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MICRO ECONOMICS ANALYSIS

BUSINESS
ECONOMICS

2: LAW OF DEMAND

TABLE OF CONTENTS
1
...
Introduction
3
...
Demand
What is Demand?
The shape of the Demand Curve
The Willingness to Pay- the law of diminishing marginal benefit
The income effect
The substitution effect
The Demand Curve/Schedule
Movement along the demand curve versus shift in the demand curve
4
...
The Law of Demand
6
...
Learning Outcomes
After studying this module, you will have an understanding of




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

Aconsumer’s behavior and its key characteristics
Why do we need to study consumer’s behavior
The concept of Demand
DemandVs quantity Demanded
Identify the factors affecting Demand
The Law of Demand

2
...
An understanding of the
consumer’s behavior helps us to understand the reasons why a typical consumer behaves in a
certain manner
...
The study of consumer
behaviour describes the decision making or the choice process of a consumer
...
Consumer theory aims to model economic behavior/activities of individuals
pursuing his/her own private interests
...
A key assumption about an individual’s behavior is that
an individual is self-interested
...
But which are most
important ones for us to study consumer’s behavior in making choices?
A basic question which arises is: how does a consumer choose a good to be consumed? The
theory is very simple: Economists assume that consumers choose the best bundle of goods they
can afford
...
We will describe consumers’ preferences and behaviour and study how it gets
converted into demand
...
It will be followed by the concept of market demand, factors affecting
demand and from these, we will derive the law of demand
...
CONSUMER BEHAVIOUR
The economic model of consumer behavior is very simple: people choose the best things they can
afford
...
e
...
This depends on the consumer’s characteristics and his
behaviour
...
Whereas, the concept of best things and affordable bundle will be covered
in detail in the subsequent units on consumer theory
...

To grasp the most important features in studying consumer behavior, its fundamental
determinants and choices in modern consumer theory, it is assumed that the key characteristics of
a consumer consists of three essential components: the consumption set, initial endowments, and
the preference relation
...


Consumption set
Suppose there are 2 goods X and Y
...
Such combinations of
goods are called consumption bundles
...
Points S and T)
The consumption set represents the set of all feasible alternatives or combinations of x and y and
it is sometimes also called the choice set
...
Then consumption set would include all those combinations of x and y which
have x≥x^ and y≥y^
...
This
implies point S is not in the consumption set as it is not feasible combination of x and y but
pointT is inside the consumption set
...

Figure1: Consumption Set

Y
T
S

y^
x^

X

Initial endowments
An initial endowment represents the amount of various goods the consumer initially has and can
consume or trade with other individuals
...
every months he gets 10X and 30Y as income
...
e
...


Preference relations
The preference relation captures theoretically the consumer’s tastes and preferences across
differentgoods and services
...

Therefore, we need to assume that they satisfy certain standard properties that ensure the
individual is rational and his/her preferences are consistent
...
Given a relation,
 The symbol ≽ between 2 goods describes “weak preference relation” which means “
consumer prefers one bundle at least as much as the other bundle
...

The symbol ~ describes “indifference” of the consumer between any two bundles
...
This means A is strictly preferred to B
...

Now Defining the standard properties,
Reflexive preference relation
For any consumption bundle A(x1, y1) in the consumption setC, A ≽ A
This is a trivial assumption which says that every consumption bundle is as good as itself
...

The consumption bundle A would be ranked higher or preferred to another bundle B if bundle A
yields more satisfaction than B
...
When
a consumer can rank all conceivable bundles of x and y, the consumer's preferences are said to be
complete
...
Consumer prefers bundle A to bundle B (A≽B)
2
...
Consumer is indifferent between bundle A and bundle B (A~B)
In other words, for all A and B in X, either A≽ B orB≽A or A~B
...

Transitive preference relation
Besides completeness, consumer preferences must also be transitive
...
If bundle A is preferred
to bundle B, and bundle B is preferred to bundle C, then by transitivity, bundle A is preferred to
bundle C
...

