Unit – 2: Demand and Supply theory and their Elasticity
Law of Demand – Meaning, Assumptions and Exceptions
Meaning: Among the many causal factors affecting demand, price is the most significant and the price- quantity relationship called as the Law of Demand is stated as follows: "The greater the amount to be 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 a rise in price" (Alfred Marshall).
In simple words other things being equal, quantity demanded will be more at a lower price than at higher price. The law assumes that income, taste, fashion, prices of related goods, etc. remain the same in a given period. The law indicates the inverse relation between the price of a commodity and its quantity demanded in the market. However, it should be remembered that the law is only an indicative and not a quantitative statement. This means that it is not necessary that such variation in demand be proportionate to the change in price.
Assumptions to law of demand
The statement of the law of demand, demonstrates that that this law operates only when all other things remain constant. These are then the assumptions of the law of demand. We can state the assumptions of the law of demand as follows:
1. Income level should remain constant: The law of demand operates only when the income level of the buyer remains constant. If the income rises while the price of the commodity does not fall, it is quite likely that the demand may increase.
2. Tastes of the buyer should not alter: It often happens that when tastes or fashions change people revise their preferences. As a consequence, the demand for the commodity which goes down the preference scale of the consumers declines even though its price does not change.
3. Prices of other goods should remain constant: Changes in the prices of other goods often affect the demand for a particular commodity. Therefore, for the law of demand to operate it is imperative that prices of other goods do not change.
4. No new substitutes for the commodity: If some new substitutes for a commodity appear in the market, its demand generally declines. This is quite natural, because with the availability of new substitutes some buyers will be attracted towards new products and the demand for the older product will fall even though price remains unchanged. Hence, the law of demand operates only when the market for a commodity is not threatened by new substitutes.
5. Price rise in future should not be expected: If the buyers of a commodity expect that its price will rise in future they raise its demand in response to an initial price rise which violates the law of demand. Therefore, it is necessary that there must not be any expectations of price rise in the future.
6. Advertising expenditure should remain the same If the advertising expenditure of a firm increases, the consumers may be tempted to buy more of its product. Therefore, the advertising expenditure on the good under consideration is taken to be constant.
The law of demand does not apply in every case and situation. The circumstances when the law of demand becomes ineffective are known as exceptions of the law. Some of these important exceptions are as under.
Some special varieties of inferior goods are termed as Giffen goods. Cheaper varieties of this category like bajra, cheaper vegetable like potato come under this category. Giffens’s Paradox describes a peculiar experience in case of such inferior goods. When the price of an inferior commodity declines, the consumer, instead of purchasing more, buys less of that commodity and switches on to a superior commodity.
Conspicuous Consumption refers to the consumption of those commodities which are bought as a matter of prestige. Naturally with a fall in the price of such goods, there is no distinction in buying the same. As a result the demand declines with a fall in the price of such prestige goods. Gold, Diamond etc are the examples of such commodities.
Certain things become the necessities of modern life. So we have to purchase them despite their high price. The demand for T.V. sets, automobiles and refrigerators etc. has not gone down in spite of the increase in their price. So they are purchased despite their rising price.
A consumer’s ignorance is another factor that at times induces him to purchase more of the commodity at a higher price. This is especially so when the consumer is haunted by the phobia that a high-priced commodity is better in quality than a low-priced one.
Emergencies like war, famine etc. negate the operation of the law of demand. At such times, households behave in an abnormal way. Households accentuate scarcities and induce further price rises by making increased purchases even at higher prices during such periods. During depression, on the other hand, no fall in price is a sufficient inducement for consumers to demand more.
Households also act speculators. When the prices are rising households tend to purchase large quantities of the commodity out of the apprehension that prices may still go up. When prices are expected to fall further, they wait to buy goods in future at still lower prices.
A change in fashion and tastes affects the market for a commodity. When a broad toe shoe replaces a narrow toe, no amount of reduction in the price of the latter is sufficient to clear the stocks.
