lect. 2, chapter 2, demand
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Chapter 2
Demand
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Major Divisions of Economics
Consumption: Optimizing unlimited human
wants, limited means with alternative uses
and consequent priced goods and services.
Production: Meaning creation of values to
satisfy consumption and growth needs
Exchange: Money is the medium ofexchange,
DistributionManagerial Economics OxfordUniversity Press, 2006
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Demand
Consumption results in demands of all sorts
Demand: meaning: desire backed by willingness
and ability to pay for a commodity/service. Compliments and substitute goods:
Compliments have to be used together: car and
petrol Substitutes: When one can replace the other:
tea/coffee or wheat and riceQx
Px
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Demand schedule and graphs
Individual demand schedule: table
Market demand schedule: table
Demand curve: linear
Effect on demand of changes in its own price
results in movement alongthe demand curve.
Effect on demand of changes in other factorsresults inshifts in demand curve
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The law of demand
States the relationship between price and
quantity demanded of the same good. This
relationship is mostly inverse. Thus the lawof demand states that demand for a good or
service is inversely related to its price
subject to the condition other thingsremaining the same These other things are
income, prices of other goods, tastes and
preferences( Ceteris peribus).Managerial Economics OxfordUniversity Press, 2006
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Why is demand curve negatively sloped?
1. when price falls, commodity becomes
relatively cheaper than its substitutes: this is
called substitution effect 2. When price falls, real income rises, so
consumer may buy more of it with the same
amount as before: income effect
3. The total effect of a price change equals
income plus substitution effects
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Exceptions to the law of demand
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1.When prices are expected to rise in
future.
2. Absolute necessities: when their price
goes up, poor consumers may buy more
even at the higher prices. This happens
because these necessities even at higherprices remain the cheapest sources of their
consumption, rather survival.
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Exceptions to the law
Such goods are known by Giffen Goods.
The poor consumers buy more of these by
giving up the consumption of superior
goods as prices of absolute necessities
increase.
Sir Robert Giffen (1837-1910) used incomeand substitution effects to explain this
phenomenon.
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Giffen Goods..
1. If the negative income effect works
against the substitution effects and
outweighs it, we would have a positiverelationship between Px and Qx.Income
effect is negative when a consumer buys
less of a commodity when his real incomegoes up.
2. If real income falls, he may buyanagerial Economics Oxford
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Giffen goods
more quantity of the good whose price goes
up.
Giffen goods are those where the combined
effect of substitution and income effects
results in a positive relationship between
PX and Qx.
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Giffen good
Income effect
Price effect +
Substitution effect
Substitution effect is inversely related to price.
Income effect can be inversely related to
changes in incomeInferior Good Income effect can be positively related to
income-Superior good
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Giffen Goods
If income effect of a price increase is inverse
and large enough to offset the substitutioneffect, then it is a Giffen Good
The Demand curve for Giffen Good will have apositive slope
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Shifts in demand
When the price of a commodity changes,
other things remain constant, the
relationship between price and quantitydemanded happens on the same demand
curve. This gives us extension/contraction
of demand. When other things like income change,
demand curve shifts up or down and we
have increase and decrease in demand.Managerial Economics OxfordUniversity Press, 2006All rights reserved
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Slope and Elasticity of Demand
Slope can not be standard measure of
elasticity as this measure is sensitive to
unit of measurement.
Proportionate change: proportionate
change in quantity demanded to a
proportionate change inprice/income/other price is the exact
measure and independent of units
choosen.
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Elasticity
Pe Greater than1 (ignoringsign): Elastic
Pe Equal to 1 (ignoringsign) : Unit Elastic
Pe Less than 1 ( ignoringsign): Inelastic
Price Elasticity and Expenditure:
- Pe less than 1 a fall in price lower exp
- Pe equal to 1 a fall in price exp.constant
- Pe greater than 1 a fall in price higher exp
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Elasticity
Income Elasticity
Qx/I * I/Qx
Could be negative or positive:
Negative for Inferior goods
Positive for Superior goods
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Elasticity
Cross Price Elasticity:
Qx/Py * Py/Qx
Could be negative or positive
- Negative for complements
- Positive for substitutes
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Point and arc elasticity
Point Elasticity: when price change is very small.
Arc Elasticity: when price change is large enough.
Price Elasticity measurements:
i) Proportionate method: Q/ P x P/Q
Examples: if demand function is Q =30 -5P + P2
Marginal function Q/ P = -5+ 2P and averagefunction, or Q/P = (30 -5P + P2)/ P
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Elasticity of demand
Now ed = Q/ P x P/Q, so it equals
Marginal function/average function, or
Ed= (-5 +2P) x P/( 30 -5P + P2)
If P = Rs. 5, ed = (-5 + 10) x 5/( 3010 +
25) = 50/45 = 1.1,
Find ed when P = Rs.3/2, Rs 10
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Demand schedule
Price Rs. Quantity demanded
6 50
5 72
4 112.5
3 200
2 450
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Elasticity .
The interesting feature of this type of
demand function is that price elasticity of
demand is constant and is equal to to theexponent of P.
