4 Demand Analysis.ppt

• Demand means– ‘A desire for a commodity
backed by the ability and willingness to pay
for it.
• Any statement regarding the demand for a
product without reference to its price,
time of purchase & place is meaningless & is
of no practical use.
• A consumer purchases a commodity
because he derives utility from this
commodity.
• This utility is the basis for the demand.

• Utility can be defined as:
• The want satisfying property of a commodity.
• The psychological feeling of satisfaction, pleasure and
happiness which a consumer derives from the
consumption, possession and use of a good.
• Total utility is the sum of the utilities
derived by a consumer from the various
units of goods & services he consumes
• TUx = U1 +U2 + ….Un
• Marginal utility is the utility derived from
the marginal unit consumed. Or the addition
to the TU resulting from the consumption of
one more unit

Law of diminishing marginal utility
• As the quantity consumed of a commodity
increases, the utility derived from each
successive unit decreases.
No. of
units
TU MU
1 30 30
2 50 20
3 60 10
4 65 05
5 60 -05
6 45 -15
0
U
Q
TU
MU

Cardinal & Ordinal Utility
• If utility is measurable & quantifiable then
that utility is called cardinal utility. i.e a
utility can be assigned a cardinal number like
1,2,3… One unit of utility is measured by a
term called ‘UTIL’, meaning one util is equal
to one unit of money & that utility of money
remains constant.

• Ordinal utility is based on the fact that
expression of utility is not possible in
absolute terms but it is always possible to
tell whether a commodity is more or less or
equally useful as compared to another.
• The degree of measurement & not the
absolute figure is the concept of ordinal
utility.

Cardinal utility approach
• The fundamental postulate of the consumer
behavior or consumption theory is that all the
consumers ‘aim at utility maximisation’ and all
their decisions & actions are directed towards
this.
• The theory seeks to answer questions like–
How does a consumer decide the optimum
quantity of a commodity that he chooses to
consume? (how does he attain the equilibrium?).
And how does he allocate his disposable income
between various commodities?

Assumptions
• Rationality: The consumer satisfies his
wants in the order of their preference
• Limited money income
• Maximisation of satisfaction: The 2nd & 3rd
assumptions make the choice between goods
inevitable
• Utility is cardinally measurable: i.e one util
= one unit of money
• Diminishing marginal utility
• Constant marginal utility of money

• Utility is additive: Utility can be derived
from various goods consumed & can be
added together to obtain the total utility.
– U=f(X1, X2,…Xn)
– where U=utility; X1,X2=total quantity of various
goods consumed.
– Total utility Un=U1(X1)+U2(X2)+…+Un(Xn)
• This is the utility function, which the
consumer aims to maximise.

Consumer Equilibrium
• A utility maximising consumer reaches his
equilibrium position when allocation of his
expenditure is such that the last penny
spent on each commodity yields the same
utility.
• Consumer has limited income & derived
utility is subject to diminishing returns &
the MU of various goods need not be same.
• Some goods yield a higher MU & some lower
for the same No. of units. In some cases MU
decreases more rapidly than others for the
same No. of units.

• A rational consumer first picks up that good
which yields the highest utility followed by
the commodity which yields the next
highest utility & so on.
• He switches his expenditure from one
commodity to another in accordance with
their MU. He continues this till he reaches a
stage where MU of each commodity is the
same per unit of expenditure.
• This is the state of consumer equilibrium

Consumer equilibrium: one
commodity model
• A consumer with certain money income
consumes only one commodity-X.
• Since both money & commodity X have utility
for him, he can either spend his money income
on commodity X or retain it in the form of
asset.
• If the MU of commodity X (MUx) is greater
than MU of money (MUm) as asset, a utility
maximiser will exchange his money income for
the commodity. (MUx is subject to diminishing
returns & Mum as an asset remains same)

MU
Price
E
Px
MUx
Px(MUm)
Qx
0
The consumer will
exchange his money
income on commodity X
so long as MUx >
Px(MUm) where
Px=price of X and
MUm=1
The consumer reaches
his equilibrium where
MUx=Px(MUm) or MUx
/ Px(MUm)=1

Consumer equilibrium: multiple
commodity model
• The law of equimarginal utility: It explains
the consumer’s equilibrium in a multi-
commodity model. i.e How does a consumer
consuming multiple goods reach his
equilibrium?
• The law states that a consumer consumes
various goods in such quantities that the MU
derived per unit of expenditure on each
good is the same. i.e each rupee spent on
each good yields the same MU.