DETERMINANTS OF DEMAND
1. Price of a commodity: Price of the commodity is the most important factor that determine demand. An increase in price of a commodity leads to a reduction in demand and a decrease in price leads to an increase in demand.
2. Price of related goods: Demand for a commodity depends on Price of related goods also. Related goods include both substitutes and complementary goods.
Substitutes are those goods which can be used one another or the goods with same use are substitutes. e.g.:- tea and coffee. When price of tea falls demand for coffee also falls. Because when price of tea falls people buy more tea and less coffee.
Complementary goods are those goods which can be used only jointly. e.g.: - car, petrol or pen, ink. When price of a commodity raises demand for its complementary goods falls. If x and y are complementary goods we cannot use x without y. When price of x raises demand for x falls and y cannot be used without x and demand for y also falls.
3. Income of the consumer: Income of the consumer and demand for a commodity are positively related. For normal goods when income increases demand also increases and vice versa. But for inferior goods there is a negative relationship between income and demand. So when income increases, demand decreases.
4. Taste and Preferences of consumers: Taste and Preferences of consumers also brings out changes in demand for a commodity. Tendency to imitate other fashions, advertisements etc affect demand for a commodity. It change from person to person, place to place and time to time.
5. Rate of Interest: Higher will be demanded at lower rates of interest and lower will be demanded at higher rate of interest.
6. Money supply: Demand is positively related to money supply. If the supply of money increases people will have more purchasing power and hence the demand will increase and vice versa.
7. Business condition: Demand will be high during boom period and low during depression.
8. Distribution of income: Distribution income in the society also affects the demand of commodity. If there is equal distribution of income demand for necessary goods and comforts will be greater.
9. Government policy: Government policy also affects the demand of commodities.
10. Consumers’ expectations: Consumers’ expectation about a further rise or fall in future price will affect the demand of a commodity. If consumers expect a rise in the price of a commodity in the near future, they may purchase large quantity even though there is some rise in the price. When the price of a commodity decreases, people expect a further fall in price and postpone their purchase.
INTRODUCTION – ELASTICITY OF DEMAND
Demand is desire backed by willingness to pay and ability to pay i.e. a wish to have a commodity does not become demand. A person wishing to have a commodity should be willing to pay for it and should have ability to pay for it. Thus a desire becomes demand if it is backed by willingness to pay and ability to pay. Demand is meaningless unless it is stated with reference to a price.
Decisions regarding what to produce, how to produce and for whom to produce are taken on the basis of price signals coming from the market. The law of demand explains inverse relationship between price and quantity demanded. When price falls quantity demanded of that commodity will increase. The deficiency of law of demand is removed by the concept of elasticity of demand.
MEANING AND DEFINITION OF ELASTICITY OF DEMAND
The term elasticity was developed by Alfred Marshall, and is used to measure the relationship between price and quantity demanded. The law states that the price of a commodity falls, the quantity demanded of that commodity will increase, i.e. it explains only the direction of change in demand and not the extent of change. This deficiency is removed by the concept of elasticity of demand.
Elasticity means responsiveness. Elasticity of demand refers to the responsiveness of quantity demanded of a commodity to change in its price.
According to E.K. Estham, “Elasticity of demand is a measure of the responsiveness of quantity demanded to a change in price”.
According to Muyers “Elasticity of demand is a measure of the relative change in the amount purchased in response to any change in price or a given demand curve”.
According to A.K. Cairncross “The elasticity of demand for a commodity it is the rate at which quantity bought changes as the price changes.”
TYPES OF ELASTICITY: These are three types of elasticity:-
a) Price elasticity
b) Income elasticity
Ø Zero income elasticity
Ø Negative income elasticity
Ø Positive income elasticity
c) Cross elasticity
Ø Advertisement elasticity and
Ø Elasticity of price expectation.
a) Price Elasticity: Price elasticity of demand may be defined as the degree of responsiveness of quantity demanded of a commodity in response to change in its price i.e. it measures how much a change in price of a good affects demand for that good, all other factors remaining constant. It is calculated by dividing the proportionate change in quantity demanded by the proportionate change in price.
