What are the factors that determine the
individual consumption
Firms and Households: The Basic
Decision-Making Units
firm An organization that transforms resources
(inputs) into products (outputs). Firms are the
primary producing units in a market economy.
entrepreneur A person who organizes, manages,
and assumes the risks of a firm, taking a new idea
or a new product and turning it into a successful
business.
households The consuming units in an economy.
Input Markets and Output Markets:
The Circular Flow
product or output markets The markets in which goods and
services are exchanged.
input or factor markets The markets in which the resources used
to produce goods and services are exchanged.
FIGURE 1 The
Circular Flow of
Economic Activity
Here goods and services flow
clockwise: Labor services
supplied by households flow to
firms, and goods and services
produced by firms flow to
households.
Payment (usually money) flows in
the opposite (counterclockwise)
direction: Payment for goods and
services flows from households to
firms, and payment for labor
services flows from firms to
households.
labor market The input/factor market in which households
supply work for wages to firms that demand labor.
capital market The input/factor market in which
households supply their savings, for interest or for claims to
future profits, to firms that demand funds to buy capital
goods.
factors of production The inputs into the production process. Land,
labor, capital and entrepreneurship are the key factors of production.
Input and output markets are connected through the
behavior of both firms and households.
Firms determine the quantities and character of outputs
produced and the types and quantities of inputs demanded.
Households determine the types and quantities of products
demanded and the quantities and types of inputs supplied.
The Law of
Demand
A households decision about what quantity of a particular
output, or product, to demand depends on a number of factors,
including:
The price of the product in question.
The income available to the household.
The households amount of accumulated wealth.
The prices of other products available to the household.
The households tastes and preferences.
The households expectations about future income,
wealth, and prices.
In the ordinary parlance demand means desire or
willingness to buy a commodity.
In economics, demand has a particular meaning distinct
from its ordinary usage.
In the Economics terminology demand means Effective
Demand i.e., the amount the buyers are willing to
purchase at a given price and over a given period of
time
1. Desire for a commodity
2. Ability to buy a commodity
3. Willingness to spend money to acquire that
commodity.
Effective Demand = desire to buy + Willing to buy + Ability to buy
Therefore, demand means desire backed by the willingness to buy a
commodity and the purchasing power to buy.
The demand for a product is always defined in reference to three key
factors, price, point of time and market place.
For example, the demand for milk is 100 liters per day at a price of
Rs. 50 litre in Mangalore city.
The Concept of Demand
The term demand refers to the quantity demanded of a commodity per
unit of time at a given price.
It implies a desire backed by ability and willingness to pay. A mere
desire of a person to purchase a commodity is not his demand.
He must possess adequate resources and must be willing to spend his
resources to buy the commodity.
Besides, the quantity demanded has always a reference to
a price and a unity of time.
Apparently there may be some problems in applying this
flow concept to the demand for durable consumer goods
like house, car, refrigerators, etc.
But this apparent difficulty may be resolved by
considering the fact that the total service of a durable
good is not consumed at one point of time and its utility is
not exhausted in a single use.
The service of a durable good is consumed over time. At a time, only a
part of its service is consumed.
Therefore, the demand for the services of durable consumer goods may
also be visualised as a demand per unit of time.
Important features of Demand
1.
It is desires and willingness backed by adequate purchasing power.
2.
There is an inverse relationship between price and demand
3.
Price is an independent variable and demand is a dependent variables
4.
It is only a qualitative statement and as such it does not indicate
qualitative changes in price and demand
5.
Generally, the demand curve slopes downwards from left to right
Law of Demand
The law of demand is one of the fundamental laws of economics.
The law of demand states that the quantity of a product demanded per unit
of time increases when its price falls, and decreases when its price
increases , other factors remaining constant.
The law of demand states, there is an inverse relationship between the
price and quantity of demand. The other things which is generally stated
as ceteris paribus is an important qualification of the law of demand.
Demand is a dependent variable, while price is an independent variable. Therefore,
demand is a function of price and can be expressed as follows:
D = f (P)
demand schedule Shows how much of a given product a
household would be willing to buy at different prices for a
given time period.
demand curve A graph illustrating how much of a given
product a household would be willing to buy at different
prices.
Assumptions of Law of demand
1.
There is no changes in consumers taste and preferences.
2.
The Income of consumer remains same and constant
3.
The prices of related commodities remains same
4.
The commodity should not confer any distinction.
5.
The demand for the commodity should be continuous.
6.
No changes in weather condition
Demand Schedule
The demand schedule explains the functional relationship between price
and quantity variations.
It is a list of various amounts of a commodity that a consumer is willing to
buy at different prices at one instant of time.
It is necessary to note that the demand schedule is prepared with reference
to the price of the given commodity alone.
Alfred Marshall was the first economist developed the techniques of
price theory it is a list of price and quantities.
The difference between demand and
quantity demanded
In economic terminology, demand is not the same as quantity demanded. When
economists talk about demand, they mean the relationship between a range of
prices and the quantities demanded at those prices, as illustrated by a demand
curve or a demand schedule.
When economists talk about quantity demanded, they mean only a certain
point on the demand curve or one quantity on the demand schedule. In short,
demand refers to the curve, and quantity demanded refers to a specific point on
the curve.
Demand scheduled is a list of quantities of a
commodity purchased by a consumer at different
prices
Demand Schedule
Individual Demand Schedule
Market Demand Schedule
Individual Demand
refers to the demand for a commodity from the individual point
of view a family, household or person.
Individual demand is a single consuming entitys demand
D = f (P).
Market Demand
Refers to the total demand of all the buyers taken together.
Market demand is an aggregate of the quantities of product
demanded by all the individual buyers at a give price.
How much quantity the consumers in general would buy at a
given period of time.
Market demand is more important from the business point of
view sales depend on the market demand business policy and
planning are base on the market demand price are determined
on the basis of market demand.
Dx = f (Px Pr M, T, A, U)
Dx = f (Px Pr M, T, A, U)
Dx = Quantity demanded for commodity x
f
= functional relationship
Px = Price of commodity x
Pr = Prices of related commodities
M
= The money income of the
consumer
T = the taste of the consumers
A = the advertisement effect
U
= unknown variable
The Demand Curve
The law of demand can be presented through a curve called
demand curve.
A demand curve is a locus of points showing various
alternative price-quantity combinations.
It shows the quantities of a commodity that consumers or
users would buy a different prices per unit of time under the
assumptions of the law of demand.
Individual Demand Schedule
Price of Oranges (Rs)
Quantity demanded
of oranges (kg)
100
90
80
70
60
11
13
Table 2. Market Demand Schedule for orange
Price of
Oranges (Rs.
Per Kg
Quantity demanded of Oranges by
consumers (kg)
Market
Demand for
Oranges (kg)
100
90
14
80
25
70
11
12
10
37
60
13
14
12
45
Examples 1
The demand function for beer in a city Qd = 400 4P where Qd = quantity
demanded of beer per week) P = the price of beer per bottle
Construct a demand curve assuming price Rs. 10, 12, 15,
20 and 25 per bottle.
b. At what price would demand be zero
c. If the producer want to sell 3,80,000 bottles per week.
What price should it charge?
a.
Solution
P = 10 : Qd = 400 4 x 10 = 360
P = 12 : Qd = 400 4 x 12 = 352
P = 15 : Qd = 400 4 x 15 = 340
P = 20 : Qd = 400 4 x 20 = 320
P = 25 : Qd = 400 4 x 25 = 300
DD
DD
b. At what price would demand be zero
Where the equation, lets up Qd = 0
Qd = 400 4p
400 4P = 0
4P = 400
P = 400/4 = 100
Therefore, at price Rs. 100 per bottle, the demand for beer will be zero
If the producer want to sell 3,80,000 bottles
per week. What price should it charge?
C.
Given demand equation
Qd = 400 4P
Qd = 380
380 = 400 4P
By Manipulation
4P = 400 380 = 20
P = 20/4 = 5
Rs. 5 per bottle in order to sell 3,80,000 bottles
Example 2
Truett and Truett (1980), started the following demand function for a brand X
of Microwave Ovens
Qx = f (PX, PZ, NW, Y, A), Where
QX = Quantity demanded per year for brand X
of microwave Ovens in a city
PX = Price of X Brand
PZ = Price of Z brand
NW = Number of working women
Y = Mean annual household income
A = Annual advertising expenditure
Assuming hypothetical data
QX = 26,500 100 PX + 20PZ + 0.002 NW + 1.8Y +
0.3A
On the basis, given that
PX = Rs. 800
PZ = Rs. 9,000
NW = 8,00,000 in a city
Y = Rs. 1,00,000
A = Rs. 60,000
We can estimate the demand for X Brand Microwave Oven as follows
QX = 26,500 (100 x 8,000) + (20 x 9,000) + (0.002
x 8,00,000) + (1.8 x 1,00,000 ) + (0.3 x 60,000)
= 26,500 (8,00,000 + 1,80,000 + 1,600 + 1,80,000 + 1,800)
11,93,200 11,634,000
29,800
Answer is 29,800 Microwave Ovens of X
Brand are purchase annually in this city
Example 3
Rajkumar & Co. the cabinet-maker has estimated the following demand
function for the steel cabinets produced by them
Qd = 1,500 0.03P + 0.09AE
Qd = quantity demanded of steel cabinets
P = average price of the steel cabinet
AE = the firms advertising expenses
All date are on a quarterly basis. The firm currently spends Rs. 10,000 per
quarter on advertising
State the demand curve equation for the price-demand relationship. Give
graphical representation assuming rice variable values to be Rs. 10,000, Rs.
9,000, Rs. 8,000, Rs. 7,000 & Rs. 6,000
Solution - Substituting the value for AE variable in the above equation
Qd = 1,500 + 900 0.03P
Thus,
P1 = Rs. 10,000 Q1 = 2,400 0.03 X 10,000 = 2,400 300 = 2,100
P2 = Rs. 9,000 Q2 = 2,400 0.03 X 9,000 = 2,400 270 = 2,130
P3 = Rs. 8,000 Q3 = 2,400 0.03 X 8,000 = 2,400 240 = 2,160
P4 = Rs. 7,000 Q4 = 2,400 0.03 X 7,000 = 2,400 210 = 2,190
P5 = Rs. 6,000 Q5 = 2,400 0.03 X 6,000 = 2,400 180= 2,200
Downward Sloping
Demand Curve and
Exception to the Law of
Demand
Why does the demand curve slope
downwards
Demand curves slope downwards from left to
right.
This is because of the inverse relationship
between the price and quantity demanded.
But the question is why do people demand more
if prices come down ?
This is because of the following reasons -
Dx = f (Px)
Reasons for downward sloping demand curve from
left right
1.
The operation law of diminishing marginal
utility.
2.
Substitution effect.
3.
Income effect
4.
New consumers enter to market
5.
Several uses/multiple uses
6.
Psychological effects
1. Diminishing marginal utility
Diminishing marginal utility is responsible for increase in
demand for a commodity when its price falls.
When a person buys a commodity, he exchanges his money
income with the commodity in order to maximise is
satisfaction.
He continues to buy goods and services so long as marginal
utility of money (MUm) is less then marginal utility of the
commodity (MUc)
Given the price of a commodity, he adjusts his purchase so that MUc
= MUm
This proposition holds good under both Marshallian assumption of
constant Mum and Hicksian assumption of diminishing MUm.
Under Marshallian approach, MUm remaining constant, MUc = Pc and
a utility maximising consumer reaches his equilibrium where
MUm = Pc = MUc
When price falls, (MUm = Pc) < MUc. Thus, equilibrium
condition is disturbed. To regain his equilibrium condition,
MUm = Pc = MUc
He purchases more of the commodity. When the stock of
commodity increases, its MU decreases and once again
MUm= MUc.
That is why demand for a commodity increases when its
price decreases.
Law of Diminishing Marginal Utility
Number of orange
Marginal Utility
Total Utility
20
20
16
36
12
48
56
60
60
-4
56
2. Substitution effect
When the price of a commodity falls it becomes relatively
cheaper if price of all other related goods, particularly of
substitutes, remain constant. In other words, substitute
goods become relatively costlier.
Since consumers substitute cheaper goods for costlier ones,
demand for the relatively cheaper commodity increases.
3. Income effect
The fall in the price of a commodity is equivalent to an increase in
the income of the consumer.
After falling prices, - he has spend less money for purchasing the
same amount of commodity as before.
A part of this money can be used for purchasing some more units of
that commodity.
Similarly, if the price increases, the consumers income effect
reduced and he has to curtail his expenditure on the commodity.
4. New consumers
When the price of commodities falls new consumer can enter into
market.
For example computer sets, laptops, mobile, refrigerators, washing
machines etc falling prices even the poor people can also buying
these goods.
5. Several uses
Some commodities can be put to several uses which lead to downward
slope of the demand curve.
When the price of such commodities goes up they will be used for
important purposes.
When price falls, the commodities will be uses for various purpose For
example electricity/power
6. Psychological effects
When the price of a commodity falls, people favour to buy more which is
natural & psychological entity.
Therefore, the demand increases with the fall in prices.
Exception to Law of Demand
Law of demand is a general statement describe that
prices and quantities of demanded a commodities
are inversely related.
There are certain peculiar cases law of demand
will not hold good.
Certain cases with the increases in price quantity
demand will increases and with the fall in price
quantity demand will falls. In such a case demand
curves slopes upward from left to right.
Robert Giffen was the first person to expose this
rare occasion, which is known as Giffen Paradox.
Veblen (ostentatious) goods, Giffen Goods and consumer
expectations.
Both Veblen goods and Giffen goods have upward sloping
demand curve.
There is a positive relationship between the price of a
Veblen good and its quantity demanded.
Veblen goods are also called status-symbol or ostentatious
goods. Veblen goods are luxury goods
Prices of Commodities
P2
P1
Q1
Quantity of Demanded
Q2
Factors influences on exception to the law of demand
1.
Prestige goods (Veblen effects).
2.
Giffen effects or Paradox.
3.
Speculative goods.
4.
Scarcity and Inflation.
5.
Ignorance of the people
6.
Demand for necessaries
7.
War or emergency
1. Prestige Goods or Status Goods
Articles of prestige value Snob appeal or articles of conspicous
consumption only rich people affording such article diamond,
gold, Luxurious Houses luxurious cars, precious stones, rare
painting etc.
Veblen in his doctrine of conspicuous consumption and hence this
effect is called Veblen Effect.
When prices of such goods rise, their status will increases and they are
purchase in larger quantities.
On the other hand, as the price of Veblen goods falls, their capacity to
perform the function of ostentation diminishes.
2. Speculative goods
The speculative market, particularly in stocks and shares,
more will be demanded when the prices are rising and less
demanded when the price declines.
People tend to buy more shares, bond & debentures when
their prices are rising in the hope that making profits in
future and they can reduces buying prices are falling.
3. Giffen Effect or Giffen Paradox
Robert Giffen is an Irish economist of 19th century discovered
Giffen Paradox.
It does not mean to any specific commodity.
Let us assume
monthly minimum consumption of family household is 20kg
of Bajra at Rs 10 and 10 Kg of wheat at Rs 20.
If the price of the bajra increases by Rs 12kg, the household forced
to reduce the consumption of wheat by 5Kg.
First Empirical Study
Some special varieties of inferior goods are termed as Giffen goods.