• Eg. A consumer consumes 2 goods X & Y at
price Px & Py. The consumer will distribute
his income between goods—X & Y so that-
• MUx=Px(MUm) & MUy=Py(MUm).
• i.e the consumer is in equilibrium where-
MUx/Px(MUm) = 1 = MUy/Py(MUm)

The law of demand
• The law of demand states that the demand
for a commodity increases when its price
decreases & falls when its price rises, other
things remaining constant.
• i.e there is an inverse relationship between
the price & quantity demanded.
• Other things include other determinants of
demand viz., consumer income; price of
substitutes; tastes & preference of
consumers etc..

• The factors remain constant only in the
short run & they change in the long run.
Therefore the law of demand holds only in
the short run.
P
0
Q
D
D’
•DD’ is the demand
curve. (i,.e locus of all
points showing various
alternative price-
quantity combinations.)

Factors affecting the law of demand
• Substitution Effect: When the price of a
commodity falls, with no change in the price of
its substitutes, the commodity becomes
cheaper compared to its substitutes. The
demand for the commodity increases. This
increase in demand is on account of substitution
effect.
• Income Effect: When the price of a commodity
falls, then the real income or the purchasing
power of the consumer increases. He can
purchase more of the commodity. This increase
in demand is on account of income effect.

Exceptions to the law of demand
• Expectations regarding further prices:
When a consumer expects a price increase,
he buys more of it. When he anticipates
price fall, he postpones the purchase. Eg. In
stock market, when price falls, people expect
it to fall further & vice versa. Under such
cases, demand moves in the same direction
as their price.
• Status Goods: Rich people buy gold, diamond
& costly items when they become costly for
enhancing social prestige or for displaying
wealth & rich.

• Giffin Goods: A giffin good is an inferior
good much cheaper than its superior
substitutes, consumed by poor people as an
essential commodity. If the price of the
giffin good increases, its demand also
increases instead of falling. This is because
poor people cut the consumption of superior
substitutes so that they can buy sufficient
quantity of the inferior good to meet their
basic need
• Middle class

Ordinal Utility Approach
• This approach uses a tool called
‘Indifference Curve’ to analyse the consumer
behavior.

Assumptions
• Rationality: Consumer aims at maximising his
total satisfaction.
• Ordinal utility: Ordinal utility is based on the
fact that it may not be possible for consumers to
express the utility of a commodity in absolute
terms but he can tell whether a commodity is
more or less or equally useful as compared to
another.
• Transitivity & Consistency of choice:
Transitivity choice means that if a consumer
prefers A to B & B to C, he must prefer A to C.
Consistency of choice means, if he prefers A to B
in one period, he will not prefer B to A in another
period.

• Nonsatiety: Consumer is never over-supplied
with goods. (He has not reached the point of
saturation) He always prefers larger quantity
of all the goods.
• Diminishing marginal rate of substitution:
MRS is the rate at which a consumer is
willing to substitute one commodity X for
another Y so that his total satisfaction
remains the same. MRS goes on diminishing
when a consumer continues to substitute X
for Y.

Indifference Curve:
• It is defined as the locus of points, each
representing a different combination of 2
substitute goods which yield the same utility
or level of satisfaction to the consumer
(Therefore he is indifferent between any 2
combinations of goods when it comes to
making a choice between them).
• A consumer can make various combinations of
2 substitutable goods, which give him the
same level of satisfaction. For these
combinations, he would be indifferent. i.e he
would not prefer any 1 particular
combination.

• The graphical representation of such
combination is called ‘Indifference Curve’.
Combination= Units of + Units of =TU
A 15 1 U
B 12 2 U
C 10 3 U
D 9 4 U
A
B
C
D
E
X
Y
0
Mango Banana

Properties of Indifference Curve:
• IC are convex to the origin.
• They do not intersect
• They are not tangent to one another
• They have a negative slope
• Upper IC indicate a higher level of
satisfaction

• Given the Indifference map, a utility
maximising consumer would like to reach the
highest possible IC on his indifference map.
However, he is assumed to have a limited
income. This limitedness of income acts as a
constraint on how high a consumer can ride
on his indifference map. This is known as
‘Budgeraty Constraint’

Effects of change in income on consumer
demand
• The understanding of IC was on the assumption
that the consumer’s income and market price of
goods remain constant.
• When a consumer’s income changes (keeping
others constant), his capacity to buy goods
changes too.
• When it increases, his budget line shifts
upwards & when it decreases, it moves
downwards. With the change in income, the
consumer moves from 1 equilibrium point to
another.
• This is called income effect.