A preference relation that satisfies these three properties is called a preference ordering
...
In the current unit, we focus on the consumer’s demand
behavior for a single good, which is taken to the next level when we discuss choice over more
than one good when we talk about best bundles in next few units
...
It attempts to identify the factors that
influence the choices that are made by consumer
...
We have already defined consumer behavior
...


4
...
Typically there
are many goods available and consumers show a preference for a particular good over the others
available in the choice set
...
A person would like to go out with friends, another would like to stay at
home and read a book and yet another would like to spend some leisure time with family
members
...
Besides the want or preference,
another important aspect is “how much an individual is willing to pay to satisfy the want?’
...
Another factor determining how much you are
willing to give up is how much you can afford
...
But the choices we actually make reflect our willingnessand
abilityto give up something in exchange
...
(So you can see demand
is not just about what consumers want)
...


Ability to pay depends on the consumers income/budget, which is discussed in detail in
subsequent modules
...


The shape of the demand curve
The demand curve for a particular good, say X, is downward sloping in the price-quantity space
That is, quantity of the good demanded falls as its price rises, given other things (like income, for
instance)
...
These are discussed below:
The willingness to pay- the Law of diminishing Marginal Benefit
In scorching heat when a person is really thirsty, he is willing to pay a good amount to get a
thirst-quenching glass of water
...
When given a 2nd glass of water, the
additionalsatisfaction or benefit he derives is a little less than that from the 1 stglass
...

The economist’s term for additional benefit is “marginal benefit”
...
Marginal benefit means extra benefit derived from consumption of an extra unit of the
good
...
You may note that marginal benefit is not same as
total benefit
...
Willingness to pay depends on the
marginal benefit and not total benefit
...
This explains the shape of the demand schedule
...
The consumer is now in a position to purchase more
commodities with the same income
...

The Substitution Effect
When price of a good falls, it becomes relatively cheaper, so consumers substitute other goods
with this cheaper good
...

All these factors lead to a negatively sloped demand curve
...

This leads to the mathematical relation between the quantity
demanded of a good with its own price
...
These factors are
discussed in section 5 and on the basis of those factors, we get the full functional form of the
demand curve
...
Larger is the quantity demanded, lower is the price a consumer is willing to pay
...
This is individual demand curve
...


Market Demand curve
The market for any good or service consists of millions of potential consumers just like the one
discussed above, each trying to make a choice (and hence demand) about what to buy
...
Suppose there are just 2 consumers C-I and C-II, then sum of their
demands, at each price gives the aggregate demand
...
50 per kg, C-I demands 2 kgs of rice and C-II demands 5 kgs of rice, then the
market demand will be 7 kgs, corresponding to the price level of Rs
...
When price rises, the
quantity of rice demanded by both consumers would be lower and this would be reflected in a fall
in market demand
...

When price falls, the demand for a commodity increases not only from the existing buyers but
also from the new buyers who were earlier unable to purchase at higher price
...


Market demand for a good is the summation of the demands of all individuals
willing and able to buy that good or service
...
Points on the demand
curve denote the quantity of good X demanded at each price of the good
...
As we move
down a demand curve, i
...
as the price of a good falls, the quantity demanded of the good
increases
...
We will now discuss in detail the
other determinants of demand, apart from the own price of a good
...
Hence to isolate the effect of
price change on demand, we use the assumption ‘Ceteris paribus’ or ‘other things held constant’
...
There are four important factors that can change demand i
...
the willingness and ability to
pay for a good/service
...
These
factors are:
a) Income of the consumer: Demand reflects your willingness and abilityto pay
...
Hence when income increases, you are able to purchase a larger
quantity of the good at the same price
...
Similarly, when income falls, the consumer demands less at the same price, hence
leading to a leftward shift in the demand curve
...
There are certain goods that you buy less of, when
your income increases
...
Clearly a decrease in
income would cause an increase in demand for inferior goods
...