Cheaper varieties of this category like Ragi, bajra, potato and jower
cheaper vegetable 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.
Second Empirical study
A research paper by Jensen and Miller suggests that there is
empirical evidence of Giffen behavior for rice in southern
China and for noodles in the north of China.
They noted that the very poors diet in China mainly
consists of rice and meat in the south, and of noodles and
meat in the north.
Rice/Noodles Inferior Goods
Meat
Superior Goods
They also noted that an increase in the price of rice results in an
increase in rice consumption in the south, while an increase in the
price of noodles results in an increase in noodle consumption in the
north.
This behavior could be attributed to the increase in the price of the
giffen good resulting in a decrease in the income available to spend
on the other good, which induces them to buy more of the giffen
good, which is more filling.
4. Demand for Necessaries
The law of demand does not apply in the case of necessaries of
life food, clothing and shelter
Irrespective of price changes, people have to consume the
minimum quantities of necessary commodities.
5. Scarcity and Inflation
The law of demand cannot apply in the case of acute scarcity/shortage
of commodities.
People buying more out of panic when prices are rising.
Even at the time of hyper-inflationary situation people will try to
purchase more commodities even there is higher prices of
commodities.
6. Consumers ignorance
Sometimes, people buy more of a commodities at a higher
price out of sheer of ignorance.
7. War or emergency
During the period of war, if there is fear of shortage,
people may start buying for hoarding & building stocks
even at higher prices.
On the other hand, if there is depression, they will buy
less at low prices.
Changes in Demand curve
Changes in demand curve takes place in two ways
1. Increase and decrease demand
2. Extension and Contraction demand
1. Increase and decrease demand - When demand changes due to changes
in other factors such as tastes & preferences, income of consumers,
prices of the related good (substitutes and complementary) etc it is
called as increase & decrease demand
2. Extension and contraction demand - A movement along a demand
curve takes place when there is a change in the quantity demanded due
to change in the commoditys own price and not due to any other
factor.
1. Increased and decreased demand
When demand changes due to changes in other
factors such as tastes & preferences, income of
consumers, prices of the related good (substitutes and
complementary) etc it is called as increased &
decreased demand.
Due to changes in other factors, if the consumers buy
more goods it is called increased demand.
On the other hand, if the consumers buy less goods it
is called decreased demand
Figure. 2
Figure. 1
Y
Y
D
D1
D1
A
Price
D1
D1
D
O
Increased Demand
Q1
Q1
Quantity of Demanded
Decreased Demand
Figure 1 original demand curve is DD, the price is
OP and quantity demanded is OQ.
Due to change in the conditions of demand (income,
taste & price of substitute & complementary) the
quantity demand increases from OQ to OQ1 this is
called as increased demand.
Figure. 2 - Where OP is the original price of OP and
the OQ is the quantity demand. Due to fall in (other
factors) quantity demand decreases to OQ1 this
situation is called as decreased demand.
2.
Extension and contraction demand
A movement along a demand curve takes place when
there is a change in the quantity demanded due to
change in the commoditys own price and not due to
any other factor.
Prices
P2
P
P
P1
Contraction demand
Expansion demand
D
M2 M M1
Quantity Demanded
When the price of the commodity is OP, the
quantity demanded is OM.
If the price of the good falls from OP to OP1
quantity demanded increases from OM to OM1 is
called as expansion demanded.
While, on the other hand, when the price of good
rises from OP to OP2 quantity demand decreases
from OM to OM2, thus situation is called as
contraction demand.
Determinants of demand
Demand may change not only because of a change in price
but also due to other factors.
These factors such as tastes & habits of the people, income
of the consumers, weather conditions, size of population &
substitution goods etc are leads to changes in demand ( nonprice factors) either rightward or leftward directions.