Let P = 3, ed = P/Q> dQ/dP = 3/200X
3600/27 = -2, Let P = 2, ed = 2/450X -3600/8 = -2
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Elasticity
If Q = 20/(P + 1), find elasticity with
respect to price.
Now dQ/dP = -20( P +1)-2,
Ed = P/Q. dQ/dP = P/Q X -20P/ Q( P + 1)2
= -20P/20/(P + 1)( P + 1)2 = -P/( P + 1)
If, P = 5, ed = -5/6 = .833
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Income elasticity
Q. If income increases from Rs. 80,000 toRs. 81000, the quantity demanded of good
Q1 increases from 3000 to 3050, findincome elasticity of demand.
Given a small change in income, we usepoint elasticity method, therefore
Ed (income) = I/Q1XdQ1/dI=(80000/3000) X 50/1000 = 1.33
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Cross price elasticity of demand
The price of desktop computers declines from
Rs.50,000 to rs.25,000, sale of printers goes up
from 50 to 150 per month: Ed (cross price) = dQx/dPy x Py/Qx, Since the the
change is large, we use arc elasticity measure, so
Qx = (50 + 150)/2 = 100,
Py = (50000 + 25000)/2 = 37500, dQx = 100, and
dPy = 25000, Ed = 100/25000(37500/100) = - 1.5
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Elasticity
If price elasticity of petrol is 0.5, how much
of price increase would be required to
reduce consumption by 10%? Ed = (dQ/Q)/ dP/P= 0.5
Now dQ/Q = 10% = 0.1, so dP/P = .1/.5= .2
or 20%
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Elasticity of demand
Elasticity of demand can also be expressed
as: ed = Marginal quantity demanded
divided by Average quantity demanded=Q/ P divided by Q/P,
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Determinants of price elasticity
Availability of substitutes: Cases of closesubstitutes like cold drinks and no substitutes likesalt
Number of uses for a commodity: greater usesleads to greater elasticity like for electricity, whenrestricted uses like for wheat demand is relativelyinelastic
Relative importance of a commodity in totalexpenditure of a consumer: Salt/ match box casesvs cloth/ readymade garments. Consider theimpact of doubling of their prices on total demandof consumer
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Determinants of elasticity continued
Nature of the need being satisfied by a
commodity, like necessities, comforts, luxuries
Time allowed for adjustment to price change, thelonger the time period
greater the elasticity and vice versa
* Habits tend to make demand inelastic
* Joint demand like for machine oil and machines
makes demand relatively inelastic
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Determinants of elasticity continued
Nature of the need being satisfied by a
commodity, like necessities, comforts, luxuries
Time allowed for adjustment to price change, thelonger the time period
greater the elasticity and vice versa
* Habits tend to make demand inelastic
* Joint demand like for machine oil and machines
makes demand relatively inelastic
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Distinctive types of elasticity
Industry elasticity:
Refers to the change in total industry sales
with a change in the general level of pricesfor the industry as a whole. The industry
demand has elasticity with respect to
competition from other industries.
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Distinctive types of el
Market share elasticity:
Relates the change in companys share of
industry-wide sales to the price differentialbetween the companys price and industry-
wise price level.
Expectations elasticity:
Refers to responsiveness of sales to buyers
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Distinctive types.
guesses about the values of demand determinants, such asthe future price of a commodity or of its substitutes, futureincomes of buyers, prospects of easy availability or
otherwise in the future, or future promotional outlays.
Interest rate elasticity and demand for consumersdurables:
In USA elasticity of interest rates to housing demand isestimates at .15 which means a ten per cent increase ininterest rates would result in 1.5% change in housingdemand.
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Engles Law of Consumption
Dr. Engle was a German statistician.
He made a study of family budgets around themiddle of the nineteenth century
He arrived at the following major conclusions:
i) As income increases the percentage expenditureon food decreases and vice versa
ii) The percentage expenditure on clothing, etc.remains more or less constant at all levels ofincome
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Engles
iii) The percentage expenditure on fuel, light,
rent, etc. also remains practically the same
at all levels of income.iv) However, the percentage expenditure on
what may be called comforts and luxuries
of life increases with increase in incomeand vice versa.
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Propensity to consume and save
concepts These are macro-economic concepts.
The propensity to consume refers to theproportion of income consumed
Average propensity to consume refers to economyas a whole, say like C/I
Marginal propensity to consume refers to the
proportion of change in consumption toproportion of change in income, say, C/ Iincome to
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Propensity to save and consume..
The propensity to save is reverse of
propensity to consume.
The concepts, especially marginalpropensity to consume and save, exercise
considerable influence on the growth
performance of an economy
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Propensity continued
A higher marginal propensity to consume
leads to faster economic growth through its
multiplier effects, unless there existbottlenecks on the supply side like in the
developing world
The propensity to consume declines asincomes keep on increasing
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Hyperbolic demand functions
Q = ap-n or Q = a/Pn where a and n are
constants,
Suppose a = 1800 and n = 2, demand funct
Q = 1800/P2 = 1800x p-2 , the resulting demandschedule at different prices can be as follows: