Problem of Choice
- In any choice problem, there is a feasible set of alternatives. The alternatives which are available to the individual constitute this feasible set.
- The individual is assumed to be clear in her mind about her likes and dislikes (preferences) and has the capacity to compare any two alternatives (rational) in the feasible set using this capacity it can prepare the order of preferences starting from the best. The feasible set and the preference relation defined over the set of alternatives together constitute the basis of choice.
- In economics the meaning of desire is different from desire, want, need, will or wish. In economics, the word demand has three constituent.
Demand = Desire to buy + Ability to pay + Willingness to play
If any of this condition is not satisfied, it is not a demand.
- Demand is an economic concept that describes a consumer’s desire, ability, and willingness to pay a price for a specific good or service. The demand depends on the prices of the goods, the consumer’s income, and his/her preferences.
Characteristics of Demand:
- It is backed by adequate purchasing power.
- It is always at some price.
- It is related with time
- It is always expressed in a specific quantity.
- The demand schedule shows exactly how many units of a good or service will be bought at each price. They are further classified as
Individual Demand Schedule:
- It is a list of various amounts of a commodity that an individual consumer is willing to buy (and seller to sell) at different prices at a particular period of time.
|Month in 2014||Price/kg (In Rupees).||Quantity (in kg)|
- From the demand schedule, we can observe that the demand is inversely proportional to price. i.e. as the price decreases then the demand increases and when price increases the demand decreases.
Market Demand Schedule:
- When the demand schedules of all buyers are taken together, we get the aggregate or market demand schedule.
|Month in 2014||Price/kg
|Quantity (in kg)|
|Consumer A||Consumer B||Consumer C||Total Market Demand|
What is a Function?:
- Consider any two variables x and y. A function y = f (x) is a relation between the two variables x and y such that for each value of x,
there is a unique value of the variable y. Thus f (x) is a rule which assigns a unique value y for each value of x.
- The value of y depends on the value of x, hence y is called the dependent variable and x is called the independent variable.
- A function y = f (x) is an increasing function if the value of y does not decrease with increase in the value of x. It is a decreasing function if the value of y does not increase with the increase in the value of x.
- The relation between y and x can be shown graphically. Usually, in a graph, the independent variable is plotted along the horizontal axis (x-axis) and the dependent variable is measured along the vertical axis (y-axis). However, in economics, often the opposite is done. For example, to plot the demand curve, the independent variable (price) is taken along the vertical axis (y-axis) and the dependent variable (quantity) along the horizontal axis (x-axis).
- The graph of an increasing function is upward sloping or and the graph of a decreasing function is downward sloping.
- The demand for a product or service is affected by the income of an individual, availability of other substitutes, the price of other substitutes, population, habit etc. Thus demand is a function of demand of commodity, price of commodity, price of the compliment, income of the consumer, tastes and preferences of consumers, impact of advertisement, price of the substitute, expected future price, expected income in future, wealth of consumer and other factors which may impact the demand (for e.g. weather conditions, inflation, deflation, standard of living, composition of population, culture, customs, fashions, styles, etc.).
- If the prices of other goods, the consumer’s income and his/her tastes and preferences remain unchanged, the amount of a good that the consumer optimally buys, becomes entirely dependent on its price. The relation between the consumer’s optimal choice of the quantity of a good and its price is very important and this the relation is called the demand function.
q = f(p)
Where q is demand (quantity) whose value depends on p the price.
q is dependent variable while p is the independent variable.
- The demand curve is a graphical representation of how many units of a good or service will be bought at each possible price. It plots the relationship between quantity and price that’s been calculated on the demand schedule.
- The graphical representation of the demand function is called the demand curve.
- The negative slope of demand curve shows that the quantity demanded goes on increasing with the increase as price falls and vice versa.
The Law of Demand:
- Statement: Demand varies inversely with price.
Assumptions of the law
- There is no change in income of consumers.
- There is no change in the quality of the product.
- There is no substitute for the commodity in the market.
- The prices of related commodities (complements) remain the same.
- There is no change in customs, tastes, habits, and preference of consumers.
- The size of the population and their disposable income remain the same.
- The climate and weather conditions are same.
- The tax rates and other fiscal measures remain the same.
- Government policy towards the product remains the same.
Explanation of the Law of Demand (Negative Slope of Demand Curve):
- When there is an increase in the price of a commodity, the consumers reduce the consumption of such commodity. The result is that there is the decrease in demand for that commodity. Hence the demand curve slopes downward.
- The demand curve slopes downward due to negative price effect.
- if the income of the consumer does not change due to the fall in the price of the commodity, the purchasing power of the consumer increases. Thus the real income of consumer rises due to the fall in prices. Hence the consumer consumes more of the commodity. The change in the optimal quantity of a commodity when the purchasing power changes consequent upon a change in the price of the commodity is called the income effect.
- The demand curve slopes downward due to positive income effect.