Factors determines the demand for a commodities
1. Price of the commodity
2. Income of the consumers
3. Tastes & preferences of the consumers
4. Prices of related goods
5. Advertisement & sales propaganda
6. Consumers expectations
7. Changes in size of population
8. Changes in weather condition
9. Prosperity and depression
10. Distribution of income and wealth
1. Price of the Commodity
The most important factor affecting amount demanded
is the price of the commodity.
There is a close relationship between the quantity
demanded and the price of the product.
Normally a larger quantity is demanded at a lower
price and vice-versa.
There is inverse relationship between the price and
quantity demanded.
It is not only the existing price but also the expected
changes in price which affect demand.
2. Income of the Consumer
The second most important factor influencing demand
is consumer income.
The relationship between the consumer income and
the demand at different level of income higher
income leads higher demanded for goods and vice
versa.
The ability to buy or purchasing power a commodity
depends upon the income of the consumer.
The demand for a normal commodity goes up when
income rises and falls down when income falls.
But in case of Giffen goods the relationship is the
opposite.
3. Tastes and Preferences of the Consumers
The demand for a product depends upon tastes and
preferences of the consumers.
Demand for several products like ice-cream,
chocolates, beverages and so on depends on
individuals tastes.
People with different tastes and habits have different
preferences for different goods.
A Strict Vegetarian no demand for meat at any
price.
Non-Vegetarian liking chicken even at high price.
Smokers and Non-smokers.
4. Prices of Related Goods
The demand for a commodity is also affected by the changes
in prices of the related goods.
There are two types of goods Substitute and
complementary goods
Substitutes - Tea and Coffee, Jower and Bajra, Pear and Beans,
Ground nut and Til-oil
The change in price of a substitute has effect on a
commoditys demand in the same direction in which price
changes.
The rise in price of coffee shall raise the demand for tea
Complementary goods satisfy one wants two or three
goods are needed in combination Joint Demand
Example Car and Petrol, Pen and Ink, Tea, Sugar and Milk,
Shoes and socks, Sarees and Blouse, Gun and Bullets etc
[Link] and Sales Propaganda
In modern time, the preferences of consumers can be
altered by advertisement and sales propaganda.
Advertisement helps in increasing demand by
informing the potential consumers.
Advertisement are given in various means such as
news papers, radio, television.
6. Consumer Expectations
Changes in future expectation are also influence to
changes in demand.
If consumer expects as rise in prices he may buy large
quantities of that commodity and vice versa.
Expectation of rising income tend to increase his
current consumption.
7. The Growth of Population
The growth of population is also another
important fact that affects the market demand.
When population increases demand also increases
irrespective of the price level.
Similarly, composition of population of
population also brings about change in demand.
If the population consists more of babies then
demand for baby food, toys, feeding bottles will
increases.
8. Changes in weather condition
Demand for a commodity may change due to a change in
climatic conditions.
For example, during summer demand for cool drinks, icecreams cotton clothes, fan, cooler etc increases.
While, during winter and rainy seasons demand for woolen
clothes, rain-coats, umbrella increases.
9. Prosperity & depression
Demand for goods increases during the period of
prosperity and decreases during depression without any
reference to price.
10. Distribution of income and wealth
When income wealth is equally distributed the demand
will increase more than it is unequally distributed.
The Law Of Supply
The law of supply can be stated as the supply
of a product increase with increase in its price
and decreases with decrease in its price,
other things remaining constant.
TABLE 3.3 Clarence Browns Supply
Schedule for Soybeans
Price (per Bushel)
Quantity Supplied
(Bushels per Year)
$1.50
1.75
10,000
2.25
20,000
3.00
30,000
4.00
45,000
5.00
45,000
Clarence Browns Individual Supply Curve
A producer will supply more when the
price of output is higher. The slope of
a supply curve is positive.
Determinants of Supply curve
CHANGE IN INPUT PRICES
TECHNOLOGICAL PROGRESS
PRICE OF PRODUCT SUBSTITUTES
LEVEL OF CONSUMPTION AND SIZE OF THE INDUSTRY
GOVERNMENT POLICY
NON ECONOMIC FACTORS
