PRINCIPLES OF ECONOMICS Demand, Supply and Market Equilibrium
DEMAND
Demand:
Demand is the quantity of a good or service which buyers are ready or willing to buy at different price
levels in a given period of time.
Every desire or want is not demand.
Demand is the combination of want plus purchasing power or willing plus able to buy.
Demand = Wants + Purchasing Power
If a consumer holds only one of them demand does not exist.
For example in the case of a poor farmer, he may be willing to purchase an expensive Tractor, but he
has not ability to buying due to insufficient amount of money. In this case demand does not exist.
Demand = willing + Able to buy
DETERMINANTS OF DEMAND
1. Price of the product:
If price of a product Increases, its quantity demanded Decreases and vice versa.
2. Average Income of consumers:
If the income of consumer increases, the number of Normal goods demanded also increases.
If the income of consumer increases, the number of Inferior goods demanded also
decreases.
3. Size of Population:
If the size of population (no. of buyers) increases in market, demand for the product will also
increase.
4. Expectations about Price and Shortage in Future:
If it is expected that the price of a product decreases, current demand for that product will also
decreases.
5. Expectations about Shortage in Future:
If a shortage of product is expected in future, current demand for the product will increase.
6. Tastes or Preferences:
Our tastes, desires, emotions, or preferences change due to change in culture, fashion, weather or
special occasions in favor of a product. This will increase in demand for a product.
7. Advertisement:
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PRINCIPLES OF ECONOMICS Demand, Supply and Market Equilibrium
A successful advertisement will also increase the demand.
8. Price of Related Goods:
Related goods are classified as either substitutes or complements.
a) Substitutes are goods that satisfy a similar need or we can consume one in place of the
other.
For example: Coke and Pepsi
In the case of substitute goods the quantity demands of one good (Coke) increases with rise
in price of other good (Pepsi).
The relationship of substitute goods in demand/consumption is Positive.
b) Complements are goods that are used jointly or consumed together.
For Example: Petrol and car
In case of complementary goods the quantity demanded of one goods (Petrol) increases
with fall in price of other good (Car).
The relationship of complementary goods in demand/consumption is Negative.
LAW OF DEMAND
Law of Demand:
“Other things remain same (ceteris paribus), when the price of a commodity or services increases
or rise, its quantity demanded decreases or contraction and when its price decreases or fall, its
quantity demanded increases or extension”.
QD = f ( P )
“Ceteris Paribus” means other determinants remaining same/ constant / equal /unchanged.
Sometimes Increase or Decrease in demand is called “Expansion-Contraction of demand” and
“Rise-Fall of demand”.
The law of supply proves true when these assumptions are fulfilled.
Essentials or Assumptions of the law of demand
Essentials or Assumptions of the law of demand
There is no change in average income of consumers.
There is no change in population size.
No change in prices of related goods (price of substitutes and complements goods are not
changed).
No change in Taste, Fashion and weather
No change in Future Expectations regarding the prices and shortage of any product.
There is no change in advertisement that will impact demand.
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PRINCIPLES OF ECONOMICS Demand, Supply and Market Equilibrium
The law of demand can be explained with the help of Schedule
Let’s consider, quantity demanded of product A (Meat) at different prices.
Price Rs./Kg Quantity Demanded (kg)
5 100
4 200
Fall 3 Rise Contraction 300 Extension
2 400
1 500
It is clear from the schedule as the price of the commodity or a product falls, demand is entanding.
Price has fallen from Rs. 5/kg to Rs.1/kg and demand extended from 100kg to 500kg.
In the graph, we have measured quantity demanded on
x-axis and price on y-axis.
When price is Rs. 5/ kg the demand of product is just
[Link] price decreases the quantity demanded
increases.
Demand curve “D” slopes downward from left to right
(i.e., it has negative slope). It indicates that there is an
inverse relationship between price and quantity
demand.
Why demand curve is Negatively Sloped?