- When the price of a commodity falls, the prices of substitutes remaining the same, the consumer can buy more of the commodity and vice versa. The commodity is used as the substitute for other uses. The demand curve slopes downward due to the substitution effect.
Marginal utility Effect:
- When a consumer buys more units of a commodity, the marginal utility of such commodity continues to decrease.
- Due to the lower price of the commodity, it comes into reach of poor people and they start consuming it (which they were doing before), hence the demand increases.The demand curve slopes due to the consumption by poor people.
Multiple Uses Effect:
- If there are multiple uses of the same commodity, then when prices of such goods increase these goods are put into important uses only. If the price falls, the commodity is used in many alternate uses, thus the demand increases.
Exceptions to the Law of Demand:
Inferior Goods (Giffen’s paradox):
- The law of demand does not apply in case of inferior goods. When the price of an inferior commodity decreases and it is found that the demand for the commodity decrease and the savings are used to spend on the superior commodity.
- For example, the wheat and rice are superior food grains while maize is inferior food grain. The fall in the price of maize decreases the consumption of maize and increases the consumption of wheat and rice.
Demonstration Effect (Veblen’s Effect):
- The law of demand does not apply in case of luxurious goods like diamonds, jewelry, precious stones, world-famous paintings, things used by famous personalities, antiques, etc. There is more demand when prices are high. The rich people like to demonstrate such items that only they have such commodities.
- These goods are not bought for the satisfaction but for their ‘snob appeal’ or ‘ostentation’. The prestige of owning such goods is important than the satisfaction.
Fear of Shortage:
- When there is an anticipation of a shortage of the commodity in near future due to the possibility of war or natural calamity like famine, consumer start buying the commodity at the available price, even at higher price.
Fear of Future Rise in Price:
- When there is an anticipation of a rise in the price of the commodity consumer start buying the commodity at the available price, even at the higher price and start stocking up the commodity. This phenomenon is called hoarding. Actually, it increases the price of the commodity further.
- The speculators buy or sell the commodity with the hope that the price may rise or fall in short period to maximize speculative profit. This is mainly observed in the stock market and commodity markets.
Ignorance of Consumers:
- The consumer usually judge the quality of a commodity from its price. A low priced commodity is considered as inferior and less quantity is purchased. A high priced commodity is treated as superior and more quantity is purchased. Thus low-quality product may be purchased at a higher price.and it is just due to ignorance. The law of demand is not applicable in such case.
- During emergency periods like war, famine, flood, cyclone, earthquake, accidents. etc.people by certain commodities even their prices are high.
- These are the items purchased by consumers whatever may be the price. A consumer buys these commodities (staples, food material, clothing) irrespective of their higher price.
- These are the commodities though their prices are increasing due to their special uses in the modern life. Examples of such goods are high-end mobiles, motorcycles, cars etc.
Out of Trend or Fashion:
- As the commodity or the good is out of fashion, irrespective of low prices their sell is less. Example: 2G mobile phones without internet facilities.
- There is a difference between fear of shortage and less supply. Fear of shortage is assumption while less supply is an actual condition. The law of demand does not work when there is less supply of the commodity. The people buy more of the commodity in spite of its high price.
- The prices of commodities are low but there is no increase in demand due to the low purchasing power of people i.e. less disposable income.
Importance of the Law of Demand:
- An economist can know the effect on demand due to increase or decrease in price and using the demand schedule and the law of demand he/she can determine the price of a commodity.
Policy of Tax on Commodities:
- The finance minister decides the policy using this law. The effect of the tax on different commodities is checked. The commodity must be taxed if its demand is relatively inelastic. A commodity cannot be taxed if its sales fall to a great extent.
- The law of demand helps to fix floor prices for agricultural commodities. When there are good crops, the prices come down. In case of bad crops, the prices go up if demand remains the same.
Fiscal Policy of Central Bank:
- Government and central bank use the law of demand effectively to control inflation, deflation, and recession. During the expansion phase of the business cycle the central bank tries to reduce demand for all goods and services by raising the price of everything. It does this with contractionary monetary policy (It increases the lending rate). It increases interest rates on loans and mortgages. Thus in chain action price of everything increases. The inflation of 2 % per year is maintained.
- During a recession or the contraction phase of the business cycle, central bank uses expansionary monetary phase (lowering of interest rates). Thus in chain action price of everything decreases.
- An individual demand schedule is used in planning for individual goods and industries. The effect of the change in price on the demand of commodity at national and world level is studied. Using the outcome planning is done.
Changes or Shift in Demand:
- If demand changes due to change in price only, then the expansion or contraction of demand can be explained on the basis of one demand curve only.
- If the demand changes due to any other factor then there is either increase or decrease in the demand. If the demand increases the new demand curve is shifts towards the right of the normal demand curve. It is called forward shift. If the demand decreases the new demand curve is shifts towards the left of the normal demand curve. It is called backward shift.