• IC1, IC2, IC3 represents
indifference map;
• AG, BH, CI represents
budget lines;
• E1, E2, E3 represents
equilibrium points & the
curve joining them is called
Income Consumption Curve.
•The movement from E1 to E3 indicates increase in
consumption of normal goods X & Y.
•This is called Income effect.
•The income effect can be +ve, –ve or neutral. In
case of normal goods, the income effect is +ve & in
case of inferior goods it is –ve. (inferior good is one whose consumption decreases
when income increases)
A
B
C C
G H I
I
ICC
E1
E2
E3
IC1
IC2
IC3
Qnty X
Qnty
y
0

Effects of change in price on consumption
• When the price of a commodity changes, the
slope of the budget line changes disturbing
the equilibrium.
•The price effect may be
defined as the total
change in the quantity
consumed of a commodity
due to a change in its price.
•As the price decreases, the budget line
increases from LU to LR & the consumer reaches
a higher IC—IC2 & equilibrium from E1 to E2.
•This is called price effect.
L
U R T
E1
E2 E3
PCC
IC1 IC2
IC3
0

• The analysis of market demand is crucial for
decision making.
• A manager can know the factors
– which determine the size of demand;
– how responsive or sensitive is the demand to the
changes in its determinants;
– possibility of sales promotion thru manipulation
of price;
– optimum level of sales, inventories, advt.cost
etc..

• Market demand is the sum of individual
demands for a product at a price per unit of
time.
• The determinants of demand are—
– Price of the product
– Price of the related goods (substitutes &
Complements)
– Consumer income
– Consumer taste & preference
– Advt.
– Expectation relating to their future income &
future price of goods

• Price of the product: The price of the product &
its quantity is inversely related (as price reduces,
demand increases).
• Price of the related goods: When a change in the
price of 1 commodity influences the demand of
the other commodity, then the 2 products are
related.
• 2 goods are substitutes for one another if change
in the price of 1 affects the demand for the
other in the same direction. (Tea & Coffee)
• When the price of 1 good & the demand of the
other good moves in the opposite direction, then
the 2 goods are said to be complementary to each
other.

• Consumer income: As the income increases, a
consumer buys increased amount of the
goods.
• Usually the qnty. demanded of a good &
income of the consumer move in the same
direction.
• As the income increases the demand for
inferior good decreases.
• Consumer taste & preference: Changes in
taste & preference of a consumer in favor of
a good, result in greater demand for the
good & vice versa.

• Function is a symbolic statement of
relationship between the dependent &
independent variable.
• Demand function states the relationship
between the demand for a product
(dependent variable) and its
determinants (independent variables).

• Let us take price as the determinant variable
(keeping other determinants constant) & compare it
with the quantity demanded.
• The demand function can be stated as:-
– Qnty demanded of X (Dx) depends on its
price (Px)
– It can be symbolically written as :
Dx = f(Px)
– In this function, Dx is dependent variable
& Px is independent variable.
– It is read as – demand for product X (Dx)
is the function of its price (Px). i.e a
change in Px (independent variable) causes a
change in Dx (dependent variable)

• The above function does not give the
quantitative relationship between Dx & Px
• Such a function is usually given by linear
demand function
Dx = a – bPx
– Where ‘a’ is a constant denoting total
demand at zero price;
– ‘b’ is also a constant specifying the change
in Dx in response to a change in Px.

Linear Demand Function
• A demand function is said to be linear when
it results in a linear demand curve.
• Eg. If a = 100 & b = 5, the linear demand
function is written as: Dx = 100 – 5Px.
• Suppose Px = 0, 10, 15, 20, what is the
demand?
From this demand
function, we can obtain
the price function also.
Px = a – Dx
b

Long term demand function
• In the long term, none of the demand determinants
remain constant. So the long term demand function
is given by –
• Dx = f (Px, Y, P1…Pn, T, A, Ey, Ep, Pop, u)
– Where, Px = price of X;
– Y = Consumer income;
– P1….Pn = Price of related goods;
– T = Taste & preference of consumer;
– A = Advt. exp;
– Ey = Expected future income of consumer;
– Ep = Consumers’ expectations of future prices;
– Pop = Population;
– U = all other determinants not covered above

• Suppose if the market demand function is
given as–
• Dx = a1 Px + a2 Yx + a3 Popx + a4 Ax,
• Then, Dx is linear function of the price of
the product (Px), average per capita income
(Yx), Population (Popx) & Advt. Exp (Ax)
• The terms a1, a2, a3 & a4 are called as
parameters of demand function & they
indicate how the quantity demanded for a
product is related to the value of their
respective variables in the demand function.