EP= Proportionate change in quantity demanded/ Proportionate change in price
b) Income elasticity: Income elasticity of demand measures how much a change in income affects demand for that commodity if the price and other factors remains constant.
EY= Proportionate change in quantity demanded/ Proportionate change in income
A product with an income elasticity of more than one will experience a growth in demand that is higher than growth in consumer’s income. Luxury goods tend to have relatively high income elasticity. Low quality goods have negative income elasticities, as people stop buying them when they can afford to.
There are three types of income elasticity:
Zero income elasticity – Here a change in income will have no effect of quantity demanded. For example: - salt, matches, cigarettes.
Negative income elasticity – Here an increase in income leads to a decrease in quantity demanded. This happens in inferior goods.
Positive income elasticity – In this an increase in income will leads to an increase in quantity demanded. For most goods income elasticity is positive.
c) Cross elasticity: This measures the change in demand for a commodity due to change in price of another commodity.
ED= Percentage change in quantity demanded of commodity A/ Percentage change in price of commodity B
If the goods having substitutes the cross elasticity is positive i.e. an increase in the price of X will result in an increase in sales of Y. If the goods are complementary and increase in the price of one commodity will depress the demand for the other. So cross elasticity will be negative. If the goods are unrelated cross elasticity will be zero. Because however much the price of one commodity increased demand for the other will not be affected by that increase. There exist another two types of cross elasticity viz.
Ø Advertisement elasticity and
Ø Elasticity of price expectation.
Advertisement elasticity or Promotional elasticity: The expenditure n advertisement and other sales promotion activities does help in promoting sales, but not in the same degree at all levels of the total sales. The concept of advertisement elasticity is useful in determining the optimum level of advertisement expenditure. It may be defined as, “the responsiveness of demand t to changes in advertising or other promotional expenses”.
Elasticity of price expectations: The price expectation elasticity refers to the expected change in future price as a result of change in current price of a product.
rpc/pc rpc pf
Where Pc and Pf are current and future price. The coefficient ex gives the measure of expected percentage change in future price as a result of 1 percent change in present price. If ex > 1 it indicates the future change in price will be greater than the present change in price. If ex=1, it indicates that the future change in price will be equal to the change in current price. In ex > 1, the sellers will sell more in the future at higher prices.
VARIOUS DEGREES OF ELASTICITY
Since the responsiveness of quantity demanded varies from commodity to commodity and from market to market, it is important to study the degrees of price elasticity. We can identify five degrees of elasticity. They are: -
1. Perfectly elastic demand
2. Perfectly inelastic demand
3. Unitary elastic demand
4. Relatively elastic demand
5. Relatively inelastic demand
1. Perfectly elastic demand: Perfectly elastic demand is the situation where a small change in price causes a substantial change in quantity demanded i.e. a slight decline in price causes an infinite increase in quantity demanded and a slight increase in price leads to demand contracting to zero. The demand is hypersensitive and the elasticity of demand is infinite.
2. Perfectly inelastic demand: It is the situation where changes in price cause no change in quantity demanded. Quantity demanded is non-responsive or inelastic.
3. Unitary elastic demand: It refers to that situation where a given proportionate change in price is accompanied by an equally proportionate change in quantity demanded. For example, if price changes by 10%, quantity demanded also changes by 10%. \ ep= 10/10 = 1
4. Relatively elastic demand: Demand is said to be relatively elastic when a given proportionate change in Price causes a more than proportionate change in quantity demanded.
5. Relatively Inelastic demand: Demand is relatively inelastic when a given proportionate change in price causes a less than proportionate change in quantity demanded. Demand curve will be a very steep curve. Elasticity is less than 1. For example, If price changes by 20% quantity demanded changes by 10% Then ep = 10/20 = .5 ie; ep<1.
Of the five degrees of elasticity perfectly elastic and perfectly inelastic are extreme cases i.e. rarely found in actual life. Unitary elasticity, relatively elastic and relatively inelastic demand are the most widely used price elasticties.
