Online COaching for Chapter on Law of Demand from CA - CPT study Material

1. CA – CPT – Economicschapter 2 – Unit 1Demand and supply www.winningnotes.com

2. Demand Demand for a commodity refers to the desire backed by ability to pay and willingness to buy it. If a person below poverty line wants to buy a car, it is only a desire but not a demand as he cannot pay for the car. 2

3. Demand Function Demand for any commodity mainly depends on the price of that commodity. The other determinants include price of related commodities, the income of consumers, tastes and preferences of consumers, and the wealth of consumers. Hence the demand function can be written as Dx = F (Px, Ps, Y, T, W) where Dx represents demand for good x Px is price of good X Ps is price of related goods Y is income T refers to tastes and preferences of the consumers W refers to wealth of the consumer. 3

4. Law of Demand Law of Demand The law of demand states that there is a negative or inverse relationship between the price and quantity demanded of a commodity over a period of time. Definition: Alfred Marshall stated that “ the greater the amount sold, the smaller must be the price at which it is offered, in order that it may find purchasers; or in other words, the amount demanded increases with a fall in price and diminishes with rise in price”. According to Ferguson, the law of demand is that the quantity demanded varies inversely with price 4

5. Assumption of Law of Demand Assumptions of the Law No change in the consumer’s income No change in consumer’s tastes and preferences No changes in the prices of other goods No new substitutes for the goods have been discovered People do not feel that the present fall in price is a prelude to a further decline in price. 5

6. Factors affecting demand Tastes and preferences of the consumer Income of the consumer Price of substitutes Number of consumers Expectation of future price change Distribution of income Climate and weather conditions State of business Consumer Innovativeness 6

8. The above chart is for the demand of 1 product, when all the products in a market and their prices are considered, we get a Market Demand Schedule.7

9. Rationale for the law of demand Substitution effect – When price of 1 commodity falls, it becomes cheaper as compared to another commodity or “relatively cheaper”. Consumer substitutes this commodity for other commodities. For example, if price of tea falls compared to coffee. It comes cheaper and its consumption increases. Income effect – When price falls, the consumer can buy more in same price, given his fixed income. Hence, purchasing power increases. Additional demand – When price falls, people who could not afford it earlier can now buy it, hence more demand is created. 8

10. Exceptions to Law of Demand Veblen Effect / Conspicuous Goods – Veblen has pointed out that there are some goods demanded by very rich people for their social prestige or prestige / snob value. When price of such goods rise, their use becomes more attractive and they are purchased in larger quantities. Demand for diamonds, designer clothes Giffen Paradox – As per Sir Robert Giffen discovered that the poor people will demand more of inferior goods if their prices rise and demand less if their prices fall. Inferior goods are those goods which people buy in large quantities when they are poor and in small quantities when they become rich (e.g. ragi, cholam are bought more by poor, even if their prices rise). Conspicuous necessities – These are conspicuous goods which have becomes necessities over time. For ex - TV, Coolers etc. 9

11. Exceptions to Law of Demand Future expectations about price – In case of price rise, if people expect them to rise further, the demand for that product increases. For ex – Gold Irrational consumer and Impulsive purchases Demand for necessary goods – These goods are still demanded in the same quantity irrespective of the price rise. Speculative market – For goods like shares and stocks, more the price rises, more that is bought by people. 10

12. Expansion / Increase in demand Expansion in demand - When on the same demand curve, the price falls, the Quantity demanded expands – This is a downward movement on the same curve, as other factors remain constant Contraction – Price rises  demand falls – this is upward movement on the same curve Increase in demand – This is change in demand, due to any of the determinants change – for Ex, rise in income etc. In this case, at the same price higher quantity is demanded. Hence the demand curve shifts to the right and more is demanded at each price Decrease in demand – less is demanded at each price, demand curve shifts to the left. Ex – fall in rice of a substitute, decrease in population, changes in tastes against the commodity 11

13. Elasticity of Demand Elasticity means “responsiveness” The law of demand explains that demand will change due to a change in the price of the commodity. But it does not explain the rate at which demand changes to a change in price. The concept of elasticity of demand measures the rate of change in demand. Introduced by Alfred Marshall - “the elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price”. 12

14. Types of Elasticity Price elasticity of demand; Income elasticity of demand; Cross-elasticity of demand; Price elasticity of demand “The degree of responsiveness of quantity demanded to a change in price is called price elasticity of demand”, Similarly, Income elasticity = due to change in income Cross elasticity = due to changes in prices of related goods 13

15. Formulae for elasticity Price Elasticity = E p = % change in quantity demanded % change in price Price elasticity varies from minus infinity to approach zero from a negative sign. As price and quantity are negatively related, hence Epis negative. Point elasticity – Elasticity measured at a given point on a straight line demand curve. Elasticity is different at different points on the demand curve. 14

16. In the chart given on the right, the elasticity at point A will be lower segment of demand curve (AD) / upper segment of the demand curve (above A). Hence, Point A has higher elasticity than point B. 15

17. Price Elasticity at Different Points Price Elasticity at point B=1, C is <1, A > 1, where D curve touches X axis, E = 0 and where it touches Y axis it is ∞ infinity 16

18. Arc Elasticity In cases where the price elasticity is to be found between 2 prices, we take average of the 2 prices and quantities. E = Q-q x P + p Q+q P - p Where Q and P are original quantity & price and q and p are new ones. 17

19. More Other topics covered in this chapter are Income elasticity Cross elasticity Durable, non durable goods Theory of consumer behavior Indifference curves Elasticity of supply And many more.. Subscribe now to www.WinningNotes.com to gain FULL access to course, audio / visuals, questions, practice tests and query solver. 18