The demand curve is usually negatively sloped explaining the inverse relationship between price of a
commodity and its quantity demanded. Following are the reasons of the downward slopping of
demand curve are given below:
1. Substitute Effects:
When price of a product increases, consumer’s shift from the expensive to cheaper (alternative
orsubstitute) good.
2. Income effect or Purchasing power effect:
When the price of a commodity decreases, the real income or purchasing power of the buyer
increases because he can purchase the same quantity of the commodity more at a lower price.
3. Law of Diminishing Marginal utility:
The utility of an additional unit of a commodity is the Marginal Utility.
The law of diminishing marginal utility states that with each increasing quantity of the
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PRINCIPLES OF ECONOMICS Demand, Supply and Market Equilibrium
commodity, its marginal utility declines.
For example, when a person is very hungry the first slice of pizza that he eats will give him the most
satisfaction. As he will consume more slices, his level of satisfaction will diminish.
Thus, when the quantity of goods is more, the marginal utility of the commodity is less. Thus, the
consumer is not willing to pay more prices for the commodity and its demand will decline.
Also, when the price of the commodity is low, its demand increases.
Note: Explanation is not compulsory to learn of Law of marginal utility.
Exceptions or Limitations of the Law of Demand
There are certain cases wherein the law of demand does not apply i.e., the demand does not increase
when the prices fall and vice versa. These exceptions or limitations are as under:
Basic necessities of life:
The law of demand is not applicable to the basic necessities such as sugar, wheat etc. because
people will keep on buying these commodities irrespective of the prices increase or decrease.
Use as confer distinction:
Those goods which retain some distinctive features are considered as exception of law of demand.
Because price of such goods increases, their demand increases for a particular group of society.
Change in income:
If income of consumer increases, demand of product will increase, even if its price is going up.
Ignorance of the consumer:
Due to the lack of market knowledge, consumer may pay the higher price for a product.
It is possible that he may be able to pay less for the same good.
Uncertain conditions:
If high uncertainty is prevailing in the market, and there is a fear of being shortage of a commodity
in near future, people will buy more of it in spite of higher prices.
Giffin goods:
If price of a good increases its quantity demanded increases and (Vice versa)
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PRINCIPLES OF ECONOMICS Demand, Supply and Market Equilibrium
Giffen Goods
A Giffen good is a low income, non-luxury product. Demand for Giffen goods rises when the price rises
and falls when the price falls.
Giffen good has an upward-sloping demand curve, conflicting to the laws of demand which are based
on downward sloping demand curve.
Consider a poor household with a maximum monthly expenditure on food at Rs.400 and a minimum
consumption of grains at 50kg. The household consumes two goods to meet their grain consumption
demand: rice and wheat.
Rice is considered an inferior good, is cheaper than its substitutes, and represents a large portion of the
household’s spending.
Wheat is considered a normal good.
The following illustrates the household’s consumption of rice and wheat:
Good Price of good (per Kg) Quantity Demanded (kg) Expenditure
Rice Rs.5 40 Rs.200
Wheat Rs.20 10 Rs.200
Total Expenditure Rs.400
Consider a scenario where the price of rice increases to Rs.6. In this situation, to maintain its current
consumption, the household would need to spend Rs.440:
Good Price of good (per Kg) Quantity Demanded (kg) Expenditure
Rice Rs.6 40 Rs.240
Wheat Rs.20 10 Rs.200
Total Expenditure Rs.440
Therefore, for the household to get its total expenditure to remain at Rs.400 and meet its consumption
level of 50 kg, it would need to consume more rice and less wheat to meet its consumption demand:
Good Price of good (per Kg) Quantity Demanded (kg) Expenditure
Rice Rs.6 43 Rs.258
Wheat Rs.20 7 Rs.140
Total Expenditure Rs.398
As we noted, the demand for rice rose from 40 kg to 43 kg despite its increase in price. Therefore, rice
is an example of a Giffen good.