FACTORS INFLUENCING PRICE ELASTICITY OF DEMAND
1. Nature of commodity: Elasticity depends on whether the commodity is a necessity, comfort or luxury. Necessities of life have inelastic demand and comforts and luxuries have elastic demand.
2. Availability of substitutes: Goods with substitutes have elastic demand and goods without substitutes have inelastic demand. For example: coffee and tea are substitutes. If price of tea increases, people may switch over to coffee. If price of coffee raises people may shift to tea. The demand of salt is inelastic.
3. Uses of the commodity: Certain goods can be put to many uses. Example – electricity. Such goods have elastic demand because as the price decreases, they will be put to more uses.
4. Proportion of income spent on commodity: For some goods, consumers spend only a small part of their income. The demand will be inelastic. For eg: - salt and matches
5. Price of goods: Generally cheap goods have inelastic demand and expensive goods have elastic demand.
6. Income of consumers: Very rich people have inelastic demand for goods and poor people have elastic demand. Because rich people will buy the commodity at all levels of prices where poor people there is a change in quantity of consumption according to change in price.
7. Time period: Elasticity would be more in the long run than in the short run. Because in the long run consumers can adjust their demand by switching over to cheaper substitutes. Production of cheaper substitutes is possible only in the long run.
8. Distribution of income and wealth in the society: If there is unequal distribution of income, the demand of commodities will be relatively inelastic. If the distribution of income and wealth in the society is equal there will be elastic demand for commodities.
Measurement of Elasticity of Demand
Elasticity of demand can be measured through three popular methods. These methods are:
1. Percentage method or Arithmetic method
2. Total Outlay method
3. Graphic method or point method.
4. ARC Method
5. Revenue Method
1. Percentage method: According to this method elasticity is estimated by dividing the percentage change in amount demanded by the percentage change in price of the commodity.
ep = [Percentage change in demand / Percentage change in price]
In this method, three values of ‘ep’ can be obtained. Viz., ep = 1, ep > 1, ep > 1.
If 5% change in price leads to exactly 5% change in demand, i.e. percentage change in demand is equal to percentage change in price , e = 1, it is a case of unit elasticity.
If percentage change in demand is greater than percentage change in price, e > 1, it means the demand is elastic.
If percentage change in demand is less than that in price, e > 1, meaning thereby the demand is inelastic.
2. Total Outlay Method: The elasticity of demand can be measured by considering the changes in price and the consequent changes in demand causing changes in the total amount spent on the goods. The change in price changes the demand for a commodity which in turn changes the total expenditure of the consumer or total revenue of the seller.
If a given change in price fails to bring about any change in the total outlay, it is the case of unit elasticity. It means if the total revenue (price x Quantity bought) remains the same in spite of a change in price, ‘ep’ is said to be equal to 1
If price and total revenue are inversely related, i.e., if total revenue falls with rise in price or rises with fall in price, demand is said to be elastic or e > 1.
When price and total revenue are directly related, i.e. if total revenue rises with a rise in price and falls with a fall in price, the demand is said to be inelastic pr e < 1.
Graphic method is otherwise known as point method or Geometric method. According to this method elasticity of demand is measured on different points on a straight line demand curve. The price elasticity of demand at a point on a straight line is equal to the lower segment of the demand curve divided by upper segment of the demand curve.
4. ARC method: The concept of ARC elasticity was provided by Dalton and than it was further developed by Lerner. This method for the measurement of price elasticity of demand is applied when the change in price is somewhat large or the price elasticity over an ARC of demand is provided. ARC elasticity of demand is the elasticity between distinct points on the demand curve. It is an increase of average responsiveness to price change shown by a demand curve. Any two points on demand curve make an ARC.
Mrs. Joan Robinson has given this method. She says that elasticity of demand can be measured with the help of average revenue and marginal revenue.
Importance of Elasticity of Demand
While fixing the price of this product, a businessman has to consider the elasticity of demand for the product. He should consider whether a lowering of price will stimulate demand for his product, and if so to what extent and whether his profits will also increase a result thereof.
