elastic or perfectly inelastic demand, when a seller raises the price of a good, there are two effects which act in opposite directions on revenue. 
 Price effect: After a price increase (decrease), each unit sold sells at a higher (lower) price, which tends to raise (lower) the revenue. 
 Quantity effect: After a price increase (decrease), fewer (more) units are sold, which tends to lower (increase) the revenue. 

ADVERTISEMENT ELASTICITY

Advertisement elasticity of sales or promotional elasticity of demand is the responsiveness of a good’s demand to changes in the firm’s spending on advertising. The advertising elasticity of demand measures the percentage change in demand that occurs given a one percent change in advertising expenditure. Advertising elasticity measures the effectiveness of an advertisement campaign in bringing about new sales.

Advertising elasticity of demand is typically positive. Higher the value of advertising elasticity greater will be the responsiveness of demand to change in advertisement. Advertisement elasticity varies between zero and infinity. It is measured by using the formula;

As far as a business firm is concerned, the measure of advertisement elasticity is useful in understanding the effectiveness of advertising and in determining the optimum level ofadvertisement expenditure.