Conditions for a Giffen
These are certain conditions for a Giffen good:
1) The good must be inferior
2) The good must form a large percentage of total consumption
3) There must be a lack of close substitute goods
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PRINCIPLES OF ECONOMICS Demand, Supply and Market Equilibrium
Practical importance of law of demand
(i) Price determination:
Law of demand contributes to the determination of price of a certain commodity. Also, the
producer can see the effect on demand due to increase or decrease in price level and can take
decisions accordingly.
(ii) Firm’s decision making:
The demand schedule helps the entities plan for future by analyzing the impact of change in
prices on the quantity demanded at both; the national and international level.
(iii) Helpful for finance minister:
It also helps state in raising taxes
For example: If increase in tax causes the price of a commodity to be increased and decreases
demand significantly, then it will not wise to increase tax as overallamount of the taxable
revenue would remain almost the same.
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PRINCIPLES OF ECONOMICS Demand, Supply and Market Equilibrium
Movement along the Demand curve, and shift in Demand curve
Movement along the demand curve also called “Change in Quantity Demanded”:
A movement along the demand curve occurs when quantity demanded changes due to change its own
price of the commodity, while other factors in conditions of demand (income, tastes, population, price
of complements and substitutes, etc.) remain constant it is called Change in Quantity Demanded.
A rise in the price will cause quantity demanded to fall, and vice versa.
It causes Movement along the demand curve (also called Extension and Contraction in Demand
curve)
In Case of Contraction in Demand Curve:
Price Increases
Quantity Demand Decreases
In Case of Contraction in Demand Curve:
Price Decreases
Quantity Demand Increases
The above figure has shown the movement along demand curve from point B to A or B to C due to
changein price of the product from 10 to 15 or 10 to 5.
Shift in demand curve also called “Change in demand”:
A shift in the demand curve or a change in demand occurs when quantity demanded changes due to its
Non-price Factors i.e., (income,taste, weather, population size, etc.) while the price of the commodity
remains constant it is called Change in Demand.
The demand curve can shift either to the right or to the left. It causes shift in demand curve from its
original point (also called Rise/Fall in Demandcurve).
An increase in the demand for a product is shown in above diagram as a rightward shift in the demand
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PRINCIPLES OF ECONOMICS Demand, Supply and Market Equilibrium
curve and vice versa.
Factors responsible for change in demand or shift in demand curve
1. Changes in Income:
As the income of the consumer rises, he will purchase more of those products which are still
available at the same prices. Hence their demand will rise and vice versa.
2. Taste and preference:
Change of taste or liking/disliking can affect demand for a product.
3. Weather conditions:
During the winter season, the demand for tea or coffee is very high because consumers prefer
such things. However, during the summer season the situation is just the opposite as people
prefer soft drinks.
4. Changes in population:
Demand for most goods and services will increase with increase in population. As in case of
housing industry, the demand for houses increases with increase in population in town.
5. Changes in price of substitutes:
Prices of substitutes also affect the demand for a product. An increase in the price of one good will
cause an increase in demand for the other products as well as that product will become relatively
less expensive.
For Example:
If the prices of LG products will increases, few customers will shift to its substitute in spite to
change in price of other product
6. Changes in advertisement:
A successful advertising campaign for a certain good will increase demand for it.
Concept of Related goods
1. Price of Substitute Good:
Substitute Good/competitive good are goods which can be used alternatively inplace of
another good.
An increase in the price of product A will cause an increase in demand for the product B as
well as that product will become relatively less expensive.
For Example: Tea and Coffee, Petrol and CNG, butter and Coke and Pepsi.
XED of substitute goods is positive
2. Price of Complementary Goods:
Complementary Goods are those goods which are consumed together.
An increase in the price of one good A will cause decrease in demand for the other good B.
For Example: cereal and milk, bat and ball, car and petrol.
XED of complement goods is negative.
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