Price discrimination refers to the act of selling the technically same products at different prices to different section of consumers or in different in sub-markets. The policy of price-discrimination is profitable to the monopolist when elasticity of demand for his product is different in different sub-markets. Those consumers whose demand is inelastic can be charged a higher price than those with more elastic demand.
To what extent a producer can shift the burden of indirect tax to the buyers by increasing price of his product depends upon the degree of elasticity of demand. If the demand is inelastic the larger part of the indirect tax can be shifted upon buyers by increasing price. On the other hand if the demand is elastic than the burden of tax will be more on the producer.
The government can impose higher taxes and collect more revenue if the demand for the commodity on which a tax is to be levied is inelastic. On the other hand, in ease of a commodity with elastic demand high tax rates may fail to bring in the required revenue for the government. Govt., should provide subsidy on those goods whose demand is elastic and in the production of the commodity the law of increasing returns operates.
The concept of elasticity of demand is of crucial importance in many aspects of international trade. The success of the policy of devaluation to correct the adverse balance of payment depends upon the elasticity of demand for exports and imports of the country.
Factor with an inelastic demand can always command a higher price as compared to a factor with relatively elastic demand. This helps the trade unions in knowing that where they can easily get the wage rate increased. Bargaining capacity of trade unions depend upon elasticity of demand for workers services.
Super Markets is a market where in a variety of goods are sold by a single organization. These items are generally of mass consumption. Therefore, the organization is supposed to sell commodities at lower prices than charged by shopkeepers in the other bazars. Thus, the policy adopted is to charge a slightly lower price for items whose demand is relatively elastic and the costs are covered by increased sales.
The goods that are produced by a single production process are joint supply products. The cost of production of these goods is also joint. Therefore, while determining the prices of these products their elasticity of demand is considered.
The use of machines may reduce the cost of production and price. If the demand of the product is elastic then the fall in price will increase demand significantly. As a result of increased demand the production will also increase and more workers will be employed.
The nationalization of public utility services can also be justified with the help of elasticity of demand. Demand for public utilities are generally inelastic in nature. If the operation of such utilities is left in the hand of private individuals, they may exploit the consumers by charging high prices.
The elasticity of demand helps the businessman to decide about production. A businessman chooses the optimum product- mix on the basis of elasticity of demand for various products. The products having more elastic demand are preferred by the businessmen. The sale of such products can be increased with a little reduction in their prices.
From the above discussion it is amply clear that price elasticity of demand is of great significance in making business decisions.
Meaning of Supply : “The supply of good is the quantity offered for sale in a given market at a given time at various prices”. Thus, the important features of supply may be concluded as:-
(i) It is the quantity of commodity offered for sale in the market at various prices.
(ii) It is flow and is always measured in terms of time.
Determinants of Supply are follows:
a) Price of the Commodity: There is a direct relationship between price of a commodity and its quantity supplied. Generally, higher the price, higher the quantity supplied, and lower the price, lower the quantity supplied.
b) Price of Related Goods: The supply of a good depends upon the price of related goods. Example, Consider a firm selling tea. If price of coffee rise in the market, the firm will be willing to sell less tea at its existing price. Or, it will be willing to sell the same quantity only at a higher price.
c) Number of Firms: Market supply of a commodity depends upon number of firms in the market. Increase in the number of firms implies increase in market supply, and decrease in the number of firms implies decrease in market supply of a commodity.
d) Goal of the Firm: If goal of the firm is to maximize profits, more quantity of the commodity will be offered at a higher price. On the other hand, if goal of the firm is to maximize sales (or maximize output or employment) more will be supplied even at the same price.
e) Price of Factors of Production: Supply of a commodity is also affected by the price of factors used for the production of the commodity. If the factor price decreases, cost of production also reduces. Accordingly, more of the commodity is supplied at its existing price. Conversely, if the factor price increases cost of production also increases. In such a situation less of the commodity is supplied at its existing price.
f) Change in Technology: Change in technology also affects supply of the commodity. Improvement in the technique of production reduces cost of production. Consequently, more of the commodity is supplied at its existing price.
g) Expected Future Price: If the producer expects price of the commodity to rise in the near future, current supply of the commodity will reduce. If, on the other hand, fall in the price is expected, current supply will increase.
h) Government Policy: ‘Taxation and subsidy’ policy of the government affect market supply of the commodity. Increase in taxation tends to reduce supply. On the other hand, subsidies tend to increase supply of the commodity.