• Eg. The linear demand function for Nokia
handsets is given by—
• Dx = -200Px + 100Yx + 0.001Popx + 0.05Ax
– This means that demand falls by 200 units for
every Re 1 increase in its price;
– It increases by 100 units for every Re 1 increase
in income;
– It increases by 0.001 units for every addition to
population;
– It increases by 0.05 units for every additional
rupee spent in advertisement

• Suppose if Px = Rs4,000; Yx = Rs.1,000; Popx
= 700,000,000 & Ax = 100,000,000,
Calculate Dx.
• Dx= -200*4,000 + 100*1,000 +
0.001*700,000,000 + 0.05*100,000,000
• Dx = 5,000,000 units

• The demand function or the determinants of
demand tells us about the direction of
demand only. This is not sufficient for
decision making.
• Sometimes the management wants to change
its production / sales plans; it wants to
maneuver the price with a view to make
larger profits.
• Here the management wants to know the
magnitude of the impact of each of the
demand determinants on the quantity
demanded of the product.

• To measure the effect of changes in any one
of the determinants of the demand, a tool
called ‘ Elasticity of Demand’ (Ed) is used.
• It is defined as the % change in quantity
demanded caused by one % change in the
demand determinant in question, while others
remaining constant.
• Ed = % change in qnty demanded of good X
% change on determinant Z

• The larger the value of this elasticity, the
more responsive is the qnty demanded to
changes in the demand determinants.
• The different methods of elasticity are –
– Price Ed;
– Income Ed;
– Cross Ed;
– Promotional Ed;
– Expectations Ed
• There are 2 kinds of elasticity measurement
Point elasticity and Arc elasticity

• Arc Elasticity: The measure of elasticity of
demand between any 2 finite points on a
demand curve is known as Arc Elasticity
• Eg. Measuring elasticity
between point J & K is the
measure of arc elasticity. The
movement from J to K on DD’
curve shows that price has
come down from Rs. 20 to 10,
so that P=20-10=10. The fall
in price has caused an
increase in demand from 40
units to 59 units so that Q =
40—59 =-19. The elasticity
between points J &K (moving
from J to K) is--
D
D’
J
K
P
Q
0
10
20
20 40 59

• Ep=- Q * P = -19 * 20 = -0.95
P Q 10 40
• This means that a 1% decrease in price
results in a 0.95% increase in demand for it.
• Calculation of elasticity from J to K & from
K to J gives different answers.
• Thus elasticity depends on the direction of
change in price.

• Point elasticity: It is the elasticity of
demand at a finite point on a demand curve.
Point elasticity = P * Q
Q
• The derivative Q/ P is reciprocal of the
slope of the demand curve – DD’.
• Point elasticity is a product of price-
quantity ratio at a particular point on the
demand curve. This reciprocal of the slope
of the st. line DD’ at point P is
geometrically given by QN /PQ
δ P
δ
δ
δ

R P
Q
0
M
N
Price
Qnty
20 40 60 80
Q/ P = QN/PQ
Where, P = PQ & Q = OQ
δ
δ
Point elasticity = PQ * QN = QN
OQ PQ OQ
Geomatrically, QN = PN
OQ PM
Ep = QN = 80—40 = 1
OQ 40

• Price elasticity of demand: It is the measure
of relative responsiveness of quantity
demanded to price along a given demand
curve.
Ep = Proportionate change in the qnty demanded
Proportionate change in price
Ep = (Q2-Q1) / Q1
(P2-P1) / P1

• Eg. If Q1=2,000; Q2=2,500;
P1=Rs.10; P2=Rs.9, Calculate Ep
Ep = (2,500—2,000) / 2,000 = -2.5
(9—10) / 10
•The figure -2.5 indicates that 1% reduction
in price (from Rs.10 to Rs.9) will result in a
2.5% increase in the quantity demanded.
•The negativeness emphasises the inverse
relation between the price & demand.

• Perfectly elastic demand (E=∞): Where no
reduction in price is needed to cause an increase in
qnty demanded.
• Perfectly inelastic demand (E=0): Where a change
in price causes no change in qnty. Demanded.
• Unit elasticity of demand: Where a proportionate
change in price cause an equally proportionate
change in qnty, demanded.
• Relatively elastic demand: Where a change in price
causes more than proportionate change in qnty
demanded.
• Relatively inelastic demand: Where a change in
price causes less than proportionate change in qnty
demanded.

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Perfectly elastic demand Perfectly inelastic demand
Unit elasticity of demand Relatively elastic demand Relatively inelastic demand

4 Demand Analysis.ppt

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