 Substitutes are goods that can be used in place of each other to satisfy the same
want
...
A
fall in the price of a substitute causes a decrease in demand for the related good
...
For
example, fuel and vehicle are complementary to each other
...
A rise in the price of a
complement causes a decreased demand for the related good because the cost of
using both goods together has increased
...
Two consumers L and M need a car but
L’s preference may differ from that of M’s
...
Besides price there are other characteristics of a good which
attracts a consumer, like shape, size,colour etc
...
Any change in preferences causes a change in
demand
...
A decrease in preferences causes a decrease in demand (leftward shift of
demand curve)
...
An expected future price rise causes an increase in demand today
...

If we consider all the factors which impact the demand of a consumer, we get the following
equation:
Mathematical expression of the Demand curve for good x
Qx= F(Px ,Py ,M ,H)
(2)
What does it mean? It means the quantity demanded of good X (Qx) is a
function of, or depends on, the price of good X (P x), the price of related
goods (Py), the income level of consumers (M) and other factors like
personal preferences and expectation of future prices (H)
...
e
...

Moreover, X is a normal good since demand for X is positively related to income M i
...

dx/dm>0
...

For analyzing consumer behaviour, one of the most important factors is the price at which the
good is available in the market
...
This leads
us to a very important law- The law of Demand
...


5
...
The law of demand states that“Ceteris paribus, If the own price of a good/service
rises, the quantity demanded of the good/service decreases” :
↑Px → ↓Qxd
The law of demand worksas long as “ceteris paribus”, i
...
, as long as “everything else remains the
same” or other factors besides price does not change
...

Please note:
Ceteris Paribus or “Other things remaining same” means that other factors that affect demand do
NOT change
...

The following examples demonstrate when a number of factors change simultaneously it may be
hard to isolate the impact of a single factor on quantity demanded
...
If income goes up and the price of petrol goes up, we cannot be sure whether the quantity of
petrol purchased will increase (due to higher income) or decrease (due to higher prices)
...
If the price of substitutes increases, an increase in the price of the good itself might fail to
decrease the quantity demanded
...
This would not violate the law of demand, since
other things did not remain the same
...
If the price of complements decreases, an increase in the price of the good itself might fail to
decrease the quantity demanded
...

d
...
If it is reported that dark chocolate helps prevent cancer, the amount of dark
chocolate purchased will increase even if the price of dark chocolate increases
...
e
...

Some examples of the functional forms of demand curve can be given by:
a) Linear demand curve : Q = a – b P
b) Non linear demand curve: Q = a + b1/(b2*P)

Figure 4: Linear and Non-Linear Demand Curve

Px(a) Linear

Px(b) Non-Linear

P1

P1
P2

P2

X1

X2

X

X1 X2

X

At the end, we can conclusively explain the concepts of Law of Demand and Change in Demand
through the following table:
Table1: Law of Demand and Change in Demand
2

See “know more” section for links on this topic

Law of Demand (Movement along Demand Curve)
The quantity demanded of a good/service
Decreases if: Price of the good/service rises
Increases if: Price of the good/service falls
Changes in Demand (Shifts of the Demand Curve)
The demand for a good/service
Decreases if:
Increases if:
■ Preferences decrease
■ Preferences increase
■ Price of a substitute falls
■Price of a substitute rises
■Price of a complement rises
■ Price of a complement falls
■ Income decreases (normal good)
■ Income increases (normal good)
■ Income increases (inferior good)
■ Income decreases (inferior good)
■ Expected future price falls
■ Expected future price rises

6
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Consumer behavior is the study of consumers as they exchange something of
value for a good or service that satisfies their needs
...

Preference relations satisfy certain standard properties i
...
consumer preferences must be
reflexive, complete and transitive
...

Larger is the quantity demanded, lower is the price a consumer is willing to pay due to
reduction in the additional benefit derived from each consecutive unit
...
If, on the other hand, there is a change in the other
factors impacting demand, then there is a shift in the demand curve
...

Law of Demand states that, other things being equal, price and the quantity demanded are
inversely related

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