Law of Supply
In the Words of Dooley, “The law of supply states that other things remaining the same, higher the prices the greater the quantity supplied and lower the prices the smaller the quantity supplied”.
Assumption of the Law:
(i) It is assumed that incomes of buyers and sellers remain constant.
(ii) It is assumed that the tastes and preferences of buyers and sellers remain constant.
(iii) Cost of all the factors of production is also assumed to be constant.
(iv) It is also assumed that the level of technology remains constant.
(v) It is also assumed that the commodity is divisible.
(vi) Law of supply states only a static situation.
Criticisms of Law of Supply:
(i) It Explains Only the Static Situation
(ii) Expectation of Change in the Prices in
(iii) It does not Apply on Agricultural Products
(iv) It does not Apply on Artistic
(v) It does not Apply on the Goods of Auction
Elasticity of Supply
Meaning: Supply is responsive to price changes. The extent to which supply extends for a given price rise is known as elasticity of supply. Elasticity of supply may also be defined as the ratio of the percentage change or the proportionate change in quantity supplied to the percentage or proportionate change in price.
Es = proportionate change in supply/Proportionate change in price or
= (change in quantity supplied/Original quantity supplied) × (Change in price/Original price)
Let Q = Original supply
ΔQ = Change of supply
P = Original price and
ΔP = Change of price, then
Es = (ΔQ/Q) / (ΔP/P) = (ΔQ/Q) × (P/ΔP) = (ΔQ/ΔP) × (P/Q)
Methods for Measurement of Elasticity of Supply
Elasticity of supply can be measured by using two methods:
1. The point method and
2. The ratio method
1. The Point Method: On the given supply curve the price elasticity at a point is measured by the distance along a tangent to the horizontal axis divided by the distance along it to the vertical axis.
The elasticity of supply at point T is measured as RT/OT
In panel (a) RT > OT, therefore Es > 1
In panel (b) RT = OT, therefore Es = 1
In panel (c) RT < OT, therefore Es < 1
2. The Ratio method: The co-efficient of elasticity of supply is obtained by using the ratio method as follows:
Es = (ΔQ/Q) × (P/ΔP)
The co-efficient of elasticity of supply varies from zero to infinity.
Factors Determining Elasticity of Supply
Following factors affect the elasticity of supply of a commodity:
a) Nature of the Inputs used: The elasticity of supply depends on the nature of inputs used for the production of commodity. If factors of production are those which are commonly used (and therefore easily available), supply of the commodity will be elastic. On the other hand, if specialized factors are used (which are not easily available), supply will be less elastic.
b) Natural Constraints: The elasticity of supply is also influenced by the natural constraints in the production of a commodity. If we wish to produce more teak wood, it will take years of plantation before it becomes usable. Supply of teak wood will therefore be less elastic.
c) Risk Taking: The elasticity of supply depends on the willingness of entrepreneurs to take risk. If entrepreneurs are willing to take risk, the supply will be more elastic. On the other hand, if entrepreneurs hesitate to take risk, the supply will be inelastic.
d) Nature of the Commodity: Perishable goods are relatively less elastic in supply than durable goods, because it is difficult to store the perishables.
e) Cost of Production: Elasticity of supply is also influenced by cost of production. If production is subject to law of increasing costs, then supply of such goods will be inelastic.
f) Time Factor: Longer the time period, greater will be the elasticity of supply. Because, over a long period of time, more and more factors are easily available and their input can be changed to increase (or decrease) output of the commodity.
g) Technique of Production: If the technique is complex and needs large stock of capital, then the supply of the commodity will be less elastic, because production cannot be easily increased. On the other hand, goods involving simple technique of production will have more elastic supply.