Unit – 3

Theory and Demand

3.1 Theory and Demand :— Law of Demand

Theory of Demand

Theory of Demand is the principle/law that correlates the demand for a product with the price of the product. The Law of Demand is the basis for price determination in an open market.

Law Of Demand

The law of demand explains how the consumer’s choice-behaviour changes when there is a change in the price of a commodity. In a market situation , if other factors affecting demand for commodity does not change, but only the price changes, then a consumer is likely to buy more of a commodity when its price falls and less of a commodity when its price rises. This behaviour of a consumer is a commonly observed behaviour and the law of demand is based on such observed behaviour.

The law of demand, i.e., the inverse relationship between the price and the quantity demanded of a good, is explained through demand curve in Fig. 3.1.

In Fig.3.1. The price is measured on the vertical axis and quantity demanded on the horizontal axis. The lines DD is the demand curve. It slopes downwards from left to right. It shows the inverse relationship between the price and quantity demanded.

The Law of Demand is based on the following assumptions:

• No change in consumer’s income : During the operation of the law, the income of the consumer should remain the same. If income rises, the consumer may buy more at same price or buy the same quantity even if price rises.
• No changes in price of related goods : Prices of substitutes and complements should remain the same . It they change, the consumer’s preferences will change which may invalidate the law of demand .
• No change in taste : The term taste includes fashion, habits and other factors which influence consumer’s preferences. They should remain constant. If they change the demand will change at the existing price.
• No uncertainty about the future : If the consumers are uncertain about the future price, availability of goods and other economic and political factors, demand would change depending upon people’s expectations. For example, if consumers expect prices to rise and shortages in supply , they will purchase more at the same price  or even at a higher price. Such uncertainties are assumed not to be present.
• No change in the size of population and its composition : Market demand is affected by the size and composition of the population. Change in population and changes in sex and age composition will affect demand. An increase in population will increase the demand at the same price. Similarly an increase in number of children will increase demand for toys. Thus, size of population and its composition are assumed to remain constant.
• No change in advertisement : Effective and extensive advertisement of the product will affect consumers’ preferences. Thus, advertisement costs and efforts are assumed to remain constant.
• No change in government policy : Direct taxes on increase may reduce demand, while subsidies may increase the demand.
• No change in natural factors : Climates conditions are assumed to remain constant and have no effect on demand.   

The Law of demand, while explaining the relationship between price and quantity demanded, expects all factors other than the price to remain constant.

All the constant factors are put under the assumption “other things being equal “ (ceteris paribus), while explaining the law of demand.

Exceptions to Law of Demand :

The law of demand is not applicable in the following cases :

• Giffen goods : These are special types of inferior goods which are purchased more at a higher price and less at a lower price.
• Snob value : Rich consumers, who attach a snob value to owning and displaying expensive goods such a diamonds, jewellery ,etc. purchase more such goods as their prices rise. On the other hand, as their prices fall, the same consumers may buy less due to the loss of snob appeal because “everyone can afford them”.
• Price Expectations : When the prices are rising, consumers may purchase more of commodity if they expect prices will rise further. Similarly when the price falls, the consumers may not purchase more if they expect the price to fall further.
• Emergencies : In times of war, famine, major illness, etc.  households purchase more of the goods even when their price are rising.
• Fashion : When the consumers give importance to fashion, a rise in prices of these goods will not lower demand. Similarly, when a product goes out of fashion, a reduction in price of this product may not increase the demand for it. 

3.2 Elasticity of Demand Consumers Surplus

The concept of consumer surplus is derived from the law of diminishing marginal utility. As per the law, as we purchase more of a commodity, its marginal utility reduces. Since the price is fixed, for all units of the goods we purchase, we get extra utility. This extra utility is consumer surplus.

Consumer Surplus

• Alfred Marshall, British Economist defines consumer’s surplus as follows: “Excess of the price that a consumer would be willing to pay rather than go without a commodity over that which he actually pays.”
• Hence, Consumer’s Surplus = The price a consumer is ready to pay – The price he actually pays
• Further, the consumer is in equilibrium when the marginal utility is equal to the price. That is, he purchases those many numbers of units of a good at which the marginal utility is equal to the price. Now, the price is fixed for all units. Hence, he gets a surplus for all units except the one at the margin. This extra utility is consumer surplus.

Let us take a look at an example of consumer surplus.

No. Of units Marginal Utility Price (Rs.) Consumer’s Surplus

1   30   20   10

2   28   20   8

3   26   20   6

4   24   20   4

5   22   20   2

6   20   20   0

7          18   20   –

• From the table above, we see that as the consumption increase from 1 to 2 units, the marginal utility falls from 30 to 28. This diminishes further as he increases consumption. Now, Marginal utility is the price the consumer is willing to pay for that unit.
• The actual price of the unit is fixed.
• Therefore, the consumer enjoys a surplus on all purchases until the sixth unit. When he buys the sixth unit, he is in equilibrium, since the price he is willing to pay is equal to the actual price of the unit.
• Limitations
• It is difficult to measure the marginal utilities of different units of a commodity consumed by a person. Hence, the precise measurement of consumer’s surplus is not possible.
• For necessary goods, the marginal utilities of the first few units are infinitely large. Hence the consumer’s surplus is infinite for such goods.
• The availability of substitutes also affects the consumer’s surplus.
• Deriving the utility scale for prestigious goods like diamonds is very difficult.
• We cannot measure the consumer’s surplus in terms of money. This is because the marginal utility of money changes as a consumer makes purchases and his stock of money diminishes.
• This concept is acceptable only on the assumption that we can measure utility in terms of money or otherwise. Many modern economists are against the concept.

3.3 Indifference Curve Analysis

It is a curve that represents all the combinations of goods that give the same satisfaction to the consumer. Since all the combinations give the same amount of satisfaction, the consumer prefers them equally. Hence the name Indifference Curve.

Here is an example to understand the indifference curve better. Peter has 1 unit of food and 12 units of clothing. Now, we ask Peter how many units of clothing is he willing to give up in exchange for an additional unit of food so that his level of satisfaction remains unchanged.

Peter agrees to give up 6 units of clothing for an additional unit of food. Hence, we have two combinations of food and clothing giving equal satisfaction to Peter as follows:

1 unit of food and 12 units of clothing

2 units of food and 6 units of clothing

By asking him similar questions, we get various combinations as follows:

Combination Food Clothing

A         1 12

B   2 6

C   3 4

D   4 3

The diagram shows an Indifference curve (IC). Any combination lying on this curve gives the same level of consumer satisfaction. It is also known as Iso-Utility Curve.

Books Recommended :

1. Dewett K. K.—Adhunik Arth Shastra Ke Sidhant (Modarn Econoinic Theory).

2. Marshall—Principles of Economics.

3.Roy, L. M.—Arthshastra.

4. Sundharam K. P. M. And Vaish M. C.—Principles of Economics.

5. Stonier and Hague -A Text Book of Economic Theory.

6. Jain K. P.—Arthshastra Ke Sidhanta.

7. Ahuja, H. L.—Advanced Economic Theory,

8. Ahuja, H. L.—Uchatar Arthic Sidhanta